chapter 15: measuring a nation’s income · pdf filechapter 15: measuring a...

Principles of Economics – Chapters 15-20 BUS499(2011A)

CHAPTER 15: MEASURING A NATION’S INCOME

CHAPTER SYNOPSIS

Chapter 15 is the third chapter in a five-chapter sequence dealing with firm behavior

and the organization of industry. Chapter 13 developed the cost curves on which firm

behavior is based. These cost curves were employed in Chapter 14 to show how a

competitive firm responds to changes in market conditions. In Chapter 15, these cost

curves are again employed, this time to show how a monopolistic firm chooses the

quantity to produce and the price to charge. Chapters 16 and 17 will address the

decisions made by monopolistically competitive, and oligopolistic firms.

The purpose of this chapter is to provide students with an understanding of the

measurement and the use of gross domestic product (GDP). GDP is the single most

important measure of the health of the macro-economy. Indeed, it is the most widely

reported statistic in every developed economy.

CHAPTER OBJECTIVES

� why an economy’s total income equals its total expenditure.

� how gross domestic product (GDP) is defined and calculated.

� the breakdown of GDP into its four major components.

� the distinction between real GDP and nominal GDP.

� whether GDP is a good measure of economic well-being.

REVIEW AND DISCUSSION

A) Gross Domestic Product (GDP) is the market value of all final goods and

services produced by the factors of production located in a country in one year’s

time.

B) GDP can be divided into four final use categories:

1. Personal Consumption Expenditures are the goods and services purchased

by households for their consumption.

2. Government Expenditures for Goods and Services are the goods and

services purchased by the government at all levels (federal, state and local).

Government Transfer Payments are not included because they do not

(directly) purchase a good or service.


3. Investments are the goods purchased, mainly by business firms, to add to the

nation’s capital stock. Depreciation is the value of the existing capital stock

that has been used up in the process of producing output.

4. Net Exports are the domestically produced goods purchased by foreigners

minus domestic purchases of foreign produced goods.

C) Real GDP measures the volume of real goods and services produced by the

economy by removing the effect of changing prices from nominal GDP. Nominal

GDP is the value of the output of final goods and services expressed using

prevailing prices;

D) Gross National Product (GNP) measures the production of the factors of

production supplied by residents of the country, whether that production took

place at home or abroad. It is calculated as GDP plus income generated by

U.S.-owned factors located in other nations minus income paid in the United

States to foreign-owned factors of production.

E) National Income equals GNP minus depreciation and indirect business taxes

(such as sales taxes). National income also equals the sum of payments made to

the factors of production.

F) Personal Income equals the sum of all income people actually receive. Personal

Disposable Income equals personal income minus personal income tax payments.

Thus, personal disposable income is all the income people actually have to spend

or save.

G) Since GDP equals the sum of total expenditures on consumption investment,

government spending, and net exports, and also equals the amount of income that

can be spent on consumption, savings and taxes investment must be equal to

saving. The amount of investment is limited by both household saving and public

saving.

H) The Natural Level of Real GDP is the output associated with the natural rate of

unemployment


PRACTICE QUIZ

Students are encouraged to complete the following practice quiz prior to reviewing

the provided answers.

True/False

If the statement is correct, write true in the space provided; if it is wrong, write false.

Below the question give a short statement that supports your answer.

_____ 1. Extensive economic growth can occur if more people decide to work rather

than retire early or continue in school.

_____ 2. A government policy that encourages investment in human capital, such as

providing below cost of college educations, can help increase a nation’s growth rate.

_____ 3. Intensive growth refers to economic growth that is the result of increases in

the amount of a nation’s productive inputs.

_____ 4. Real GDP can fall even if nominal GDP rises.

Multiple Choice Questions

Circle the letter corresponding to the correct answer.

5. The stage of the business cycle during which output is at its lowest point is

(a) the recession.

(b) when the stock market is falling.

(c) the peak.

(d) the recovery.

(e) the trough.

6. Which of the following is not a final use of GDP?

(a) Consumption expenditures

(b) Government expenditures for goods and services

(c) Government expenditures for transfer payments to individuals

(d) Investment

(e) Net exports of goods and services


7. Which of the following is an example of intensive growth?

(a) Growth caused by an increase in technology that allows more output to be

produced without any change in the inputs utilized

(b) Growth caused by an expansion of the nation’s capital stock that takes place as

a result of changes in the nation’s tax laws

(c) Growth caused by an increase in the nation’s labor force

(d) All of the above

(e) None of the above

8. The amount of goods and services produced by an economy is measured by

(a) national income.

(b) depreciation.

(c) consumption.

(d) the business cycle.

(e) real GDP.

