Quiz 4 Prep

(Inflation) Why is a relatively constant and predictable inflation rate less harmful to an economy than a rate that fluctuates unpredictably?

A constant inflation rate means less uncertainty about real dollar flows (e.g., incomes, rents, interest of payments) compared with a variable rate. Consequently, there is less risk associated with lending and less unintended redistribution of real output because of unanticipated inflation.

(Basic and Applied Research) What is the difference between basic and applied research? Relate this to the human genome project—research aimed at developing a complete map of human chromosomes, showing the location of every gene.

Basic research is not designed for practical applications; it is the search for knowledge for the sake of knowledge itself. Applied research uses basic research to answer specific questions (for example, how to reduce wind resistance for an automobile) or develop specific products (for example, the photocopying process). The human genome project is basic research, but it has great potential for leading to applied research. Locating the genes for certain illnesses such as breast cancer or cystic fibrosis can lead to the development of new therapies for treating these illnesses.

(Inflation) Here are some recent data on the U.S. consumer price index: Year CPI Year CPI Year CPI 1997 160.5 2003 184.0 2009 214.5 1998 163.0 2004 188.9 2010 218.1 1999 166.6 2005 195.3 2011 226.3 2000 172.2 2006 201.6 2012 230.3 2001 177.1 2007 207.3 2013 233.5 2002 179.9 2008 215.3 2014 237.1 Compute the inflation rate for each year 1998-20141 and determine which years were years of inflation. In which years did deflation occur? In which years did disinflation occur? Was there hyperinflation in any year?

Deflation, an actual decrease in the price level, occurred during the recession year of 2009. Inflation occurred in all the other years given. Disinflation, a decrease in the rate of inflation, occurred in 2001, 2002, 2006, 2007, 2012, and 2013. Hyperinflation, a very high rate of inflation, did not occur over this period.

(International Comparisons of Unemployment) How has the U.S. unemployment rate compared with rates in other major economies? Can you offer any reasons why rates on average have differed across major economies since 1981?

During the decades before the Great Recession, unemployment trended down in the United States, trended up in Japan, and remained high in Europe. During the Great Recession of 2007-2009, the unemployment rate spiked in the United States, even briefly exceeding the average in Europe. The rate in Japan remained relatively low. In recent years, the U.S. rate has dropped. Since 1980 the unemployment rate in Europe has averaged 8.3 percent versus a U.S. average of 6.4 percent. The ratio of unemployment benefits to average pay is higher in Europe than in the United States, and unemployment benefits last longer there, sometimes years. So those collecting unemployment benefits have less incentive to find work. What's more, government regulations have made European employers more reluctant to hire new workers because firing them can be difficult. Historically, unemployment has been low in Japan, averaging only 3.5 percent since 1980, because many firms there offer job security for life.

(Slowdown in Labor Productivity Growth) What slowed the rate of growth in labor productivity during the 1973-1982 period?

First, an increase in oil prices boosted inflation and contributed to three recessions. Second, legislation to protect the environment and improve workplace safety caused production costs to increase.

(Inflation and Interest Rates) Using a demand-supply diagram for loanable funds (like Exhibit 11), show what happens to the nominal interest rate and the equilibrium quantity of loans when both borrowers and lenders increase their estimates of the expected inflation rate from 2 percent to 4 percent.

Higher expected inflation reduces the real rate of interest for a given nominal rate. Therefore, at each nominal rate, suppliers are less willing to lend and demanders are more willing to borrow. As a result, supply falls from S to S', demand rises from D to D', and the equilibrium nominal rate rises from i to i'. Because both sides of the market experience the same change in expectations, the nominal rate should adjust to exactly compensate for the higher expected inflation and the total quantity of loans should not change.

(Research and Development) What's the relevance of research and development to an economy's productivity? Among major economies, how does the United States rank in R&D spending as a share of GDP?

Human capital has benefitted from better education, better health care, and more job training. Better technology embodied in physical capital has also helped labor productivity. Because technological change is the fruit of research and development (R&D), investment in R&D improves productivity through technological discovery. Overall R&D spending in the United States has remained relatively constant, averaging 2.7 percent of GDP during the 1980s and 1990s, and 2.8 percent in 2013. During the 1990s, the United States ranked second among the major economies behind Japan. In 2013, the United States tied with Germany for second place behind Japan.

