ECON 2020 - Midterm Study Guide
27. Next to each of the following items indicate in the table which items belongs to GDP and which to GNP: Rent paid to an American who owns land in Mexico Salary paid to foreigners working in the U.S. for a U.S. - owned company Interest paid on a bond in a foreign-owned company to a U.S. citizen Profits earned in the U.S. by a foreign-owned company
GNP GDP GNP GDP
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.
26. Label the following as either being a final or intermediate good: Recycled steel purchased by a steel manufacturer An automobile purchased by a package delivery company Bubble gum A computer purchased by a professor for use in the classroom An architect builds a scale model of a house he has designed A minivan purchased by a family
intermediate good final good final good final good intermediate good final good
59. Identify the following individuals as either "better off", "worse off" or "no different" from unanticipated inflation: Creditors who make variable interest rate mortgages that are tied to the Consumer Price Index Creditors who make fixed interest rate loans Homeowners who pay fixed interest rate mortgages Landlords who receive rent in multi-year contracts
no different worse off better off worse off
1. Draw a graph of the consumption function and explain what the vertical intercept means and the slope. Make sure to label both axes.
1. The fact that the consumption function crosses the vertical axis at a positive value simply means that even if household income were zero there would still have to be consumption for the household to survive. It would either live off savings or borrow. The slope of the consumption function represents the fraction of each additional dollar of income that the households choose to consume.
10. Assume planned aggregate expenditure exceeds aggregate output (income). Explain what will happen to unplanned inventories and the adjustment process towards equilibrium output.
10. First, there is an unplanned fall in inventories. Firms will increase output. This increased output leads to increased income and even more consumption. This process will continue as long as output (income) is below planned aggregate expenditure. If firms react to unplanned inventory reductions by increasing output, an economy with planned spending greater than output will adjust to a new equilibrium, with Y higher than before.
10. 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.
10. a. Fiscal policy b. Monetary policy c. Fiscal policy d. Monetary policy
11. What event provided the impetus for the development of modern macroeconomics? Why did this event require a fundamental rethinking of how the macroeconomy operated?
11. 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.
11. Define the multiplier.
11. The multiplier is the ratio of the change in the equilibrium level of output to a change in some autonomous variable.
12. What was the Great Depression?
12. It was a period of severe economic contraction and high unemployment that began in 1929 and continued throughout the 1930s.
12. Suppose there is an economy in which aggregate expenditure is greater than aggregate output by $30 billion. In addition, firms react by increasing planned investment by $30 billion. Explain why this does not restore equilibrium.
12. It will not restore equilibrium because the increase in output by $30 billion generates even more consumption spending. This of course creates more income and the cycle starts all over again.
13. Classical economists believed that recessions were self-correcting. In their view, how did the economy self-correct?
13. 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.
13. Why doesn't the multiplier process go on forever?
13. Only a fraction of the increase in income is consumed in each spending round. Successive increases in income become smaller and smaller in each round of the multiplier process until equilibrium is restored.
14. Discuss some of the factors that would cause the actual multiplier to be different from 1/(1 - MPC).
14. In this model, we have not taken into account income taxes. An income tax rate will affect the size of the multiplier (makes it smaller). We have also not taken into account the effect of interest rates on the economy. Once interest rates are included, the size of the multiplier will be further reduced. And finally, we have assumed that the aggregate price level is fixed. Allowing for the aggregate price level to change will reduce the multiplier.
14. What are the basic tenets of Keynesian theory that help explain the level of employment?
14. 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.
15. Explain why the multiplier that is calculated in the textbook and the size of the multiplier in the real world are likely to be different. What are the two reasons?
15. First the text assumed that planned investment is fixed and does not respond to changes in the economy. Second, it ignores the role of government, financial markets and the rest of the world.
15. Assume that the demand for computer programmers drops precipitously. Explain using Keynesian reasoning why this will cause unemployment.
15. 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.
16. 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.
16. 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.
16. What are the two types of macroeconomic policy channels that are available to the government and describe how they work?
16. The two types of macroeconomic policies are fiscal policy and monetary policy. Fiscal policy refers to the government's spending and taxing behavior or budget policy. Monetary policy refers to the behavior of the Federal Reserve regarding the nation's money supply.
17. If the government wants to reduce unemployment, what are some ways it should change spending and taxes?
17. In order for the government to reduce unemployment it must either increase government spending, cut taxes, or some combination of the two.
17. Define stagflation and explain why it undermined faith in the simple Keynesian model.
17. 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.
