2.2 – What is Orthodox Economics?
Learning Objectives
By the end of this section, you will be able to:
- Discuss the importance of studying orthodox economics
- Explain the relationship between production and division of labor
- Evaluate the significance of scarcity in orthodox economics
Orthodox (or Neoclassical) Economics is the study of how humans make decisions in the face of scarcity. These can be individual decisions, family decisions, business decisions or societal decisions. If you look around carefully, you will see that scarcity is a fact of life. Scarcity means that human wants for goods, services and resources exceed what is available. Resources, such as labor, tools, land, and raw materials are necessary to produce the goods and services we want but they exist in limited supply. Of course, the ultimate scarce resource is time- everyone, rich or poor, has just 24 hours in the day to try to acquire the goods they want. At any point in time, there is only a finite amount of resources available.
Think about it this way: In 2015 the labor force in the United States contained over 158.6 million workers, according to the U.S. Bureau of Labor Statistics. Similarly, the total area of the United States is 3,794,101 square miles. These are large numbers for such crucial resources, however, they are limited. Because these resources are limited, so are the numbers of goods and services we produce with them. Combine this with assumption in orthodox economics that human wants are virtually infinite, and you can see why scarcity is a problem.
In every country in the world, there are people who are hungry, homeless (for example, those who call park benches their beds, as shown in Figure 1), and in need of healthcare, just to focus on a few critical goods and services. Why is this the case? From the orthodox economic perspective scarcity is the cause. Let’s delve into the orthodox economic concept of scarcity a little deeper, because it is crucial to understanding this perspective.
The Orthodox Economic Problem of Scarcity
Every society, at every level, must make choices about how to use its resources. Families must decide whether to spend their money on a new car or a fancy vacation. Towns must choose whether to put more of the budget into police and fire protection or into the school system. Nations must decide whether to devote more funds to national defense or to protecting the environment. In most cases, there just aren’t/isn’t enough resources/money in the budget to do everything.
Think about all the things you consume: food, shelter, clothing, transportation, healthcare, and entertainment. How do you acquire those items? You do not produce them yourself. You buy them. How do you afford the things you buy? You work for pay. Or if you do not, someone else does on your behalf. Yet, what if most of us never have enough to buy all the things we want. This could be explained by scarcity. So what steps can be taken to mitigate scarcity?
The Division of and Specialization of Labor
Think back to pioneer days, when individuals knew how to do so much more than we do today, from building their homes, to growing their crops, to hunting for food, to repairing their equipment. Most of us do not know how to do all—or any—of those things. It is not because we could not learn. Rather, we do not have to. The reason why is something called the division and specialization of labor, an idea first put forth by Adam Smith, Figure 2, in his book, The Wealth of Nations.
The formal study of economics began when Adam Smith (1723–1790) published his famous book The Wealth of Nations in 1776. Many authors had written on economics in the centuries before Smith, but he was (at least, among) the first to comprehensively address the functioning of a capitalist market economy. In the first chapter, Smith introduces the division of labor, which means that the way a good or service is produced is divided into a number of tasks that are performed by different workers, instead of all the tasks being done by the same person.
To illustrate the division of labor, Smith counted how many tasks went into making a pin: drawing out a piece of wire, cutting it to the right length, straightening it, putting a head on one end and a point on the other, and packaging pins for sale, to name just a few. Smith counted 18 distinct tasks that were often done by different people—all for a pin, believe it or not!
Modern businesses divide tasks as well. Even a relatively simple business like a restaurant divides up the task of serving meals into a range of jobs like top chef, sous chefs, less-skilled kitchen help, servers to wait on the tables, a greeter at the door, janitors to clean up, and a business manager to handle paychecks and bills—not to mention the economic connections a restaurant has with suppliers of food, furniture, kitchen equipment, and the building where it is located. A complex business like a large manufacturing factory, such as the shoe factory shown in Figure 3, or a hospital can have hundreds of job classifications.
Why the Division of Labor Increases Production
When the tasks involved with producing a good or service are divided and subdivided, workers and businesses can produce a greater quantity of output. In his observations of pin factories, Smith observed that one worker alone might make 20 pins in a day, but that a small business of 10 workers (some of whom would need to do two or three of the 18 tasks involved with pin-making), could make 48,000 pins in a day. How can a group of workers, each specializing in certain tasks, produce so much more than the same number of workers who try to produce the entire good or service by themselves? Smith offered three reasons.
First, specialization in a particular small job allows workers to focus on specific parts of the production process which allows workers to focus on learning a limited number of tasks and to improve at performing those tasks. This pattern holds true for many workers, including assembly line laborers who build cars, stylists who cut hair, and doctors who perform heart surgery. A similar pattern often operates within businesses. In many cases, a business that focuses on one or a few products (sometimes called its “core competency”) is more successful than firms that try to make a wide range of products. Whatever the reason, specialization in production improves productivity more than if producers attempt a combination of tasks.
Second, specialization limits distractions and the loss of time associated with transitioning from one type of work to another. If a worker is responsible for one task and is then asked to do another task, it will take that worker time to adjust to the new task. Productivity that otherwise would have been generated by having a worker perform only one task will be lost as the worker transitions to another task.
Third, specialized workers often know their jobs well enough to suggest innovative ways to do their work faster and better. Frequently this means that workers improve upon the ways in which they use the tools, machines, and equipment associated with their work.
The ultimate result of workers who can focus on their preferences and talents, learn to do their specialized jobs better, and work in larger organizations is that society as a whole can produce and consume far more than if each person tried to produce all of their own goods and services.
Trade and Markets
Specialization only makes sense, though, if workers can use the pay they receive for doing their jobs to purchase the other goods and services that they need. In short, specialization requires trade.
You do not have to know anything about electronics or sound systems to play music—you just buy an iPod or MP3 player, download the music and listen. You do not have to know anything about artificial fibers or the construction of sewing machines if you need a jacket—you just buy the jacket and wear it. You do not need to know anything about internal combustion engines to operate a car—you just get in and drive. Instead of trying to acquire all the knowledge and skills involved in producing all of the goods and services that you wish to consume, the market allows you to learn a specialized set of skills and then use the pay you receive to buy the goods and services you need or want.
Summary
Orthodox economics seeks to apply the concept of scarcity, which is when human wants for goods and services exceed the available supply, in the study of how a market capitalist economy functions. In a modern capitalism, the division of labor, in which people earn income by specializing in what they produce and then use that income to purchase the products they need or want, enhances productivity. The division of labor allows individuals and firms to specialize and to produce more for several reasons: a) It allows the agents to focus on areas of advantage due to natural factors and skill levels; b) It encourages the agents to learn and invent; c) It allows agents to take advantage of economies of scale. The division and specialization purportedly then enhance efficiency and allows scarce resources to be stretched further, ideally meeting an increasing amount of seemingly infinite wants.
References
Bureau of Labor Statistics, U.S. Department of Labor. 2015. “The Employment Situation—February 2015.” Accessed March 27, 2015. http://www.bls.gov/news.release/pdf/empsit.pdf.
Williamson, Lisa. “US Labor Market in 2012.” Bureau of Labor Statistics. Accessed December 1, 2013. http://www.bls.gov/opub/mlr/2013/03/art1full.pdf.
Glossary
- division of labor
- the way in which the work required to produce a good or service is divided into tasks performed by different workers
- economics (orthodox definition)
- the study of how humans make choices under conditions of scarcity
- economies of scale
- when the average cost of producing each individual unit declines as total output increases
- scarcity
- when human wants for goods and services exceed the available supply
- specialization
- when workers or firms focus on particular tasks for which they are well-suited within the overall production process
Principles of Economics: Scarcity and Social Provisioning takes a pluralistic approach to the standard topics of introductory economics courses. The text builds on the chiefly neoclassical (or orthodox economics) material of the OpenStax Principles of Economics text, adding extensive content from heterodox economic thought. Emphasizing the importance of pluralism and critical thinking, the text presents the method and theory of neoclassical economics alongside critiques thereof and heterodox alternatives in both method and theory. This approach is taken from the outset of the text, where contrasting definitions of economics are discussed in the context of the various ways in which orthodox and heterodox economists study the subject. The same approach–of theory and method, critique, and alternative theory and method–is taken in the study of consumption, production, market exchange, macroeconomic equilibrium, fiscal and monetary policy, as well as in the applied theory chapters. Historical and contemporary examples are given throughout, and both theory and application are presented with a balanced approach.
This textbook will be of interest especially to instructors and students who wish to go beyond the traditional approach to the fundamentals of economic theory, and explore the wider spectrum of economic thought.
About the Authors
Erik Dean is an instructor of economics at Portland Community College in Portland, Oregon.
Justin Elardo is an instructor of economics at Portland Community College in Portland, Oregon.
Mitch Green is an instructor of economics at Portland Community College in Portland, Oregon.
Benjamin Wilson is an assistant professor of economics at Eastern Oregon University.
Sebastian Berger is a senior lecturer in economics at the University of the West of England - Bristol.
History of the Text
OpenStax
As noted above, the foundational content for this text comes from OpenStax. OpenStax is a non-profit organization committed to improving student access to quality learning materials. Their free textbooks go through a rigorous editorial publishing process, and are developed and peer-reviewed by educators to ensure they are readable, accurate, and meet the scope and sequence requirements of today’s college courses. Unlike traditional textbooks, OpenStax resources live online and are owned by the community of educators using them. Through partnerships with companies and foundations committed to reducing costs for students, OpenStax is working to improve access to higher education for all. OpenStax is an initiative of Rice University and is made possible through the generous support of several philanthropic foundations.
To develop Principles of Economics, OpenStax acquired the rights to Timothy Taylor’s second edition of Principles of Economics and solicited ideas from economics instructors at all levels of higher education, from community colleges to Ph.D.-granting universities. The pedagogical choices, chapter arrangements, and learning objective fulfillment were developed and vetted with feedback from educators dedicated to the project. They thoroughly read the material and offered critical and detailed commentary. The outcome was a balanced approach to micro and macro economics, to both Keynesian and classical views, and to the theory and application of economics concepts. Data current as of 2015 are incorporated for topics that range from average U.S. household consumption to the total value of all home equity. Current events are treated in a politically-balanced way as well.
Pluralist Project
The current text, emphasizing a pluralist approach, began with the awarding of an Open Oregon grant in 2016. That grant allowed the authors to develop a pluralist textbook for introductory microeconomics courses. The text has since been expanded to cover both micro- and macroeconomics.
Organization of the Book
The book is organized into four main parts:
- Introduction. Including a look at the various ways that economists, orthodox and heterodox, define the subject
- Metal and Modern Money. The macroeconomics section, differentiating orthodox and heterodox perspectives by the traditional divide between neoclassical and post Keynesian theorists.
- Markets and Management. The microeconomics section, differentiating orthodox and heterodox perspectives with a focus, for the latter, on institutionalist and post Keynesian perspectives.
- International Economics. Introduces the international dimensions of economics, including international trade and protectionism.
About the OpenStax Team
Senior Contributing Author
Timothy Taylor, Macalester College
Timothy Taylor has been writing and teaching about economics for 30 years, and is the Managing Editor of the Journal of Economic Perspectives, a post he’s held since 1986. He has been a lecturer for The Teaching Company, the University of Minnesota, and the Hubert H. Humphrey Institute of Public Affairs, where students voted him Teacher of the Year in 1997. His writings include numerous pieces for journals such as the Milken Institute Review and The Public Interest, and he has been an editor on many projects, most notably for the Brookings Institution and the World Bank, where he was Chief Outside Editor for the World Development Report 1999/2000, Entering the 21st Century: The Changing Development Landscape. He also blogs four to five times per week at http://conversableeconomist.blogspot.com. Timothy Taylor lives near Minneapolis with his wife Kimberley and their three children.
Steven A. Greenlaw, University of Mary Washington
Steven Greenlaw has been teaching principles of economics for more than 30 years. In 1999, he received the Grellet C. Simpson Award for Excellence in Undergraduate Teaching at the University of Mary Washington. He is the author of Doing Economics: A Guide to Doing and Understanding Economic Research, as well as a variety of articles on economics pedagogy and instructional technology, published in the Journal of Economic Education, the International Review of Economic Education, and other outlets. He wrote the module on Quantitative Writing for Starting Point: Teaching and Learning Economics, the web portal on best practices in teaching economics. Steven Greenlaw lives in Alexandria, Virginia with his wife Kathy and their three children.
Contributing Authors
| Eric Dodge | Hanover College |
| Cynthia Gamez | University of Texas at El Paso |
| Andres Jauregui | Columbus State University |
| Diane Keenan | Cerritos College |
| Dan MacDonald | California State University San Bernardino |
| Amyaz Moledina | The College of Wooster |
| Craig Richardson | Winston-Salem State University |
| David Shapiro | Pennsylvania State University |
| Ralph Sonenshine | American University |
Expert Reviewers
| Bryan Aguiar | Northwest Arkansas Community College |
| Basil Al Hashimi | Mesa Community College |
| Emil Berendt | Mount St. Mary’s University |
| Zena Buser | Adams State University |
| Douglas Campbell | The University of Memphis |
| Sanjukta Chaudhuri | University of Wisconsin – Eau Claire |
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| Teresa Laughlin | Palomar Community College |
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| Heather Luea | Kansas State University |
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| Nick Noble | Miami University |
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| Mark Owens | Middle Tennessee State University |
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| Brian Peterson | Central College |
| Jennifer Platania | Elon University |
| Robert Rycroft | University of Mary Washington |
| Adrienne Sachse | Florida State College at Jacksonville |
| Hans Schumann | Texas AM |
| Gina Shamshak | Goucher College |
| Chris Warburton | John Jay College of Criminal Justice, CUNY |
| Mark Witte | Northwestern |
| Chiou-nan Yeh | Alabama State University |
Ancillaries
Instructors may contact Open Oregon Educational Resources for quiz question test banks associated with each chapter.
Copyright
© May 18, 2016 OpenStax Economics. Textbook content produced by OpenStax Economics as well as by the present authors are licensed under a Creative Commons Attribution License 4.0 license.
For questions regarding this license, please contact partners@openstaxcollege.org.
Keywords/Tags:
Economics, Microeconomics, Macroeconomics, Introductory
Copyright: 2016 by Rice University; 2020 Erik Dean, Justin Elardo, Mitch Green, Benjamin Wilson, Sebastian Berger.
Inflation Chapter
Self-Check Questions
[link] shows the fruit prices that the typical college student purchased from 2001 to 2004. What is the amount spent each year on the "basket" of fruit with the quantities shown in column 2?
| Items | Qty | (2001) Price | (2001) Amount Spent | (2002) Price | (2002) Amount Spent | (2003) Price | (2003) Amount Spent | (2004) Price | (2004) Amount Spent |
|---|---|---|---|---|---|---|---|---|---|
| Apples | 10 | $0.50 | $0.75 | $0.85 | $0.88 | ||||
| Bananas | 12 | $0.20 | $0.25 | $0.25 | $0.29 | ||||
| Grapes | 2 | $0.65 | $0.70 | $0.90 | $0.95 | ||||
| Raspberries | 1 | $2.00 | $1.90 | $2.05 | $2.13 | $2.13 | |||
| Total |
[reveal-answer q="904989"]Show Answer[/reveal-answer]
[hidden-answer a="904989"]
To compute the amount spent on each fruit in each year, you multiply the quantity of each fruit by the price.
- 10 apples × 50 cents each = $5.00 spent on apples in 2001.
- 12 bananas × 20 cents each = $2.40 spent on bananas in 2001.
- 2 bunches of grapes at 65 cents each = $1.30 spent on grapes in 2001.
- 1 pint of raspberries at $2 each = $2.00 spent on raspberries in 2001.
Adding up the amounts gives you the total cost of the fruit basket. The total cost of the fruit basket in 2001 was $5.00 + $2.40 + $1.30 + $2.00 = $10.70. The total costs for all the years are shown in the following table.
| 2001 | 2002 | 2003 | 2004 |
|---|---|---|---|
| $10.70 | $13.80 | $15.35 | $16.31 |
[/hidden-answer]
Construct the price index for a "fruit basket" in each year using 2003 as the base year.
[reveal-answer q="769"]Show Answer[/reveal-answer]
[hidden-answer a="769"]
If 2003 is the base year, then the index number has a value of 100 in 2003. To transform the cost of a fruit basket each year, we divide each year’s value by $15.35, the value of the base year, and then multiply the result by 100. The price index is shown in the following table.
| 2001 | 2002 | 2003 | 2004 |
|---|---|---|---|
| 69.71 | 89.90 | 100.00 | 106.3 |
Note that the base year has a value of 100; years before the base year have values less than 100; and years after have values more than 100.[/hidden-answer]
Compute the inflation rate for fruit prices from 2001 to 2004.