9. At the natural rate of unemployment, real GDP _________ the natural level of real

GDP and the inflation rate is _________.

(a) is greater than; rising

(b) is greater than; rising

(c) is equal to; rising, constant, or falling, depending on other factors

(d) is equal to; not changing

(e) is less than; falling

10. The production function says that

(a) real GDP depends on the economy’s capital stock..

(b) real GDP should increase when labor inputs increase.

(c) real GDP rises when there are technological improvements.

(d) (a), (b), and (c).

(e) None of the above

Essay Questions

Write a short essay or otherwise answer each question.

11. What is the difference between real and nominal GDP?


12. What are the four final use categories of GDP?

13. Suppose an economy’s production function is given by:

Y = 0.75 L + 0.25 K + T, where the italics denote annual growth rates.

Output grows at 5% per year, labor grows at 4% per year, and capital grows at 6%

per year. How much of the growth in output is explained by technology?

14. Suppose that you have the following information for the U.S. economy:

Item Amount

Consumption Expenditure $67 million

Depreciation $10 million

Exports $22 million

Government Expenditure $31 million

Imports $25 million

Investment $35 million

Transfer Payments $8 million

(a) What is the value of GDP?

(b) Is there a trade surplus of deficit? By how much?

ANSWERS TO PRACTICE QUIZ

True/False

1. True. Extensive growth occurs when productive inputs increase. By retiring later

or leaving school earlier, people increase the nation’s labor force and so labor, a

productive resource, increases.

2. True. This sort of productivity-enhancing policy can raise intensive growth.

3. False. The definition of intensive growth is growth caused by more output per

input, not growth caused by possessing more inputs.

4. True. Even if the number of goods and services produced in an economy declines

(so that real GDP falls), it is possible for the inflation rate to be high enough so


that nominal GDP, which includes both the effects of higher prices and lower

output, rises.


5. (e) The trough is the moment when the economy is at the bottom of the business

cycle, passing from the recession phase into the recovery phase.

6. (c) The final use breakdown of GDP depends on who or what purchases the goods

and services. Transfer payments are given to people, but nothing—that is, no good

or service—is received in exchange. Thus, transfer payments are not part of the

government expenditure on goods and services. (Transfer payments can be spent

by the recipients to help finance some of the consumption part of GDP.)

7. (a) This is virtually the definition of intensive growth: Growth that occurs when

more output can be produced from the same amount of inputs.

8. (e) Real GDP measures the number of goods and services produced by an

economy.

9. (d) When the economy is at the natural rate of unemployment, employment is not

changing and so there is no wage pressure either upwards or downwards. Because

employment does not change, the economy is producing at the natural level of real

GDP. And, because there is no wage pressure, the inflation rate is constant.

10. (d) The production function says output depends on labor, capital, and technology.

Essay Questions

11. Real GDP measures the number of goods and services produced by an economy.

Nominal GDP is the market value of these goods and services. Nominal GDP

depends on the quantities produced as well as on their prices. Real GDP depends

on only the quantities.

12. The four final use categories of GDP depend on the sector that purchases the

good.

(a) Consumption: Goods purchased by the household sector.


(b) Government purchases of goods and services: Goods purchased by the

government sector.

(c) Investment: Goods purchased by firms to add to their capital stock.

(d) Net exports of goods and services: Goods purchased by foreign residents

less the purchase of foreign goods by domestic residents.

13. Plugging the information into the growth formula:

5% = 0.75 X 4% + .25 X* 6% + T

5% – 3% – 1.5% = T

T = 0.5%

14. (a) GDP = C + I + G + X – M = 67 + 35 + 31 +

22 – 25 = $130 million

(b) There is a trade deficit since imports are larger than exports. The deficit is $3

million.


CHAPTER 16: MEASURING THE COST OF

LIVING

CHAPTER SYNOPSIS

Chapter 16 introduces students to two vital statistics that economists use to monitor

the macroeconomy—GDP and the consumer price index (CPI).

The purpose of Chapter 16 is twofold: first, to show students how to generate a price

index and, second, to teach them how to employ a price index to compare dollar

figures from different points in time and to adjust interest rates for inflation. In

addition, students will learn some of the shortcomings of using the consumer price

index as a measure of the cost of living.

CHAPTER OBJECTIVES

� how the consumer price index (CPI) is constructed.

� why the CPI is an imperfect measure of the cost of living.

� how to compare the CPI and the GDP deflator as measures of the overall price

level.

� how to use a price index to compare dollar figures from different times.

� the distinction between real and nominal interest rates.


1. A 10% increase in the price of chicken has a greater effect on the consumer price

index than a 10% increase in the price of caviar because chicken is a bigger part of

the average consumer's market basket.