18. Explain why a cut in spending to bring down inflation during a period of stagflation does not solve all macroeconomic problems.
18. The reason that the cut in spending does not solve all macroeconomic problems is that it exacerbates the unemployment problem associated with the stagflation.
18. Write the equation for disposable income and identify each component.
18. Yd = Y - T Disposable income = Total income - Net taxes
19. How do Classical economists and Keynesian economists differ in their perceptions of how well markets and prices function?
19. 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.
19. Given that Yd C + S, prove that Y C + S + T. Explain the importance of this relationship.
19. Since Yd = Y - T and Yd = C + S we can then write Y - T = C + S. Adding T to both sides yields: Y = C + S + T. The importance of the relationship is that is says that aggregate income gets cut into three pieces. Government takes a piece, and then households divide the rest between saving and taxes.
2. Assume a consumption function that takes on the following algebraic form: C = $100 + .8Y. Assume that Y = $1000 what is the level of consumption at this income level.
2. C = $100 + .8($1000) = $100 + $800 = $900.
Explain what sticky prices are in terms of macroeconomic equilibrium.
2. Sticky prices are prices that do not always adjust rapidly to maintain equality between quantity supplied and quantity demanded.
20. Define GDP in broad terms.
20. 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.
20. How would a strong economy affect the size of the budget deficit?
20. The budget deficit would fall in the face of a strong economy for the simple reason that it means higher incomes, which translate into higher corporate profit and a larger personal income tax base which will lead to higher tax revenues.
21. How would a weak economy affect the size of the budget deficit?
21. The budget deficit would rise in face of a strong economy for the simple reason that it means lower incomes, which translate into lower corporate profit and a lower personal income tax base which will lead to lower tax revenues.
21. Why aren't intermediate goods counted in GDP?
21. 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.
22. Explain why it might not be necessary for the government to cut spending to reduce the deficit when the economy is expanding.
22. The reason is that as the economy expands gross tax revenues will rise and transfer payments will fall which will result in more net tax revenue. This will result in a reduction in the government budget deficit on its own.
22. Explain what is meant by the concept of "value added" and how it can be used to calculate GDP.
22. 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.
23. Suppose the economy is slipping into a recession and the budget deficit begins to grow. In response Congress cuts government spending to reduce the deficit. What might the macroeconomic consequences of Congress' action?
23. This action may actually have the effect of making the recession worse since it involves a reduction in aggregate demand.
24. Define GNP and GDP. Explain the difference between GNP and GDP. Why is the difference between GNP and GDP small for most countries?
24. 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.
25. 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.
25. 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.
25. Assume the following behavioral equations for a macroeconomy: C = 100 + .9Yd, I = 50, T = 100 and G = 40 Calculate the equilibrium level of output.
25. In equilibrium AE = Y. Since AE = C + I + G we can write C + I + G = Y. Rewriting the consumption function yields: 100 + .9 (Y - 100) since Y d = Y - T. This reduces to 10 + .9Y. When added to I and G yields 10 + .9Y + 50 + 40. Combining terms this equals 100 + .9Y. Since this is AE we must then set it equal to Y and solve for Y. We then get 100 + .9Y = Y. Rearranging and solving for Y yields 1000
26. Identify the broad contrasting views regarding the role of government within the macroeconomy
26. The proponents of government action argue that public policy is needed to insure long-term economic stability and growth because of the disruptions associated with cyclical fluctuations. The critics of government policy argue that it is incapable of stabilizing the economy and contributes to inflation and recession.
28. You are given the following income-expenditures model for the economy of Vulcan. C = 200 + .8Yd T = 50 G = 100 I = 140 (a) What is the equilibrium level of income in Vulcan? (b) At the equilibrium level of income, what is the amount of consumption? (c) What is the value of the government spending multiplier in this economy? (d) If government spending increases to 150, what is the new level of equilibrium income?
28. (a) The equilibrium level of income is 2,000. (b) At the equilibrium level of output, consumption is 1,760. (c) The government spending multiplier is 5. (d) If government spending increases to 150, the new equilibrium level of output is 2,250.
29. Explain why we must take into account changes in business inventories when calculating GDP.
29. 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.
29. Determine the impact of an increase in government spending of $5 billion when the MPC is 0.9.
29. The government spending multiplier will be 10. Thus, the increase in government spending of $5 billion will increase aggregate output and income by $50 billion.
3. Define an expansion or boom.
3. 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.