[reveal-answer q="861842"]Show Answer[/reveal-answer]
[hidden-answer a="861842"]The inflation rate is calculated as the percentage change in the price index from year to year. For example, the inflation rate between 2001 and 2002 is (84.61 – 69.71) / 69.71 = 0.2137 = 21.37%. The inflation rates for all the years are shown in the last row of the following table, which includes the two previous answers.
| Items | Qty | (2001) Price | (2001) Amount Spent | (2002) Price | (2002) Amount Spent | (2003) Price | (2003) Amount Spent | (2004) Price | (2004) Amount Spent |
|---|---|---|---|---|---|---|---|---|---|
| Apples | 10 | $0.50 | $5.00 | $0.75 | $7.50 | $0.85 | $8.50 | $0.88 | $8.80 |
| Bananas | 12 | $0.20 | $2.40 | $0.25 | $3.00 | $0.25 | $3.00 | $0.29 | $3.48 |
| Grapes | 2 | $0.65 | $1.30 | $0.70 | $1.40 | $0.90 | $1.80 | $0.95 | $1.90 |
| Raspberries | 1 | $2.00 | $2.00 | $1.90 | $1.90 | $2.05 | $2.05 | $2.13 | $2.13 |
| Total | $10.70 | $13.80 | $15.35 | $16.31 | |||||
| Price Index | 69.71 | 84.61 | 100.00 | 106.3 | |||||
| Inflation Rate | 21.37% | 18.19% | 6.3% |
[/hidden-answer]
Edna is living in a retirement home where most of her needs are taken care of, but she has some discretionary spending. Based on the basket of goods in [link], by what percentage does Edna’s cost of living increase between time 1 and time 2?
| Items | Quantity | (Time 1) Price | (Time 2) Price |
|---|---|---|---|
| Gifts for grandchildren | 12 | $50 | $60 |
| Pizza delivery | 24 | $15 | $16 |
| Blouses | 6 | $60 | $50 |
| Vacation trips | 2 | $400 | $420 |
[reveal-answer q="548585"]Show Answer[/reveal-answer]
[hidden-answer a="548585"]Begin by calculating the total cost of buying the basket in each time period, as shown in the following table.
| Items | Quantity | (Time 1) Price | (Time 1) Total Cost | (Time 2) Price | (Time 2) Total Cost |
|---|---|---|---|---|---|
| Gifts | 12 | $50 | $600 | $60 | $720 |
| Pizza | 24 | $15 | $360 | $16 | $384 |
| Blouses | 6 | $60 | $360 | $50 | $300 |
| Trips | 2 | $400 | $800 | $420 | $840 |
| Total Cost | $2,120 | $2,244 |
The rise in cost of living is calculated as the percentage increase:
(2244 – 2120) / 2120 = 0.0585 = 5.85%.[/hidden-answer]
Review Questions
How do economists use a basket of goods and services to measure the price level?
Why do economists use index numbers to measure the price level rather than dollar value of goods?
What is the difference between the price level and the rate of inflation?
Critical Thinking Question
Inflation rates, like most statistics, are imperfect measures. Can you identify some ways that the inflation rate for fruit does not perfectly capture the rising price of fruit?
Problems
The index number representing the price level changes from 110 to 115 in one year, and then from 115 to 120 the next year. Since the index number increases by five each year, is five the inflation rate each year? Is the inflation rate the same each year? Explain your answer.
The total price of purchasing a basket of goods in the United Kingdom over four years is: year 1=£940, year 2=£970, year 3=£1000, and year 4=£1070. Calculate two price indices, one using year 1 as the base year (set equal to 100) and the other using year 4 as the base year (set equal to 100). Then, calculate the inflation rate based on the first price index. If you had used the other price index, would you get a different inflation rate? If you are unsure, do the calculation and find out.
Self-Check Questions
How to Measure Changes in the Cost of Living introduced a number of different price indices. Which price index would be best to use to adjust your paycheck for inflation?
[reveal-answer q="774973"]Show Answer[/reveal-answer]
[hidden-answer a="774973"]Since the CPI measures the prices of the goods and services purchased by the typical urban consumer, it measures the prices of things that people buy with their paycheck. For that reason, the CPI would be the best price index to use for this purpose.[/hidden-answer]
The Consumer Price Index is subject to the substitution bias and the quality/new goods bias. Are the Producer Price Index and the GDP Deflator also subject to these biases? Why or why not?
[reveal-answer q="453751"]Show Answer[/reveal-answer]
[hidden-answer a="453751"]The PPI is subject to those biases for essentially the same reasons as the CPI is. The GDP deflator picks up prices of what is actually purchased that year, so there are no biases. That is the advantage of using the GDP deflator over the CPI.[/hidden-answer]
Review Questions
Why does "substitution bias" arise if we calculate the inflation rate based on a fixed basket of goods?
Why does the "quality/new goods bias" arise if we calculate the inflation rate based on a fixed basket of goods?
Critical Thinking Question
Given the federal budget deficit in recent years, some economists have argued that by adjusting Social Security payments for inflation using the CPI, Social Security is overpaying recipients. What is their argument, and do you agree or disagree with it?
Why is the GDP deflator not an accurate measure of inflation as it impacts a household?
Imagine that the government statisticians who calculate the inflation rate have been updating the basic basket of goods once every 10 years, but now they decide to update it every five years. How will this change affect the amount of substitution bias and quality/new goods bias?
Describe a situation, either a government policy situation, an economic problem, or a private sector situation, where using the CPI to convert from nominal to real would be more appropriate than using the GDP deflator.
Describe a situation, either a government policy situation, an economic problem, or a private sector situation, where using the GDP deflator to convert from nominal to real would be more appropriate than using the CPI.
Self-Check Question
Go to this website for the Purchasing Power Calculator at MeasuringWorth.com. How much money would it take today to purchase what one dollar would have bought in the year of your birth?
[reveal-answer q="746759"]Show Answer[/reveal-answer]
[hidden-answer a="746759"]
The calculator requires you to input three numbers:
- The first year, in this case the year of your birth
- The amount of money you would want to translate in terms of its purchasing power
- The last year—now or the most recent year the calculator will accept
My birth year is 1955. The amount is $1. The year 2012 is currently the latest year the calculator will accept. The simple purchasing power calculator shows that $1 of purchases in 1955 would cost $8.57 in 2012. The website also explains how the true answer is more complicated than that shown by the simple purchasing power calculator.[/hidden-answer]
Review Questions
What has been a typical range of inflation in the U.S. economy in the last decade or so?
Over the last century, during what periods was the U.S. inflation rate highest and lowest?
What is deflation?
Critical Thinking Question
Why do you think the U.S. experience with inflation over the last 50 years has been so much milder than in many other countries?
Problems
Within 1 or 2 percentage points, what has the U.S. inflation rate been during the last 20 years? Draw a graph to show the data.
Self-Check Question
If inflation rises unexpectedly by 5%, would a state government that had recently borrowed money to pay for a new highway benefit or lose?
[reveal-answer q="228091"]Show Answer[/reveal-answer]
[hidden-answer a="228091"]The state government would benefit because it would repay the loan in less valuable dollars than it borrowed. Plus, tax revenues for the state government would increase because of the inflation.[/hidden-answer]
Review Question
Identify several parties likely to be helped and hurt by inflation.
Critical Thinking Questions
If, over time, wages and salaries on average rise at least as fast as inflation, why do people worry about how inflation affects incomes?
Who in an economy is the big winner from inflation?
Self-Check Questions
How should an increase in inflation affect the interest rate on an adjustable-rate mortgage?
[reveal-answer q="802598"]Show Answer[/reveal-answer]
[hidden-answer a="802598"]Higher inflation reduces real interest rates on fixed rate mortgages. Because ARMs can be adjusted, higher inflation leads to higher interest rates on ARMs.[/hidden-answer]
A fixed-rate mortgage has the same interest rate over the life of the loan, whether the mortgage is for 15 or 30 years. By contrast, an adjustable-rate mortgage changes with market interest rates over the life of the mortgage. If inflation falls unexpectedly by 3%, what would likely happen to a homeowner with an adjustable-rate mortgage?
[reveal-answer q="892510"]Show Answer[/reveal-answer]
[hidden-answer a="892510"]Because the mortgage has an adjustable rate, the rate should fall by 3%, the same as inflation, to keep the real interest rate the same.[/hidden-answer]
Review Questions
What is indexing?
Name several forms of indexing in the private and public sector.
Critical Thinking Questions
If a government gains from unexpected inflation when it borrows, why would it choose to offer indexed bonds?
Do you think perfect indexing is possible? Why or why not?
Problems
If inflation rises unexpectedly by 5%, indicate for each of the following whether the economic actor is helped, hurt, or unaffected:
- A union member with a COLA wage contract
- Someone with a large stash of cash in a safe deposit box
- A bank lending money at a fixed rate of interest
- A person who is not due to receive a pay raise for another 11 months
Rosalie the Retiree knows that when she retires in 16 years, her company will give her a one-time payment of $20,000. However, if the inflation rate is 6% per year, how much buying power will that $20,000 have when measured in today’s dollars? Hint: Start by calculating the rise in the price level over the 16 years.
International Trade and Capital Flow Chapter
Self-Check Questions
If foreign investors buy more U.S. stocks and bonds, how would that show up in the current account balance?
[reveal-answer q="126832"]Show Answer[/reveal-answer]
[hidden-answer a="126832"]The stock and bond values will not show up in the current account. However, the dividends from the stocks and the interest from the bonds show up as an import to income in the current account.[/hidden-answer]
If the trade deficit of the United States increases, how is the current account balance affected?
[reveal-answer q="813802"]Show Answer[/reveal-answer]
[hidden-answer a="813802"]It becomes more negative as imports, which are a negative to the current account, are growing faster than exports, which are a positive.[/hidden-answer]
State whether each of the following events involves a financial flow to the Mexican economy or a financial flow out of the Mexican economy:
- Mexico imports services from Japan
- Mexico exports goods to Canada
- U.S. investors receive a return from past financial investments in Mexico
[reveal-answer q="750414"]Show Answer[/reveal-answer]
[hidden-answer a="750414"]
- Money flows out of the Mexican economy.
- Money flows into the Mexican economy.
- Money flows out of the Mexican economy.
[/hidden-answer]
Review Questions
If imports exceed exports, is it a trade deficit or a trade surplus? What about if exports exceed imports?
What is included in the current account balance?
Critical Thinking Questions
Occasionally, a government official will argue that a country should strive for both a trade surplus and a healthy inflow of capital from abroad. Explain why such a statement is economically impossible.
A government official announces a new policy. The country wishes to eliminate its trade deficit, but will strongly encourage financial investment from foreign firms. Explain why such a statement is contradictory.
Problems
In 2001, the United Kingdom's economy exported goods worth £192 billion and services worth another £77 billion. It imported goods worth £225 billion and services worth £66 billion. Receipts of income from abroad were £140 billion while income payments going abroad were £131 billion. Government transfers from the United Kingdom to the rest of the world were £23 billion, while various U.K government agencies received payments of £16 billion from the rest of the world.
- Calculate the U.K. merchandise trade deficit for 2001.
- Calculate the current account balance for 2001.
- Explain how you decided whether payments on foreign investment and government transfers counted on the positive or the negative side of the current account balance for the United Kingdom in 2001.
Self-Check Questions
In what way does comparing a country’s exports to GDP reflect its degree of globalization?
[reveal-answer q="479611"]Show Answer[/reveal-answer]
[hidden-answer a="479611"]GDP is a dollar value of all production of goods and services. Exports are produced domestically but shipped abroad. The percent ratio of exports to GDP gives us an idea of how important exports are to the national economy out of all goods and services produced. For example, exports represent only 14% of U.S. GDP, but 50% of Germany’s GDP[/hidden-answer]
At one point Canada’s GDP was $1,800 billion and its exports were $542 billion. What was Canada’s export ratio at this time?
[reveal-answer q="73675"]Show Answer[/reveal-answer]
[hidden-answer a="73675"]Divide $542 billion by $1,800 billion.[/hidden-answer]
The GDP for the United States is $18,036 billion and its current account balance is –$484 billion. What percent of GDP is the current account balance?
[reveal-answer q="509848"]Show Answer[/reveal-answer]
[hidden-answer a="509848"]Divide –$400 billion by $16,800 billion.[/hidden-answer]
Why does the trade balance and the current account balance track so closely together over time?
[reveal-answer q="7035"]Show Answer[/reveal-answer]
[hidden-answer a="7035"]The trade balance is the difference between exports and imports. The current account balance includes this number (whether it is a trade balance or a trade surplus), but also includes international flows of money from global investments.[/hidden-answer]
Review Question
In recent decades, has the U.S. trade balance usually been in deficit, surplus, or balanced?
Critical Thinking Questions
If a country is a big exporter, is it more exposed to global financial crises?
If countries reduced trade barriers, would the international flows of money increase?
Self-Check Questions
State whether each of the following events involves a financial flow to the U.S. economy or away from the U.S. economy:
- Export sales to Germany
- Returns paid on past U.S. financial investments in Brazil
- Foreign aid from the U.S. government to Egypt
- Imported oil from the Russian Federation
- Japanese investors buying U.S. real estate
[reveal-answer q="515704"]Show Answer[/reveal-answer]
[hidden-answer a="515704"]
- An export sale to Germany involves a financial flow from Germany to the U.S. economy.
- The issue here is not U.S. investments in Brazil, but the return paid on those investments, which involves a financial flow from the Brazilian economy to the U.S. economy.
- Foreign aid from the United States to Egypt is a financial flow from the United States to Egypt.
- Importing oil from the Russian Federation means a flow of financial payments from the U.S. economy to the Russian Federation.
- Japanese investors buying U.S. real estate is a financial flow from Japan to the U.S. economy. How does the bottom portion of
[/hidden-answer]
[link], showing the international flow of investments and capital, differ from the upper portion?
[reveal-answer q="408966"]Show Answer[/reveal-answer]
[hidden-answer a="408966"]The top portion tracks the flow of exports and imports and the payments for those. The bottom portion is looking at international financial investments and the outflow and inflow of monies from those investments. These investments can include investments in stocks and bonds or real estate abroad, as well as international borrowing and lending.[/hidden-answer]
Explain the relationship between a current account deficit or surplus and the flow of funds.
[reveal-answer q="9618"]Show Answer[/reveal-answer]
[hidden-answer a="9618"]If more monies are flowing out of the country (for example, to pay for imports) it will make the current account more negative or less positive, and if more monies are flowing into the country, it will make the current account less negative or more positive.[/hidden-answer]
Review Question
Does a trade surplus mean an overall inflow of financial capital to an economy, or an overall outflow of financial capital? What about a trade deficit?
Critical Thinking Question
Is it better for your country to be an international lender or borrower?
Self-Check Questions
Using the national savings and investment identity, explain how each of the following changes (ceteris paribus) will increase or decrease the trade balance:
- A lower domestic savings rate
- The government changes from running a budget surplus to running a budget deficit
- The rate of domestic investment surges
[reveal-answer q="175665"]Show Solution[/reveal-answer]
[hidden-answer a="175665"]Write out the national savings and investment identity for the situation of the economy implied by this question:
[latex]\begin{array}{rcl}\text{Supply of capital}& \text{ = }& \text{Demand for capital}\\ \text{S +\hspace{0.17em} (M - X) + (T - G)}& \text{ = }& \text{I} \\ \text{Savings +\hspace{0.17em} (trade deficit) +\hspace{0.17em} (government budget surplus)}& \text{=}& \text{Investment}\end{array}[/latex]
If domestic savings increases and nothing else changes, then the trade deficit will fall. In effect, the economy would be relying more on domestic capital and less on foreign capital. If the government starts borrowing instead of saving, then the trade deficit must rise. In effect, the government is no longer providing savings and so, if nothing else is to change, more investment funds must arrive from abroad. If the rate of domestic investment surges, then, ceteris paribus, the trade deficit must also rise, to provide the extra capital. The ceteris paribus—or "other things being equal"—assumption is important here. In all of these situations, there is no reason to expect in the real world that the original change will affect only, or primarily, the trade deficit. The identity only says that something will adjust—it does not specify what.[/hidden-answer]
If a country is running a government budget surplus, why is (T – G) on the left side of the saving-investment identity?