(Output per Capital) Explain how output per capita can grow faster than labor productivity. Is it possible for labor productivity to grow faster than output per capita? If so, how?

If employment grows faster than the population as a whole, output per capita can increase faster than productivity per worker. With a higher percentage of the population working, output per capita can grow faster than output per worker. If population grows at a faster rate than employment, it is possible for labor productivity to grow faster than output per capital.

(Anticipated Versus Unanticipated Inflation) If actual inflation exceeds anticipated inflation, who will lose purchasing power and who will gain?

In the case described, those who have borrowed at fixed nominal rates will gain purchasing power, and those who have lent at such rates will lose. Also, workers whose wages are not tied directly to the price level will lose.

(Industrial Policy) Define industrial policy. What are some arguments for and against industrial policy?

Industrial policy is the use by the government of taxes, subsidies, and regulations, specifically with the purpose of nurturing certain industries and technologies that the government considers important for the country's future health. Policies are designed to provide domestic producers with an advantage over foreign producers. One argument for industrial policy is that the necessary research and development to expand the target industries is often very expensive—so much that an individual firm cannot raise the needed funds. Another argument is that one firm's research may provide spillover effects for other industries—benefits that do not accrue to the developer. Because developers do not realize all of the gains from their research and base their decisions only on the gains that they do realize, there is a tendency to underinvest in research. Critics of industrial policy believe the markets allocate scarce resources better than governments do. There is also concern that industrial policy will evolve into a give away program. And finally some believe that the focus should be on happiness and well-being, not production.

(Inflation) Why do people dislike inflation?

Inflation distorts purchasing power and, especially if variable and unanticipated, causes other problems including the arbitrary redistribution of income and wealth from one group to another, a reduction in the ability to make long-term plans, and an increase in transaction costs due to less transparent relative price changes that force buyers and sellers to pay more attention to prices.

(The Meaning of Full Employment) When the economy is at full employment, is the unemployment rate at zero percent? Why or why not? How would a more generous unemployment insurance system affect the full employment figure?

No, even at "full employment," frictional, seasonal, and structural unemployment still exist. Full employment implies that only cyclical unemployment is zero. A more generous unemployment insurance system might lead to more unemployment because incentives to work would be lower and more people could qualify for benefits for, perhaps, a longer period of time.

(Unemployment in Various Groups) Does the overall unemployment rate offer an accurate picture of the impact of unemployment on each U.S. population group?

No, the overall unemployment rate does not show the wide differences that occur across age, race, and gender categories. For example, blacks have a higher unemployment rate than whites. Teenagers also have higher unemployment rates than adults, while women have higher rates than men do. Wide disparities also exist across geographical regions in the country. For example, unemployment in Midwestern industrial states substantially exceeds the overall unemployment rate. The unemployment rate also does not indicate the duration of unemployment. This is important, because the longer an individual is unemployed, the greater is its impact.

(Sources of Inflation) Using the concepts of aggregate supply and aggregate demand, explain why inflation usually accelerates during wartime.

One of the most important reasons why prices rise so quickly during wartime is that household incomes increase as more workers are employed in the armed forces. Fewer consumer goods are available as production shifts towards military goods. Military spending by the government also rises. Thus, the aggregate demand curve shifts to the right. In some countries, war creates a reduction in aggregate supply if many of the plants and much of the equipment are destroyed. This occurred in both Germany and Japan during World War II. Increasing aggregate demand and falling aggregate supply both lead to higher prices.

(International Productivity Comparisons) How does output per capita in the United States compare with output per capita in other major industrial economies? How does U.S. output per capita compare with the world average and with China?

Output per capita is total output divided by the population. The U.S. produces more output per capita than any other major economy. Among the seven major industrialized market economies, the U.S. growth in output per capita has also been high. Depending on political and technological changes, the ranking of the U.S. has varied. With nominal GDP per capita of $54,800 in 2014, the United States stood alone at the top, with a per capita GDP 23 percent above second-ranked Germany. Thus, the United States produced more per capita than any other major economy. U.S. output per capita is more than four times that of China.