2. The three problems in the consumer price index as a measure of the cost of living

are: (1) substitution bias, which arises because people substitute toward goods that

have become relatively less expensive; (2) the introduction of new goods, which

are not reflected quickly in the CPI; and (3) unmeasured quality change.

3. If the price of a Navy submarine rises, there is no effect on the consumer price

index, because Navy submarines are not consumer goods. But the GDP price

index is affected, because Navy submarines are included in GDP as a part of

government purchases.


4. Because the overall price level doubled, but the price of the candy bar rose

six-fold, the real price (the price adjusted for inflation) of the candy bar tripled.

5. The nominal interest rate is the rate of interest paid on a loan in dollar terms. The

real interest rate is the rate of interest corrected for inflation. The real interest rate

is the nominal interest rate minus the rate of inflation.


CHAPTER 17: PRODUCTION AND GROWTH

CHAPTER SYNOPSIS

Chapter 17 is the first chapter in a four-chapter sequence on the production of output

in the long run. Chapter 17 addresses the determinants of the level and growth rate of

output. We find that capital and labor are among the primary determinants of output.

In Chapter 18, we address how saving and investment in capital goods affect the

production of output, and in Chapter 19, we learn about some of the tools people and

firms use when choosing capital projects in which to invest. In Chapter 20, we address

the market for labor.

The purpose of Chapter 17 is to examine the long-run determinants of both the level

and the growth rate of real GDP per person. Along the way, we will discover the

factors that determine the productivity of workers and address what governments

might do to improve the productivity of their citizens.

CHAPTER OBJECTIVES

� how much economic growth differs around the world.

� why productivity is the key determinant of a country’s standard of living.

� the factors that determine a country’s productivity.

� how a country’s policies influence its productivity growth.


I. The level of a nation’s GDP measures both the total income earned in the

economy and the total expenditure on the economy’s output of goods and

services. The level of real GDP is a good gauge of economic prosperity, and

the growth of real GDP is a good gauge of economic progress. You would

rather live in a nation with a high level of GDP, even though it had a low

growth rate, than in a nation with a low level of GDP and a high growth rate,

because the level of GDP is a measure of prosperity.

A) A Price Index shows the current year’s cost of buying a particular basket of

goods as a percentage of the cost of the same basket of goods bought in some

year earlier. Two common indices are:

1. The Consumer Price Index (CPI) measures the change in consumer

prices; the price of a market basket of goods purchased by an average

urban household.


2. The GDP Deflator measures the change in prices of all goods and services

produced in the economy.

B) Since WWII, there has been a continuing increase in prices (inflation) but at

different rates. This is different that prior to 1930 when prices were just as

likely to rise as they were to fall.

C) There are three general effects of inflation:

1. When inflation is unanticipated it redistributes income.

2. Inflation can reduce economic efficiency since agents search for ways to

beat inflation.

3. Rapid inflation diverts resources from productive to non productive

investments and reduces an economy’s productive capacity.

II. Productivity

A) The four determinants of productivity are: (1) physical capital, which is the

stock of equipment and structures that are used to produce goods and services;

(2) human capital, which consists of the knowledge and skills that workers

acquire through education, training, and experience; (3) natural resources,

which are inputs into production that are provided by nature; and (4)

technological knowledge, which is society’s understanding of the best ways to

produce goods and services.

B) A college degree is a form of human capital. The skills learned in earning a

college degree increase a worker's productivity.

C) Higher saving means fewer resources are devoted to consumption and more to

producing capital goods. The rise in the capital stock leads to rising

productivity and more rapid growth in GDP for a while. In the long run, the

higher saving rate leads to a higher standard of living. A policymaker might be

deterred from trying to raise the rate of saving because doing so requires that

people reduce their consumption today and it can take a long time to get to a

higher standard of living.


PRACTICE QUIZ



Essay Questions

Write a short essay or otherwise answer each question.

1. If a worker is offered a wage of $12/hour, and if the average price of goods is

$4/good, how many goods can be purchased for an hour’s work? Suppose the

worker has underestimated the inflation rate so that the worker believes the

average price is $3/good. How many goods does the worker believe an hour’s

work will buy? Is the worker more likely to accept the job if he or she believes the

prices of goods are $3/good or $4/good?

2. Suppose people’s inflationary expectations are formed adaptively. What would be

the immediate effect on inflationary expectations if the government announced

that it was going to lower the growth rate of the money supply?

3. If people’s inflationary expectations are formed rationally, what would be the

immediate effect on inflationary expectations if the government announced that it

was going to lower the growth rate of the money supply? Does your answer

depend on whether the public believes the government’s announcement?

