ANSWERS TO END-OF-CHAPTER PROBLEMSCHAPTER 1

Quick Check1. a. True.

b. True.c. True. d. Uncertain. It is true that the growth of output per worker increased in the mid-1990s, but

economists disagree about the degree to which this increase in growth will persist. The growth of output per worker fluctuates a great deal from year to year, which makes it difficult to draw inferences from the data.

e. True.f. False. The European “unemployment miracle” refers to the low rate of unemployment

in Europe in the 1960s.g. False. The slump was triggered by the collapse of the Japanese stock market. h. False.

2. a. 1960-2000 1994-2000 2001-2004

US 3.2% 3.9% 2.45%EU 3.1% 2.3% 2.3%Japan 4.7% 1.4% 2.3%

Growth rates in all three regions are lower in the most recent period than over the period 1960-2004. However, compared to the period 1994-2000, U.S. growth is lower in the most recent period, Japanese growth is higher, and European growth is unchanged.

b. Answers will vary.

3. a. Low unemployment might lead to an increase in inflation.

b. Tax cuts may have been useful to stimulate the U.S. economy during the 2001 recession. However, the tax cuts were permanent. The recession is over and the deficit remains high.

c. Although labor market rigidities may be important, it is also important to consider that these rigidities may not be excessive, and that high unemployment may arise from flawed macroeconomic policies.

d. Although poor regulation of the financial system may be contributing to the length of Japan's slump, most economists believe that the collapse in Japanese asset prices triggered the economic downturn. Moreover, tightening regulation would likely involve more pain in the short run since some banks and firms would be forced to close.

e. Although the Euro will remove obstacles to free trade between European countries, each country will be forced to give up its own monetary policy.

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Dig Deeper4. This is a discussion question, so answers will vary. Based on the discussion in the text, there are

clear similarities in the policy responses of the U.S. and Japanese governments. Central banks in both countries reduced interest rates, and governments in both countries tried to stimulate the economy with lower taxes. Government spending also increased in both countries; explicitly for economic stimulus in Japan, and as part of foreign and security policy in the United States. As for the differences, the text leaves the implication that Japanese banking system is less efficient than the U.S. banking system, which perhaps allows for easier recovery in the United States. There is also an allusion to the liquidity trap in Japan, since interest rates are zero. However, the mechanics of the liquidity trap are not discussed in detail until Chapter 22.

5. a. 10 years: (1.01)10≈1.10 or 10 % higher; 20 years: 22% higher; 50 years: 64% higher

b. 22%; 49%; 169% higherc. Take output per worker as a measure of the standard of living.

10 years: 1.22/1.1≈1.11, so the standard of living would be about 11% higher; 20 years: 22% higher; 50 years: 64% higher

d. No. Labor productivity growth fluctuates a lot from year to year. The last few years may represent good luck. Some economists believe there has been a lasting change in the U.S. economy that will lead to continued high productivity growth in the future, but we cannot be certain.

6. China overtakes the United States in 2044, or 41 years from 2003. The problem asks students to find the answer by using a spreadsheet. Algebraically,

11(1.03)t=1.6(1.08)t

11/1.6 = (1.08/1.03)t

t = ln(11/1.6)/ln(1.08/1.03) ≈ 40.7 yrs

Explore Further 7. a-c. As of June 2005, there have been 5 recessions since 1960. The numbers are seasonally-

adjusted annual percentage growth rates of GDP in chained 2000 dollars.

1969:4 -1.9 1980:2 -7.81970:1 -0.7 1980:3 -0.7

1974:3 -3.8 1981:4 -4.91974:4 -1.6 1982:1 -6.41975:1 -4.8

1990.4 -3.0 1991:1 -2.0

8. a-b. % point increase in unemployment rate for the 5 recessions1969-70 0.7 1981-82 1.11974-75 3.1 1990-91 0.91980 0.9 Jan. 2001 – Jan. 2002 1.5

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CHAPTER 2

Quick Check1. a. False.

b. Uncertain. True for nominal GDP, false for real GDP.c. True.d. True.e. False. The level of the CPI means nothing. Its rate of change tells us about inflation.f. Uncertain. Which index is better depends on what we are trying to measure—inflation

faced by consumers or by the economy as a whole.

2. a. no change: intermediate good

b. +$100; Personal Consumption Expenditures

c. +$200 million; Gross Private Domestic Fixed Investment

d. +$200 million; Net Exports

e. no change: the jet was already counted when it was produced, i.e., presumably when Delta (or some other airline) bought it new as an investment.

3. a. $1,000,000, the value of the silver necklaces.

b. 1st Stage: $300,000. 2nd Stage: $1,000,00-$300,000=$700,000. GDP: $300,000+$700,000=$1,000,000.

c. Wages: $200,000 + $250,000=$450,000. Profits: ($300,000-$200,000)+($1,000,000-$250,000-300,000)

=$100,000+$450,000=$550,000.GDP: $450,000+$550,000=$1,000,000.

4. a. 2003 GDP: 10*$2,000+4*$1,000+1000*$1=$25,0002004 GDP: 12*$3,000+6*$500+1000*$1=$40,000 Nominal GDP has increased by 60%.

b. 2003 real (2003) GDP: $25,0002004 real (2003) GDP: 12*$2,000+6*$1,000+1000*$1=$31,000Real (2003) GDP has increased by 24%.

c. 2003 real (2004) GDP: 10*$3,000+4*$500+1,000*$1=$33,0002004 real (2004) GDP: $40,000.Real (2004) GDP has increased by 21.2%.

d. The answers measure real GDP growth in different units. Neither answer is incorrect, just as measurement in inches is not more or less correct than measurement in centimeters.

5. a. 2003 base year: Deflator(2003)=1; Deflator(2004)=$40,000/$31,000=1.29

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Inflation=29%

b. 2004 base year:Deflator(2003)=$25,000/$33,000=0.76; Deflator(2004)=1Inflation=(1-0.76)/0.76=.32=32%

c. Analogous to 4d.

6. a. 2003 real GDP = 10*$2,500 + 4*$750 + 1000*$1 = $29,000 2004 real GDP = 12*$2,500 + 6*$750 + 1000*$1 = $35,500

b. (35,500-29,000)/29,000 = .224 = 22.4%

c. Deflator in 2003=$25,000/$29,000=.862 Deflator in 2004=$40,000/$35,500=1.127

Inflation = (1.13 -.86)/.86 = .307 = 30.7%.

d. Yes, see appendix for further discussion.

Dig Deeper7. a. The quality of a routine checkup improves over time. Checkups now may include EKGs,

for example. Medical services are particularly affected by this problem due to constant improvements in medical technology.

b. 10%.

c. The quality-adjusted price of checkups is 5% higher. The remaining 10% of the price increase reflects a quality improvement.

d. We need to know the price of checkups using the old method in the year the new ultrasound information is introduced. Even without this information, we can say that the quality-adjusted price increase of checkups is less than 15%, since there has been some quality improvement.

8. a. Measured GDP increases by $10+$12=$22. (Strictly, this involves mixing the final goods and income approaches to GDP. Assume here that the $12 per hour of work creates a final good worth $12.)

b. True GDP should increase by less than $22 because by working for an extra hour, you are no longer producing the work of cooking within the house. Since cooking within the house is a final service, it should count as part of GDP. Unfortunately, it is hard to measure the value of work within the home, which is why measured GDP does not include it. If we assume, for this problem, that the value of home cooking is equal to the value of restaurant cooking, and that eating out simply replaces home cooking, then working late increases true GDP by only the value of the work, in this case $12.

9. a. As of revisions through June 2005, there were 3 quarters of negative growth during the period 1999-2002. The numbers are seasonally-adjusted annual percentage growth rates of GDP in chained 2000 dollars.

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2000:3 -0.52001:1 -0.52001:3 -1.4

b. The unemployment rose in 2001 and continued to rise until mid-2003, when it began to fall. Unemployment is not the whole story because discouraged workers may leave the labor force and thus not be counted as unemployed. The participation rate fell over 2001, and continued to all (albeit more slowly and with substantial monthly variation) over the period.

c. Although we graph employment against time in this problem (since the book does not use logarithms), the result would be similar if we used a logarithmic scale. From the graph, employment growth was negative over 2001. Then, employment growth continued at roughly the same rate (perhaps lower, as would be clear with a logarithmic scale) as before the recession. In other words, employment did not rapidly catch up to its previous trajectory. Indeed, as of June 2005, the graph is consistent with a permanent, negative effect on employment. The employment to population ratio fell by about 1.5 percentage points over 2001 and continued to fall until August, 2003, when it leveled off and then rose slightly.

d. Clearly, the labor market recovered much more slowly than GDP.

