Chapters 5-7 macroecon

If real GDP and nominal GDP both rise by 10% and 15% respectively from one year to the next what can we say is true about production and inflation between these two years and why?

Real GDP is nominal GDP adjusted for changes in the price level. Since real GDP rose we can be confident that production rose as well. Since nominal GDP grew faster than real GDP we can also assume that the price level rose. That is there must have been some inflation. The residual, or 5% amount, gives us the approximate inflation rate.

Explain what sticky prices are in terms of macroeconomic equilibrium.

Sticky prices are prices that do not always adjust rapidly to maintain equality between quantity supplied and quantity demanded.

Below are different groups of people in society. Explain how each one of them would fair under unanticipated inflation: a) Social Security recipient b) Welfare beneficiary c) Union worker d) Landlord e) Savers

) Social Security recipient - they are neither made better off or worse off. Their benefits are indexed to the CPI. b) Welfare beneficiary - they are made worse off because benefits are not tied to an inflation index. c) Union worker - typically union workers have clauses in their contracts which automatically raise their wages with increases in the cost of living. d) Landlord - usually writes one-year or multiple year leases therefore they are usually hurt by unanticipated inflation. e) Savers - usually earn fixed interest rate on their accounts and are made worse off by unanticipated inflation.

The Bahamas is a group of islands whose economy relies heavily on tourism. The majority of the hotels and resorts in the islands are owned by foreign countries. Which do you think is larger, Bahamas' GDP or GNP? Explain why.

Bahamas' GDP will exceed its GNP because GNP measures production by a nation's resources, regardless of location, whereas GDP measures output within the nation's boundaries. Much of the Bahamas' economic activities take place in the island. However, those activities are owned by foreign countries.

Define what is meant by capital and discuss the various types of capital.

Capital is anything that is produced that is later used as an input to produce other goods and services. Physical capital would represent machinery and factories. Human capital would represent the knowledge and skills acquired by workers. Capital can also be private and public (e.g., highways).

Explain why we must take into account changes in business inventories when calculating GDP.

Changes in business inventories can be positive, negative, or zero. If they are positive, some goods produced in a given period were not purchased. Because GDP measures the value of the goods and services produced in a given period, we must take into account these goods that were produced but not sold. When the changes in business inventories are negative, some of the goods sold in a given period were produced in a previous period. For the same reason, we need to take this into account to obtain an accurate measure of economic activity for a GIVEN period.

Explain how an unanticipated increase in inflation would affect creditors and debtors.

Creditors, on the one hand, are hurt by this because the unexpected rise in inflation will cause the real rate of return to fall. Debtors, on the other hand, benefit because the real interest rate on any loan, for example, will fall.

Why might retired persons argue that their cost of living is much higher than what is reported by the CPI? What is going on here that might support this claim?

Elderly citizens are likely to spend more money on health care than other groups. If health care costs rise faster than other items in the CPI basket, then the elderly's true cost of living may indeed be rising at a faster clip than the CPI would reveal.

List and explain the three major types of unemployment.

Frictional unemployment - caused by short-run job mismatch and is often voluntary. People are in search of better paying jobs. Structural unemployment - this is caused by the skills of workers suddenly becoming obsolete because of changes in technology or the structure of the economy. Cyclical unemployment - caused by the recessionary phase of the business cycle.

Define GNP and GDP. Explain the difference between GNP and GDP. Why is the difference between GNP and GDP small for most countries?

GDP is the total market value of all final goods and services produced within a given period by factors of production located within a country. GNP is the total market value of all final goods and services produced within a given period by factors of production owned by a country's citizens, regardless of where the output is produced. For most countries, the difference between GNP and GDP is small because the payments of factor income to the rest of the world is approximately the same value as the receipt of factor income from the rest of the world.

Define GDP in broad terms

GDP stands for Gross Domestic Product. It represents the total market value of a country's output. It is the market value of all final goods and services produced within a given period of time by factors of production located within a country.