[reveal-answer q="926062"]Show Solution[/reveal-answer]
[hidden-answer a="926062"]The government is saving rather than borrowing. The supply of savings, whether private or public, is on the left side of the identity.[/hidden-answer]
What determines the size of a country’s trade deficit?
[reveal-answer q="589459"]Show Solution[/reveal-answer]
[hidden-answer a="589459"]A trade deficit is determined by a country’s level of private and public savings and the amount of domestic investment.[/hidden-answer]
If domestic investment increases, and there is no change in the amount of private and public saving, what must happen to the size of the trade deficit?
[reveal-answer q="294694"]Show Solution[/reveal-answer]
[hidden-answer a="294694"]The trade deficit must increase. To put it another way, this increase in investment must be financed by an inflow of financial capital from abroad.[/hidden-answer]
Why does a recession cause a trade deficit to increase?
[reveal-answer q="845118"]Show Solution[/reveal-answer]
[hidden-answer a="845118"]Incomes fall during a recession, and consumers buy fewer good, including imports.[/hidden-answer]
Both the United States and global economies are booming. Will U.S. imports and/or exports increase?
[reveal-answer q="491913"]Show Solution[/reveal-answer]
[hidden-answer a="491913"]A booming economy will increase the demand for goods in general, so import sales will increase. If our trading partners’ economies are doing well, they will buy more of our products and so U.S. exports will increase.[/hidden-answer]
Review Questions
What are the two main sides of the national savings and investment identity?
What are the main components of the national savings and investment identity?
Critical Thinking Questions
Many think that the size of a trade deficit is due to a lack of competitiveness of domestic sectors, such as autos. Explain why this is not true.
If you observed a country with a rapidly growing trade surplus over a period of a year or so, would you be more likely to believe that the country's economy was in a period of recession or of rapid growth? Explain.
Occasionally, a government official will argue that a country should strive for both a trade surplus and a healthy inflow of capital from abroad. Is this possible?
Problems
Imagine that the U.S. economy finds itself in the following situation: a government budget deficit of $100 billion, total domestic savings of $1,500 billion, and total domestic physical capital investment of $1,600 billion. According to the national saving and investment identity, what will be the current account balance? What will be the current account balance if investment rises by $50 billion, while the budget deficit and national savings remain the same?
[link] provides some hypothetical data on macroeconomic accounts for three countries represented by A, B, and C and measured in billions of currency units. In [link], private household saving is SH, tax revenue is T, government spending is G, and investment spending is I.
| A | B | C | |
|---|---|---|---|
| SH | 700 | 500 | 600 |
| T | 00 | 500 | 500 |
| G | 600 | 350 | 650 |
| I | 800 | 400 | 450 |
- Calculate the trade balance and the net inflow of foreign saving for each country.
- State whether each one has a trade surplus or deficit (or balanced trade).
- State whether each is a net lender or borrower internationally and explain.
Imagine that the economy of Germany finds itself in the following situation: the government budget has a surplus of 1% of Germany’s GDP; private savings is 20% of GDP; and physical investment is 18% of GDP.
- Based on the national saving and investment identity, what is the current account balance?
- If the government budget surplus falls to zero, how will this affect the current account balance?
Self-Check Questions
For each of the following, indicate which type of government spending would justify a budget deficit and which would not.
- Increased federal spending on Medicare
- Increased spending on education
- Increased spending on the space program
- Increased spending on airports and air traffic control
[reveal-answer q="453339"]Show Solution[/reveal-answer]
[hidden-answer a="453339"]a. Increased federal spending on Medicare may not increase productivity, so a budget deficit is not justified.
b. Increased spending on education will increase productivity and foster greater economic growth, so a budget deficit is justified.
c. Increased spending on the space program may not increase productivity, so a budget deficit is not justified.
d. Increased spending on airports and air traffic control will increase productivity and foster greater economic growth, so a budget deficit is justified.[/hidden-answer]
How did large trade deficits hurt the East Asian countries in the mid 1980s? (Recall that trade deficits are equivalent to inflows of financial capital from abroad.)
[reveal-answer q="532520"]Show Solution[/reveal-answer]
[hidden-answer a="532520"]Foreign investors worried about repayment so they began to pull money out of these countries. The money can be pulled out of stock and bond markets, real estate, and banks.[/hidden-answer]
Describe a scenario in which a trade surplus benefits an economy and one in which a trade surplus is occurring in an economy that performs poorly. What key factor or factors are making the difference in the outcome that results from a trade surplus?
[reveal-answer q="873126"]Show Solution[/reveal-answer]
[hidden-answer a="873126"]A rapidly growing trade surplus could result from a number of factors, so you would not want to be too quick to assume a specific cause. However, if the choice is between whether the economy is in recession or growing rapidly, the answer would have to be recession. In a recession, demand for all goods, including imports, has declined; however, demand for exports from other countries has not necessarily altered much, so the result is a larger trade surplus.[/hidden-answer]
Review Questions
When is a trade deficit likely to work out well for an economy? When is it likely to work out poorly?
Does a trade surplus help to guarantee strong economic growth?
Critical Thinking Question
What is more important, a country’s current account balance or GDP growth? Why?
Self-Check Questions
The United States exports 14% of GDP while Germany exports about 50% of its GDP. Explain what that means.
[reveal-answer q="901034"]Show Solution[/reveal-answer]
[hidden-answer a="901034"]Germany has a higher level of trade than the United States. The United States has a large domestic economy so it has a large volume of internal trade.[/hidden-answer]
Explain briefly whether each of the following would be more likely to lead to a higher level of trade for an economy, or a greater imbalance of trade for an economy.
- Living in an especially large country
- Having a domestic investment rate much higher than the domestic savings rate
- Having many other large economies geographically nearby
- Having an especially large budget deficit
- Having countries with a tradition of strong protectionist legislation shutting out imports
[reveal-answer q="659515"]Show Solution[/reveal-answer]
[hidden-answer a="659515"]a. A large economy tends to have lower levels of international trade, because it can do more of its trade internally, but this has little impact on its trade imbalance.
b. An imbalance between domestic physical investment and domestic saving (including government and private saving) will always lead to a trade imbalance, but has little to do with the level of trade.
c. Many large trading partners nearby geographically increases the level of trade, but has little impact one way or the other on a trade imbalance.
d. The answer here is not obvious. An especially large budget deficit means a large demand for financial capital which, according to the national saving and investment identity, makes it somewhat more likely that there will be a need for an inflow of foreign capital, which means a trade deficit.
e. A strong tradition of discouraging trade certainly reduces the level of trade. However, it does not necessarily say much about the balance of trade, since this is determined by both imports and exports, and by national levels of physical investment and savings.[/hidden-answer]
Review Questions
What three factors will determine whether a nation has a higher or lower share of trade relative to its GDP?
What is the difference between trade deficits and balance of trade?
Critical Thinking Questions
Will nations that are more involved in foreign trade tend to have higher trade imbalances, lower trade imbalances, or is the pattern unpredictable?
Some economists warn that the persistent trade deficits and a negative current account balance that the United States has run will be a problem in the long run. Do you agree or not? Explain your answer.
Chapter 6 (now 4)
Section 6.1
Self-Check Questions
Country A has export sales of $20 billion, government purchases of $1,000 billion, business investment is $50 billion, imports are $40 billion, and consumption spending is $2,000 billion. What is the dollar value of GDP?
[reveal-answer q="293818"]Show Answer[/reveal-answer]
[hidden-answer a="293818"]GDP is C + I + G + (X – M). GDP = $2,000 billion + $50 billion + $1,000 billion + ($20 billion – $40 billion) = $3,030[/hidden-answer]
Which of the following are included in GDP, and which are not?
- The cost of hospital stays
- The rise in life expectancy over time
- Child care provided by a licensed day care center
- Child care provided by a grandmother
- A used car sale
- A new car sale
- The greater variety of cheese available in supermarkets
- The iron that goes into the steel that goes into a refrigerator bought by a consumer.
[reveal-answer q="23073"]Show Answer[/reveal-answer]
[hidden-answer a="23073"]
- Hospital stays are part of GDP.
- Changes in life expectancy are not market transactions and not part of GDP.
- Child care that is paid for is part of GDP.
- If Grandma gets paid and reports this as income, it is part of GDP, otherwise not.
- A used car is not produced this year, so it is not part of GDP.
- A new car is part of GDP.
- Variety does not count in GDP, where the cheese could all be cheddar.
- The iron is not counted because it is an intermediate good.[/hidden-answer]
Review Questions
What are the main components of measuring GDP with what is demanded?
What are the main components of measuring GDP with what is produced?
Would you usually expect GDP as measured by what is demanded to be greater than GDP measured by what is supplied, or the reverse?
Why must you avoid double counting when measuring GDP?
Critical Thinking Question
U.S. macroeconomic data are among the best in the world. Given what you learned in the Clear It Up "How do statisticians measure GDP?", does this surprise you, or does this simply reflect the complexity of a modern economy?
What does GDP not tell us about the economy?
Problem
Last year, a small nation with abundant forests cut down $200 worth of trees. It then turned $100 worth of trees into $150 worth of lumber. It used $100 worth of that lumber to produce $250 worth of bookshelves. Assuming the country produces no other outputs, and there are no other inputs used in producing trees, lumber, and bookshelves, what is this nation's GDP? In other words, what is the value of the final goods the nation produced including trees, lumber and bookshelves?
Section 6.2
Self-Check Question
Using data from [link] how much of the nominal GDP growth from 1980 to 1990 was real GDP and how much was inflation?
[reveal-answer q="349098"]Show Answer[/reveal-answer]
[hidden-answer a="349098"]From 1980 to 1990, real GDP grew by (8,225.0 – 5,926.5) / (5,926.5) = 39%. Over the same period, prices increased by (72.7 – 48.3) / (48.3/100) = 51%. So about 57% of the growth 51 / (51 + 39) was inflation, and the remainder: 39 / (51 + 39) = 43% was growth in real GDP.[/hidden-answer]
Review Questions
What is the difference between a series of economic data over time measured in nominal terms versus the same data series over time measured in real terms?
How do you convert a series of nominal economic data over time to real terms?
Critical Thinking Question
Should people typically pay more attention to their real income or their nominal income? If you choose the latter, why would that make sense in today’s world? Would your answer be the same for the 1970s?
Problems
The "prime" interest rate is the rate that banks charge their best customers. Based on the nominal interest rates and inflation rates in [link], in which of the years would it have been best to be a lender? Based on the nominal interest rates and inflation rates in [link], in which of the years given would it have been best to be a borrower?
| Year | Prime Interest Rate | Inflation Rate |
|---|---|---|
| 1970 | 7.9% | 5.7% |
| 1974 | 10.8% | 11.0% |
| 1978 | 9.1% | 7.6% |
| 1981 | 18.9% | 10.3% |
A mortgage loan is a loan that a person makes to purchase a house. [link] provides a list of the mortgage interest rate for several different years and the rate of inflation for each of those years. In which years would it have been better to be a person borrowing money from a bank to buy a home? In which years would it have been better to be a bank lending money?
| Year | Mortgage Interest Rate | Inflation Rate |
|---|---|---|
| 1984 | 12.4% | 4.3% |
| 1990 | 10% | 5.4% |
| 2001 | 7.0% | 2.8% |
Section 6.3
Self-Check Questions
Without looking at [link], return to [link]. If we define a recession as a significant decline in national output, can you identify any post-1960 recessions in addition to the 2008-2009 recession? (This requires a judgment call.)
[reveal-answer q="243710"]Show Answer[/reveal-answer]
[hidden-answer a="243710"]Two other major recessions are visible in the figure as slight dips: those of 1973–1975, and 1981–1982. Two other recessions appear in the figure as a flattening of the path of real GDP. These were in 1990–1991 and 2001.[/hidden-answer]
According to [link], how often have recessions occurred since the end of World War II (1945)?
[reveal-answer q="28688"]Show Answer[/reveal-answer]
[hidden-answer a="28688"]11 recessions in approximately 70 years averages about one recession every six years.[/hidden-answer]
According to [link], how long has the average recession lasted since the end of World War II?
[reveal-answer q="702472"]Show Answer[/reveal-answer]
[hidden-answer a="702472"]The table lists the "Months of Contraction" for each recession. Averaging these figures for the post-WWII recessions gives an average duration of 11 months, or slightly less than a year.[/hidden-answer]
According to [link], how long has the average expansion lasted since the end of World War II?
[reveal-answer q="393375"]Show Answer[/reveal-answer]
[hidden-answer a="393375"]The table lists the "Months of Expansion." Averaging these figures for the post-WWII expansions gives an average expansion of 60.5 months, or more than five years.[/hidden-answer]
Review Question
What are typical GDP patterns for a high-income economy like the United States in the long run and the short run?
Critical Thinking Questions
Why do you suppose that U.S. GDP is so much higher today than 50 or 100 years ago?
Why do you think that GDP does not grow at a steady rate, but rather speeds up and slows down?
Section 6.4
Self-Check Question
Is it possible for GDP to rise while at the same time per capita GDP is falling? Is it possible for GDP to fall while per capita GDP is rising?
[reveal-answer q="245990"]Show Answer[/reveal-answer]
[hidden-answer a="245990"]Yes. The answer to both questions depends on whether GDP is growing faster or slower than population. If population grows faster than GDP, GDP increases, while GDP per capita decreases. If GDP falls, but population falls faster, then GDP decreases, while GDP per capita increases.[/hidden-answer]
The Central African Republic has a GDP of 1,107,689 million CFA francs and a population of 4.862 million. The exchange rate is 284.681CFA francs per dollar. Calculate the GDP per capita of Central African Republic.
[reveal-answer q="940166"]Show Answer[/reveal-answer]
[hidden-answer a="940166"]Start with Central African Republic’s GDP measured in francs. Divide it by the exchange rate to convert to U.S. dollars, and then divide by population to obtain the per capita figure. That is, 1,107,689 million francs / 284.681 francs per dollar / 4.862 million people = $800.28 GDP per capita.[/hidden-answer]
Review Question
What are the two main difficulties that arise in comparing different countries's GDP?
Critical Thinking Question
Cross country comparisons of GDP per capita typically use purchasing power parity equivalent exchange rates, which are a measure of the long run equilibrium value of an exchange rate. In fact, we used PPP equivalent exchange rates in this module. Why could using market exchange rates, which sometimes change dramatically in a short period of time, be misleading?
Why might per capita GDP be only an imperfect measure of a country’s standard of living?
Problems
Ethiopia has a GDP of $8 billion (measured in U.S. dollars) and a population of 55 million. Costa Rica has a GDP of $9 billion (measured in U.S. dollars) and a population of 4 million. Calculate the per capita GDP for each country and identify which one is higher.
In 1980, Denmark had a GDP of $70 billion (measured in U.S. dollars) and a population of 5.1 million. In 2000, Denmark had a GDP of $160 billion (measured in U.S. dollars) and a population of 5.3 million. By what percentage did Denmark’s GDP per capita rise between 1980 and 2000?
The Czech Republic has a GDP of 1,800 billion koruny. The exchange rate is 25 koruny/U.S. dollar. The Czech population is 20 million. What is the GDP per capita of the Czech Republic expressed in U.S. dollars?
Section 6.5
Self-Check Question
Explain briefly whether each of the following would cause GDP to overstate or understate the degree of change in the broad standard of living.
- The environment becomes dirtier
- The crime rate declines
- A greater variety of goods become available to consumers
- Infant mortality declines
[reveal-answer q="740578"]Show Solution[/reveal-answer]
[hidden-answer a="740578"]a. A dirtier environment would reduce the broad standard of living, but not be counted in GDP, so a rise in GDP would overstate the standard of living.
b. A lower crime rate would raise the broad standard of living, but not be counted directly in GDP, and so a rise in GDP would understate the standard of living.
c. A greater variety of goods would raise the broad standard of living, but not be counted directly in GDP, and so a rise in GDP would understate the rise in the standard of living.
d. A decline in infant mortality would raise the broad standard of living, but not be counted directly in GDP, and so a rise in GDP would understate the rise in the standard of living.[/hidden-answer]
Review Question
List some of the reasons why economists should not consider GDP an effective measure of the standard of living in a country.
Critical Thinking Questions
How might you measure a "green" GDP?
Chapter 7 (now 5)
Section 7.1
Self-Check Questions
Explain what the Industrial Revolution was and where it began.