3. Explain what the aggregate consumption function is?
3. The aggregate consumption function shows the level of consumption at every level of income. The upward slope indicates that higher levels of income lead to higher levels of consumption spending.
30. Briefly explain under what condition, if any, net investment can be negative. If so, explain what this implies about the capital stock.
30. 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.
30. Determine the impact of a decrease in government spending of $2.5 billion when the MPS is 1/3.
30. The government spending multiplier will be 3. Thus, the decrease in government spending of $2.5 billion will decrease aggregate output and income by $7.5 billion.
31. Discuss an important difference between the spending and tax multipliers.
31. A change in government spending has an immediate and direct impact upon the economy's total spending and income level. In contrast, a change in taxes directly changes disposable income which then impacts upon spending and income.
31. What is the relationship between total production and sales? Explain.
31. 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.
32. Determine the impact of an increase in taxes of $20 billion when the MPS is 0.25.
32. The tax multiplier will be -3. Thus, an increase in taxes of $20 billion will decrease aggregate output and income by $60 billion.
33. Determine the impact of a decrease in taxes of $10 billion when the MPS is 0.2.
33. The tax multiplier will be -4. Thus, a decrease in taxes of $10 billion will increase aggregate output and income by $40 billion.
34. Assume that you know that the government multiplier for the economy is 3. From this information calculate the tax multiplier.
34. Since the government multiplier is 1/MPS we can conclude the MPS = 1/3. That means the MPC = 2/3. The tax multiplier = -MPC/MPS = - (2/3)/(1/3) = -2.
35. The MPC in Montavada is 0.75. (a) If taxes were reduced by $1,000 in Montavada, by how much would equilibrium output change? (b) If government spending were increased by $1,000 in Montavada, by how much would equilibrium output change? (c) Explain why a tax cut of $1,000 would have less effect on the economy of Montavada than an increase in government spending of $1,000.
35. (a) If taxes are reduced by $1,000, equilibrium output increases by $3,000. (b) If government spending is increased by $1,000, equilibrium output increases by $4,000. (c) The change in taxes has a smaller impact than the increase in government spending, because when taxes are cut the initial increase in aggregate expenditure is only MPC times the change in taxes. When government spending is increased, the initial increase in aggregate expenditure equals the increase in government spending.
35. Assume that GDP is $9 Trillion, receipts of factor income from the rest of the world are $2 Trillion, and payments of factor income to the rest of the world are $1 Trillion. Calculate GNP from this information.
35. GNP = GDP +factor payments from the rest of the world - factor payments to the rest of the world. Therefore GNP = $9 trillion + $2 Trillion - $1 Trillion = $10 trillion.
36. Explain why the government spending multiplier is different from the tax multiplier.
36. First, it is important to note that an increase in G will cause Y to increase and an increase in T will cause Y to fall! So, the spending multiplier is positive while the tax multiplier is negative. To answer this question, it is easiest to consider two options: a 100 increase in G versus a 100 reduction in T. The 100 increase in G has a direct effect on planned expenditures. Expenditures rise by 100, firms' inventories fall, and equilibrium output will rise by some multiple of that. When T is cut by 100, disposable income increases by 100. However, only part of the tax cut is used for consumption because some of it is saved. Hence, the 100 reduction in T will have a smaller effect on equilibrium output.
37. Suppose policymakers decide to increase government spending by 100 and simultaneously increase taxes by 100. Explain what effect this simultaneous increase in G and increase in T will have on the economy and on the budget deficit.
37. The 100 increase in T only partially offsets the effects of the higher G on planned expenditures. When T increases, households will reduce consumption. The reduction in C will be less than the 100 increase in T because they also reduce saving. So, the net effects of this policy action on planned expenditures are positive. When planned expenditures rise, inventories fall and firms will increase production. So, output will rise. The size of the budget deficit will not change (this assumes no tax rate). G and T both rise by the same amount.
38. Explain the difference between GNP and NNP. Explain why NNP is sometimes a better measure of how the economy is doing than GNP is.
38. 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.
39. Discuss some of the problems associated with using fixed weights to compute real GDP.
39. 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.
39. What effect does an introduction of an income tax rate have on the size of the spending multiplier? Explain.
39. The introduction of an income tax rate will reduce the size of the multiplier. When autonomous expenditures rise, inventories will fall. Firms respond by increasing production. As income rises, households experience an increase in disposable income. With no tax rate, the entire rise in Y causes a one-for-one rise in disposable income. With a tax rate, disposable income rises, but not as much. Hence, consumption will not increase as much. In short, AE is less income sensitive when a tax rate exists. Therefore, the multiplier is smaller.