Briefly explain under what condition, if any, net investment can be negative. If so, explain what this implies about the capital stock.

Net investment equals gross investment minus depreciation. If depreciation is greater than gross investment, net investment will be negative. In such a situation, there is insufficient gross investment to offset the effects of the depreciation of the capital stock. In this case, the capital stock would diminish in size during that period.

What is the underground economy and what is its relationship if any to the value of GDP?

The underground economy is the part of the economy in which transactions take place and income is generated that is unreported and therefore not counted in GDP. Examples include such illegal activity as gambling, prostitution, extortion and the narcotics trade and legal production done "off the books" to avoid income taxes.

Classify the following people as either employed, unemployed, discouraged worker or not in the labor force: a) A retired person b) A full-time student who is not working c) An individual who looked for work for six months and stopped looking five weeks ago d) A law student who finishes law school, quits his job as a law clerk and has been actively seeking work as a lawyer

a) This person is not in the labor force out of personal choice. b) This person is not in the labor force because he is devoting his time as a student. c) This person is not in the labor force because she or he is a discouraged worker and would not qualify as unemployed because he is no longer looking for work. d) This person is classified as unemployed because he is actively seeking employment.

Why would the number of fixed rate mortgages offered to the public by banks decline in the face of inflation while the offering of adjustable rate mortgages rises?

fixed rate mortgages are costly to banks in an inflationary environment because it means that their loans will be paid back in dollars of declining value. By contrast adjustable rate mortgages move with the inflation rate and help creditors insulate themselves from the effects of inflation.

Explain the difference between GNP and NNP. Explain why NNP is sometimes a better measure of how the economy is doing than GNP is.

The difference between GNP and NNP is that NNP is GNP minus depreciation. NNP is a measure of total product minus what is required to maintain the value of the capital stock. NNP is sometimes a better measure of how the economy is doing because it accounts for the capital stock that is left over after depreciation has been accounted for.

Discuss some of the problems associated with using fixed weights to compute real GDP.

The first problem is that many structural changes have taken place in the U.S. economy in the last 30 to 40 years that make using modern prices unlikely as good weights for the 1950s. Secondly, fixed price weights do not account for the responses in the economy to supply shifts like bad weather which may lower production for agricultural goods. The bottom line is that the fixed-weight procedure ignores the substitution away from goods whose prices are increasing and toward goods whose prices are decreasing or increasing less rapidly. The procedure tends to overestimate the increase in the overall price level.

What event provided the impetus for the development of modern macroeconomics? Why did this event require a fundamental rethinking of how the macroeconomy operated?

The impetus for the development of macroeconomics was the Great Depression. The Classical model could not explain the Great Depression. According to the Classical model, the economy is self- correcting and unemployment should not persist. During the Great Depression, very high levels of unemployment persisted for about 10 years. Because the classical model could not explain the Great Depression, the approach to macroeconomics had to be rethought.

Explain what the money market is. Make sure to discuss the three players in the money market.

The money market is where households purchase stocks and bonds from firms. Households supply funds to firms with the expectation of earning payment in the future in the form of interest or dividends. In addition, households borrow money in the money market to finance things like cars or homes. Firms borrow in the money market to build new factories or purchase equipment. In addition, the government borrows money in the money market to finance its obligations.

Why aren't intermediate goods counted in GDP?

The reason is that if they weren't excluded the GDP figures would be double counting some production. That is to say that the market value of the final goods already reflects the value of the intermediate goods.

Explain how using GDP may not be a very good measure of overall social welfare.

The reason that GDP is an imperfect measure of social welfare is that it does not measure many goods and services that have real economic value. The most obvious case is leisure. Leisure is a normal good. We do not work just for the sake of work but to earn money so that we may buy goods and enjoy leisure. It also does not measure a great deal of non-market activity like housework, child care, lawn cutting, painting and other activities that the household may choose to perform for itself. It also does not back out of the statistics a number of social ills like the effects of pollution or crime. In fact it is interesting to note that not only are these items not subtracted from GDP, whenever we spend money to fix them like expenditures on pollution remediation or burglar bars these expenditures are added in.