[reveal-answer q="792809"]Show Solution[/reveal-answer]
[hidden-answer a="792809"]The Industrial Revolution refers to the widespread use of power-driven machinery and the economic and social changes that resulted in the first half of the 1800s. Ingenious machines—the steam engine, the power loom, and the steam locomotive—performed tasks that would have taken vast numbers of workers to do. The Industrial Revolution began in Great Britain, and soon spread to the United States, Germany, and other countries.[/hidden-answer]
Explain the difference between property rights and contractual rights. Why do they matter to economic growth?
[reveal-answer q="472759"]Show Solution[/reveal-answer]
[hidden-answer a="472759"]Property rights are the rights of individuals and firms to own property and use it as they see fit. Contractual rights are based on property rights and they allow individuals to enter into agreements with others regarding the use of their property providing recourse through the legal system in the event of noncompliance. Economic growth occurs when the standard of living increases in an economy, which occurs when output is increasing and incomes are rising. For this to happen, societies must create a legal environment that gives individuals the ability to use their property to their fullest and highest use, including the right to trade or sell that property. Without a legal system that enforces contracts, people would not be likely to enter into contracts for current or future services because of the risk of non-payment. This would make it difficult to transact business and would slow economic growth.[/hidden-answer]
Review Questions
How did the Industrial Revolution increase the economic growth rate and income levels in the United States?
How much should a nation be concerned if its rate of economic growth is just 2% slower than other nations?
Critical Thinking Question
Over the past 50 years, many countries have experienced an annual growth rate in real GDP per capita greater than that of the United States. Some examples are China, Japan, South Korea, and Taiwan. Does that mean the United States is regressing relative to other countries? Does that mean these countries will eventually overtake the United States in terms of the growth rate of real GDP per capita? Explain.
Section 7.2
Self-Check Questions
Are there other ways in which we can measure productivity besides the amount produced per hour of work?
[reveal-answer q="631548"]Show Solution[/reveal-answer]
[hidden-answer a="631548"]Yes. Since productivity is output per unit of input, we can measure productivity using GDP (output) per worker (input).[/hidden-answer]
Assume there are two countries: South Korea and the United States. South Korea grows at 4% and the United States grows at 1%. For the sake of simplicity, assume they both start from the same fictional income level, $10,000. What will the incomes of the United States and South Korea be in 20 years? By how many multiples will each country’s income grow in 20 years?
[reveal-answer q="371214"]Show Solution[/reveal-answer]
[hidden-answer a="371214"]In 20 years the United States will have an income of 10,000 × (1 + 0.01)20 = $12,201.90, and South Korea will have an income of 10,000 × (1 + 0.04)20 = $21,911.23. South Korea has grown by a multiple of 2.1 and the United States by a multiple of 1.2.[/hidden-answer]
Review Questions
How is GDP per capita calculated differently from labor productivity?
How do gains in labor productivity lead to gains in GDP per capita?
Critical Thinking Questions
Labor Productivity and Economic Growth outlined the logic of how increased productivity is associated with increased wages. Detail a situation where this is not the case and explain why it is not.
Change in labor productivity is one of the most watched international statistics of growth. Visit the St. Louis Federal Reserve website and find the data section (http://research.stlouisfed.org). Find international comparisons of labor productivity, listed under the FRED Economic database (Growth Rate of Total Labor Productivity), and compare two countries in the recent past. State what you think the reasons for differences in labor productivity could be.
Refer back to the
Work It Out about Comparing the Economies of Two Countries and examine the data for the two countries you chose. How are they similar? How are they different?
Problems
An economy starts off with a GDP per capita of $5,000. How large will the GDP per capita be if it grows at an annual rate of 2% for 20 years? 2% for 40 years? 4% for 40 years? 6% for 40 years?
An economy starts off with a GDP per capita of 12,000 euros. How large will the GDP per capita be if it grows at an annual rate of 3% for 10 years? 3% for 30 years? 6% for 30 years?
Say that the average worker in Canada has a productivity level of $30 per hour while the average worker in the United Kingdom has a productivity level of $25 per hour (both measured in U.S. dollars). Over the next five years, say that worker productivity in Canada grows at 1% per year while worker productivity in the UK grows 3% per year. After five years, who will have the higher productivity level, and by how much?
Say that the average worker in the U.S. economy is eight times as productive as an average worker in Mexico. If the productivity of U.S. workers grows at 2% for 25 years and the productivity of Mexico’s workers grows at 6% for 25 years, which country will have higher worker productivity at that point?
Section 7.3
Self-Check Questions
What do the growth accounting studies conclude are the determinants of growth? Which is more important, the determinants or how they are combined?
[reveal-answer q="711715"]Show Solution[/reveal-answer]
[hidden-answer a="711715"]Capital deepening and technology are important. What seems to be more important is how they are combined.[/hidden-answer]
What policies can the government of a free-market economy implement to stimulate economic growth?
[reveal-answer q="755344"]Show Solution[/reveal-answer]
[hidden-answer a="755344"]Government can contribute to economic growth by investing in human capital through the education system, building a strong physical infrastructure for transportation and commerce, increasing investment by lowering capital gains taxes, creating special economic zones that allow for reduced tariffs, and investing in research and development.[/hidden-answer]
List the areas where government policy can help economic growth.
[reveal-answer q="461684"]Show Solution[/reveal-answer]
[hidden-answer a="461684"]Public education, low investment taxes, funding for infrastructure projects, special economic zones[/hidden-answer]
Review Questions
What is an aggregate production function?
What is capital deepening?
What do economists mean when they refer to improvements in technology?
Critical Thinking Questions
Education seems to be important for human capital deepening. As people become better educated and more knowledgeable, are there limits to how much additional benefit more education can provide? Why or why not?
Describe some of the political and social tradeoffs that might occur when a less developed country adopts a strategy to promote labor force participation and economic growth via investment in girls’ education.
Why is investing in girls’ education beneficial for growth?
How is the concept of technology, as defined with the aggregate production function, different from our everyday use of the word?
Section 7.4
Self-Check Questions
Use an example to explain why, after periods of rapid growth, a low-income country that has not caught up to a high-income country may feel poor.
[reveal-answer q="700557"]Show Solution[/reveal-answer]
[hidden-answer a="700557"]A good way to think about this is how a runner who has fallen behind in a race feels psychologically and physically as he catches up. Playing catch-up can be more taxing than maintaining one’s position at the head of the pack.[/hidden-answer]
Would the following events usually lead to capital deepening? Why or why not?
- A weak economy in which businesses become reluctant to make long-term investments in physical capital.
- A rise in international trade.
- A trend in which many more adults participate in continuing education courses through their employers and at colleges and universities.
[reveal-answer q="640435"]Show Solution[/reveal-answer]
[hidden-answer a="640435"]a. No. Capital deepening refers to an increase in the amount of capital per person in an economy. A decrease in investment by firms will actually cause the opposite of capital deepening (since the population will grow over time).
b. There is no direct connection between an increase in international trade and capital deepening. One could imagine particular scenarios where trade could lead to capital deepening (for example, if international capital inflows—which are the counterpart to increasing the trade deficit—lead to an increase in physical capital investment), but in general, no.
c. Yes. Capital deepening refers to an increase in either physical capital or human capital per person. Continuing education or any time of lifelong learning adds to human capital and thus creates capital deepening.[/hidden-answer]
What are the "advantages of backwardness" for economic growth?
[reveal-answer q="280514"]Show Solution[/reveal-answer]
[hidden-answer a="280514"]The advantages of backwardness include faster growth rates because of the process of convergence, as well as the ability to adopt new technologies that were developed first in the "leader" countries. While being "backward" is not inherently a good thing, Gerschenkron stressed that there are certain advantages which aid countries trying to "catch up."[/hidden-answer]
Would you expect capital deepening to result in diminished returns? Why or why not? Would you expect improvements in technology to result in diminished returns? Why or why not?
[reveal-answer q="704888"]Show Solution[/reveal-answer]
[hidden-answer a="704888"]Capital deepening, by definition, should lead to diminished returns because you're investing more and more but using the same methods of production, leading to the marginal productivity declining. This is shown on a production function as a movement along the curve. Improvements in technology should not lead to diminished returns because you are finding new and more efficient ways of using the same amount of capital. This can be illustrated as a shift upward of the production function curve.[/hidden-answer]
Why does productivity growth in high-income economies not slow down as it runs into diminishing returns from additional investments in physical capital and human capital? Does this show one area where the theory of diminishing returns fails to apply? Why or why not?
[reveal-answer q="461635"]Show Solution[/reveal-answer]
[hidden-answer a="461635"]Productivity growth from new advances in technology will not slow because the new methods of production will be adopted relatively quickly and easily, at very low marginal cost. Also, countries that are seeing technology growth usually have a vast and powerful set of institutions for training workers and building better machines, which allows the maximum amount of people to benefit from the new technology. These factors have the added effect of making additional technological advances even easier for these countries.[/hidden-answer]
Review Questions
For a high-income economy like the United States, what aggregate production function elements are most important in bringing about growth in GDP per capita? What about a middle-income country such as Brazil? A low-income country such as Niger?
List some arguments for and against the likelihood of convergence.
Critical Thinking Questions
What sorts of policies can governments implement to encourage convergence?
As technological change makes us more sedentary and food costs increase, obesity is likely. What factors do you think may limit obesity?
Chapter 8 (now 6)
Section 8.1
Self-Check Questions
Suppose the adult population over the age of 16 is 237.8 million and the labor force is 153.9 million (of whom 139.1 million are employed). How many people are "not in the labor force?" What are the proportions of employed, unemployed and not in the labor force in the population? Hint: Proportions are percentages.
[reveal-answer q="604439"]Show Solution[/reveal-answer]
[hidden-answer a="604439"]The population is divided into those "in the labor force" and those "not in the labor force." Thus, the number of adults not in the labor force is 237.8 – 153.9 = 83.9 million. Since the labor force is divided into employed persons and unemployed persons, the number of unemployed persons is 153.9 – 139.1 = 14.8 million. Thus, the adult population has the following proportions:
- 139.1/237.8 = 58.5% employed persons
- 14.8/237.8 = 6.2% unemployed persons
- 83.9/237.8 = 35.3% persons out of the labor force[/hidden-answer]
Using the above data, what is the unemployment rate? These data are U.S. statistics from 2010. How does it compare to the February 2015 unemployment rate computed earlier?
[reveal-answer q="83285"]Show Solution[/reveal-answer]
[hidden-answer a="83285"]The unemployment rate is defined as the number of unemployed persons as a percentage of the labor force or 14.8/153.9 = 9.6%. This is higher than the February 2015 unemployment rate, computed earlier, of 5.5%.[/hidden-answer]
Review Questions
What is the difference between being unemployed and being out of the labor force?
How do you calculate the unemployment rate? How do you calculate the labor force participation rate?
Are all adults who do not hold jobs counted as unemployed?
If you are out of school but working part time, are you considered employed or unemployed in U.S. labor statistics? If you are a full time student and working 12 hours a week at the college cafeteria are you considered employed or not in the labor force? If you are a senior citizen who is collecting social security and a pension and working as a greeter at Wal-Mart are you considered employed or not in the labor force?
What happens to the unemployment rate when unemployed workers are reclassified as discouraged workers?
What happens to the labor force participation rate when employed individuals are reclassified as unemployed? What happens when they are reclassified as discouraged workers?
What are some of the problems with using the unemployment rate as an accurate measure of overall joblessness?
What criteria do the BLS use to count someone as employed? As unemployed?
Assess whether the following would be counted as "unemployed" in the Current Employment Statistics survey.
- A husband willingly stays home with children while his wife works.
- A manufacturing worker whose factory just closed down.
- A college student doing an unpaid summer internship.
- A retiree.
- Someone who has been out of work for two years but keeps looking for a job.
- Someone who has been out of work for two months but isn’t looking for a job.
- Someone who hates her present job and is actively looking for another one.
- Someone who decides to take a part time job because she could not find a full time position.
Critical Thinking Questions
Using the definition of the unemployment rate, is an increase in the unemployment rate necessarily a bad thing for a nation?
Is a decrease in the unemployment rate necessarily a good thing for a nation? Explain.
If many workers become discouraged from looking for jobs, explain how the number of jobs could decline but the unemployment rate could fall at the same time.
Would you expect hidden unemployment to be higher, lower, or about the same when the unemployment rate is high, say 10%, versus low, say 4%? Explain.
Problems
A country with a population of eight million adults has five million employed, 500,000 unemployed, and the rest of the adult population is out of the labor force. What’s the unemployment rate? What share of population is in the labor force? Sketch a pie chart that divides the adult population into these three groups.
Section 8.2
Self-Check Questions
Over the long term, has the U.S. unemployment rate generally trended up, trended down, or remained at basically the same level?
[reveal-answer q="401076"]Show Solution[/reveal-answer]
[hidden-answer a="401076"]Over the long term, the U.S. unemployment rate has remained basically the same level.[/hidden-answer]
Whose unemployment rates are commonly higher in the U.S. economy:
- Whites or nonwhites?
- The young or the middle-aged?
- College graduates or high school graduates?
[reveal-answer q="261794"]Show Solution[/reveal-answer]
[hidden-answer a="261794"]a. Nonwhites
b. The young
c. High school graduates[/hidden-answer]
Review Questions
Are U.S. unemployment rates typically higher, lower, or about the same as unemployment rates in other high-income countries?
Are U.S. unemployment rates distributed evenly across the population?
Critical Thinking Questions
Is the higher unemployment rates for minority workers necessarily an indication of discrimination? What could be some other reasons for the higher unemployment rate?
While unemployment is highly negatively correlated with the level of economic activity, in the real world it responds with a lag. In other words, firms do not immediately lay off workers in response to a sales decline. They wait a while before responding. Similarly, firms do not immediately hire workers when sales pick up. What do you think accounts for the lag in response time?
Why do you think that unemployment rates are lower for individuals with more education?
Section 8.3
Self-Check Questions
Beginning in the 1970s and continuing for three decades, women entered the U.S. labor force in a big way. If we assume that wages are sticky in a downward direction, but that around 1970 the demand for labor equaled the supply of labor at the current wage rate, what do you imagine happened to the wage rate, employment, and unemployment as a result of increased labor force participation?
[reveal-answer q="513484"]Show Answer[/reveal-answer]
[hidden-answer a="513484"]Because of the influx of women into the labor market, the supply of labor shifts to the right. Since wages are sticky downward, the increased supply of labor causes an increase in people looking for jobs (Qs), but no change in the number of jobs available (Qe). As a result, unemployment increases by the amount of the increase in the labor supply. This can be seen in the following figure. Over time, as labor demand grows, the unemployment will decline and eventually wages will begin to increase again. But this increase in labor demand goes beyond the scope of this problem.
[/hidden-answer]
Review Questions
When would you expect cyclical unemployment to be rising? Falling?
Why is there unemployment in a labor market with flexible wages?
Name and explain some of the reasons why wages are likely to be sticky, especially in downward adjustments.
Critical Thinking Questions
Do you think it is rational for workers to prefer sticky wages to wage cuts, when the consequence of sticky wages is unemployment for some workers? Why or why not? How do the reasons for sticky wages explained in this section apply to your argument?
Problems
A government passes a family-friendly law that no companies can have evening, nighttime, or weekend hours, so that everyone can be home with their families during these times. Analyze the effect of this law using a demand and supply diagram for the labor market: first assuming that wages are flexible, and then assuming that wages are sticky downward.
Section 8.4
Self-Check Questions
Is the increase in labor force participation rates among women better thought of as causing an increase in cyclical unemployment or an increase in the natural rate of unemployment? Why?
[reveal-answer q="114859"]Show Answer[/reveal-answer]
[hidden-answer a="114859"]The increase in labor supply was a social demographic trend—it was not caused by the economy falling into a recession. Therefore, the influx of women into the work force increased the natural rate of unemployment.[/hidden-answer]
Many college students graduate from college before they have found a job. When graduates begin to look for a job, they are counted as what category of unemployed?
[reveal-answer q="316549"]Show Answer[/reveal-answer]
[hidden-answer a="316549"]New entrants to the labor force, whether from college or otherwise, are counted as frictionally unemployed until they find a job.[/hidden-answer]
Review Questions
What term describes the remaining level of unemployment that occurs even when the economy is healthy?
What forces create the natural rate of unemployment for an economy?
Would you expect the natural rate of unemployment to be roughly the same in different countries?