CHAPTER 3 Quick Check1. a. True.

b. False. Government spending without transfers was 19% of GDP.c. False. The propensity to consume must be less than one for our model to be well defined.d. True.e. False.f. False. The increase in output is one times the multiplier.g. False.

2. a. Y=160+0.6*(Y-100)+150+150Y=1000

b. YD=Y-T=1000-100=900

c. C=160+0.6*(900)=700

3. a. Equilibrium output is 1000. Total demand=C+I+G=700+150+150=1000. Total demand equals production. This is the equilibrium condition used to solve for output.

b. Output falls by: 40*multiplier = 40/.4=100. So equilibrium output is now 900. Total demand=C+I+G=160+0.6*(800)+150+110=900. Again, total demand equals production.

c. Private saving=Y-C-T=900-160-0.6*(800)-100=160. Public saving =T-G=-10. National saving (or in short, saving) equals private plus public saving, or 150. National saving equals investment. This statement is mathematically equivalent to the equilibrium

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condition that total demand equals production. Thus, national saving equals investment is an alternative statement of the equilibrium condition.

Dig Deeper4. a. Y increases by 1/(1-c1)

b. Y decreases by c1/(1- c1)

c. The answers differ because government spending affects demand directly, but taxes affect demand through consumption, and the propensity to consume is less than one.

d. The change in Y equals 1/(1-c1) - c1/(1- c1) = 1. Balanced budget changes in G and T arenot macroeconomically neutral.

e. The propensity to consume has no effect because the balanced budget tax increase aborts the multiplier process. Y and T both increase by on unit, so disposable income, and hence consumption, do not change.

5. a. Y=c0+c1YD+I+G impliesY=[1/(1-c1+c1t1)]*[c0-c1t0+I+G]

b. The multiplier = 1/(1-c1+c1t1) <1/(1- c1), so the economy responds less to changes in autonomous spending when t1 is positive. After a positive change in autonomous spending, the increase in total taxes (because of the increase in income) tends to lessen the increase in output. After a negative change in autonomous spending, the fall in total taxes tends to lessen the decrease in output.

c. Because of the automatic effect of taxes on the economy, the economy responds less to changes in autonomous spending than in the case where taxes are independent of income. So, output tends to vary less, and fiscal policy is called an automatic stabilizer.

6. a. Y=[1/(1-c1+c1t1)]*[c0-c1t0+I+G]

b. T = t0 + t1*[1/(1-c1+c1t1)]*[c0-c1t0+I+G]c. Both Y and T decrease. d. If G is cut, Y decreases even more, so the balanced budget reinforces (or amplifies) the

effect of the fall in consumer confidence.

7. a. Disposable income and hence consumption both increase for any level of Y, so the ZZ curve shifts up, and equilibrium output increases.

b. There is no effect on equilibrium output, since T does not change.c. Presumably, equilibrium output increases. The fall in consumption from the tax increase

is smaller in magnitude than the increase in consumption from the transfer increase, because of the difference in the propensities to consume. So, demand and equilibrium output increase.

d. People with high wealth probably have a lower propensity to consume than people with low wealth. At the extreme, those in poverty may spend most of any additional dollar on basic needs. Since wealth and income are usually related, people with high income probably have a lower propensity to consume than people with low income. Therefore, tax cuts are likely to be more effective at stimulating output when they are directed

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toward people with low income, who are likely to spend more of the extra disposable income.

8. a. Y= c0 + c1(Y-T) + b0+b1Y + GY=[1/(1- c1- b1)]*[c0 - c1T + b0 + G]

b. The multiplier is 1/(1- c1- b1), and increases with b1. Allowing investment to depend on output increases the multiplier. Intuitively, an increase in autonomous spending now has a multiplier effect through two channels, consumption and investment, so the multiplier increases. For the multiplier to be positive, we need c1+ b1<1. If this inequality were reversed, the economy would not have a well-defined equilibrium. One extra unit of autonomous spending would lead to a greater than one unit increase in spending (consumption plus investment) in every round of the multiplier, so the economy would explode into infinite output.

c. Equilibrium output increases. Investment increases by more than the increase in business confidence, since the increase in output also leads investment to increase. In equilibrium, national saving equals investment. If investment increases in equilibrium, then so does national saving.

9. Answers will vary depending upon when the website is accessed.

CHAPTER 4

Quick Check1. a. False.

b. False.c. True.d. False.e. False.f. True.

2. a. i=0.05: Money demand = $18,000i=0.10: Money demand = $15,000

b. Money demand decreases when the interest rate increases because bonds, which pay interest, become more attractive. For the same reason, bond demand increases.

c. The demand for money falls by 50%.

d. The demand for money falls by 50%.

e. A 1% increase (decrease) in income leads to a 1% increase (decrease) in money demand. This effect is independent of the interest rate.

3. a. i=100/$PB –1; i≈ 33%; 18%; 5% when $PB =$75; $85; $95.

b. When the price increases, the interest rate falls.

c. $PB =100/(1.08) ≈ $93

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4. a. $20=MD=$100*(.25-i)i=5%

b. M=$100*(.25-.15)M=$10

Dig Deeper 5. a. BD = 50,000 - 60,000*(.35-i)

An increase in the interest rate of 10% increases bond demand by $6,000.

b. An increase in wealth increases bond demand, but has no effect on money demand, which depends on income (a proxy for transactions demand).

c. An increase in income increases money demand, but decreases bond demand, since we implicitly hold wealth constant.

d. When people earn more income, this does not change their wealth right away. Thus, they increase their demand for money and decrease their demand for bonds.

6. An increase in the interest rate makes the purchase of bonds more attractive because it reduces their price. A purchaser of a bond can receive the same nominal payment for a lower price.

7. a. $16 is withdrawn on each trip to the bank. Money holdings—day one: $16; day two: $12; day three: $8; day four: $4.

b. Average money holding is ($16+$12+$8+$4)/4=$10.

c. $8 dollar withdrawals. Money holdings of $8; $4; $8; $4.d, Average money holdings is $6.

e. $16 dollar withdrawals; money holdings of $0; $0; $0; $16. f. Average money holding is $4.

g. Based on these answers, ATMs and credit cards have reduced money demand.

8. a. velocity=1/(M/$Y)=1/L(i)b. Velocity increased from 3.7 to 9.1 between 1960 and 2003.c. ATMS and credit cards reduced L(i) so velocity increased.

9. a. Demand for central bank money=0.1*$5,000b*(.8-4i)

b. $100 b = 0.1*$5,000b*(.8-4i)i=15%

c. M=(1/.1)*$100 b=$1,000 b M= Md at the interest derived in part (b).

d. If H increases to $300 b, the interest rate falls to 5%.

e. The interest rate falls to 5%, since when H equals $300 b, M=(1/.1)*$300 b=$3,000 b.

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10. The ratio of currency to total money (the parameter c in the text) would rise, leading to a fall in the money multiplier.

Explore Further 11. Answers will vary depending upon when the website is accessed.

CHAPTER 5

Quick Check1. a. True.

b. True.c. False.d. False. The balanced budget multiplier is positive (it equals one), so the IS curve shifts

right.e. False.f. Uncertain. An increase in G leads to an increase in Y (which tends to increase

investment), but also to an increase in the interest rate (which tends to reduce investment).

g. True.

2. a. Y=[1/(1-c1)]*[c0-c1T+I+G]The multiplier is 1/(1-c1).

b. Y=[1/(1-c1-b1)]*[c0-c1T+ b0-b2i +G]The multiplier is 1/(1-c1-b1). Since the multiplier is larger than the multiplier in part (a), the effect of a change in autonomous spending is bigger than in part (a). An increase in autonomous spending now leads to an increase in investment as well as consumption.

c. Substituting for the interest rate in the answer to part (b):Y=[1/(1-c1-b1+ b2d1/d2)]*[c0-c1T+ b0+(b2*M/P)/d2 +G]The multiplier is 1/(1-c1-b1+ b2d1/d2).

d. The multiplier is greater (less) than the multiplier in part (a) if (b 1- b2d1/d2) is greater (less) than zero. The multiplier is big if b1 is big, b2 is small, d1 is small, and/or d2 is big, i.e., if investment is very sensitive to Y, investment is not very sensitive to i, money demand is not very sensitive to Y, money demand is very sensitive to i.

3. a. The IS curve shifts left. Output and the interest rate fall. The effect on investment is ambiguous because the output and interest rate effects work in opposite directions. The fall in output tends to reduce investment, but the fall in the interest rate tends to increase it.

b. From 2c: Y=[1/(1-c1-b1+ b2d1/d2)]*[c0-c1T+ b0+(b2*M/P)/d2 +G]

c. From the LM relation: i= Y*d1/d2 – (M/P)/d2

To obtain the equilibrium interest rate, substitute for equilibrium Y from part (b).

d. I= b0+ b1Y- b2i= b0+ (b1- b2d1/d2)*Y+ b2(M/P)/d2

To obtain equilibrium investment, substitute for Y from part (b).