4. Explain using the evidence at the end of this chapter why some experts think we

have entered a new era of low inflation and low unemployment in the 1990s?

5. Suppose the market basket used to calculate a price index contains five CD’s,

twenty hamburgers and twenty beers. The table below list the price of these goods

in 2003 and 2004.

Good 2003 Prices 2004 Prices

CD’s $16.00 $15.00

Hamburger $2.00 $2.50

Beer $3.00 $3.25

(a) What is the 2004 price index?

(b) What is the inflation rate from 2003 to 2004?


6. Since the late 1980’s what one factor was contributed to periods of high inflation?

What type of inflation is this? Explain.

7. Suppose that from 2003 to 2004 the money supply increased by 6% and real GDP

increased by 4%. If velocity was constant over the year, what was the inflation

rate according to the equation of exchange? If velocity actually fell by 2%, what

would the inflation rate have been?

8. Suppose a person forms their expectations of inflation adaptively. In the simplest

case assume that they expect the inflation rate today to be the same as it was

yesterday. The following table shows the actual inflation rates over 7 years.

Year Actual Inflation Rate Expected Inflation Rate Forecast

Error

1 0% — —

2 2%

3 3%

4 5%

5 4%

6 2%

7 1%

(a) Complete the table. The forecast error is the difference between what you

expected and what actually occurred. Pay careful attention to the sign of

your error (positive or negative).

(b) Do you notice a pattern with the relationship between the sign of you

forecast error and whether inflation is rising or falling? What does this say

about adaptive expectations?


1. An hour’s work actually purchases 3 goods. The worker expects that an hour’s

work buys 4 goods. Clearly the worker is more likely to accept the job if he or she

thinks an hour’s work is worth 4 goods. This example shows how unexpected

inflation can cause workers to more readily accept jobs. If the worker were aware

of how much the actual inflation rate had increased the price of goods, the worker

would be less inclined to accept the job offer.


2. Adaptive expectations depend on only past experiences. Thus, there would be no

immediate effect on people’s expectations.

3. Rational expectations depend on all available information. So, if people believe

the government’s announcement, they would promptly lower their inflationary

expectations. If they did not believe the government, they would not alter their

inflationary expectations.

4. The new era of low inflation and low unemployment of the 1990s has supposedly

been caused by increased foreign competition, low energy prices, and the

deflationary effects of the crisis in Asia.

5. (a) The cost of the market basket in 2003 is $180 (5 X $16 20 X $2 20 X $3). The cost of the market basket in 2004 is $190 (5 X $15 20

X $2.50 20 X $3.25). The 2004 price index is 105.56.

(b) 5.56%.

6. Since the late 1980’s increases in energy prices have given rise to periods of high

inflation three times: the Iran-Iraq War in the late 1980’s, the first Gulf War in

1991, and the second Gulf War. Each time the price of crude oil increased

significantly. When the price of crude oil increases, production costs increase as

well, which causes the aggregate supply curve to shift to the left. Therefore, oil

price shocks lead to supply-side inflation.

7. The equation of exchanges (in growth rates) is:

%∆M + %∆ V = %∆ P + %∆ Y.

If velocity is constant the %∆V = 0, and %∆ P = 6% – 4% = 2%. If velocity fell by 2%, then %∆P = 6% – 2% – 4% = 0%.

Therefore, there was no inflation.


8. (a)

Year Actual Inflation Rate Expected Inflation Rate Forecast

Error

1 0% — —

2 2% 0 –2

3 3% 2 –1

4 5% 3 –2

5 4% 5 1

6 2% 4 2

7 1% 2 1

(b) When the inflation rate is increasing (from year 1 to year 4) the forecast error

is negative. When the inflation rate is falling (from year 5 to year 7) the

forecast error is positive. There is a consistent pattern to the errors you make.

More formally, you make systematic errors. This is one of the things that is

troubling about adaptive expectations. If you know you are making a mistake

and you know how you are making the mistake, shouldn’t you correct for it?


CHAPTER 18: SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

APTER SYNOPSIS

Chapter 18 is the second chapter in a four-chapter sequence on the production of

output in the long run. In Chapter 17, we found that capital and labor are among the

primary determinants of output. For this reason, Chapter 18 addresses the market for

saving and investment in capital, and Chapter 19 addresses the tools people and firms

use when choosing capital projects in which to invest. Chapter 20 will address the

market for labor.

The purpose of Chapter 18 is to show how saving and investment are coordinated by

the loanable funds market. Within the framework of the loanable funds market, we are

able to see the effects of taxes and government deficits on saving, investment, the

accumulation of capital, and ultimately, the growth rate of output.