4. Define the business cycle.
4. It is the cycle of short-term ups and downs in the economy.
4. What are the four determinants of consumption? Also, explain how a change in each would bring about a reduction in consumption.
4. The four determinants are income, wealth, interest rates, and expectations about the future. A reduction in income will cause individuals to reduce consumption. A reduction in wealth (assets minus liabilities) will also cause a reduction in consumption. An increase in the interest rate, by raising the cost of borrowing will cause a reduction in consumption. And finally, if individuals become concerned about the future (e.g., future income and/or the state of the economy), they will reduce consumption.
40. 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?
40. 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.
40. Explain the government spending multiplier.
40. The government spending multiplier is the ratio of the change in the equilibrium level of output to a change in government spending.
41. Explain how using GDP may not be a very good measure of overall social welfare.
41. 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.
41. Suppose that the MPS = 0.2 and the government is interested in raising the level of output in the economy by $100 billion. Calculate how much the government would have to spend to achieve this objective.
41. Y = m x G. Since Y = $100 billion and the m = 1/mps or 1/.2 or 5, then the change in government spending that would be necessary to achieve this objective would be $20 billion.
42. Define the tax multiplier and give the algebraic expression.
42. The tax multiplier is the ratio of change in the equilibrium level of output to a change in taxes. The algebraic equivalent is - (MPC/MPS).
42. What is the underground economy and what is its relationship if any to the value of GDP?
42. 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.
43. A demographer discovers that more mothers are choosing to stay home and take care of their own children rather than send them to child care centers. An economist picks up on this information and concludes that GDP will contract as a result. How can this be possible?
43. GDP measures the market value of final goods and services. If more mothers stay home to take care of their children instead of taking them to child care centers, then the child care that is still being produced (only this time by mothers) doesn't get measured in the official GDP statistics whereas it was before this trend took hold.
43. Assume the economy was originally at an output level of $800 billion. The government then cut taxes by $20 billion. If the economy expands by $60 billion, what is the value of the tax multiplier? 44. Why does the tax multiplier differ from the spending multiplier?
43. The tax multiplier is the ratio of change in the equilibrium level of output to a change in taxes. Therefore, the tax multiplier must be -3. ($60 billion / -$20 billion)
44. How does the Bureau of Labor Statistics officially characterize an employed person?
44. 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.
44. Why does the tax multiplier differ from the spending multiplier?
44. When the government increases spending, there is an immediate and direct impact on the economy's total spending. When taxes are cut, there is no direct impact on spending. Taxes indirectly affect consumption through the impact that they have on household disposable income. Furthermore, households have two things that they can do with this increase in income - save and consume. Therefore, the initial impact of a cut in taxes is only MPC times the first dollar's worth of the tax cut. By contrast, when government spending increases by $1, planned aggregate expenditure increases initially by the full amount of the rise in G.
45. If the tax multiplier is -2 what must be the value of the MPC. Show all work.
45. The tax multiplier is equal to -MPC/MPS. We can therefore write that the tax multiplier is also equal - (1 - MPS)/(MPS). This leads to 2 = (1 - MPS)/(MPS) or 2MPS = 1 - MPS which yields 3MPS = 1. MPS therefore = 1/3 and the MPC must be equal to 2/3.
46. Calculate how much output would expand by if the government increased spending by $500 billion and financed this spending by increasing lump-sum taxes by the same amount.
46. Y = G (or T) x 1 due to the balanced budget multiplier. Therefore, output would expand by $500 billion.
47. Suppose there are 10 million unemployed out of a labor force of 100 million. This means an unemployment rate of 10/100 = .10, or 10 percent. Recalculate the unemployment rate if 1 million previously discouraged workers re-enter the workforce and start looking for work but don't immediately find employment.
47. Now the labor force is 101 million workers and there are 11 million unemployed workers. The unemployment rate is now 10.89%.
47. Explain the balanced budget multiplier?
47. The ratio of change in the equilibrium level of output to a change in government spending where the spending is balanced by a change in taxes so as to have no affect on the budget. The value of this multiplier is equal to one.
48. Explain how some government tax revenue and spending can depend on the state of the economy.
48. As the economy expands, people's incomes go up and more people are employed. This increases the size of the tax base. Even if Congress does not raise taxes it will collect more tax revenue when the tax base grows. Just the reverse is true in a recession. Likewise, some government transfers will move in the opposite direction of the state of the economy. For instance, if the economy expands the number of people on the welfare rolls and collecting unemployment compensation will decline. Again, these expenditures will rise when the economy is in recession.