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e. From parts b and d, holding M/P constant, I increases by (b1- b2d1/d2)/ (1-c1-b1+ b2d1/d2), in response to a one-unit increase in G. So, if G decreases by one unit, investment will increase when b1<b2 d1/d2.

f. A fall in G leads to a fall in output (which tends to reduce investment) and to a fall in the interest rate (which tends to increase investment). Thus, for investment to increase, the output effect (b1) must be smaller than the interest rate effect (b2 d1/d2). Note that the interest rate effect contains two terms: (i) d1/d2, the slope of the LM curve, which gives the effect of a one unit change in equilibrium output on the interest rate, and (ii) b2, which gives the effect of a one unit change in the equilibrium interest rate on investment.

4. a. Y=C+I+G=200+.25*(Y-200)+150+.25Y-1000i+250Y=1100-2000i

b. M/P=1600=2Y-8000ii=Y/4000-1/5

c. Substituting b into a: Y=1000

d. Substituting c into b: i=1/20=5%

e. C=400; I=350; G=250; C+I+G=1000

f. Y=1040; i=3%; C=410; I=380. A monetary expansion reduces the interest rate and increases output. The increase in output increases consumption. The increase in output and the fall in the interest rate increase investment.

g. Y=1200; i=10%; C=450; I=350. A fiscal expansion increases output and the interest rate. The increase in output increases consumption.

Dig Deeper5. Firms deciding how to use their own funds will compare the return on bonds to the return on

investment. When the interest rate on bonds increases, they become more attractive, and firms are more likely to use their funds to purchase bonds, rather than to finance investment projects.

6. a. If the interest rate were negative, people would hold only money and not bonds. Money would be a better store of value than bonds.

b. See hint.

c. See hint.

d. Little effect. If the interest rate is actually zero, than the increase in M has literally no effect.

e. No. If there is no effect on the interest rate, which affects investment, monetary policy cannot affect output.

7. a. The fall in T shifts IS right. The increase in M shifts LM up. Output increases.

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b. Clinton-Greenspan (loosely): contractionary fiscal policy (IS left) and expansionary monetary policy (LM up).

c. There was a recession. The growth rate was low and for parts of the year, negative. The expansionary monetary and fiscal policy were partly in response to the recession. There were other shocks, especially a fall in investment spending after the fall in the stock market, and the events of September 11, which had direct effects and affected consumer confidence. The fall in investment spending was the proximate cause of the recession, which was well under way by September 11, 2001.

8. a. Increase G (or reduce T) and increase M.

b. Reduce G (or increase T) and increase M. The interest rate falls. Investment increases, since the interest rate falls while output remains constant.

Explore Further9. a. The IS curve shifts left and the LM curve shifts right. The interest rate falls and

investment rises.

b. From the 2005 Economic Report of the President (ERP):

Receipts Outlays Surplus(all numbers as % of GDP)

1992 17.5 22.1 -4.72000 20.9 18.4 2.4

c. The Fed kept the target federal funds rate at 3% from September 1992 until February 1994. Then, the Fed increased the target rate steadily until February 1995, reduced the target rate (more or less steadily) until June 1999, and increased the target rate after that.

d. From the 2005 ERP, investment rose from 12.1% of GDP in 1992 to 17.7% of GDP in 2000.

e. From the 2005 ERP, the average growth rate (GDP per capita) over 1992-2000 was 2.5%.

10. a. As of June 2005, the quarters of negative growth in 2000 and 2001 were 2000:III, 2001:I, and 2001:3.

b. Investment had the bigger percentage change.

c. As of June 2005, contributions to growth (seasonally adjusted at annual rates):

Consumption InvestmentAvg. Change Avg. Change

1999 3.3 1.62000 2.7 -0.6 0.3 -1.32001 1.9 -0.9 -2.4 -2.6

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The fall in investment was the proximate cause of the recession.

d. Investment fell in the 2001:III and fell by a bigger percentage in 2001:IV. Nonresidential fixed investment continued to fall in the first two quarters of 2002, although overall investment (gross private domestic investment) grew. Consumption picked up strongly in the 4th quarter of 2001. Lower interest rates and discounts offered by automakers played a role. Perhaps psychology played a role as well. The recession was clearly underway before the events of September 11.

CHAPTER 6

Quick Check1. a. False.

b. False.c. False. 44% of unemployed workers leave the unemployment pool each month.d. True.e. False.f. Uncertain/False. Most workers have some bargaining power, depending upon how easy

they are to replace. Workers in low skill, entry level jobs may have very little or no bargaining power.

g. True.h. False.

2. a. Putting aside the 3.5 million who move from job to job, the average flow is (1.5+1.7+1.8+1.5)/127=5.1%

b. 1.8/7.0=25.7%

c. (1.8+1.3)/7.0=44.3%. Duration is 1/.443 or 2.3 months.

d. (1.5+1.1+1.7+1.3)/66.7=5.6=8.4%.

e. As a percentage of flows into the labor force, new workers account for 0.4/(1.5+1.8)=12%. As a percentage of flows into and out of the labor force, new workers account for 0.4/5.6=7%.

3. a. W/P=1/(1+)=1/1.05=.95

b. From the wage setting relation, un=1-W/P=5%

c. W/P=1/1.1=.91; u=1-.91=9%. The natural rate of unemployment rises. The increase in the markup is essentially a fall in labor demand (actually a shift of the labor demand curve). Intuitively, less competition in the product market leads to lower desired output by firms and therefore to a fall in labor demand. The fall in labor demand increases unemployment and reduces the real wage.

Dig Deeper 4. a. Answers will vary.

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b-c. Most likely, the job you will have ten years later will pay a lot more than your reservation wage at the time (relative to your typical first job).

d. The later job is more likely to require training and will probably be a much harder job to monitor. So, as efficiency wage theory suggests, your employer will be willing to pay a lot more than your reservation wage for the later job, to ensure low turnover and low shirking.

5. a. The computer network administrator has more bargaining power. She is much harder to replace.

b. The rate of unemployment is a key statistic. For example, when there are many unemployed workers it becomes easier for firms to find replacements. This reduces the bargaining power of workers.

c. Given the constant returns to labor assumption, the real wage is always determined by the price setting relation alone. Worker bargaining power has no effect.

6. a. As the unemployment rate gets very low, it gets very difficult for firms to find workers to hire. Therefore, worker bargaining power increases, and so does the wage.

b. As the unemployment rate gets lower and lower, the wage gets higher and higher (tending toward infinity as the unemployment rate goes to zero). So, there is some unemployment rate at which the wage becomes so high that firms will not want to hire more workers.

7. a. EatIn EatOutemployment 70 95unemployment 5 5labor force 75 100unemployment rate 6.7% 5%participation rate 75% 100%

Measured GDP is higher in EatOut.

b. Measured employment, the measured labor force, the measured participation rate, and measured GDP increasae in EatIn. Unemployment is unchanged, but the measured unemployment rate falls.

c. It is difficult to measure the value of work at home. In this case, you could attempt to value food preparation at home by using the market price of food preparation in restaurants (assuming that eating at home has the same value for a given meal as eating out). This would be difficult in EatIn before there are restaurants. Likewise, you could count workers involved in food preparation at home as employed.

d. If food preparation at home is counted in GDP and workers involved in food preparation at home are counted as employed, then the labor market statistics and measured GDP would be the same in the two economies and the experiment in part (b) would have no effect.

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Explore Further8. a. 2/3=67%; (2/3)2= 44%; (2/3)6 = 9%

b. 2/3

c. second month: (2/3)2=44%; sixth month: (2/3)6 = 9%

d. Average proportion 27 weeks or more over 1990-1999= 16.1%2000: 11.4% 2003: 22.1%2001: 11.8% 2004: 21.8%2002: 18.3%

Long-term unemployed exit unemployment less frequently than the average.9. a-b. Answers will depend on when the page is accessed.

c. The decline in unemployment does not equal the increase in employment, because the labor force is not constant.

CHAPTER 7

Quick Check1. a. True.

b. True.c. False.d. False.e. True.f. False.g. False.