CHAPTER OBJECTIVES

� some of the important financial institutions in the U.S. economy.

� how the financial system is related to key macroeconomic variables.

� the model of the supply and demand for loanable funds in financial markets.

� how to use the loanable-funds model to analyze various government policies.

� how government budget deficits affect the U.S. economy.


I. Consumption and Savings

A) Household Savings (or personal savings) is what we have left over from our

income after buying goods and services and paying our income taxes.

B) We can save only by reducing consumption. When we save, we add to our

assets by increasing funds in savings accounts, by purchasing bonds, stocks,

etc.

C) How much of our income we consume depends on the income we earn after

taxes and the interest rate.

D) The Consumption Function shows how much a household wishes to

consume at each level of income and interest rate: C =f (Y, r).

Consumption increases with income and decreases with the interest rate.


E) The Saving Function shows how much a household wishes to save at each

level of income and interest rate: S = F (Y, r). Saving increases with

income and increases with the interest rate.

II. The financial system

A) The financial system's role is to help match one person's saving with another

person's investment. Two markets that are part of the financial system are

the bond market, through which large corporations, the federal government,

or state and local governments borrow, and the stock market, through which

corporations sell ownership shares. Two financial intermediaries are banks,

which take in deposits and use the deposits to make loans, and mutual funds,

which sell shares to the public and use the proceeds to buy a portfolio of

financial assets.

B) It is important for people who own stocks and bonds to diversify their

holdings because then they will have only a small stake in each asset, which

reduces risk. Mutual funds make such diversification easy by allowing a

small investor to purchase parts of hundreds of different stocks and bonds.

C) National saving is the amount of a nation's income that is not spent on

consumption or government purchases. Private saving is the amount of

income that households have left after paying their taxes and paying for their

consumption. Public saving is the amount of tax revenue that the

government has left after paying for its spending. The three variables are

related because national saving equals private saving plus public saving.

D) Investment refers to the purchase of new capital, such as equipment or

buildings. It is equal to national saving.

E) A change in the tax code that might increase private saving is the expansion

of eligibility for special accounts that allow people to shelter some of their

saving from taxation. This would increase the supply of loanable funds,

lower interest rates, and increase investment.

F) A government budget deficit arises when the government spends more than

it receives in tax revenue. Because a government budget deficit reduces

national saving, it raises interest rates, reduces private investment, and thus

reduces economic growth.

G) For an example, when the Russian government defaulted on its debt,

investors perceived a higher chance of default (than they had before) on

similar bonds sold by other developing countries. Thus, the supply of


loanable funds shifted to the left, as shown in Figure 1. The result was an

increase in the interest rate.

Figure 1

PRACTICE QUIZ


the provided answers

True/False



_____ 1. The consumption function is the same as the saving function since both are

determined by a household income and interest rate.

_____ 2. Given a constant rate of interest, both consumption and saving increase as

the income increases.

_____ 3. Given an unchanging level of income, consumption falls and saving rises as

the rate of interest increases.

_____ 4. The life-cycle theory of consumption states that people base their

consumption and saving decisions on their current level of income.



5. Which of the following is correct? Savings can be made by

(a) government.

(b) households.

(c) businesses.

(d) (b) and (c).

(e) all of the above.

6. People are able to smooth out fluctuations in their consumption because they can

(a) borrow over entire lifetimes.

(b) save over entire lifetimes.

(c) borrow when they expect their income to rise and save when they expect their

income to decline.

(d) borrow and/or save depending on the real rate of interest.

(e) borrow and/or save depending on the nominal rate of interest.

ANSWERS TO REVIEW QUESTIONS

True/False

1. False. Although both functions have similar form, their meanings are different: the

consumption function shows how much a household wishes to consume at each

level of income and interest rate, and the saving function deals with that portion of

income that is left over after consumption.

2. True. If the interest rate holds constant, a household will normally spend and save

more as its income increases.

3. True. The interest rate is the reward for saving. When our income does not change,

we usually choose to save more and spend less as the interest rate increases.

4. False. The life-cycle theory of consumption predicts that people tend to smooth

out fluctuations in consumption over time by anticipating future changes in their

incomes. Young people borrow, expecting future rises in their incomes, while

mature people consume less and save more, expecting their income to shrink as

they become old.



5. (e) Not all saving in the economy is the personal saving. Businesses save by

retaining profits that are not distributed to owners as dividends and by setting

aside funds to replace capital that is depreciating. Also the government saves by

spending less than it collects in taxes.

6. (c) According to the life-cycle theory of consumption, in order to avoid swings in

consumption, people borrow when they are young, expecting that their incomes

will eventually rise; and people save as they become mature, expecting that their

incomes will fall when they are old.