49. Explain what structural unemployment is and give some examples.
49. 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.
49. Why do you suppose that state governments cannot rely on automatic stabilizers but the federal government can?
49. While state governments may experience changes in tax revenue brought about by a change in the macroeconomy state governments cannot run deficits like the federal government can. Therefore, in the case of a recession a state government may be faced with a budget shortfall (tax revenues forecast to be smaller than expenditures) however, the state must come up with a method of balancing the budget by either raising taxes or cutting state expenditures. Neither of these remedies serve as an automatic stabilizer.
5. Explain any differences between actual investment and planned investment. Also, is it possible for actual investment to be greater than planned investment? If so, explain.
5. Actual investment represents the amount of investment that takes place during a given period. Actual investment, therefore, also takes into account any unplanned changes in inventories. Planned investment represents those additions to the capital stock that are planned by firms. Yes, it is possible for actual investment to exceed planned investment. For this to occur, production must exceed sales. In this case, firms experience an unplanned increase in inventories that causes actual investment to exceed planned investment.
5. 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.
5. 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.
50. Why might a balanced budget requirement be potentially destabilizing for the economy?
50. Any requirement to balance the budget (constitutional or otherwise) essentially forestalls any opportunity by the government to use fiscal policy as a tool to stimulate the economy. For example, if the economy was in a severe recession, the budget deficit would automatically rise because of lower tax revenue and increased transfer payments. Under a balanced budget requirement this would require either a cut in spending or a tax increase. Both responses would serve to further contract the economy and make the recession worse.
50. List and explain the three major types of unemployment.
50. 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.
51. You are an employee of the Bureau of Labor Statistics involved in the monthly survey of households used to estimate the unemployment rate. In each of the following cases, classify the individual as employed, unemployed, or not in the labor force. Explain your classification. a) During the entire week containing the 12th of the month, Rosie the Riveter misses work simply because she didn't feel like going in to work. b) Jenny Wren is a volunteer 20 hours a week on a Rape Crisis telephone hotline. She feels she makes an important contribution to society and would not accept a paid job if one were offered to her. c) Cauley McCulkin is a hugely successful film star, age 12, who has earned over $5,000,000 each year for the past five years. Currently, Cauley is filming a new movie on location in Tenerife. d) Maxwell Edison, a full-time Ph.D. student, is involved in ground-breaking research in fiber optics. His dissertation advisor has already claimed that Maxwell's work will revolutionize telecommunications. e) Maggie Madd, 84, works 10 hours a week doing cleaning services for her son, Norman Neurotic. He pays her minimum wage.
51. (a) Rosie is employed. If Rosie is temporarily absent, with or without pay, she is considered employed. (b) Jenny is not in the labor force. She is not seeking a job nor does she meet the criteria required to be classified as employed. (c) Cauley is not in the labor force. He is less than 16 years old. (d) Maxwell is not in the labor force. He is a full-time student. (e) Maggie is paid and employed.
51. What do economists mean by the concept of a full-employment budget? Explain your answer in relation to the structural and cyclical deficit.
51. The full-employment budget is what the federal budget would be if the economy were producing at a full-employment level of output. In other words, if the economy were in recession it would clearly bring about a larger federal budget deficit than otherwise. But this does not accurately show the intent or the success of fiscal policy. The reason is that a large part of this deficit is simply due to the recessionary phase of the business cycle. This portion is called the cyclical deficit. The amount of the deficit that would still remain even if the economy were operating at full employment is called the structural deficit.
52. Compare and contrast the following two proposals to deal with a federal budget surplus in an economy that is operating at full employment. Proposal #1 would require that significant portions of the surplus be returned to the public in the form of tax cuts. Proposal #2 would require that an equal portion instead be impounded to augment the Social Security Trust Fund. Make sure to point out the effect that each may have on inflation.
52. If a sizeable portion of the surplus is returned to the public in the form of a tax cut this would increase the level of disposable income in the economy. In turn this would induce further household consumption which could generate inflation. On the other hand, by impounding the surplus to augment the Social Security Trust Fund this action would tend to be contractionary because it keeps spending from the economy that would have otherwise taken place. It would in effect reduce potential inflationary pressures.
52. Explain why some economists argue that counting discouraged workers as unemployed gives a better picture of the unemployment situation. How would the magnitude of the unemployment rate change if discouraged workers were counted as unemployed?
52. 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.