2. a. IS right, AD right, AS up, LM up, Y same, i up, P up

b. IS left, AD left, AS down, LM down, Y same, i down, P down

3. WS PS AS AD LM IS Short run: up same up same up same Medium run: up same up further same up further same

Y i P Short run: down up up Medium run: down further up further up further

4. a. Money is neutral in the sense that the nominal money supply has no effect on output or the interest rate in the medium run. Output returns to its natural level. The interest rate is determined by the position of the IS curve and the natural level of output. Despite the neutrality of money in the medium run, an increase in money can increase output and reduce the interest rate in the short run. In particular, expansionary monetary policy can be used to speed up the economy's return to the natural level of output when output is low.

b. In the medium run, investment and the interest rate both change with fiscal policy.

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c. False. Labor market policies, such as unemployment insurance, can affect the natural level of output.

Dig Deeper5. a. Open answer. Firms may be so pessimistic about sales that they do not want to borrow at

any interest rate.

b. The IS curve is vertical; the interest rate does not affect equilibrium output.

c. No change.

d. The AD curve is vertical; the price level does not affect equilibrium output.

e. The increase in z reduces the natural level of output and shifts the AS curve up. Since the AD curve is vertical, output does not change, but the price level increases. Note that output is above its natural level.

f. The AS curve shifts up forever, and the price level increases forever. Output does not change; it remains above its natural level forever.

6. a. The LM curve is flat.

b. No effect.

c. The AD curve is vertical. A change in P, which affects M/P, has no effect on the interest rate or output.

d. There is no effect on output in the short run or the medium run. Since the money stock does not affect the interest rate, it does not affect output.

7. a. The AD curve shifts left in the short run. Output and the price level fall in the short run.In the medium run, the expected price level falls, and AS shifts right, returning the economy to the original natural level of output, but at a lower price level.

b. The unemployment rate rises in the short run, but returns to its original level (the natural rate, which is unchanged) in the medium run.

c. The Fed should increase the money supply, which shifts the AD curve right. A monetary expansion of the proper size exactly offsets the effect of the decline in business confidence on the AD curve. The net effect is that the AD curve does not move in the short run or medium run, and neither does the AS curve.

d. Under the policy option in part (c), output and the price level are higher in the short run. In the medium run, output is the same in parts (a) and (c), but the price level is higher in part (c).

e. The unemployment rate is lower in the short run in part (c). In the medium run, the unemployment rate is the same in parts (b) and (c).

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8. a. The AS curve shifts up in the short run and shifts up further in the medium run. Output falls in the short run and falls further in the medium run. The price level rises in the short run and rises further in the medium run.

b. The unemployment rate rises in the short run and rises further in the medium run.

c. The Fed could increase the money supply in the short run and shift the AD curve to theright. The AS curve would shift up over time.

d. Output and the price level are higher in the short run in part (c). Output is the same in the medium run in parts (a) and (c), but the price level is higher in part (c).

e. The unemployment rate in the short run is lower in part (c), but the same in the medium run in parts (a) and (c).

9. The Fed’s job is not so easy. It has to distinguish changes in the actual rate of unemployment from changes in the natural rate of unemployment. The Fed can use monetary policy to keep the unemployment rate near the natural rate, but it cannot affect the natural rate.

10. a. The unemployment rate rises in the short run and rises further in the medium run. The real wage falls immediately to its new medium-run level.

b. The unemployment rate falls in the short run but returns to the original natural rate in the medium run. The real wage is unaffected. However, after tax income rises.

c. In our model, the real wage depends only upon the markup. A fall in the markup increases the real wage. Policy measures that improve product market competition – for example, more vigorous anti-trust enforcement – could increase the real wage.

d. The fall in income taxes tended to increase the after-tax real wage. The increase in oil prices tended to reduce the after-tax real wage. Intuitively, the immediate effect of an oil price increase is to reduce the real wage by increasing gas prices. Thus, the increase in gas prices tends to absorb the extra after-tax income provided by the tax cut.

Explore Further11. a. 1959:IV – 1969:IV 52.9%

1969:IV – 1979:IV 38.2%1979:IV – 1989:IV 35.1%1989:IV – 1999:IV 37.6%

b. The 70s, 80s, and 90s look remarkably similar. The 60s look most unusual.

Note, although the problem did not ask for the growth rates of per capita real GDP, the results would be similar. The growth rates of per capita GDP are:

1959:IV – 1969:IV 33.9%1969:IV – 1979:IV 24.4%1979:IV – 1989:IV 23.0%1989:IV – 1999:IV 21.8%

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CHAPTER 8

Quick Check1. a. True.

b. False.c. False.d. True.e. False.f. True.

2. a. No. In the 1970s, we experienced high inflation and high unemployment. The expectations-augmented Phillips curve is a relationship between inflation and unemployment conditional on the natural rate and inflation expectations. Given inflation expectations, increases in the natural rate (which result from adverse shocks to labor market institutions—increases in z—or from increases in the markup—which encompass oil shocks) lead to an increase in both the unemployment rate and the inflation rate. In addition, increases in inflation expectations imply higher inflation for any level of unemployment. (Increases in inflation expectations also tend to increase the unemployment rate in the short run from the supply side—think of an increase in the expected price level, given last period’s price, in the AD-AS framework. However, increases in inflation expectations may tend to increase short run output from the demand side, because of the real interest rate effect. The real interest rate is introduced in Chapter 14.) In the 1970s, both the natural rate and expected inflation increased, so both unemployment and inflation were relatively high.

b. No. The expectations-augmented Phillips curve implies that maintaining a rate of unemployment below the natural rate requires increasing (not simply high) inflation. This is because inflation expectations continue to adjust to actual inflation.

3. a. un=0.1/2 =5%

b. πt =0.1-2*.03 = 4% every year beginning with year t.

c. πet= 0 and πt=4% forever. Inflation expectations will be forever wrong. This is

unlikely.

d. might increase because people’s inflation expectations adapt to persistently positive inflation. The increase in has no effect on un.

e. π5= π 4+.1-.06=4%+4%=8%π6=12%; π7=16%

f. Inflation expectations will again be forever wrong. This is unlikely.

4. a. A higher cost of production means a higher markup of prices over wages. The markup reflects all nonwage components of the price of a good.

b. un=(0.08+0.1)/2; Thus, the natural rate of unemployment increases from 5% to 6% as μ increases from 20% to 40%.

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Dig Deeper5. a. π t = π t-1 + 0.1 - 2ut = π t-1 + 2%=2%

π t = 2%; π t+1 = 4%; π t+2 = 6%; π t+3 = 8%.

b. π t = 0.5 π t + 0.5 π t-1 + 0.1 - 2ut

or, π t = π t-1 + 4%

c. π t = 4%; π t+1 = 8%; π t+2 = 12%; π t+3 = 16%

d. As indexation increases, low unemployment leads to a larger increase in inflation over time.

6. a. Yes. The average rate of unemployment was lower in the 1990s. Indeed, even though the unemployment rate was at a historical low, inflation rose very little.

b. The natural rate of unemployment probably decreased.

7. a. un=(+z)/; un = 6% if =1; un = 3% if =2As increases the natural rate of unemployment falls. Intuitively, higher wage flexibility allows the economy to respond to any given set of institutions ( and z) with less unemployment.

b. un = 9% if =1; un = 4.5% if =2In absolute terms, less wage flexibility (lower ) implies that a given supply shock willlead to a greater increase in the natural rate of unemployment.

Explore Further8. a-c. The equation that seems to fit well is πt – πt-1 = 6 – ut, which implies a natural rate of

6%.

9. The relationships imply a lower natural rate in the more recent period.

CHAPTER 9

Quick Check1. a. False.

b. True.c. True.d. False.e. False.f. True.g. True.h. True.i. True.

2. a. The unemployment rate will increase by 1% per year when g=0.5%. Absent output growth, productivity growth tends to increase the unemployment rate, since fewer workers are required to produce a given quantity of goods. Absent output growth, labor force growth also tends to increase the unemployment rate, since more workers are

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competing for the same number of jobs. Therefore, unemployment will increase unless the growth rate exceeds the sum of productivity growth and labor force growth.

b. We want the unemployment rate to decrease by 0.5% per year for the next four years. We need growth of 4.25% per year for each of the next four years.

c. Okun’s law is likely to become: ut-ut-1=-0.4*(gyt-5%)

3. a. un= 5%

b. Assume the economy has been at the natural rate of unemployment for two years (this year and last year). Then, gyt = 3%; gmt = gyt + πt = 11%

c. π u gyt gmt

t-1: 8% 5% 3% 11% t: 4% 9% -7% -3%

t+1: 4% 5% 13% 17%t+2: 4% 5% 3% 7%t+3: 4% 5% 3% 7%

4. a. See text for full answer. Gradualism reduces need for large policy swings, with effects that are difficult to predict, but immediate reduction may be more credible and encourage rapid, favorable changes in inflation expectations. On the other hand, the staggering of wage decisions suggests that, if the policy is credible, a gradual disinflation is the option consistent with no change in the unemployment rate.

b. Not clear. Based in Ball's evidence, probably fast disinflation, depending on the features listed in part (c).

c. Some important features: the degree of indexation, the nature of the wage-setting process, and the initial rate of inflation.