Would you expect the natural rate of unemployment to remain the same within one country over the long run of several decades?
What is frictional unemployment? Give examples of frictional unemployment.
What is structural unemployment? Give examples of structural unemployment.
After several years of economic growth, would you expect the unemployment in an economy to be mainly cyclical or mainly due to the natural rate of unemployment? Why?
What type of unemployment (cyclical, frictional, or
structural) applies to each of the following:
- landscapers laid off in response to a drop in new
housing construction during a recession. - coal miners laid off due to EPA regulations that
shut down coal fired power - a financial analyst who quits his/her job in
Chicago and is pursing similar work in Arizona - printers laid off due to drop in demand for
printed catalogues and flyers as firms go the
internet to promote an advertise their products. - factory workers in the U.S. laid off as the plants shut down and move to Mexico and Ireland.
Critical Thinking Questions
Under what condition would a decrease in unemployment be bad for the economy?
Under what condition would an increase in the unemployment rate be a positive sign?
As the baby boom generation retires, the ratio of retirees to workers will increase noticeably. How will this affect the Social Security program? How will this affect the standard of living of the average American?
Unemployment rates have been higher in many European countries in recent decades than in the United States. Is the main reason for this long-term difference in unemployment rates more likely to be cyclical unemployment or the natural rate of unemployment? Explain briefly.
Is it desirable to pursue a goal of zero unemployment? Why or why not?
Is it desirable to eliminate natural unemployment? Why or why not? Hint: Think about what our economy would look like today and what assumptions would have to be met to have a zero rate of natural unemployment.
The U.S. unemployment rate increased from 4.6% in July 2001 to 5.9% by June 2002. Without studying the subject in any detail, would you expect that a change of this kind is more likely to be due to cyclical unemployment or a change in the natural rate of unemployment? Why?
Problems
As the baby boomer generation retires, what should happen to wages and employment? Can you show this graphically?
Chapter 9 (now 7)
Section 9.1
Section 9.2
Section 9.3
Section 9.4
Section 9.5
Chapter 11 (now 9)
Section 11.1
Key Concepts and Summary
Neoclassical economists emphasize Say’s law, which holds that supply creates its own demand. Keynesian economists emphasize Keynes’ law, which holds that demand creates its own supply. Many mainstream economists take a Keynesian perspective, emphasizing the importance of aggregate demand, for the short run, and a neoclassical perspective, emphasizing the importance of aggregate supply, for the long run.
Self-Check Questions
Describe the mechanism by which supply creates its own demand.
[reveal-answer q="781079"]Show Solution[/reveal-answer]
[hidden-answer a="781079"]In order to supply goods, suppliers must employ workers, whose incomes increase as a result of their labor. They use this additional income to demand goods of an equivalent value to those they supply.[/hidden-answer]
Describe the mechanism by which demand creates its own supply.
[reveal-answer q="891129"]Show Solution[/reveal-answer]
[hidden-answer a="891129"]When consumers demand more goods than are available on the market, prices are driven higher and the additional opportunities for profit induce more suppliers to enter the market, producing an equivalent amount to that which is demanded.[/hidden-answer]
Review Questions
What is Say’s law?
What is Keynes’ law?
Do neoclassical economists believe in Keynes’ law or Say’s law?
Does Say’s law apply more accurately in the long run or the short run? What about Keynes’ law?
Critical Thinking Question
Why would an economist choose either the neoclassical perspective or the Keynesian perspective, but not both?
Section 11.2
Key Concepts and Summary
The upward-sloping short run aggregate supply (SRAS) curve shows the positive relationship between the price level and the level of real GDP in the short run. Aggregate supply slopes up because when the price level for outputs increases, while the price level of inputs remains fixed, the opportunity for additional profits encourages more production. The aggregate supply curve is near-horizontal on the left and near-vertical on the right. In the long run, we show the aggregate supply by a vertical line at the level of potential output, which is the maximum level of output the economy can produce with its existing levels of
workers, physical capital, technology, and economic institutions.
The downward-sloping aggregate demand (AD) curve shows the relationship between the price level for outputs and the quantity of total spending in the economy. It slopes down because of: (a) the wealth effect, which means that a higher price level leads to lower real wealth, which reduces the level of consumption; (b) the interest rate effect, which holds that a higher price level will mean a greater demand for money, which will tend to drive up interest rates and reduce investment spending; and (c) the foreign price effect, which holds that a rise in the price level will make domestic goods relatively more expensive, discouraging exports and encouraging imports.
Self-Check Questions
The short run aggregate supply curve was constructed assuming that as the price of outputs increases, the price of inputs stays the same. How would an increase in the prices of important inputs, like energy, affect aggregate supply?
[reveal-answer q="349873"]Show Solution[/reveal-answer]
[hidden-answer a="349873"]Higher input prices make output less profitable, decreasing the desired supply. This is shown graphically as a leftward shift in the AS curve.[/hidden-answer]
In the AD/AS model, what prevents the economy from achieving equilibrium at potential output?
[reveal-answer q="104967"]Show Solution[/reveal-answer]
[hidden-answer a="104967"]Equilibrium occurs at the level of GDP where AD = AS. Insufficient aggregate demand could explain why the equilibrium occurs at a level of GDP less than potential. A decrease (or leftward shift) in aggregate supply could be another reason.[/hidden-answer]
Review Questions
What is on the horizontal axis of the AD/AS diagram? What is on the vertical axis?
What is the economic reason why the SRAS curve slopes up?
What are the components of the aggregate demand (AD) curve?
What are the economic reasons why the AD curve slopes down?
Briefly explain the reason for the near-horizontal shape of the SRAS curve on its far left.
Briefly explain the reason for the near-vertical shape of the SRAS curve on its far right.
What is potential GDP?
Critical Thinking Questions
On a microeconomic demand curve, a decrease in price causes an increase in quantity demanded because the product in question is now relatively less expensive than substitute products. Explain why aggregate demand does not increase for the same reason in response to a decrease in the aggregate price level. In other words, what causes total spending to increase if it is not because goods are now cheaper?
Problems
Review the problem in the Work It Out titled "Interpreting the AD/AS Model." Like the information provided in that feature, [link] shows information on aggregate supply, aggregate demand, and the price level for the imaginary country of Xurbia.
| Price Level | AD | AS |
|---|---|---|
| 110 | 700 | 600 |
| 120 | 690 | 640 |
| 130 | 680 | 680 |
| 140 | 670 | 720 |
| 150 | 660 | 740 |
| 160 | 650 | 760 |
| 170 | 640 | 770 |
- Plot the AD/AS diagram from the data. Identify the equilibrium.
- Imagine that, as a result of a government tax cut, aggregate demand becomes higher by 50 at every price level. Identify the new equilibrium.
- How will the new equilibrium alter output? How will it alter the price level? What do you think will happen to employment?
The imaginary country of Harris Island has the aggregate supply and aggregate demand curves as [link] shows.
| Price Level | AD | AS |
|---|---|---|
| 100 | 700 | 200 |
| 120 | 600 | 325 |
| 140 | 500 | 500 |
| 160 | 400 | 570 |
| 180 | 300 | 620 |
- Plot the AD/AS diagram. Identify the equilibrium.
- Would you expect unemployment in this economy to be relatively high or low?
- Would you expect concern about inflation in this economy to be relatively high or low?
- Imagine that consumers begin to lose confidence about the state of the economy, and so AD becomes lower by 275 at every price level. Identify the new aggregate equilibrium.
- How will the shift in AD affect the original output, price level, and employment?
[link] describes Santher's economy.
| Price Level | AD | AS |
|---|---|---|
| 50 | 1,000 | 250 |
| 60 | 950 | 580 |
| 70 | 900 | 750 |
| 80 | 850 | 850 |
| 90 | 800 | 900 |
- Plot the AD/AS curves and identify the equilibrium.
- Would you expect unemployment in this economy to be relatively high or low?
- Would you expect prices to be a relatively large or small concern for this economy?
- Imagine that input prices fall and so AS shifts to the right by 150 units. Identify the new equilibrium.
- How will the shift in AS affect the original output, price level, and employment?
Section 11.3
Key Concepts and Summary
The aggregate demand/aggregate supply (AD/AS) diagram shows how AD and AS interact. The intersection of the AD and AS curves shows the equilibrium output and price level in the economy. Movements of either AS or AD will result in a different equilibrium output and price level. The aggregate supply curve will shift out to the right as productivity increases. It will shift back to the left as the price of key inputs rises, and will shift out to the right if the price of key inputs falls. If the AS curve shifts back to the left, the combination of lower output, higher unemployment, and higher inflation, called stagflation, occurs. If AS shifts out to the right, a combination of lower inflation, higher output, and lower unemployment is possible.
Self-Check Questions
Suppose the U.S. Congress passes significant immigration reform that makes it more difficult for foreigners to come to the United States to work. Use the AD/AS model to explain how this would affect the equilibrium level of GDP and the price level.
[reveal-answer q="633799"]Show Solution[/reveal-answer]
[hidden-answer a="633799"]Immigration reform as described should increase the labor supply, shifting SRAS to the right, leading to a higher equilibrium GDP and a lower price level.[/hidden-answer]
Suppose concerns about the size of the federal budget deficit lead the U.S. Congress to cut all funding for research and development for ten years. Assuming this has an impact on technology growth, what does the AD/AS model predict would be the likely effect on equilibrium GDP and the price level?
[reveal-answer q="675310"]Show Solution[/reveal-answer]
[hidden-answer a="675310"]Given the assumptions made here, the cuts in R&D funding should reduce productivity growth. The model would show this as a leftward shift in the SRAS curve, leading to a lower equilibrium GDP and a higher price level.[/hidden-answer]
Review Questions
Name some factors that could cause the SRAS curve to shift, and say whether they would shift SRAS to the right or to the left.
Will the shift of SRAS to the right tend to make the equilibrium quantity and price level higher or lower? What about a shift of SRAS to the left?
What is stagflation?
Critical Thinking Questions
Economists expect that as the labor market continues to tighten going into the latter part of 2015 that workers should begin to expect wage increases in 2015 and 2016. Assuming this occurs and it was the only development in the labor market that year, how would this affect the AS curve? What if it was also accompanied by an increase in worker productivity?
If new government regulations require firms to use a cleaner technology that is also less efficient than what they previously used, what would the effect be on output, the price level, and employment using the AD/AS diagram?
During spring 2016 the Midwestern United States, which has a large agricultural base, experiences above-average rainfall. Using the AD/AS diagram, what is the effect on output, the price level, and employment?
Hydraulic fracturing (fracking) has the potential to significantly increase the amount of natural gas produced in the United States. If a large percentage of factories and utility companies use natural gas, what will happen to output, the price level, and employment as fracking becomes more widely used?
Some politicians have suggested tying the minimum wage to the consumer price index (CPI). Using the AD/AS diagram, what effects would this policy most likely have on output, the price level, and employment?
Section 11.4
Key Concepts and Summary
The AD curve will shift out as the components of aggregate demand—C, I, G, and X–M—rise. It will shift back to the left as these components fall. These factors can change because of different personal choices, like those resulting from consumer or business confidence, or from policy choices like changes in government spending and taxes. If the AD curve shifts to the right, then the equilibrium quantity of output and the price level will rise. If the AD curve shifts to the left, then the equilibrium quantity of output and the price level will fall. Whether equilibrium output changes relatively more than the price level or whether the price level changes relatively more than output is determined by where the AD curve intersects with the AS curve.
The AD/AS diagram superficially resembles the microeconomic supply and demand diagram on the surface, but in reality, what is on the horizontal and vertical axes and the underlying economic reasons for the shapes of the curves are very different. We can illustrate long-term economic growth in the AD/AS framework by a gradual shift of the aggregate supply curve to the right. We illustrate a recession when the intersection of AD and AS is substantially below potential GDP, while we illustrate an expanding economy when the intersection of AS and AD is near potential GDP.
Self-Check Questions
How would a dramatic increase in the value of the stock market shift the AD curve? What effect would the shift have on the equilibrium level of GDP and the price level?
[reveal-answer q="176900"]Show Solution[/reveal-answer]
[hidden-answer a="176900"]An increase in the value of the stock market would make individuals feel wealthier and thus more confident about their economic situation. This would likely cause an increase in consumer confidence leading to an increase in consumer spending, shifting the AD curve to the right. The result would be an increase in the equilibrium level of GDP and an increase in the price level.[/hidden-answer]
Suppose Mexico, one of our largest trading partners and purchaser of a large quantity of our exports, goes into a recession. Use the AD/AS model to determine the likely impact on our equilibrium GDP and price level.
[reveal-answer q="255023"]Show Solution[/reveal-answer]
[hidden-answer a="255023"]Since imports depend on GDP, if Mexico goes into recession, its GDP declines and so do its imports. This decline in our exports can be shown as a leftward shift in AD, leading to a decrease in our GDP and price level.[/hidden-answer]
A policymaker claims that tax cuts led the economy out of a recession. Can we use the AD/AS diagram to show this?
[reveal-answer q="347330"]Show Solution[/reveal-answer]
[hidden-answer a="347330"]Tax cuts increase consumer and investment spending, depending on where the tax cuts are targeted. This would shift AD to the right, so if the tax cuts occurred when the economy was in recession (and GDP was less than potential), the tax cuts would increase GDP and "lead the economy out of recession."[/hidden-answer]
Many financial analysts and economists eagerly await the press releases for the reports on the home price index and consumer confidence index. What would be the effects of a negative report on both of these? What about a positive report?
[reveal-answer q="955895"]Show Solution[/reveal-answer]
[hidden-answer a="955895"]A negative report on home prices would make consumers feel like the value of their homes, which for most Americans is a major portion of their wealth, has declined. A negative report on consumer confidence would make consumers feel pessimistic about the future. Both of these would likely reduce consumer spending, shifting AD to the left, reducing GDP and the price level. A positive report on the home price index or consumer confidence would do the opposite.[/hidden-answer]
Review Questions
Name some factors that could cause AD to shift, and say whether they would shift AD to the right or to the left.
Would a shift of AD to the right tend to make the equilibrium quantity and price level higher or lower? What about a shift of AD to the left?
Critical Thinking Questions
If households decide to save a larger portion of their income, what effect would this have on the output, employment, and price level in the short run? What about the long run?
If firms become more optimistic about the future of the economy and, at the same time, innovation in 3-D printing makes most workers more productive, what is the combined effect on output, employment, and the price-level?
If Congress cuts taxes at the same time that businesses become more pessimistic about the economy, what is the combined effect on output, the price level, and employment using the AD/AS diagram?
Section 11.5
Key Concepts and Summary
Cyclical unemployment is relatively large in the AD/AS framework when the equilibrium is substantially below potential GDP. Cyclical unemployment is small in the AD/AS framework when the equilibrium is near potential GDP. The natural rate of unemployment, as determined by the labor market institutions of the economy, is built into what economists mean by potential GDP, but does not otherwise appear in an AD/AS diagram. The AD/AS framework shows pressures for inflation to rise or fall when the movement from one equilibrium to another causes the price level to rise or to fall. The balance of trade does not appear directly in the AD/AS diagram, but it appears indirectly in several ways. Increases in exports or declines in imports can cause shifts in AD. Changes in the price of key imported inputs to production, like oil, can cause shifts in AS. The AD/AS model is the key model we use in this book to understand macroeconomic issues.
Self-Check Questions
What impact would a decrease in the size of the labor force have on GDP and the price level according to the AD/AS model?
[reveal-answer q="71494"]Show Solution[/reveal-answer]
[hidden-answer a="71494"]A smaller labor force would be reflected in a leftward shift in AS, leading to a lower equilibrium level of GDP and higher price level.[/hidden-answer]
Suppose, after five years of sluggish growth, the European Union's economy picks up speed. What would be the likely impact on the U.S. trade balance, GDP, and employment?
[reveal-answer q="424593"]Show Solution[/reveal-answer]
[hidden-answer a="424593"]Higher EU growth would increase demand for U.S. exports, reducing our trade deficit. The increased demand for exports would show up as a rightward shift in AD, causing GDP to rise (and the price level to rise as well). Higher GDP would require more jobs to fulfill, so U.S. employment would also rise.[/hidden-answer]
Suppose the Federal Reserve begins to increase the supply of money at an increasing rate. What impact would that have on GDP, unemployment, and inflation?