53. Explain why some unemployment is inevitable. How can unemployment actually benefit the economy?
53. 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.
54. "If inflation is fully anticipated by all parties, the redistributional effects would be minimal. It's the fact that inflation surprises us that causes there to be winners and losers." Comment. Which costs still occur even with fully anticipated inflation?
54. It is true that unanticipated inflation can cause income redistribution. Individuals on fixed incomes may suffer greatly, for example, whereas workers in powerful unions may thrive. However, some costs are borne by society in general, even when inflation is fully anticipated. Administrative costs, hoarding of real goods, additional search costs, and so on reduce the welfare of society in general.
55. What is the CPI or consumer price index?
55. 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.
56. Provide an explanation for why the Consumer Price Index may somewhat overstate changes in the cost of living.
56. 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.
57. Suppose you want to earn a 7% rate of return on a one-year loan you are about to make and the expected inflation rate for the duration of the loan is 5%. How much interest should be charged? Secondly, suppose that your forecasts are 2% below the actual level. What would happen to your real rate of return? What if you overestimated inflation by 2%?
57. You would need to assess an interest rate of 12% to earn 7%. The 5% is simply an inflation premium. However, if you underestimate inflation by 2% your real rate of return will only be 5% not 7%. Likewise, if you overestimate the inflation rate you will be in the happy circumstance of earning a 9% rate of return (12% - 3%).
6. Draw a graph of a business cycle. Label and explain the phases of a business cycle.
6. During an expansion, the level of economic activity is increasing. The peak is the highest level of economic activity. A contraction means that the level of economic activity is falling. A trough is the lowest level of economic activity.
6. In 1995 the Apex television manufacturing company planned to invest $1,100,000 by building a brand-new factory wing at a cost of $1,000,000 and increasing its inventories by $100,000 worth of television sets. However, by the end of the year the actual amount of investment for the company was $1,200,000. What could explain this apparent difference between the company's planned investment and actual investment?
6. Perhaps the sales of television sets were not as high as they expected. This caused inventories to accumulate to $200,000 instead of the $100,000 they had planned for.
60. 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?
60. 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.
61. Explain how an unanticipated increase in inflation would affect creditors and debtors.
61. 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.
62. 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.
62. 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%.
63. 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?
63. 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.
64. Why is anticipated inflation less of a problem than unanticipated inflation?
64. 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.
65. For the United States, explain why the amount of output that each worker can produce per hour has risen in the last half century.
65. 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.
66. Define what is meant by capital and discuss the various types of capital.
66. 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).
67. Explain how labor productivity is measured.
67. Labor productivity is measured by taking total output in the economy and dividing it by the total number of worker hours during the period.
7. Assume a two-sector economy where C = $100 + .9Y and I = $50. Calculate the equilibrium level of output for this hypothetical economy. What would the level of consumption be if the economy were operating at 1400? What would be the amount of unplanned investment at this level? In which direction, would you expect the economy to move to at $1400 and why?
7. Equilibrium in a two sector economy is where C + I = Y. In this case that is 100 + .9Y + 50 = Y. Rearranging terms yields 150 = .1Y. Solving for Y results in an equilibrium of $1500. If the economy is operating at 1400 the level of unplanned investment is -$10. Proof: Consumption would be $1360 (100 + .9(1400)). With investment of 50 this means aggregate spending is $1410. This is $10 above the level of aggregate output. With inventories being drawn down the expectation would be that firms would step up production and the economy would expand beyond $1400.
7. 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
7. Microeconomics: a, b, d, e, h. Macroeconomics: c, f, g, i, j.
8. What is the circular flow diagram and why is it useful?
8. 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.
9. Explain what the money market is. Make sure to discuss the three players in the money market.
9. 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.
9. Explain the path to equilibrium when output is greater than planned spending.
9. When output is greater than planned spending, there is unplanned inventory investment. Firms planned to sell more of their goods than they sold, and the difference shows as an unplanned increase in inventories. Equilibrium will be restored when output is reduced to the point where it is just in line with planned spending.
58. 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
a) 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.
48. 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.
8. Assume consumption is represented by the following: C = 400 + .5Y. Also assume that planned investment (I) equals 100. a) Given the information, calculate the equilibrium level of income. b) Given the information, calculate the level of consumption and saving that occurs at the equilibrium level of income. c) Write out the saving function for this economy. What is the marginal propensity to save?
a) Y = 1000 b) (b) C = 900 and S = 100 c) (c) S = -400 + .5Y; the MPS = .5