5. a. Inflation will start increasing.

b. It should let unemployment increase to its new, higher, natural rate.

Dig Deeper6. a. sacrifice ratio=1

b. πt = 11%; πt+1 = 10%; πt+2 = 9%; πt+3 = 8%; πt+4 = 7%

c. 10 years; sacrifice ratio=(10 point years of excess unemployment)/(10 percentage point reduction in inflation)=1

d. πt = 8.5%; πt+1 = 5.875%; πt+2 = 3.906%; πt+3 = 2.430%; πt+4 = 1.322% Less than 5 years are required.

sacrifice ratio: 5/(12-1.322)=.468The sacrifice ratio is lower because people are somewhat forward looking and incorporate the target inflation rate into their expectations.

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e. The central bank can let the unemployment rate return to the natural rate beginnng at time t+1. The ex post sacrifice ratio from this scenario = (1 point year of excess unemployment)/(10 point reduction of inflation) = 0.1

f. Take measures to enhance credibility.

7. a. πt-πt-1= -(ut-.05)ut- ut-1= -.4*(gmt-πt-.03)

b. Assuming gm,t-1=13%, πt-1= 10%, ut-1=5%, and gm=3% beginning in year t:

π ut: 7.1% 7.9%t+1: 3.1% 9.1%t+2: -0.7% 8.8%t+3: -3.2% 7.5%t+4: -4.1% 5.9%t+5: -3.5% 4.4%t+6: -2.1% 3.6%t+7: -0.5% 3.4%t+8: 0.8% 3.7%t+9: 1.5% 4.3%t+10: 1.6% 4.9%

c. Inflation does not decline smoothly. In the early years, the large unemployment rates (relative to the natural rate) reduce inflation to negative values. Since money growth = 3 % = normal output growth in this example, negative inflation drives real money growth (and hence output growth) above the normal output growth rate, and unemployment falls. Eventually, unemployment falls below the natural rate, inflation begins to increase again. These cycles continue, with decreasing amplitude.

d. u=5% and π=0% in the medium run.

Explore Further8. a. Yes.

b. The unemployment rate increased from 5,8% in June 2002 to 6.3% in June 2003.

c. Although growth was positive, it was low – well below 3% for most of the period. Growth was too low to prevent the unemployment rate.

d. Employment fell by 0.7%.

e. Yes.

f. Productivity grew.

CHAPTER 10

Quick Check

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1. a. True.b. True.c. False.d. False.e. True.f. False.g. True.h. Uncertain.

2. a. Example: France: (1.04)50*5,519=$39.2 k. Japan: $85.8 k; UK: $25.0 k; U.S.: $34.7 k

b. 2.47

c. For Japan, yes; for France and the UK, no.

3. a. $5,000

b. 6000 pesos

c. $600

d. $800

e. Mexican standard of living relative to the U.S.—exchange rate method: 600/5000 =.12; PPP method: 800/5000=.16

4. a. Y=63

b. Y doubles.

c. Yes.

d. Y/N=(K/N)1/2

e. K/N=4 implies Y/N=2. K/N=8 implies Y/N=2.83. Output less than doubles.

f. No.

g. No. In part (f), we are looking at what happens to output when we increase capital only, not capital and labor in equal proportion. There are decreasing returns to capital.

h. Yes.

Dig Deeper5. a. Y/Y = .5 K/K

growth rate of output = 1/2 growth rate of capital

b. 4 %

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c. K/Y increases.

d. No. Since capital is growing faster than output, the saving rate will have to increase to maintain the same pace. Eventually, the required saving will exceed output. Capital must grow faster than output because there are decreasing returns to capital in the production function.

6. Even though the United States was making the most important technical advances, the othercountries were growing faster because they were importing technologies previously

developed in the United States. In other words, they were reducing their technological gap with the United States.

Explore Further7. a-d. Convergence for the France, Belgium, and Italy; no convergence for the second set of

countries.

8. a. Russian GDP per capita in rubles = 7305.65/0.145612 ≈ 50,172 rublesRussian GDP per capita in dollars = 50, 172/28.129 ≈ $1784

b. U.S. GDP per capita = 9816.97/0.285003 ≈ $34445

c. Russian GDP per capita/U.S. GDP per capita = 1784/34445 ≈ 5.2%

d. 28.6%

e. The Penn numbers are PPP numbers. They correct for the lower price of subsistence goods in Russia.

CHAPTER 11

Quick Check1. a. True, if saving includes public and private saving.

b. False.c. True. A constant saving rate would produce a positive but declining rate of growth.d. Uncertain.e. True. (Output per capita equals output per worker times the participation rate, which is at

about 66% for the United States today. So, roughly 60% is true.)f. False.g. Uncertain. The U.S. capital stock is below the golden rule, but that does not necessarily

imply that there should be tax breaks for saving. Even if the tax breaks were effective in stimulating saving, the increase in future consumption would come at the cost of current consumption.

h. Uncertain/false. Even if the endogenous growth model is true, the growth rate won't be related to the level of human capital. The statement could be true if higher education levels lead to a faster rate of technological progress.

i. False. Even if you accept the premise (that educational investment increases output, as would be implied by the Mankiw, Romer, Weil paper), it does not necessarily follow that countries should increase educational saving, since future increases in output will come at the expense of current consumption. Of course, there are other arguments for subsidizing education, particularly for low-income households.

154

2. No. (1) The Japanese rate of growth is not so high anymore. (2) If the Japanese saving rate hasalways been high, then this cannot explain the difference between the rate of growth in Japan andthe United States in the last 40 or 50 years. (3) If the Japanese saving rate has been higher than itused to be, then this can explain some of the high Japanese growth. The contribution of highsaving to growth in Japan should, however, come to an end.

3. After a decade: higher growth rate. After five decades: growth rate back to normal, higher level of output per worker.

Dig Deeper4. a. Higher saving. Higher output per worker

b. Same output per worker. Higher output per capita.

5. a. K/N=(s/(2))2; Y/N=s/(4)

b. C/N=(1-s)Y/N=s(1-s)/(4)

c-e. Y/N increases with s; C/N increases until s=.5, then decreases.

6. a. Yes.

b. Yes.

c. Yes.

d. Y/N = (K/N)1/3

e. In steady state, sf(K/N) = K/N, which, given the production function in part (d), implies:K/N=(s/)3/2

f. Y/N =(s/)1/2

g. Y/N = 2

h. Y/N = 21/2

7 a. Substituting from 6e: K/N=1

b. Substituting from 6f: Y/N=1

c. K/N=.35; Y/N=.71

d. Using equation (11.3), the evolution of K/N is: 0.9, 0.81, 0.74. The evolution of Y/N is: 0.97, 0.93, 0.91

8. b. K/N = (.15/.075)2 = 4Y/N= (4)1/2=2

c. K/N=(.2/.075)2 =7.1Y/N=(7.1)1/2=2.7

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Capital per worker and output per worker increase.

Explore Further9. a. For 2003, the national saving rate was approximately 13.5%.

In steady state, K/N = (.135/.075)2 =3.24, and Y/N=(3.25)1/2 =1.8.

b. For 2003, the budget deficit (including the off budget items) was 3.5%.If national saving increases to 17%, then in steady state, K/N = (.17/.075)2 5.14, and Y/N=(5.14)1/2 =2.27. Steady-state output per worker increases by approximately 26%.

CHAPTER 12

Quick Check1. a. True.

b. True.c. False.d. True.e. False.f. True.g. False.h. False.

2. a. Most technological progress seems to come from R&D activities. See discussion on fertility and appropriability in Chapter 12.2.

b. Lower growth in poorer countries. Higher growth in rich countries.

c. Increase in R&D spending. If fertility does not fall, there will be higher technological progress and a higher rate of output growth.

d. A decrease in the fertility of applied research; a (small) decrease in growth.

e. A decrease in the appropriability of drug research. A drop in the development of new drugs. Lower technological progress and lower growth.

3. A shift to a fully funded system should increase output per worker in the long run. It should have no effect on the long run growth rate of output per worker.

4. See discussion in Chapter 12.2.

Dig Deeper5. a. Both lead to an initial decrease in growth.

b. Only the first leads to a permanent decrease in growth.

6. a. Year 1: 3000; Year 2: 3960

b. Real GDP= 3300; growth rate of real GDP=10%

c. 20%

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c. Real GDP/Worker=30 in both years; labor productivity growth is zero.

e. Using $13 as the price of banking services in Year 2: real GDP =3990; output growth= 33%.

f. -0.8%

g. Proper measurement implies real gdp/worker=36.3 in year 2. Labor productivity growth is 21%.

h. True, assuming there is progress in the banking services sector.