CHAPTER 19: THE BASIC TOOLS OF FINANCE

CHAPTER SYNOPSIS

Chapter 19 is the third chapter in a four-chapter sequence on the level and growth of

output in the long run. In Chapter 17, we discuss how capital and labor are among the

primary determinants of output and growth. In Chapter 18, we addressed how saving

and investment in capital goods affect the production of output. In Chapter 20, we will

show some of the tools people and firms use when choosing capital projects in which

to invest. Because both capital and labor are among the primary determinants of

output, Chapter 20 will address the market for labor.

The purpose of Chapter 19 is to introduce the students to some tools that people use

when they participate in financial markets. We will show how people compare

different sums of money at different points in time, how they manage risk, and how

these concepts combine to help determine the value of a financial asset, such as a

share of stock.

CHAPTER OBJECTIVES

� the relationship between present value and future value.

� the effects of compound growth.

� how risk-averse people reduce the risk they face.

� how asset prices are determined.


I. Interest Rates and Savings

A) Consumption today is preferable over consumption tomorrow: by consuming

our income today, we get instant satisfaction.

B) The Interest Rate constitutes the reward for postponing consumption into

the future.

C) Interest rates determine saving decisions: an increase in the rate of interest,

holding other factors constant, encourages us to save more (to postpone more

consumption).


II. Interest Rates and Investment

A) The term Investment refers to business investment in new plants, equipment,

and inventories.

B) The key determinants of investment are

1. the expectations of the future profits.

2. the costs of borrowing.

C) Businesses compare the rate of return of an investment to the cost of

acquiring additional capital.

Firms carry out additional investments as long as their rate of return exceeds

the market rate of interest. The last investment project should yield a rate of

return equal to the market interest rate.

D) The firm’s Investment Demand Curve shows the amount of investment

desired at different interest rates, and the investment demand curve is

negatively sloped: the amount of desired investment increases as the interest

rate falls. The investment demand curve of the economy shows the amount of

investment desired at different interest rates by the economy as a whole.

III. The Structure of the Interest Rates

A) There are many types of borrowers in credit markets: businesses who wish to

launch new projects, households who wish to finance home purchase or new

cars, governments whose budgets are in deficit. The interest rate is not the

same for all borrowers, and different interest rates are paid on different

financial assets.

B) Interest rates vary with the conditions of Risk, Liquidity, and Maturity

associated with a loan.

1. Lenders must be compensated for the extra risk of lending to borrowers

with poor credit ratings. The greater the risk associated with the loan, the

higher the interest rate. The risk premium is the additional interest paid

by high risk borrowers.

2. Financial assets are called liquid if they can be turned into cash quickly

or with a small penalty. Interest rates vary inversely with liquidity.

3. Interest rates vary with the term of maturity, that is, the length of the

borrowing period.


PRACTICE QUIZ


the provided answers

True/False



_____ 1. The nominal rate of interest is crucial in making saving decisions since it

adjusts for inflation.

_____ 2. The real interest rate equals the nominal rate of interest when there is no

inflation.

_____ 3. The greater the real interest rate, the more people are encouraged to save.

_____ 4. Demand for investment by the entire economy increases as the business

expectations become more optimistic.



5. Suppose a $20 million investment project promises to add $1 million to profits

each year for an almost infinite period. What is the rate of return on this

investment project?

(a) 5 percent

(b) 10 percent

(c) 19 percent

(d) 20 percent

(e) 21 percent

6. The market interest rate is the rate of interest that equates

(a) the real rate of interest with the rate of return on an investment project.

(b) the quantity of investment with the quantity of saving.

(c) the amount of savings with consumption expenditures.

(d) the real rate of interest with the nominal interest rate.


(e) present and future consumption.

7. In the situation when lenders cannot find enough borrowers, the interest rate

(a) increases.

(b) drops.

(c) remains the same until the businesses find profitable projects, and then

increases.

(d) remains the same until the businesses find profitable projects, and then

drops.

(e) all of the above is possible.

8. The real interest rate formula includes

(a) the nominal rate of interest and the actual rate of inflation.

(b) the nominal rate of interest and the anticipated rate of inflation.

(c) the market interest rate and the expected demand for investment.

(d) the nominal rate of interest and market prices.

(e) all of the above.

9. Under which of the following conditions will the interest rate on a loan tend to be

the highest?

(a) High risk, high liquidity, short term of maturity

(b) High risk, low liquidity, long term of maturity

(c) Low risk, high liquidity, long term of maturity

(d) Low risk, low liquidity, long term of maturity

(e) Both a and d

ANSWERS TO REVIEW QUESTIONS

True/False

1. False. It is the real interest rate that anticipates inflation and affects saving

decisions.