[reveal-answer q="921823"]Show Solution[/reveal-answer]
[hidden-answer a="921823"]Expansionary monetary policy shifts AD to the right. A continuing expansionary policy would cause larger and larger shifts (given the parameters of this problem). The result would be an increase in GDP and employment (a decrease in unemployment) and higher prices until potential output was reached. After that point, the expansionary policy would simply cause inflation.[/hidden-answer]
Review Questions
How is long-term growth illustrated in an AD/AS model?
How is recession illustrated in an AD/AS model?
How is cyclical unemployment illustrated in an AD/AS model?
How is the natural rate of unemployment illustrated in an AD/AS model?
How is pressure for inflationary price increases shown in an AD/AS model?
What are some of the ways in which exports and imports can affect the AD/AS model?
Critical Thinking Questions
Suppose the level of structural unemployment increases. How would you illustrate the increase in structural unemployment in the AD/AS model? Hint: How does structural unemployment affect potential GDP?
If foreign wealth-holders decide that the United States is the safest place to invest their savings, what would the effect be on the economy here? Show graphically using the AD/AS model.
The AD/AS model is static. It shows a snapshot of the economy at a given point in time. Both economic growth and inflation are dynamic phenomena. Suppose economic growth is 3% per year and aggregate demand is growing at the same rate. What does the AD/AS model say the inflation rate should be?
Section 11.whatever (last section)
Key Concepts and Summary
We can divide the SRAS curve into three zones. Keynes’ law says demand creates its own supply, so that changes in aggregate demand cause changes in real GDP and employment. We can show Keynes’ law on the horizontal Keynesian zone of the aggregate supply curve. The Keynesian zone occurs at the left of the SRAS curve where it is fairly flat, so movements in AD will affect output, but have little effect on the price level. Say’s law says supply creates its own demand. Changes in aggregate demand have no effect on real GDP and employment, only on the price level. We can show Say’s law on the vertical neoclassical zone of the aggregate supply curve. The neoclassical zone occurs at the right of the SRAS curve where it is fairly vertical, and so movements in AD will affect the price level, but have little impact on output. The intermediate zone in the middle of the SRAS curve is upward-sloping, so a rise in AD will cause higher output and price level, while a fall in AD will lead to a lower output and price level.
Self-Check Questions
If the economy is operating in the neoclassical zone of the SRAS curve and aggregate demand falls, what is likely to happen to real GDP?
[reveal-answer q="465664"]Show Solution[/reveal-answer]
[hidden-answer a="465664"]Since the SRAS curve is vertical in the neoclassical zone, unless the economy is bordering the intermediate zone, a decrease in AS will cause a decrease in the price level, but no effect on real economic activity (for example, real GDP or employment).[/hidden-answer]
If the economy is operating in the Keynesian zone of the SRAS curve and aggregate demand falls, what is likely to happen to real GDP?
[reveal-answer q="788612"]Show Solution[/reveal-answer]
[hidden-answer a="788612"]Because the SRAS curve is horizontal in the Keynesian zone, a decrease in AD should depress real economic activity but have no effect on prices.[/hidden-answer]
Review Questions
What is the Keynesian zone of the SRAS curve? How much is the price level likely to change in the Keynesian zone?
What is the neoclassical zone of the SRAS curve? How much is the output level likely to change in the neoclassical zone?
What is the intermediate zone of the SRAS curve? Will a rise in output be accompanied by a rise or a fall in the price level in this zone?
Critical Thinking Questions
Explain why the short-run aggregate supply curve might be fairly flat in the Keynesian zone of the SRAS curve. How might we tell if we are in the Keynesian zone of the AS?
Explain why the short-run aggregate supply curve might be vertical in the neoclassical zone of the SRAS curve. How might we tell if we are in the neoclassical zone of the AS?
Why might it be important for policymakers to know which in zone of the SRAS curve the economy is?
In your view, is the economy currently operating in the Keynesian, intermediate or neoclassical portion of the economy’s aggregate supply curve?
Are Say’s law and Keynes’ law necessarily mutually exclusive?
The Keynesian perspective
Self-check questions
In the Keynesian framework, which of the following events might cause a recession? Which might cause inflation? Sketch AD/AS diagrams to illustrate your answers.
- A large increase in the price of the homes people own.
- Rapid growth in the economy of a major trading partner.
- The development of a major new technology offers profitable opportunities for business.
- The interest rate rises.
- The good imported from a major trading partner become much less expensive.
[reveal-answer q="354003"]Show Solution[/reveal-answer]
[hidden-answer a="354003"]a. An increase in home values will increase consumption spending (due to increased wealth). AD will shift to the right and may cause inflation if it goes beyond potential GDP.
b. Rapid growth by a major trading partner will increase demand for exports. AD will shift to the right and may cause inflation if it goes beyond potential GDP.
c. Increased profit opportunities will increase business investment. AD will shift to the right and may cause inflation if it goes beyond potential GDP.
d. Higher interest rates reduce investment spending. AD will shift to the left and may cause recession if it falls below potential GDP.
e. Demand for cheaper imports increases, reducing demand for domestic products. AD will shift to the left and may be recessionary.[/hidden-answer]
In a Keynesian framework, using an AD/AS diagram, which of the following government policy choices offer a possible solution to recession? Which offer a possible solution to inflation?
- A tax increase on consumer income.
- A surge in military spending.
- A reduction in taxes for businesses that increase investment.
- A major increase in what the U.S. government spends on healthcare.
[reveal-answer q="222000"]Show Solution[/reveal-answer]
[hidden-answer a="222000"]a. A tax increase on consumer income will cause consumption to fall, pushing the AD curve left, and is a possible solution to inflation.
b. A surge in military spending is an increase in government spending. This will cause the AD curve to shift to the right. If real GDP is less than potential GDP, then this spending would pull the economy out of a recession. If real GDP is to the right of potential GDP, then the AD curve will shift farther to the right and military spending will be inflationary.
c. A tax cut focused on business investment will shift AD to the right. If the original macroeconomic equilibrium is below potential GDP, then this policy can help move an economy out of a recession.
d. Government spending on healthcare will cause the AD curve to shift to the right. If real GDP is less than potential GDP, then this spending would pull the economy out of a recession. If real GDP is to the right of potential GDP, then the AD curve will shift farther to the right and healthcare spending will be inflationary.[/hidden-answer]
Review Questions
Name some economic events not related to government policy that could cause aggregate demand to shift.
Name some government policies that could cause aggregate demand to shift.
Critical Thinking Questions
In its recent report, The Conference Board’s Global Economic Outlook 2015, updated November 2014 (http://www.conference-board.org/data/globaloutlook.cfm), projects China’s growth between 2015 and 2019 to be about 5.5%. International Business Times (http://www.ibtimes.com/us-exports-china-have-grown-294-over-past-decade-1338693) reports that China is the United States’ third largest export market, with exports to China growing 294% over the last ten years. Explain what impact China has on the U.S. economy.
What may happen if growth in China continues or contracts?
Self-Check Questions
Use the AD/AS model to explain how an inflationary gap occurs, beginning from the initial equilibrium in [link].
[reveal-answer q="810769"]Show Solution[/reveal-answer]
[hidden-answer a="810769"]An inflationary gap is the result of an increase in aggregate demand when the economy is at potential output. Since the AS curve is vertical at potential GDP, any increase in AD will lead to a higher price level (i.e. inflation) but no higher real GDP. This is easy to see if you draw AD1 to the right of AD0.[/hidden-answer]
Suppose the U.S. Congress cuts federal government spending in order to balance the Federal budget. Use the AD/AS model to analyze the likely impact on output and employment. Hint: revisit [link].
[reveal-answer q="832781"]Show Solution[/reveal-answer]
[hidden-answer a="832781"]A decrease in government spending will shift AD to the left.[/hidden-answer]
Review Questions
From a Keynesian point of view, which is more likely to cause a recession: aggregate demand or aggregate supply, and why?
Why do sticky wages and prices increase the impact of an economic downturn on unemployment and recession?
Explain what economists mean by "menu costs."
Critical Thinking Questions
Does it make sense that wages would be sticky downwards but not upwards? Why or why not?
Suppose the economy is operating at potential GDP when it experiences an increase in export demand. How might the economy increase production of exports to meet this demand, given that the economy is already at full employment?
Math from Keynesian Cross Appendix (this stuff is to complex)
USING AN ALGEBRAIC APPROACH TO THE EXPENDITURE-OUTPUT MODEL
In the expenditure-output or Keynesian cross model, the equilibrium occurs where the aggregate expenditure line (AE line) crosses the 45-degree line. Given algebraic equations for two lines, the point where they cross can be readily calculated. Imagine an economy with the following characteristics.
Y = Real GDP or national income
T = Taxes = 0.3Y
C = Consumption = 140 + 0.9(Y – T)
I = Investment = 400
G = Government spending = 800
X = Exports = 600
M = Imports = 0.15Y
Step 1. Determine the aggregate expenditure function. In this case, it is:
AE = C + I + G + X – M
AE = 140 + 0.9(Y – T) + 400 + 800 + 600 – 0.15Y
Step 2. The equation for the 45-degree line is the set of points where GDP or national income on the horizontal axis is equal to aggregate expenditure on the vertical axis. Thus, the equation for the 45-degree line is: AE = Y.
Step 3. The next step is to solve these two equations for Y (or AE, since they will be equal to each other). Substitute Y for AE:
Y = 140 + 0.9(Y – T) + 400 + 800 + 600 – 0.15Y
Step 4. Insert the term 0.3Y for the tax rate T. This produces an equation with only one variable, Y.
Step 5. Work through the algebra and solve for Y.
Y = 140 + 0.9(Y – 0.3Y) + 400 + 800 + 600 – 0.15Y
Y = 140 + 0.9Y – 0.27Y + 1800 – 0.15
Y = 1940 + 0.48Y
Y – 0.48Y = 1940
0.52Y = 1940
$$\frac{0.52Y}{0.52}$$ = $$\frac{1940}{0.52}$$
Y = 3730
This algebraic framework is flexible and useful in predicting how economic events and policy actions will affect real GDP.
Step 6. Say, for example, that because of changes in the relative prices of domestic and foreign goods, the marginal propensity to import falls to 0.1. Calculate the equilibrium output when the marginal propensity to import is changed to 0.1.
Y = 140 + 0.9(Y – 0.3Y) + 400 + 800 + 600 – 0.1Y
Y = 1940 – 0.53Y
0.47Y = 1940
Y = 4127
Step 7. Because of a surge of business confidence, investment rises to 500. Calculate the equilibrium output.
Y = 140 + 0.9(Y – 0.3Y) + 500 + 800 + 600 – 0.15Y
Y = 2040 + 0.48Y
Y – 0.48Y = 2040
0.52Y = 2040
Y = 3923
For issues of policy, the key questions would be how to adjust government spending levels or tax rates so that the equilibrium level of output is the full employment level. In this case, let the economic parameters be:
Y = National income
T = Taxes = 0.3Y
C = Consumption = 200 + 0.9(Y – T)
I = Investment = 600
G = Government spending = 1,000
X = Exports = 600
Y = Imports = 0.1(Y – T)
Step 8. Calculate the equilibrium for this economy (remember Y = AE).
Y = 200 + 0.9(Y – 0.3Y) + 600 + 1000 + 600 – 0.1(Y – 0.3Y)
Y – 0.63Y + 0.07Y = 2400
0.44Y = 2400
Y = 5454
Step 9. Assume that the full employment level of output is 6,000. What level of government spending would be necessary to reach that level? To answer this question, plug in 6,000 as equal to Y, but leave G as a variable, and solve for G. Thus:
6000 = 200 + 0.9(6000 – 0.3(6000)) + 600 + G + 600 – 0.1(6000 – 0.3(6000))
Step 10. Solve this problem arithmetically. The answer is: G = 1,240. In other words, increasing government spending by 240, from its original level of 1,000, to 1,240, would raise output to the full employment level of GDP.
Indeed, the question of how much to increase government spending so that equilibrium output will rise from 5,454 to 6,000 can be answered without working through the algebra, just by using the multiplier formula. The multiplier equation in this case is:
$$\frac{1}{1-0.56}$$ = 2.27
Thus, to raise output by 546 would require an increase in government spending of 546/2.27=240, which is the same as the answer derived from the algebraic calculation.
This algebraic framework is highly flexible. For example, taxes can be treated as a total set by political considerations (like government spending) and not dependent on national income. Imports might be based on before-tax income, not after-tax income. For certain purposes, it may be helpful to analyze the economy without exports and imports. A more complicated approach could divide up consumption, investment, government, exports and imports into smaller categories, or to build in some variability in the rates of taxes, savings, and imports. A wise economist will shape the model to fit the specific question under investigation.
A second example is provided below to help you to fully understand the different parts of the model.
FINDING EQUILIBRIUM
Table gives some information on a hypothetical economy. The Keynesian model assumes that there is some level of consumption even without income. That amount is $236 – $216 = $20. That is, $20 will be consumed when national income equals zero. Assume that taxes are 0.2 of real GDP. Let the marginal propensity to save of after-tax income be 0.1. The level of investment is $70, the level of government spending is $80, and the level of exports is $50. Imports are 0.2 of after-tax income. Given these values, you need to complete Table and then answer these questions:
- What is the consumption function?
- What is the equilibrium?
- Why is a national income of $300 not at equilibrium?
- How do expenditures and output compare at this point?
| National Income | Taxes | After-tax income | Consumption | I + G + X | Imports | Aggregate Expenditures |
|---|---|---|---|---|---|---|
| $300 | $236 | |||||
| $400 | ||||||
| $500 | ||||||
| $600 | ||||||
| $700 |
Step 1. Calculate the amount of taxes for each level of national income(reminder: GDP = national income) for each level of national income using the following as an example:
National Income (Y) $300
Taxes = 0.2 or 20% × 0.2
Tax amount (T) $60
Step 2. Calculate after-tax income by subtracting the tax amount from national income for each level of national income using the following as an example:
National income minus taxes $300
–$60
After-tax income $240
Step 3. Calculate consumption. The marginal propensity to save is given as 0.1. This means that the marginal propensity to consume is 0.9, since MPS + MPC = 1. Therefore, multiply 0.9 by the after-tax income amount using the following as an example:
After-tax Income $240
MPC × 0.9
Consumption $216
Step 4. Consider why the table shows consumption of $236 in the first row. As mentioned earlier, the Keynesian model assumes that there is some level of consumption even without income. That amount is $236 – $216 = $20.
Step 5. There is now enough information to write the consumption function. The consumption function is found by figuring out the level of consumption that will happen when income is zero. Remember that:
C = Consumption when national income is zero + MPC (after-tax income)
Let C represent the consumption function, Y represent national income, and T represent taxes.
C = $20 + 0.9(Y – T)
= $20 + 0.9($300 – $60)
= $236
Step 6. Use the consumption function to find consumption at each level of national income.
Step 7. Add investment (I), government spending (G), and exports (X). Remember that these do not change as national income changes:
Step 8. Find imports, which are 0.2 of after-tax income at each level of national income. For example:
After-tax income $240
Imports of 0.2 or 20% of Y – T × 0.2
Imports $48
Step 9. Find aggregate expenditure by adding C + I + G + X – I for each level of national income. Your completed table should look like Table.
| National Income (Y) | Tax = 0.2 × Y (T) | After-tax income (Y – T) | Consumption C = $20 + 0.9(Y – T) | I + G + X | Minus Imports (M) | Aggregate Expenditures AE = C + I + G + X – M |
|---|---|---|---|---|---|---|
| $300 | $60 | $240 | $236 | $200 | $48 | $388 |
| $400 | $80 | $320 | $308 | $200 | $64 | $444 |
| $500 | $100 | $400 | $380 | $200 | $80 | $500 |
| $600 | $120 | $480 | $452 | $200 | $96 | $556 |
| $700 | $140 | $560 | $524 | $200 | $112 | $612 |
Step 10. Answer the question: What is equilibrium? Equilibrium occurs where AE = Y. Table shows that equilibrium occurs where national income equals aggregate expenditure at $500.
Step 11. Find equilibrium mathematically, knowing that national income is equal to aggregate expenditure.
Y = AE
= C + I + G + X – M
= $20 + 0.9(Y – T) + $70 + $80 + $50 – 0.2(Y – T)
= $220 + 0.9(Y – T) – 0.2(Y – T)
Since T is 0.2 of national income, substitute T with 0.2 Y so that:
Y = $220 + 0.9(Y – 0.2Y) – 0.2(Y – 0.2Y)
= $220 + 0.9Y – 0.18Y – 0.2Y + 0.04Y
= $220 + 0.56Y
Solve for Y.