(Rules of the Game) How do "rules of the game" affect productivity and growth? What types of "rules" should a government establish to encourage growth?

Rules of the game are the formal and informal institutions that promote economic activity. A stable political climate and well-established property rights are paramount to encouraging investment. Improvements in political stability, the establishment and enforcement of property rights, the creation of incentives for research and development, and improvements in infrastructure would all encourage growth

(Technological Change and Unemployment) Explain how technological change can lead to unemployment in certain industries. How can it increase employment?

Technological change can lead to unemployment if it reduces the number of workers needed to produce a given amount of output. In addition, it can make certain skills obsolete so that workers with those skills are no longer employed. However, technological change increases labor productivity and can make output more affordable, leading to an increased quantity demanded, increased production, and increased employment. Also, technological change can lead to the development of new industries, which would result in the creation of new jobs.

(Productivity) As discussed in the text, per capita GDP in many developing countries depends on the fertility of land there. However, many richer economies have little land or land of poor quality. How can a country with little land or unproductive land prosper?

The ability to produce food is important in certain countries with very large populations and relatively small manufacturing sectors. Recalling that "land" includes all natural resources, nations (such as Saudi Arabia and Kuwait) that rely on oil exports for revenue also depend on the productivity of land. Some small countries have eliminated their reliance on land productivity by developing manufacturing sectors while importing the necessary raw materials or creating service sectors. Switzerland is a small country with one of the highest per-capita income levels in the world. To some extent, Sweden also relies on large exports of services, such as banking.

(Inflation and Relative Price Changes) What does the consumer price index measure? Does the index measure changes in relative prices? Why, or why not?

The consumer price index measures the price level as the cost of a fixed "market basket" of consumer goods and services. Percentage changes in the cost of this basket are used as a measure of inflation. Because it looks at the overall cost of that basket, it masks changes in relative prices. Within the basket, prices of some goods may be falling, some may be rising more slowly than the overall basket's cost, and others may be rising more rapidly. Goods whose prices are rising more rapidly have an increased relative price compared to goods whose prices are rising more slowly.

(Inflation and Interest Rates) Explain as carefully as you can why borrowers would be willing to pay a higher rate of interest if they expected the inflation rate to increase in the future

The cost of borrowing is the opportunity cost today of purchasing power given up in the future. Thus, an increase in the expected inflation rate means that borrowers can increase their nominal repayment rate without increasing the lost future purchasing power. The real rate of interest falls for the initial lower nominal rate

(Case Study: Hyperinflation in Zimbabwe) In countries such as Zimbabwe, which had problems with high inflation, the increased use of another country's currency (such as the U.S. dollar) became common. Why do you suppose this occurred?

The desire to replace one's currency with some other currency having stable value is the reason. If successful, you don't have to worry about a reduction in purchasing power due to your country's unstable currency because you have moved your cash into a more stable currency.

(Technology and Productivity) What measures can government take to promote the development of practical technologies?

The government can use taxes, subsidies, and regulations to promote particular technologies. The government can provide tax credits or accelerate depreciation for selected areas. Subsidies provide direct government underwriting of the costs of the necessary research and development. Pollution regulations, for example, can encourage firms to develop new technologies for controlling emissions, create more fuel-efficient automobiles, and so on.

(Productivity) What factors might contribute to a low level of labor productivity in an economy? Regardless of the level of labor productivity, what impact does growth in labor productivity have on the economy's standard of living?

The low level of labor productivity of an economy may be due to a variety of factors, such as (a) a low quality of its workforce, (b) a low quantity of physical capital, (c) deficient quality of physical capital, (d) a low level of technology, (e) poor methods for organizing production, and (f) institutional and social factors that adversely affect incentives of the resource suppliers. Growth in labor productivity leads to more goods and services produced from a given amount of resources, thus increasing the standard of living.