2. True. The real interest rate is defined as the nominal rate of interest minus

anticipated inflation.


3. True. Changes in the real interest rate affect the terms on which we can exchange

current and future consumption. Thus, a higher interest rate translates into cheaper

future consumption.

4. False. Demand for investment by the entire economy increases as the interest rate

declines.


5. (a) The rate of return on a $20 million investment project is 5 percent—the annual

addition to profit divided by the cost of the project.

6. (b) The credit market is in equilibrium at an interest rate that equates the desired

amount of investment with the desired amount of saving.

7. (b) If the amount of desired investment exceeds the amount of desired saving, and

lenders cannot find enough borrowers, the interest rate drops until the credit

market reaches an equilibrium.

8. (b) The real interest rate is the nominal rate minus anticipated inflation. This

formula does not claim that we correctly anticipate inflation. Actual inflation can

be different from expected. After the fact, however, we can look back and observe

the actual interest rate earned by savers by deducting the actual inflation rate from

the nominal rate.

9. (b) Interest rates vary with the conditions of risk, liquidity, and maturity

associated with a loan. Higher risk, lower liquidity, and longer term of maturity

make the loans less profitable for the lenders. To compensate, lenders will charge

higher interest rates on loans if one or more of these conditions are met.


CHAPTER 20: UNEMPLOYMENT AND ITS NATURAL RATE

CHAPTER SYNOPSIS

Chapter 20 is the fourth chapter in a four-chapter sequence on the level and growth of

output in the long run. In Chapter 17, we learned that capital and labor are among the

primary determinants of output and growth. In Chapter 18, we addressed how saving

and investment in capital goods affect the production of output. In Chapter 19, we

learned about some of the tools people and firms use when choosing capital projects

in which to invest. In Chapter 20, we see how full utilization of our labor resources

improves the level of production and our standard of living.

The purpose of Chapter 20 is to introduce students to the labor market. We will see

how economists measure the performance of the labor market using unemployment

statistics. We will also address a number of sources of unemployment and some

policies that the government might use to lower certain types of unemployment.

CHAPTER OBJECTIVES

� the data used to measure the amount of unemployment.

� how unemployment can result from minimum-wage laws.

� how unemployment can arise from bargaining between firms and unions.

� how unemployment results when firms choose to pay efficiency wages.


1 The unemployment rate is the percentage of those who would like to work but do

not have jobs. The Bureau of Labor Statistics calculates this statistic monthly

based on a survey of thousands of households.

2 The unemployment rate is an imperfect measure of joblessness. Some people who

call themselves unemployed may actually not want to work, and some people who

would like to work have left the labor force after an unsuccessful search and

therefore are not counted as employed.

3 In the U.S. economy, most people who become unemployed find work within a

short period of time. Nonetheless, most unemployment observed at any given time

is attributable to the few people who are unemployed for long periods of time.


4 One reason for unemployment is the time it takes for workers to search for jobs

that best suit their tastes and skills. This frictional unemployment is increased as a

result of unemployment insurance, a government policy designed to protect

workers’ incomes.

5 A second reason why our economy always has some unemployment is

minimum-wage laws. By raising the wage of unskilled and inexperienced workers

above the equilibrium level, minimum-wage laws raise the quantity of labor

supplied and reduce the quantity demanded. The resulting surplus of labor

represents unemployment.

6 A third reason for unemployment is the market power of unions. When unions

push the wages in unionized industries above the equilibrium level, they create a

surplus of labor.

7 A fourth reason for unemployment is suggested by the theory of efficiency wages.

According to this theory, firms find it profitable to pay wages above the

equilibrium level. High wages can improve worker health, lower worker turnover,

raise worker quality, and increase worker effort.

8 The Bureau of Labor Statistics (BLS) categorizes each adult (16 years of age and

older) as either employed, unemployed, or not in the labor force. The labor force

consists of the sum of the employed and the unemployed. The unemployment rate

is the percentage of the labor force that is unemployed. The labor-force

participation rate is the percentage of the total adult population that is in the labor

force.

9 Unemployment is typically short term. Most people who become unemployed are

able to find new jobs fairly quickly. But some unemployment is attributable to the

relatively few workers who are jobless for long periods of time.

10 Frictional unemployment is inevitable because the economy is always changing.

Some firms are shrinking while others are expanding. Some regions are

experiencing faster growth than other regions. Transitions of workers between

firms and between regions are accompanied by temporary unemployment.

The government could help to reduce the amount of frictional unemployment

through public policies that provide information about job vacancies in order to

match workers and jobs more quickly, and through public training programs that


help ease the transition of workers from declining to expanding industries and

help disadvantaged groups escape poverty.