7. a. (K/(AN)) = (s/(+gA+gN))2 = 1; (Y/(AN)) = (1); gY/(AN) = 0; gY/N = 4%; gY = 6%

b. (K/(AN)) = (4/5)2; (Y/(AN)) = (4/5); gY/(AN) = 0; gY/N = 8%; gY = 10%

c. (K/(AN)) = (4/5)2; (Y/(AN)) = (4/5); gY/(AN) = 0; gY/N = 4%; gY = 10%People are better off in case a. Given any set of initial values, the level of technology is the same in cases a and c, but the level of capital per effective worker is higher at every point in time in case a. Thus, since Y/N=A*(Y/(AN))=A*(K/(AN))1/2, output per worker is always higher in case a.

8. a. Probably affects A. Think of climate.

b. Affects H and possibly A, if better education leads to more fertile research.

c. Affects A. Strong protection tends to encourage more R&D but also to limit diffusion of technology.

d. May affect A through diffusion.

e. May affect K, H, and A. Lower tax rates increase the after-tax return on investment, and thus tend to lead to more accumulation of K and H and more R&D spending.

f. If we interpret K as private capital, than infrastructure affects A (e.g., better transportation networks may make the economy more productive by reducing congestion time).

g. Assuming no technological progress, lower population growth implies a higher steady state level of output per worker. Lower population growth leads to higher capital per worker. If there is technological progress, there is no steady-state level of output per worker. In this case, however, lower population growth implies that output per worker will be higher at every point in time, for any given path of technology. See the answer to problem 7c.

Explore Further9. a. The quantity gK – gN is the growth rate of output per worker. The quantity gK – gN is the

growth rate of capital per worker.b. gK – gN = 3[gY – gN] – 2gA

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c. United States1950 – 1973: gK – gN = 3(2.7%) – 2(2.9%) = 2.3%1974 – 2000: gK – gN = 3(1.2%) – 2(1.4%) = 0.8%

d. Japan1950 – 1973: gK – gN = 3(7.1%) – 2(7%) = 7.3%1974 – 2000: gK – gN = 3(2.1%) – 2(1.4%) = 3.5%

CHAPTER 13

Quick Check1. a. False. Productivity growth is unrelated to the natural rate of unemployment. If the

unemployment rate is constant, employment grows at same rate as the labor force.b. False.c. True.d. True.e. True. The jobless recovery of 2002-2003 perhaps provides a recent example.f. True.g. False.

2. a. u = 1-(1/(1+))(A/Ae)

b. u = 1-(1/(1+)) = 4.8%

c. No. Since wages adjust to expected productivity, an increase in productivity eventually leads to equiproportional increases in the real wage implied by wage setting and the real wage implied by price setting, at the original natural rate of unemployment. Thus, equilibrium can be maintained without any change in the natural rate of unemployment.

3. Discussion question.

4. a. Reduce the gap, if this leads to an increase in the relative supply of skilled workers.

b. Reduce the gap, since it leads to a decrease in the relative supply of unskilled workers.

c. Reduce the gap, if it leads to an increase in the relative supply of skilled workers.

d. Increase the gap, if U.S. firms hire unskilled workers in Central America, since it reducesthe relative demand for U.S. unskilled workers.

5. Consider an increase in the level of A in the AD-AS diagram. Combine the wage-setting and price-setting equations into an AS equation:

P = Pe(1+)(Ae/A)F(1-Y/(AL), z).

An increase in A has two effects:

158

i. To the extent that Ae lags behind A, Ae/A falls. This is the effect that tends to reduce the actual and natural rates of unemployment for a time.

ii. For a given level of Y, an increase in A reduces Y/A, increases u, reduces W (through the F function), and reduces P. This is the effect that tends to increase the actual rate of unemployment in the short run.

The effects in (i) and (ii) both shift the AS curve down, so output increases in the short run. The effect on short-run unemployment depends on the relative strength of the effects in (i) and (ii).

Dig Deeper6. Discussion question.

7. a. P = Pe(1+)(Ae/A)(Y/L)(1/A)

b. AS shifts down. Given Ae/A=1, an increase in A implies a fall in P, given Y. This occurs because for a given level of Y, unemployment is higher, so wages are lower and so, in turn, is the price level.

c. There is now an additional effect, a fall in Ae/A. In effect, workers do not receive as

much of an increase in wages as warranted by the increase in productivity. Compared to part (b), nominal wages are lower, leading to a lower value of P given Y.

8. a. Labor supply slopes up. As N increases, u falls for given L, so W/P increases.

b. Labor demand slopes down. As N increases, the MPL falls, so W/P falls.

c. In the high skill market, labor demand shifts right, and W/P rises. In the low skill market, labor demand shifts left, and W/P falls.

d. In Europe, the minimum wage is binding, so the shift of labor demand to the left hasno effect on W/P but leads to a fall in N, and thus to an increase in the unemployment rate, given L. N

e. The increase in wage inequality is larger in the United States. However, in Europe there is an increase in unemployment in the low skill market.

f. The United States has had a large increase in wage inequality over the past 25 years, and Europe has had a large increase in the unemployment rate.

Explore Further9. a. Some examples:

Stock clerks and order fillers – technological changeTextile winding, twisting, and drawing out machine setters, operators, and

tenders – foreign competition (partly as a result of the end of the

Multifiber Agreement)

b. Some examples:Computer systems analysts – technological change.

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Home health aides – aging

c. More occupations that are forecast to grow require degrees as opposed to on-the-job training.

10. a. For a given markup, the real wage grows at the rate of technological progress.

b. 1973: $8.98; 2003: 8:27

c. The real wage of low skill workers has fallen markedly.

d. The relative demand for low skill workers has fallen markedly.

CHAPTER 14

Quick Check1. a. True.

b. True.c. True.d. False.e. True.f. False.g. True.h. True. The nominal interest rate is always positive.i. False. The real interest rate can be negative.

2. a. Real. Nominal profits are likely to move with inflation; real profits are easier to forecast.

b. Nominal. The payments are nominal.

c. Nominal. If lease payments are in nominal terms, as is typical.

3. a. Exact: r = (1+.04)/(1+.02)-1 = 1.96%; Approximation: r .04-.02 = 2%

b. 3.60%; 4%

c. 5.48%; 8%

4. a. No. Otherwise, nobody would hold bonds. Money would be more appealing: it pays at least a zero nominal interest rate and can be used for transactions.

b. Yes. The real interest rate will be negative if expected inflation exceeds the nominal interest rate. Even so, the real interest rate on bonds (which pay nominal interest) will exceed the real interest rate on money (which does not pay nominal interest) by the nominal interest rate.

c. A negative real interest rate makes borrowing very attractive and leads to a large demand for investment.

d. Answers will vary.

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5. a. The discount rate is the interest rate. So EPDV are (i) $2,000*(1-.25) under either interest rate and (ii) (1-.2)*$2,000 under either interest rate.

b. The interest rate does not enter the calculation. Hence, you prefer (ii) to (i) since 20%<25%.

Note that the answer to part (a) does not imply that saving will not accumulate. By retirement, the initial investment will have grown by a factor of (1+i)40 in nominal terms and (1+r)40 in real terms. As long as r is positive, the purchasing power of the initial investment will grow.

Of course, it is possible that the tax rate you pay upon retirement is lower than the tax rate you will pay during your working years, which would alter this calculation. In addition, this simple example omits an important real-world feature of retirement savings: the tax-free accrual of interest. As a result of this feature, the effective interest rate on retirement saving is much higher than the effective (after-tax) interest rate on ordinary saving.

6. a. =$100/0.1 = $1000

b. Since the first payment occurs at the end of the year, $V = $z[(1+i)n-(1+i)]/[i*(1+i)n].10 years: $575.90; 20 years: $836.49; 30 years: $936.96; 60 years: $996.39

c. i = 2%: consol $5000; 10 years: $816.22; 20 years: $1567.85; 30 years: $2184.44; 60 years: $3445.61

i = 5%: consol $2000; 10 years: $710.78; 20 years: $1208.53; 30 years: $1514.11; 60 years: $1887.58

7. a. In the medium run, changes in inflation are reflected one for one in changes in the nominal interest rate. In other words, in the medium run, changes in inflation have no effect on the real interest rate.

b. Support.

c. The line should not go through the origin. The real interest rate is positive.

d. No. Even if monetary policy does not affect output or the real interest rate in the mediumrun, it can be used in the short run.