Explain why a cut in spending to bring down inflation during a period of stagflation does not solve all macroeconomic problems.

The reason that the cut in spending does not solve all macroeconomic problems is that it exacerbates the unemployment problem associated with the stagflation.

Classical economists believed that recessions were self-correcting. In their view, how did the economy self-correct?

According to Classical economists, the economy adjusts because wages and prices are flexible. If there is unemployment, wages would fall and unemployment would be reduced.

Define an expansion or boom.

An expansion is the period in the business cycle from a trough (the bottom part of the cycle) up to a peak during which output and employment increase.

Why is anticipated inflation less of a problem than unanticipated inflation?

Anticipated inflation is less of a problem because economic agents can take actions to reduce or eliminate the impact that it has on their economic well-being. Unanticipated inflation is more of a problem because it catches people off guard and generally causes undesirable redistributions of income.

How do Classical economists and Keynesian economists differ in their perceptions of how well markets and prices function?

In general, Classical economists conclude that markets work well and that prices are flexible. Excess demand or supply is competed away. In contrast, Keynesians observe that prices do not always adjust rapidly to maintain equality between quantity supplied and quantity demanded. Examining the labor market, for example, Keynesians find sticky prices and persistent mismatches between the quantity of labor demanded and supplied.

What is the circular flow diagram and why is it useful?

It is a diagram showing the income received and payments made by each sector of the economy. It is a useful way of seeing the economic interactions among the four groups in the economy and shows the income received and payments made by each group.

What is the CPI or consumer price index?

It is an index computed each month by the Bureau of Labor Statistics using a bundle that is meant to represent the "market basket" purchased monthly by the typical urban consumer. It is the ratio of the cost of that basket in any particular year to its cost in an arbitrarily chosen base year.

How does the Bureau of Labor Statistics officially characterize an employed person?

It is anyone who is 16 years of age or older who is working for pay either for someone else as an employee or in his or her own business for one or more hours per week. It can also be someone who works without pay in a family run business at least 15 hours per week, or who has a job but has been temporarily absent, with or without pay.

Define the business cycle.

It is the cycle of short-term ups and downs in the economy.

What was the Great Depression?

It was a period of severe economic contraction and high unemployment that began in 1929 and continued throughout the 1930s.

Assume that the demand for computer programmers drops precipitously. Explain using Keynesian reasoning why this will cause unemployment

Keynes argued that wages may not adjust right away. Thus, the decline in the demand for labor is not met by a commensurate drop in the wage rate. This means that there will be many more programmers actively seeking employment but much fewer being hired in the market.

What are the basic tenets of Keynesian theory that help explain the level of employment?

Keynes' view was that prices and wages do not determine the level of employment as the classical school assumed but rather the level of aggregate demand for goods and services. Hence, Keynes believed that the government could intervene in the economy by directly stimulating aggregate demand and thereby pull the economy out of recession.

Explain how labor productivity is measured.

Labor productivity is measured by taking total output in the economy and dividing it by the total number of worker hours during the period.

Explain the difference between macroeconomics and microeconomics.

Macroeconomics focuses on the economy as a whole and in particular on the determinants of total national output. Microeconomics by contrast looks at the functioning of individual decision-making units like the household and the firm.

Identify the following topics as either predominantly macroeconomic or microeconomic. a) Provision by firms of medical benefits for employees b) The demand for coffee c) Unemployment d) The price of a government bond relative to the price of IBM stock e) Unemployment among economics professors f) The business cycle g) Consumption spending by the household sector h) Rent controls in New York i) Inflation j) The money supply

Microeconomics: a, b, d, e, h. Macroeconomics: c, f, g, i, j.