(Official Unemployment Figures) Explain why most experts believe that official U.S. data underestimate the actual rate of unemployment. What factors could make the official rate overstate the actual unemployment rate?

The official unemployment rate does not include discouraged workers—those who have given up searching for work in the belief that it is futile. In addition, the official rate does not account for underemployment.Because unemployment insurance and most welfare programs require recipients to seek employment, some people may act as if they are looking for work just to qualify for such programs. If these people do not in fact want to find a job, their inclusion among the unemployed tends to overstate the official unemployment figures.

(Labor Productivity) What two kinds of changes in the capital stock can improve labor productivity? How can each type be illustrated with a per-worker production function? What determines the slope of the per-worker production function?

The two kinds of changes are an increase in the quantity of capital and improvement in the quality of capital. Quantity increases are represented by a movement along a given per-worker production function's curve. Quality improvements are illustrated by an upward rotation in the curve. The per-worker production function slopes upward because more capital per worker increases output per worker. However, the curve becomes less steep as more and more capital is added due to the law of diminishing marginal returns.

(Unemployment Rate) If people dropped out of the labor force because they could not find work, what would this do to the unemployment rate? Why?

The unemployment rate would decrease. The unemployment rate is calculated as the number of people unemployed divided by the labor force, and when discouraged workers drop out of labor force, both the number of unemployed and the labor force decrease by the number of discouraged workers, which decreases the unemployment rate.

(Case Study: Income and Happiness) How would you explain the finding that people in high-income economies seem happier than people in low-income economies, but, over generations, Americans do not seem to become happier even though the nation grew richer?

There are two possible explanations. First, the luxuries of one generation become the necessities of the next generation. People begin taking for granted products they once desired. Second, if relative income is important, as it seems to be, then a general rise in average incomes over time does not translate into a general rise in happiness because the average relative position does not necessarily improve.

(Labor Force) Refer to Exhibit 1 in the chapter to determine whether each of the following statements is true or false. a. Some people who are officially unemployed are not in the labor force. b. Some people in the labor force are not working. c. Everyone who is not unemployed is in the labor force. d. Some people who are not working are not unemployed.

a. False. To be unemployed, a person must be looking for a job. b. True. This would be the unemployed. c. False. Some adults are not looking for a job, or they choose not to work. d. True. To be classified as unemployed, a person must be looking for a job. However, there will be some adults who choose not to do so. There will also be discouraged workers who technically are not unemployed.

(Measuring Unemployment) Suppose that the U.S. noninstitutional adult population is 230 million and the labor force participation rate is 67 percent. a. What would be the size of the U.S. labor force? b. If 85 million adults are not working, what is the unemployment rate?

a. Of 230 million, 67 percent, or 154.1 million. b. Of the 230 million adults in the population, 154.1 million are in the labor force. The population (230 million) minus the number in the labor force (154.1 million) gives the number of people outside the labor force who are not working (75.9 million). Statistics given say that 85 million adults are not working, thus 85 million minus 75.9 million gives the number of people in the labor force who are not working (9.1 million) which is the number that represents the unemployed. The unemployment rate is the percentage of the labor force (not the population) that is unemployed. The unemployment rate is equal to the number of people counted as unemployed (9.1 million) divided by the labor force (154.1 million) expressed as a percentage (5.9 percent).

(Types of Unemployment) Determine whether each of the following would be considered frictional, structural, seasonal, or cyclical unemployment: a. A UPS employee who was hired for the Christmas season is laid off after Christmas. b. A worker is laid off due to reduced aggregate demand in the economy. c. A worker in a DVD rental store becomes unemployed as video-on-demand cable service becomes more popular. d. A new college graduate is looking for employment.

a. Seasonal b. Cyclical c. Structural d. Frictional

(Measuring Unemployment) Determine the impact on each of the following if 2 million formerly unemployed workers decide to return to school full time and stop looking for work: a. The labor force participation rate b. The size of the labor force c. The unemployment rate

a. The labor force participation rate drops because these workers have left the labor force. b. The size of the labor force drops by 2 million. c. The unemployment rate drops because the percentage drop in the number of unemployed is greater than the percentage drop in the labor force.