Y = $220 + 0.56Y
Y – 0.56Y = $220
0.44Y = $220
[latex]\frac{0.44Y}{0.44}=\frac{$220}{0.44}[/latex]
Y = $500
Step 12. Answer this question: Why is a national income of $300 not an equilibrium? At national income of $300, aggregate expenditures are $388.
Step 13. Answer this question: How do expenditures and output compare at this point? Aggregate expenditures cannot exceed output (GDP) in the long run, since there would not be enough goods to be bought.
Phillips Curve Section
Key Concepts and Summary
A Phillips curve shows the tradeoff between unemployment and inflation in an economy. From a Keynesian viewpoint, the Phillips curve should slope down so that higher unemployment means lower inflation, and vice versa. However, a downward-sloping Phillips curve is a short-term relationship that may shift after a few years.
Keynesian macroeconomics argues that the solution to a recession is expansionary fiscal policy, such as tax cuts to stimulate consumption and investment, or direct increases in government spending that would shift the aggregate demand curve to the right. The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inflationary rises in the price level are a concern. The Keynesian response would be contractionary fiscal policy, using tax increases or government spending cuts to shift AD to the left.
Self-Check Question
How would a decrease in energy prices affect the Phillips curve?
[reveal-answer q="588727"]Show Solution[/reveal-answer]
[hidden-answer a="588727"]A decrease in energy prices, a positive supply shock, would cause the AS curve to shift out to the right, yielding more real GDP at a lower price level. This would shift the Phillips curve down toward the origin, meaning the economy would experience lower unemployment and a lower rate of inflation.[/hidden-answer]
Review Questions
What tradeoff does a Phillips curve show?
Would you expect to see long-run data trace out a stable downward-sloping Phillips curve?
What is the Keynesian prescription for recession? For inflation?
Critical Thinking Questions
Do you think the Phillips curve is a useful tool for analyzing the economy today? Why or why not?
Keynes on Market Forces Section
Self-Check Questions
Does Keynesian economics require government to set controls on prices, wages, or interest rates?
[reveal-answer q="339421"]Show Solution[/reveal-answer]
[hidden-answer a="339421"]Keynesian economics does not require microeconomic price controls of any sort. It is true that many Keynesian economic prescriptions were for the government to influence the total amount of aggregate demand in the economy, often through government spending and tax cuts.[/hidden-answer]
List three practical problems with the Keynesian perspective.
[reveal-answer q="103639"]Show Solution[/reveal-answer]
[hidden-answer a="103639"]The three problems center on government’s ability to estimate potential GDP, decide whether to influence aggregate demand through tax changes or changes in government spending, and the lag time that occurs as Congress and the President attempt to pass legislation.[/hidden-answer]
Review Questions
How did the Keynesian perspective address the economic market failure of the Great Depression?
Critical Thinking Questions
Return to the table from the Economic Report of the President in the earlier Work It Out feature titled "The Phillips Curve for the United States." How would you expect government spending to have changed over the last six years?
Explain what types of policies the federal government may have implemented to restore aggregate demand and the potential obstacles policymakers may have encountered.
Government Spending
Self-Check Questions
When governments run budget deficits, how do they make up the differences between tax revenue and spending?
The government borrows funds by selling Treasury bonds, notes, and bills.
When governments run budget surpluses, what is done with the extra funds?
The funds can be used to pay down the national debt or else be refunded to the taxpayers.
Is it possible for a nation to run budget deficits and still have its debt/GDP ratio fall? Explain your answer. Is it possible for a nation to run budget surpluses and still have its debt/GDP ratio rise? Explain your answer.
Yes, a nation can run budget deficits and see its debt/GDP ratio fall. In fact, this is not uncommon. If the deficit is small in a given year, than the addition to debt in the numerator of the debt/GDP ratio will be relatively small, while the growth in GDP is larger, and so the debt/GDP ratio declines. This was the experience of the U.S. economy for the period from the end of World War II to about 1980. It is also theoretically possible, although not likely, for a nation to have a budget surplus and see its debt/GDP ratio rise. Imagine the case of a nation with a small surplus, but in a recession year when the economy shrinks. It is possible that the decline in the nation’s debt, in the numerator of the debt/GDP ratio, would be proportionally less than the fall in the size of GDP, so the debt/GDP ratio would rise.
Review Questions
Give some examples of changes in federal spending and taxes by the government that would be fiscal policy and some that would not.
Have the spending and taxes of the U.S. federal government generally had an upward or a downward trend in the last few decades?
What are the main categories of U.S. federal government spending?
What is the difference between a budget deficit, a balanced budget, and a budget surplus?
Have spending and taxes by state and local governments in the United States had a generally upward or downward trend in the last few decades?
Critical Thinking Questions
Why is government spending typically measured as a percentage of GDP rather than in nominal dollars?
Why are expenditures such as crime prevention and education typically done at the state and local level rather than at the federal level?
Why is spending by the U.S. government on scientific research at NASA fiscal policy while spending by the University of Illinois is not fiscal policy? Why is a cut in the payroll tax fiscal policy whereas a cut in a state income tax is not fiscal policy?
Problems
A government starts off with a total debt of $3.5 billion. In year one, the government runs a deficit of $400 million. In year two, the government runs a deficit of $1 billion. In year three, the government runs a surplus of $200 million. What is the total debt of the government at the end of year three?
Taxation
Self-Check Questions
Suppose that gifts were taxed at a rate of 10% for amounts up to $100,000 and 20% for anything over that amount. Would this tax be regressive or progressive?
Progressive. People who give larger gifts subject to the higher tax rate would typically have larger incomes as well.
If an individual owns a corporation for which he is the only employee, which different types of federal tax will he have to pay?
Corporate income tax on his profits, individual income tax on his salary, and payroll tax taken out of the wages he pays himself.
What taxes would an individual pay if he were self-employed and the business is not incorporated?
individual income taxes
The social security tax is 6.2% on employees’ income earned below $113,000. Is this tax progressive, regressive or proportional?
The tax is regressive because wealthy income earners are not taxed at all on income above $113,000. As a percent of total income, the social security tax hits lower income earners harder than wealthier individuals.
Review Questions
What are the main categories of U.S. federal government taxes?
What is the difference between a progressive tax, a proportional tax, and a regressive tax?
Critical Thinking Questions
Excise taxes on tobacco and alcohol and state sales taxes are often criticized for being regressive. Although everyone pays the same rate regardless of income, why might this be so?
What is the benefit of having state and local taxes on income instead of collecting all such taxes at the federal level?
Federal Deficits and the National Debt
Self-Check Questions
Debt has a certain self-reinforcing quality to it. There is one category of government spending that automatically increases along with the federal debt. What is it?
As debt increases, interest payments also rise, so that the deficit grows even if we keep other government spending constant.
True or False:
- Federal spending has grown substantially in recent decades.
- By world standards, the U.S. government controls a relatively large share of the U.S. economy.
- A majority of the federal government’s revenue is collected through personal income taxes.
- Education spending is slightly larger at the federal level than at the state and local level.
- State and local government spending has not risen much in recent decades.
- Defense spending is higher now than ever.
- The share of the economy going to federal taxes has increased substantially over time.
- Foreign aid is a large portion, although less than half, of federal spending.
- Federal deficits have been very large for the last two decades.
- The accumulated federal debt as a share of GDP is near an all-time high.
- As a share of GDP, this is false. In nominal dollars, it is true.
- False.
- False.
- False. Education spending is much higher at the state level.
- False. As a share of GDP, it is up about 50.
- As a share of GDP, this is false, and in real dollars, it is also false.
- False.
- False; it’s about 1%.
- False. Although budget deficits were large in 2003 and 2004, and continued into the later 2000s, the federal government ran budget surpluses from 1998–2001.
- False.
Review Questions
What has been the general pattern of U.S. budget deficits in recent decades?
What is the difference between a budget deficit and the national debt?
Critical Thinking Questions
In a booming economy, is the federal government more likely to run surpluses or deficits? What are the various factors at play?
Economist Arthur Laffer famously pointed out that, in some cases, income tax revenue can actually go up when tax rates go down. Why might this be the case?
Is it possible for a nation to run budget deficits and still have its debt/GDP ratio fall? Explain your answer. Is it possible for a nation to run budget surpluses and still have its debt/GDP ratio rise? Explain your answer.
Problems
If a government runs a budget deficit of $10 billion dollars each year for ten years, then a surplus of $1 billion for five years, and then a balanced budget for another ten years, what is the government debt?
Using Fiscal Policy to Fight Recession, Unemployment, and Inflation
Self-Check Questions
What is the main reason for employing contractionary fiscal policy in a time of strong economic growth?
To keep prices from rising too much or too rapidly.
What is the main reason for employing expansionary fiscal policy during a recession?
To increase employment.
Review Questions
What is the difference between expansionary fiscal policy and contractionary fiscal policy?
Under what general macroeconomic circumstances might a government use expansionary fiscal policy? When might it use contractionary fiscal policy?
Critical Thinking Questions
How will cuts in state budget spending affect federal expansionary policy?
Is expansionary fiscal policy more attractive to politicians who believe in larger government or to politicians who believe in smaller government? Explain your answer.
Problems
Specify whether expansionary or contractionary fiscal policy would seem to be most appropriate in response to each of the situations below and sketch a diagram using aggregate demand and aggregate supply curves to illustrate your answer:
- A recession.
- A stock market collapse that hurts consumer and business confidence.
- Extremely rapid growth of exports.
- Rising inflation.
- A rise in the natural rate of unemployment.
- A rise in oil prices.
Automatic Stabilizers
Self-Check Questions
In a recession, does the actual budget surplus or deficit fall above or below the standardized employment budget?
It falls below because less tax revenue than expected is collected.
What is the main advantage of automatic stabilizers over discretionary fiscal policy?
Automatic stabilizers take effect very quickly, whereas discretionary policy can take a long time to implement.
Explain how automatic stabilizers work, both on the taxation side and on the spending side, first in a situation where the economy is producing less than potential GDP and then in a situation where the economy is producing more than potential GDP.
In a recession, because of the decline in economic output, less income is earned, and so less in taxes is automatically collected. Many welfare and unemployment programs are designed so that those who fall into certain categories, like "unemployed" or "low income," are eligible for benefits. During a recession, more people fall into these categories and become eligible for benefits automatically. The combination of reduced taxes and higher spending is just what is needed for an economy in recession producing below potential GDP. With an economic boom, average income levels rise in the economy, so more in taxes is automatically collected. Fewer people meet the criteria for receiving government assistance to the unemployed or the needy, so government spending on unemployment assistance and welfare falls automatically. This combination of higher taxes and lower spending is just what is needed if an economy is producing above its potential GDP.
Review Questions
What is the difference between discretionary fiscal policy and automatic stabilizers?
Why do automatic stabilizers function "automatically?"
What is the standardized employment budget?
Critical Thinking Questions
Is Medicaid (federal government aid to low-income families and individuals) an automatic stabilizer?
Money and Banking Chapter
Self-Check Questions
In many casinos, a person buys chips to use for gambling. Within the casino's walls, customers often can use these chips to buy food and drink or even a hotel room. Do chips in a gambling casino serve all three functions of money?
[reveal-answer q="29937"]Show Solution[/reveal-answer]
[hidden-answer a="29937"]As long as you remain within the walls of the casino, chips fit the definition of money; that is, they serve as a medium of exchange, a unit of account, and a store of value. Chips do not work very well as money once you leave the casino, but many kinds of money do not work well in other areas. For example, it is hard to spend money from Turkey or Brazil at your local supermarket or at the movie theater.[/hidden-answer]
Can you name some item that is a store of value, but does not serve the other functions of money?
[reveal-answer q="948561"]Show Solution[/reveal-answer]
[hidden-answer a="948561"]Many physical items that a person buys at one time but may sell at another time can serve as an answer to this question. Examples include a house, land, art, rare coins or stamps, and so on.[/hidden-answer]
Review Questions
What are the four functions that money serves?
How does the existence of money simplify the process of buying and selling?
What is the double-coincidence of wants?
Critical Thinking Questions
The Bring it Home Feature discusses the use of cowrie shells as money. Although we no longer use cowrie shells as money, do you think other forms of commodity monies are possible? What role might technology play in our definition of money?
Imagine that you are a barber in a world without money. Explain why it would be tricky to obtain groceries, clothing, and a place to live.
Self-Check Questions
Imagine that you are in the position of buying loans in the secondary market (that is, buying the right to collect the payments on loans) for a bank or other financial services company. Explain why you would be willing to pay more or less for a given loan if:
- The borrower has been late on a number of loan payments
- Interest rates in the economy as a whole have risen since the bank made the loan
- The borrower is a firm that has just declared a high level of profits
- Interest rates in the economy as a whole have fallen since the bank made the loan
[reveal-answer q="69125"]Show Solution[/reveal-answer]
[hidden-answer a="69125"]a. A borrower who has been late on a number of loan payments looks perhaps less likely to repay the loan, or to repay it on time, and so you would want to pay less for that loan.
b. If interest rates generally have risen, then this loan made at a time of relatively lower interest rates looks less attractive, and you would pay less for it.
c. If the borrower is a firm with a record of high profits, then it is likely to be able to repay the loan, and you would be willing to pay more for the loan.
d. If interest rates in the economy have fallen, then the loan is worth more.[/hidden-answer]
Review Questions
How do banks create money?
What is the formula for the money multiplier?
Critical Thinking Questions
Should banks have to hold 100% of their deposits? Why or why not?
Explain what will happen to the money multiplier process if there is an increase in the reserve requirement?
What do you think the Federal Reserve Bank did to the reserve requirement during the 2008–2009 Great Recession?
Problems
Humongous Bank is the only bank in the economy. The people in this economy have $20 million in money, and they deposit all their money in Humongous Bank.
- Humongous Bank decides on a policy of holding 100% reserves. Draw a T-account for the bank.
- Humongous Bank is required to hold 5% of its existing $20 million as reserves, and to loan out the rest. Draw a T-account for the bank after it has made its first round of loans.
- Assume that Humongous bank is part of a multibank system. How much will money supply increase with that original $19 million loan?
Self-Check Questions
If you are out shopping for clothes and books, what is easiest and most convenient for you to spend: M1 or M2? Explain your answer.
[reveal-answer q="335952"]Show Solution[/reveal-answer]
[hidden-answer a="335952"]The currency and checks in M1 are easiest to spend. It is harder to spend M2 directly, although if there is an automatic teller machine in the shopping mall, you can turn M2 from your savings account into an M1 of currency quite quickly. If your answer is about "credit cards," then you are really talking about spending M1—although it is M1 from the account of the credit card company, which you will repay later when you credit card bill comes due.[/hidden-answer]
For the following list of items, indicate if they are in M1, M2, or neither:
- Your $5,000 line of credit on your Bank of America card
- $50 dollars’ worth of traveler’s checks you have not used yet
- $1 in quarters in your pocket
- $1200 in your checking account
- $2000 you have in a money market account
[reveal-answer q="708939"]Show Solution[/reveal-answer]
[hidden-answer a="708939"]a. Neither in M1 or M2
b. That is part of M1, and because M2 includes M1 it is also part of M2
c. Currency out in the public hands is part of M1 and M2
d. Checking deposits are in M1 and M2
e. Money market accounts are in M2[/hidden-answer]
Review Questions
What components of money do we count as part of M1?
What components of money do we count in M2?
Critical Thinking Questions
Explain why you think the Federal Reserve Bank tracks M1 and M2.
The total amount of U.S. currency in circulation divided by the U.S. population comes out to about $3,500 per person. That is more than most of us carry. Where is all the cash?
If you take $100 out of your piggy bank and deposit it in your checking account, how did M1 change? Did M2 change?
Self-Check Questions
Explain why the money listed under assets on a bank balance sheet may not actually be in the bank?
[reveal-answer q="283461"]Show Solution[/reveal-answer]
[hidden-answer a="283461"]A bank’s assets include cash held in their vaults, but assets also include monies that the bank holds at the Federal Reserve Bank (called "reserves"), loans that are made to customers, and bonds.[/hidden-answer]
Review Questions
Why do we call a bank a financial intermediary?
What does a balance sheet show?
What are a bank's assets? What are its liabilities?
How do you calculate a bank's net worth?
How can a bank end up with negative net worth?
What is the asset-liability time mismatch that all banks face?
What is the risk if a bank does not diversify its loans?