The inflation rate measured by changes in the consumer price index is 5%. Does this mean that every individual's cost of living has increased by 5%? Explain.

No. Everyone will not experience a 5% increase in the cost of living. It depends on the combination of goods and services consumers buy. If consumers spend a high percentage of their income on goods and services that have increased in price, then their cost of living may have risen by 5% or more. If consumers are able to substitute toward less-expensive goods or if they don't purchase goods whose prices increased, then their cost of living would increase by less than 5%.

Provide an explanation for why the Consumer Price Index may somewhat overstate changes in the cost of living.

One problem is that it is a fixed-bundle index. It does not account for substitutions that consumers might make in response to relative price changes.

What is the relationship between total production and sales? Explain

Regarding GDP, it is important to remember that it is not the market value of total final sales during the period, but rather the market value of total final production. The relationship between total production and total sales is as follows: GDP = Final sales + Change in business inventories.

Explain why some economists argue that counting discouraged workers as unemployed gives abetter picture of the unemployment situation. How would the magnitude of the unemployment rate change if discouraged workers were counted as unemployed?

Some argue that discouraged workers should be included because they would take jobs if a job became available. If discouraged workers were included, the unemployment rate would increase.

Explain why some unemployment is inevitable. How can unemployment actually benefit the economy?

Some unemployment is inevitable because people switch jobs or need to search for a job after finishing school. The structure of the economy is always changing, so some people will find that their skills have become outdated, and they no longer can find employment. Unemployment may benefit the economy if it leads to a better match between employee and employer.

Define stagflation and explain why it undermined faith in the simple Keynesian model.

Stagflation refers to the simultaneous occurrence of a rapid rise in the price level and persistent unemployment. This undermined faith in the simple Keynesian model because before the 1970s rising prices were generally observed only when the economy was prospering.

Explain what structural unemployment is and give some examples.

Structural unemployment arises when skills of workers become obsolete and generally refers to longer-run adjustment problems that tend to last for years. Examples might include a welder who is put out of work because of the introduction of robotics on the assembly line or a receptionist who is displaced by a modern voice mail system.

Assume that the demand for construction workers declines because of a slump in the housing market. Explain using Classical reasoning why this will not cause unemployment.

The Classical belief is that markets are resilient and that wages and prices are flexible. Thus, the decline in the demand for construction workers should result in lower wages. This will cause some workers to cease looking for work and will serve as an incentive for firms to increase the number of workers demanded. What would otherwise be a surplus (unemployment) in the labor market results in the market clearing.

Microeconomists generally do not expect to see excess supplies in most markets. However, macroeconomists will often observe that during recessions the quantity of labor supplied can exceed the quantity of labor demanded. Explain what macroeconomists are referring to and explain why the wage rate may not adjust right away.

The wage rate may stay above the market clearing level if workers have signed multi-year wage contracts or firms may be reluctant to lower wages for fear of adversely affecting morale and productivity.

For the United States, explain why the amount of output that each worker can produce per hour has risen in the last half century.

There are several reasons for this. First, the amount of capital per worker has increased. As the amount of capital per worker rises, workers will be able to produce a greater number of goods and services. Second, there have been increases in the quality of both labor and capital. As the skill level of workers rises and the quality of, for example, the equipment they use improves, workers will be able to produce more goods and services. And finally, there have been increases in technology during this period.

Explain what is meant by the concept of "value added" and how it can be used to calculate GDP

Value added simply refers to the difference between the value of goods as they leave a stage of production and the cost of the goods as they entered that stage. If you add up the "value added" at each stage of the production process, the final value is equal to GDP.

identify the following as either fiscal or monetary policy. a) The government increases spending on roads and bridges. b) The Federal Reserve lowers interest rates. c) The government increases the income tax rate. d) The government buys bonds in the open market.

a. Fiscal policy b. Monetary policy c. Fiscal policy d. Monetary policy