11 Minimum-wage laws are a better explanation for unemployment among teenagers

than among college graduates. Teenagers have fewer job-related skills than

college graduates do, so their wages are low enough to be affected by the

minimum wage. College graduates' wages generally exceed the minimum wage.

12 Unions may affect the natural rate of unemployment via the effect on insiders and

outsiders. Because unions raise the wage above the equilibrium level, the quantity

of labor demanded declines while the quantity supplied of labor rises, so there is

unemployment. Insiders are those who keep their jobs. Outsiders, workers who

become unemployed, have two choices: either get a job in a firm that is not

unionized, or remain unemployed and wait for a job to open up in the union sector.

As a result, the natural rate of unemployment is higher than it would be without

unions.

13 Advocates of unions claim that unions are good for the economy because they are

an antidote to the market power of the firms that hire workers and they are

important for helping firms respond efficiently to workers' concerns.

14 Four reasons why a firm's profits might increase when it raises wages are: (1)

better paid workers are healthier and more productive; (2) worker turnover is

reduced; (3) the firm can attract higher quality workers; and (4) worker effort is

increased.

PRACTICE QUIZ



True/False



_____ 1. Labor is a unique factor of production because its price is not determined by

the supply and demand for it.


_____ 2. The supply curve for a factor of production typically shows that the higher

the factor’s price, the greater the quantity that will be supplied.

_____ 3. Firms purchase factor inputs because the inputs directly yield satisfaction.

_____ 4. Human capital refers to people who lend funds to firms for their investment

in capital equipment.

_____ 5. Noncompeting groups are groups of jobs that are very different.

_____ 6. The two goals of unions, higher pay and greater employment, are not in

conflict with each other.

_____ 7. The notion of compensating wage differentials shows that, everything else

equal, the wages paid for less desirable jobs will be higher than those paid for more

desirable jobs.



8. All of the following increase the wage paid to carpenters except

(a) an increase in the demand for new houses.

(b) a new belief among workers that carpentry is a less desirable job.

(c) a fall in the price and marginal revenue of new houses.

(d) the introduction of new saws that increase the marginal productivity of

carpenters.

(e) an increase in the demand for carpenters.

9. If the supply curve for a factor shifts to the right, the price of the factor will

_________ while the quantity employed will _________.

(a) rise; rise

(b) rise; fall

(c) not change; not change

(d) fall; rise

(e) fall; fall


10. The labor market is different from other factor markets for all of the following

reasons except that

(a) slavery is against the law.

(b) people care about the jobs at which they work.

(c) workers can engage in alternative activities such as household production.

(d) unions may be formed.

(e) the number of people willing to work does not depend on their wage.

11. Other things equal, wages in less desirable jobs are _________ wages in more

desirable jobs.

(a) more than

(b) equal to

(c) less than

(d) sometimes more than and sometimes less than

(e) not comparable to


True/False

1. False. As with any factor, the price of labor (its wage) is determined by the supply

and demand for it.

2. True. The higher the factor’s price, the larger is the opportunity cost of failing to

supply the factor.

3. False. Firms purchase factors because they can sell the output produced by the

factors. This means

(a) the demand for factors is derived from the demand for the products

produced.

4. False. Human capital refers to the productivity-boosting investments people make

in themselves.

5. False. Noncompeting groups are groups of workers whose talents are so different

they do not compete with each other for jobs.


6. False. If the union gains higher pay, firms reduce their employment of the

unionized workers.

7. True. Essentially, in order to attract workers to less desirable jobs, these jobs must

pay higher wages to compensate for their unpleasantness.


8. (c) The fall in the price of new houses lowers the additional revenue gained by

hiring an extra carpenter (the marginal revenue product of the carpenter), so the

demand for carpenters falls.

9. (d) This is precisely the same result we get in product markets when the supply of

a commodity shifts to the right.

10. (e) The number of people willing to work generally, but not always, increases as

the wage they can receive rises.

11. (a) The difference is a compensating wage differential.

UNIT EXAM

For assessment purposes this course is divided into various units for which you will

be required to take unit exams. Please carefully read all chapters in the given unit and

try to understand their contents.

It is important to note here that the unit exams are open book exams and you may use

your textbooks and other supporting material for your reference and assistance. Please

note that you must strive to score highest grades at unit exams and as such you must

only attempt your unit exams after you are confident that you can answer most of the

questions correctly. Please also note that there is no time constraint and you may open

each unit exam in multiple times. However this does not mean that you unnecessarily

delay the course completion rather that the completion of your course should always

remain higher on your academic agenda.

YOU MAY NOW START UNIT EXAM 3!

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