Dig Deeper8. a. The IS shifts right. At the same nominal interest rate, the real interest rate is lower, so

output is higher.

b. The LM curve does not shift. Money demand depends on the nominal interest rate, not the real interest rate.

c. Output increases. The nominal interest rate is higher than in Figure 14-5. Whether the nominal interest rate is lower or higher than before the increase in money growth is

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ambiguous. Thinking in terms of the money market equilibrium, the increase in the nominal money supply tends to reduce the nominal interest rate, but the increase in nominal money demand (because of the increase in output) tends to increase the nominal interest rate.

d. Output is higher than in Figure 14-5. Reasoning from the IS relation, the real interest rate must be lower, since no exogenous variables in the IS relation have changed. (In other words, while the nominal interest rate may increase relative to Figure 14-5, it increases by less than the increase in expected inflation. So the real interest rate decreases.)

Explore Further9. Answers will vary depending upon when the website is accessed.

CHAPTER 15

Quick Check1. a. False.

b. True.c. True.d. False.e. True.f. True.g. False.h. Uncertain/False. Some of the increase in the stock market was probably justified.

However, most economists believe that there was a bubble in the stock market as well. A stock market correction followed.

2. a. 1+i =($F/$P)1/n

i =(1000/800)1/3-1 = 7.7%

b. 5.7%

c. 4.1%

3. The yield is approximately the average of the short term interest rates over the life of the bond.

a. 5%.

b. 5.25%

c. 5.5%

4. a. Unexpected shift down of the LM curve. Unexpected fall in the interest rate and increase in Y. Stock prices increase.

b. No change in stock prices.

c. Ambiguous effect on stock prices. Unexpected expansionary fiscal policy means the interest rate is higher than expected (after the expected expansionary monetary policy)

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but so is output. The interest rate effect tends to reduce stock prices; the output effect to increase them.

Dig Deeper5. a. See Chapter 15.

b. Initially after the increase, the yield curve will slope down out to one-year maturities, then slope up. After one year, the yield curve will slope up. After three years, the yield curve will be flat.

6. a. An inverted yield curve implies that the expected future interest rate is lower than the current interest rate. These expectations could arise from a belief that the IS curve will shift to the left in the future (and output will fall), say because future investment is expected to fall.

b. Given the Fisher effect, a steep yield curve probably implies that financial market participants believe that future inflation will be substantially higher than current inflation.

7. Let r be the real interest rate, g the growth rate of dividends, and x be the risk premium. The price is given by:

1000/(1 + r + x) + 1000(1 + g)/(1 + r + x)2 + 1000(1 + g)2/(1 + r + x)3 . . . = [1000/(1 + r + x)][1 + (1 + g)/(1 + r + x) + (1 + g)2/(1 + r + x)2 + . . .] = 1,000/(r + x - g)

a. $50,000; $20,000

b. $10,000; $7692.31

c. $16,666.67; $11,111.11

d. Increase. A fall in the risk premium is like a fall in the real interest rate.

Explore Further8. a. The Fed can reduce the growth rate of money. The nominal interest rate increases in the

short run, but falls in the medium run.

b. Inflation was highest in early 1980. The 12-month inflation rate peaked at 14.6% in March and April of 1980.

d. A declining spread implies that future short-term interest rates are expected to decline in the future. The one-year T-bill rate was increasing the late 1970s, but the spread was declining, so markets were not expecting the trend to continue.

e. There spread declined by almost one percentage point in October 1979. The decline is consistent with expectations of lower inflation in the future.

f. The one-year interest rate fell.

g. During the rate cut in the recession, spreads went up, as short-term rates declined. However, long-term rates did not increase, which suggests that inflation expectations did

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not increase. Instead, the increase in spreads is consistent with the expectation that the anti-inflationary policy would continue with high short term interest rates after the recession. This is indeed what happened.

9. Answers will depend on when the Web site is accessed.

10. Answers will depend on when the Web site is accessed.

CHAPTER 16

Quick Check1. a. False.

b. False.c. False.d. False.e. False.f. True.g. True.

2. a. .75*(1+1.05+1.052)*$40,000=$94,575

b. $194,575

c. $19,457.50

d. by $2,000

e. Benefits imply extra annual consumption of: 0.6*(1.052)*$40,000*7/10=$18,522

3. EPDV is /(r+) = $18,000/(r+0.08)

a. Buy. EPDV=$138,462>$100,000

b. Break-even. EPDV=$100,000

c. Do not buy. EPDV=$78,261<$100,000

4. a. $44,000*(1-.4)*36-$40,000*(1-.4)*38=$38,400

b. $44,000*(1-.3)*36-$40,000*(1-.3)*38=$44,800

Dig Deeper5. a. EPDV of future labor income = $30; consumption=$10 in all three periods.

b. young: -5; middle age: 15; old: -10

c. Total saving =n*(-5+15-10)=0

d. 0 – 5n + 10n = 5n

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e. young: 5; middle age: 12.5; old: 12.5; cannot borrow against future income when young.

f. 0 + 12.5n - 12.5n = 0

g. 0 + 0 + 12.5n = 12.5n

h. By allowing people to borrow to consume when young, financial liberalization may lead to less overall accumulation of capital.

6. a. Expected value of earnings during middle age is .5*($40,000+$100,000)=$70,000.EPDV of lifetime earnings = $90,000.Consumption plan is $30,000 per year.Consumer will save (-$10,000) when young.

b. In the worst case, EPDV of lifetime earnings = $60,000. Consumption = $20,000 and saving=0 when young.Consumption is lower than part a, and saving is higher.

c. Consumption: young: $20,000; middle age: $50,000; old: $50,000.Consumption will not be constant over the consumer’s lifetime.

d. The uncertainty leads to higher saving by young consumers.

Explore Further7. a-d. On average, consumption accounts for about 66% of GDP and investment for about 13%,

so consumption is more than four times bigger than investment. Relative to averagechanges, movements in consumption and investment are of similar magnitude, whichimplies investment is much more volatile than consumption.

8. a. Consumers may be more optimistic about the future (and spend more) when disposable income is higher, so consumer confidence might be positively related to disposable income. However, consumer confidence should depend on expectations about the future, rather than on current variables per se. Hence, there are reasons to think changes in consumer confidence might not always track changes in disposable income.

b. There appears to be positive relationship between the variables, but it is not tight.

c. Personal disposable income increased at an annual rate of 11.5% in 2001:III and at an annual rate of 10.8% in 2002:I. Consumer confidence fell in 2001:III but rose in 2002:I. Clearly the events of September 11, as well as the ongoing recession, played in role in the consumer confidence numbers for 2001:III.

CHAPTER 17

Quick Check1. a. False.

b. False.c. False.d. True/Uncertain (They can rely on forecasts by others, but somebody has to do it.)

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e. False.f. True.g. False.

2. a. Higher real stock prices increase real wealth directly, and therefore tend to increaseconsumption. Moreover, the hype about the New Economy, combined with increasingstock prices, may have led to favorable expectations about future labor income, whichwould also tend to increase consumption.

b. Subsequent declines in the stock market decreased wealth and may have led consumers torevise (downward) expectations about future labor income, effects that would tend toreduce consumption.

3. a. IS shifts right.

b. LM shifts right.

c. There are three effects. First, an increase in expected future taxes tends to reduce expected future after-tax income (for any given level of income), and therefore to reduce consumption. This effect tends to shift IS to the left. Second, the increase in future taxes (a deficit reduction program) will lead to lower real interest rates in the future. The fall in the expected future interest rate tends to shift IS to the right. Third, the fall in future real interest rates leads to an increase in investment in the medium run and an increase in output in the long run. The increase in expected future output tends to shift IS to the right. The net effect on the IS curve is ambiguous. Note that the model of the text has lump sum taxes. More generally, the tax increase may increase distortions in the economy. These effects tend to reduce output (or the growth rate).

d. IS shifts left.

4. Rational expectations may be unrealistic, but it does not imply that every consumer has perfect knowledge of the economy. It implies that consumers use the best available information—models, data, and techniques—to assess the future and make decisions. Moreover, they do not have to work out the implications of economic models for the future by themselves; they can rely on the predictions of experts on television or in the newspapers. Essentially, rational expectations rules out systematic mistakes on the part of consumers. Thus, although rational expectations may not literally be true, it seems a reasonable benchmark for policy analysis.

5. The answers below ignore any effect on capital accumulation and output in the long run. Assume the tax cut policy in the future is temporary, so we need only worry about future short run effects.

a. The effect on current output is ambiguous. The tax cut in the future will lead to a boom. Output and the real interest rate will increase. The increase in expected future output tends to shift IS right; the increase in the expected future real interest rate tends to shift IS left. Finally, the fall in expected future taxes tends to increase expected future after-tax income (for any given level of income). This effect tends to shift IS right.

b. This means that the Fed will increase the interest rate in the future (shift LM left). The expected interest rate will increase more, but there is still the effect of lower expected

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taxes on current consumption. The effect today on output is still ambiguous, but more likely to be negative than in part (a).

c. Future output will be higher, the future interest rate will not increase, and future taxes will be lower. The current IS curve definitely shifts right, and current output increases.