Critical Thinking Questions
Explain the difference between how you would characterize bank deposits and loans as assets and liabilities on your own personal balance sheet and how a bank would characterize deposits and loans as assets and liabilities on its balance sheet.
Problems
A bank has deposits of $400. It holds reserves of $50. It has purchased government bonds worth $70. It has made loans of $500. Set up a T-account balance sheet for the bank, with assets and liabilities, and calculate the bank’s net worth.
Monetary Policy Chapter
Self-Check Question
Why is it important for the members of the Board of Governors of the Federal Reserve to have longer terms in office than elected officials, like the President?
[reveal-answer q="999405"]Show Solution[/reveal-answer]
[hidden-answer a="999405"]Longer terms insulate the Board from political forces. Since the presidency can potentially change every four years, the Federal Reserve’s independence prevents drastic swings in monetary policy with every new administration and allows policy decisions to be made only on economic grounds.[/hidden-answer]
Review Questions
How is a central bank different from a typical commercial bank?
List the three traditional tools that a central bank has for controlling the money supply.
Critical Thinking Questions
Why do presidents typically reappoint Chairs of the Federal Reserve Board even when they were originally appointed by a president of a different political party?
In what ways might monetary policy be superior to fiscal policy? In what ways might it be inferior?
Self-Check Questions
Given the danger of bank runs, why do banks not keep the majority of deposits on hand to meet the demands of depositors?
Banks make their money from issuing loans and charging interest. The more money that is stored in the bank’s vault, the less is available for lending and the less money the bank stands to make.
Bank runs are often described as "self-fulfilling prophecies." Why is this phrase appropriate to bank runs?
The fear and uncertainty created by the suggestion that a bank might fail can lead depositors to withdraw their money. If many depositors do this at the same time, the bank may not be able to meet their demands and will, indeed, fail.
Review Questions
How is bank regulation linked to the conduct of monetary policy?
What is a bank run?
In a program of deposit insurance as it is operated in the United States, what is being insured and who pays the insurance premiums?
In government programs of bank supervision, what is being supervised?
What is the lender of last resort?
Name and briefly describe the responsibilities of each of the following agencies: FDIC, NCUA, and OCC.
Critical Thinking Question
The term "moral hazard" describes increases in risky behavior resulting from efforts to make that behavior safer. How does the concept of moral hazard apply to deposit insurance and other bank regulations?
Self-Check Questions
If the central bank sells $500 in bonds to a bank that has issued $10,000 in loans and is exactly meeting the reserve requirement of 10%, what will happen to the amount of loans and to the money supply in general?
The bank has to hold $1,000 in reserves, so when it buys the $500 in bonds, it will have to reduce its loans by $500 to make up the difference. The money supply decreases by the same amount.
What would be the effect of increasing the banks' reserve requirements on the money supply?
An increase in reserve requirements would reduce the supply of money, since more money would be held in banks rather than circulating in the economy.
Review Questions
Explain how to use an open market operation to expand the money supply.
Explain how to use the reserve requirement to expand the money supply.
Explain how to use the discount rate to expand the money supply.
Critical Thinking Question
Explain what would happen if banks were notified they had to increase their required reserves by one percentage point from, say, 9% to10% of deposits. What would their options be to come up with the cash?
Problems
Suppose the Fed conducts an open market purchase by buying $10 million in Treasury bonds from Acme Bank. Sketch out the balance sheet changes that will occur as Acme converts the bond sale proceeds to new loans. The initial Acme bank balance sheet contains the following information: Assets – reserves 30, bonds 50, and loans 50; Liabilities – deposits 300 and equity 30.
Suppose the Fed conducts an open market sale by selling $10 million in Treasury bonds to Acme Bank. Sketch out the balance sheet changes that will occur as Acme restores its required reserves (10% of deposits) by reducing its loans. The initial balance sheet for Acme Bank contains the following information: Assets – reserves 30, bonds 50, and loans 250; Liabilities – deposits 300 and equity 30.
Self-Check Questions
Why does contractionary monetary policy cause interest rates to rise?
Contractionary policy reduces the amount of loanable funds in the economy. As with all goods, greater scarcity leads a greater price, so the interest rate, or the price of borrowing money, rises.
Why does expansionary monetary policy causes interest rates to drop?
An increase in the amount of available loanable funds means that there are more people who want to lend. They, therefore, bid the price of borrowing (the interest rate) down.
Review Questions
How do the expansionary and contractionary monetary policy affect the quantity of money?
How do tight and loose monetary policy affect interest rates?
How do expansionary, tight, contractionary, and loose monetary policy affect aggregate demand?
Which kind of monetary policy would you expect in response to high inflation: expansionary or contractionary? Why?
Explain how to use quantitative easing to stimulate aggregate demand.
Critical Thinking Question
A well-known economic model called the Phillips Curve (discussed in The Keynesian Perspective chapter) describes the short run tradeoff typically observed between inflation and unemployment. Based on the discussion of expansionary and contractionary monetary policy, explain why one of these variables usually falls when the other rises.
Self-Check Questions
Why might banks want to hold excess reserves in time of recession?
In times of economic uncertainty, banks may worry that borrowers will lose the ability to repay their loans. They may also fear that a panic is more likely and they will need the excess reserves to meet their obligations.
Why might the velocity of money change unexpectedly?
If consumer optimism changes, spending can speed up or slow down. This could also happen in a case where consumers need to buy a large number of items quickly, such as in a situation of national emergency.
Review Questions
Which kind of monetary policy would you expect in response to recession: expansionary or contractionary? Why?
How might each of the following factors complicate the implementation of monetary policy: long and variable lags, excess reserves, and movements in velocity?
Define the velocity of the money supply.
What is the basic quantity equation of money?
How does a monetary policy of inflation target work?
Critical Thinking Questions
How does rule-based monetary policy differ from discretionary monetary policy (that is, monetary policy not based on a rule)? What are some of the arguments for each?
Is it preferable for central banks to primarily target inflation or unemployment? Why?
Problems
All other things being equal, by how much will nominal GDP expand if the central bank increases the money supply by $100 billion, and the velocity of money is 3? (Use this information as necessary to answer the following 4 questions.)
Suppose now that economists expect the velocity of money to increase by 50% as a result of the monetary stimulus. What will be the total increase in nominal GDP?
If GDP is 1,500 and the money supply is 400, what is velocity?
If GDP now rises to 1,600, but the money supply does not change, how has velocity changed?
If GDP now falls back to 1,500 and the money supply falls to 350, what is velocity?
Metalist Chapter
Self-Check Questions
What would happen if expansionary fiscal policy was implemented in a recession but, due to lag, did not actually take effect until after the economy was back to potential GDP?
Prices would be pushed up as a result of too much spending.
What would happen if contractionary fiscal policy were implemented during an economic boom but, due to lag, it did not take effect until the economy slipped into recession?
Employment would suffer as a result of too little spending.
Do you think the typical time lag for fiscal policy is likely to be longer or shorter than the time lag for monetary policy? Explain your answer?
Monetary policy probably has shorter time lags than fiscal policy. Imagine that the data becomes fairly clear that an economy is in or near a recession. Expansionary monetary policy can be carried out through open market operations, which can be done fairly quickly, since the Federal Reserve’s Open Market Committee meets six times a year. Also, monetary policy takes effect through interest rates, which can change fairly quickly. However, fiscal policy is carried out through acts of Congress that need to be signed into law by the president. Negotiating such laws often takes months, and even after the laws are negotiated, it takes more months for spending programs or tax cuts to have an effect on the macroeconomy.
Review Questions
What are some practical weaknesses of discretionary fiscal policy?
Critical Thinking Questions
What is a potential problem with a temporary tax increase designed to increase aggregate demand if people know that it is temporary?
If the government gives a $300 tax cut to everyone in the country, explain the mechanism by which this will cause interest rates to rise.
References
Leduc, Sylvain, and Daniel Wilson. Federal Reserve Bank of San Francisco: Working Paper Series. "Are State Governments Roadblocks to Federal Stimulus? Evidence from Highway Grants in the 2009 Recovery Act. (Working Paper 2013-16)." Last modified July 2013. http://www.frbsf.org/economic-research/files/wp2013-16.pdf.
Lucking, Brian, and Daniel Wilson. "FRBSF Economic Letter-Fiscal Headwinds: Is the Other Shoe About to Drop?" Federal Reserve Bank of San Francisco. Last modified June 3, 2013. http://www.frbsf.org/economic-research/publications/economic-letter/2013/june/fiscal-headwinds-federal-budget-policy/.
Recovery.gov. "Track the Money." http://www.recovery.gov/Pages/default.aspx.
Bastagli, Francesca, David Coady, and Sanjeev Gupta. International Monetary Fund. "IMF Staff Discussion Note: Income Inequality and Fiscal Policy." Last modified June 28, 2012. http://www.imf.org/external/pubs/ft/sdn/2012/sdn1208.pdf.
Self-Check Questions
In a country, private savings equals 600, the government budget surplus equals 200, and the trade surplus equals 100. What is the level of private investment in this economy?
We use the national savings and investment identity to solve this question. In this case, the government has a budget surplus, so the government surplus appears as part of the supply of financial capital. Then:
Assume an economy has a budget surplus of 1,000, private savings of 4,000, and investment of 5,000.
- Write out a national saving and investment identity for this economy.
- What will be the balance of trade in this economy?
- If the budget surplus changes to a budget deficit of 1000, with private saving and investment unchanged, what is the new balance of trade in this economy?
- Since the government has a budget surplus, the government budget term appears with the supply of capital. The following shows the national savings and investment identity for this economy.
[latex]\begin{array}{rcl}\text{Quantity supplied of financial capital}& \text{ = }& \text{Quantity demanded of financial capital}\\ \text{S + (T - G)}& \text{ = }& \text{I + (X - M)}\end{array}[/latex]
- Plugging the given values into the identity shown in part (a), we find that (X – M) = 0.
- Since the government has a budget deficit, the government budget term appears with the demand for capital. You do not know in advance whether the economy has a trade deficit or a trade surplus. But when you see that the quantity demanded of financial capital exceeds the quantity supplied, you know that there must be an additional quantity of financial capital supplied by foreign investors, which means a trade deficit of 2000. This example shows that in this case there is a higher budget deficit, and a higher trade deficit.
[latex]\begin{array}{rcl}\text{Quantity supplied of financial capital}& \text{ = }& \text{Quantity demanded of financial capital}\\ \text{S + (M - X)}& \text{ = }& \text{I + (G - T)}\\ \text{4000 + 2000}& \text{ = }& \text{5000 + 1000}\end{array}[/latex]
Review Questions
Based on the national saving and investment identity, what are the three ways the macroeconomy might react to greater government budget deficits?
How would you expect larger budget deficits to affect private sector investment in physical capital? Why?
Critical Thinking Questions
Assume there is no discretionary increase in government spending. Explain how an improving economy will affect the budget balance and, in turn, investment and the trade balance.
Explain how decreased domestic investments that occur due to a budget deficit will affect future economic growth.
The U.S. government has shut down a number of times in recent history. Explain how a government shutdown will affect the variables in the national investment and savings identity. Could the shutdown affect the government budget deficit?
Self-Check Questions
Why have many education experts recently placed an emphasis on altering the incentives that U.S. schools face rather than on increasing their budgets? Without endorsing any of these proposals as especially good or bad, list some of the ways in which incentives for schools might be altered.
In the last few decades, spending per student has climbed substantially. However, test scores have fallen over this time. This experience has led a number of experts to argue that the problem is not resources—or is not just resources by itself—but is also a problem of how schools are organized and managed and what incentives they have for success. There are a number of proposals to alter the incentives that schools face, but relatively little hard evidence on what proposals work well. Without trying to evaluate whether these proposals are good or bad ideas, you can just list some of them: testing students regularly; rewarding teachers or schools that perform well on such tests; requiring additional teacher training; allowing students to choose between public schools; allowing teachers and parents to start new schools; giving student "vouchers" that they can use to pay tuition at either public or private schools.
What are some steps the government can take to encourage research and development?
The government can direct government spending to R&D. It can also create tax incentives for business to invest in R&D.
Review Questions
What are some of the ways fiscal policy might encourage economic growth?
What are some fiscal policies for improving a society’s human capital?
What are some fiscal policies for improving the technologies that the economy will have to draw upon in the future?
Explain how cuts in funding for programs such as Head Start might affect the development of human capital in the United States.
Critical Thinking Questions
Explain why the government might prefer to provide incentives to private firms to do investment or research and development, rather than simply doing the spending itself?
Under what condition would crowding out not inhibit long-run economic growth? Under what condition would crowding out impede long-run economic growth?
What must take place for the government to run deficits without any crowding out?
Problems
During the most recent recession, some economists argued that the change in the interest rates that comes about due to deficit spending implied in the demand and supply of financial capital graph would not occur. A simple reason was that the government was stepping in to invest when private firms were not. Using a graph, explain how the use by government in investment offsets the deficit demand.
Self-Check Questions
Imagine an economy in which Ricardian equivalence holds. This economy has a budget deficit of 50, a trade deficit of 20, private savings of 130, and investment of 100. If the budget deficit rises to 70, how are the other terms in the national saving and investment identity affected?
Ricardian equivalence means that private saving changes to offset exactly any changes in the government budget. So, if the deficit increases by 20, private saving increases by 20 as well, and the trade deficit and the budget deficit will not change from their original levels. The original national saving and investment identity is written below. Notice that if any change in the (G – T) term is offset by a change in the S term, then the other terms do not change. So if (G – T) rises by 20, then S must also increase by 20.
Review Questions
What is the theory of Ricardian equivalence?
What does the concept of rationality have to do with Ricardian equivalence?
Critical Thinking Questions
Explain whether or not you agree with the premise of the Ricardian equivalence theory that rational people might reason: "Well, a higher budget deficit (surplus) means that I’m just going to owe more (less) taxes in the future to pay off all that government borrowing, so I’ll start saving (spending) now." Why or why not?
Problems
Illustrate the concept of Ricardian equivalence using the demand and supply of financial capital graph.
Self-Check Questions
In the late 1990s, the U.S. government moved from a budget deficit to a budget surplus and the trade deficit in the U.S. economy grew substantially. Using the national saving and investment identity, what can you say about the direction in which saving and/or investment must have changed in this economy?
In this case, the national saving and investment identity is written in this way:
The increase in the government budget surplus and the increase in the trade deficit both increased the supply of financial capital. If investment in physical capital remained unchanged, then private savings must go down, and if savings remained unchanged, then investment must go up. In fact, both effects happened; that is, in the late 1990s, in the U.S. economy, savings declined and investment rose.
Review Questions
Under what conditions will a larger budget deficit cause a trade deficit?
Critical Thinking Questions
Explain how a shift from a government budget deficit to a budget surplus might affect the exchange rate.
Describe how a plan for reducing the government deficit might affect a college student, a young professional, and a middle-income family.
Problems
Sketch a diagram of how a budget deficit causes a trade deficit. (Hint: Begin with what will happen to the exchange rate when foreigners demand more U.S. government debt.)
Sketch a diagram of how sustained budget deficits cause low economic growth.
Assume that the newly independent government of Tanzania employed you in 1964. Now free from British rule, the Tanzanian parliament has decided that it will spend 10 million shillings on schools, roads, and healthcare for the year. You estimate that the net taxes for the year are eight million shillings. The government will finance the difference by selling 10-year government bonds at 12% interest per year. Parliament must add the interest on outstanding bonds to government expenditure each year. Assume that Parliament places additional taxes to finance this increase in government expenditure so the gap between government spending is always two million. If the school, road, and healthcare budget are unchanged, compute the value of the accumulated debt in 10 years.
Self-Check Questions
How would a balanced budget amendment affect a decision by Congress to grant a tax cut during a recession?
The government would have to make up the revenue either by raising taxes in a different area or cutting spending.
How would a balanced budget amendment change the effect of automatic stabilizer programs?
Programs where the amount of spending is not fixed, but rather determined by macroeconomic conditions, such as food stamps, would lose a great deal of flexibility if spending increases had to be met by corresponding tax increases or spending cuts.
Review Questions
What are some of the arguments for and against a requirement that the federal government budget be balanced every year?
Critical Thinking Questions
Do you agree or disagree with this statement: "It is in the best interest of our economy for Congress and the President to run a balanced budget each year." Explain your answer.
During the Great Recession of 2008–2009, what actions would have been required of Congress and the President had a balanced budget amendment to the Constitution been ratified? What impact would that have had on the unemployment rate?
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