Dig Deeper6. a-b. See the discussion in the text.

c. The gesture seemed to indicate that the Fed supported deficit reduction, and would be willing to conduct expansionary monetary policy in the future to offset the direct negative effects on output from spending cuts and tax increases. A belief that the Fed would be willing to act in this way would tend to increase expected future output (relative to the case where the Fed did nothing) and reduce expected future interest rates. Both of these effects tend to increase output in the short-run.

7. a. Future interest rates will tend to rise. Future output will tend to fall. Both effects shift the IS curve to the left in the present. Current output and the current interest rate fall. The yield curve gets steeper on the day of the announcement.

b. No.

c. Compared to original expectations, the nominee is expected to follow a more expansionary monetary policy. The yield curve will get flatter on the day of the announcement.

Explore Further 8. a. The interest rate will increase in the short run, and increase even further in the medium

run. The yield curve will get steeper.

b. The spread increased over the period.

5-Year Yield minus 3-Month YieldAugust 2002: 1.64%January 2003: 1.86%August 2003: 2.4%January 2004: 2.22%

CHAPTER 18

Quick Check1. a. True.

b. False. c. False.d. False.e. False.f. True.

g. False.

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2. Domestic Country Balance of Payments ($)Current AccountExports 25Imports 100

Trade Balance -75 (=25-100)Investment Income Received 0Investment Income Paid 15

Net Investment Income -15 (=0-15)Net Transfers Received -25

Current Account Balance -115 (=-75-15-25)

Capital AccountIncrease in Foreign Holdings of Domestic Assets 80 (=65+15)Increase in Domestic Holdings of Foreign Assets -50Net Increase in Foreign Holdings 130 (=80-(-50))Statistical Discrepancy -15 (=115-130)

3. a. The nominal return on the U.S. bond is 10,000/(9615.38) –1 4%.The nominal return on the German bond is approximately 6%.

b. Uncovered interest parity implies that the dollar is expected to appreciate. Thus, the expected exchange rate is E*(1+i*)/(1+i)=0.75(1.06)/(1.04) .764 Euro/$.

c. If you expect the dollar to depreciate instead, purchase the German bond, since it pays a higher interest rate and you gain by holding Euros.

d. The dollar depreciates by 4%, so the total return on the German bond (in $) is approximately 6% + 4% =10%. Investing in the U.S. bond would have produced a 4% return.

e. The uncovered interest parity condition is about equality of expected returns, not equalityof actual returns.

Dig Deeper4. a. GDP is 15 in each economy. Consumers will spend 5 on each good.

b. Each country has a zero trade balance. Country A exports clothes to Country B, Country B exports cars to Country C, and Country C exports computers to Country A.

c. No country will have a zero trade balance with any other country.

d. There is no reason to expect that the United States will have balanced trade with any particular country, even if the United States eliminates its overall trade deficit.

5. a. The relative price of domestic goods falls. Relative demand for home goods rises. The home unemployment rate falls in the short run.

b. The price of foreign goods in terms of domestic currency is P*/E. A nominal depreciation (fall in E) increases the price of foreign goods in terms of domestic currency. Therefore, a nominal depreciation tends to increase the CPI.

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c. The real wage falls.

d. Essentially, a nominal depreciation stimulates output by reducing the home real wage, which leads to an increase in home employment.

Explore Further6. a. The yen appreciated form mid-1985 to mid-1995, depreciated until mid-1998,

appreciated through the end of 1999, depreciated through the end of 2001, appreciated through 2004, and then began to depreciate.. From a broader perspective, between the end of 1984 and the end of 2004, the yen appreciated by about 100%. The yen reached its strongest value against the dollar in mid-1995.

b. Depreciation of the yen.

c. The yen appreciated from the end of 2001 to the end of 2004. This did not help the Japanese recovery.

7. "U.S. Assets Abroad" refers to foreign assets acquired by the United States. The sign convention is that a negative number implies a capital outflow (not an outflow of assets), meaning U.S. acquisition of foreign assets. Loosely, a capital outflow is the exchange of home currency for foreign assets. During the period 1990-2004, the United States acquired a substantial amount of foreign assets. However, this is only one side of the capital account. Capital inflows are recorded in the category, "Foreign Assets in the U.S." In principle, the sum of "U.S. Assets Abroad" and "Foreign Assets in the U.S." (with the proper sign conventions) equals the U.S. current account. In practice, there are measurement errors, summarized in the category, "Statistical Discrepancy."

Given that the United States had a substantial current account deficit in the 1990s (except during the first half of 1991), it received, on net, capital inflows, which means the inflow from "Foreign Assets in the U.S." should have exceeded the outflow from "U.S. Assets Abroad" by the amount of the U.S. current account deficit. In all quarters except 1991:1 and 1995:4, measured U.S. capital inflows exceeded measured U.S. capital outflows, although never by exactly the amount of the U.S. current account deficit. In some quarters the statistical discrepancy was positive; in others, negative.

8. Exact answers will depend upon when the website is accessed, but the basic point is that the United States is the world’s largest debtor, and borrows more than the net lending of all the other advanced economies combined.

CHAPTER 19

Quick Check1. a. Uncertain.

b. False. c. False.d. True.e. True.f. True.g. False.

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h. False.

2. a. There is a real appreciation over time. Over time, the trade balance worsens.

b. The currency depreciates at the rate of -*.

3. a. The share of Japanese spending on U.S. goods relative to U.S. GDP is (0.07)(0.1)=0.7%.

b. U.S. GDP falls by 2(.05)(.007)=0.07%.

c. U.S. GDP falls by 2(.05)(.1)=1%.

d. This is an overstatement. The numbers above indicated that even if U.S. exports fall by 5%, the effect is to reduce growth by 1%. This is small relative to GDP, but large relative to normal growth (of around 3%).

4. Answers follow the model in the text.

Dig Deeper 5. a. The ZZ and NX lines shift up. Domestic output and domestic net exports increase.

b. Domestic investment will increase because output increases. Assuming taxes are fixed, there is no effect on the deficit.

c. Private saving must increase, since NX=S-I +T-G. Since the deficit is unchanged, and I and NX increase, S must increase.

d. Except for G and (for our purposes) T, the other variables in equation (19.5) are endogenous. Exogenous shocks can affect all of them simultaneously.

6. a. There must be a real depreciation.

b. C+I+G must fall. The government can reduce G or increase T, which will reduce C.

7. a. Y = C + I + G + X – IM = 20 + 0.8*(Y - 10) + G + 0.3Y*- 0.3YY = [1/(1 - .8 + .3)](12 + G + 0.3Y*) = 2*(12 + G + 0.3Y*) = 44 + 0.6Y*

The multiplier is 2 (=1/(1-.8+.3)) when foreign output is fixed. The closed economy multiplier is 5 (=1/.5). It differs from the open economy multiplier because, in the open economy, only some of an increase in autonomous demand falls on domestic goods.

b. Since the countries are identical, Y=Y*=110. Taking into account the endogeneity of foreign income, the multiplier equals [1/(1-0.8 -0.3*0.6 +0.3)]=3.125. The multiplier is higher than the open economy multiplier in part (a) because it takes into account the fact that an increase in domestic income leads to an increase in foreign income (as a result of an increase in domestic imports of foreign goods). The increase in foreign income leads to an increase in domestic exports.

c. If Y=125, then foreign output Y*= 44+0.6*125=119. Using these two facts and the equation Y = 2(12+G+0.3Y*) yields: 125 = 24+2G+0.6*(119). Solving for G gives

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G=14.8. In the domestic country, NX = 0.3*(119)-0.3*(125) = -1.8; T-G = 10-14.8=-4.8. In the foreign country, NX*=1.8; T*-G*=0.

d. If Y=Y*=125, then we have: 125=24+2G+0.6*(125), which implies G=G*=13. In both countries, net exports are zero, but the budget deficit has increased by 3.

e. In part, fiscal coordination is difficult to achieve because of the benefits of doing nothing, as indicated from part (c).

Explore Further8. a. NX=National Saving minus Investment.

b. As a % of GDP, gross private domestic investment was 3.6 percentage points higher in 2004 than in 1981. NX were 5.6 percentage points lower. Since, National Saving=NX+I, national saving fell by 3.6 –5.6 = 2 percentage points relative to GDP.

c. Change in Investment Change in NX (% of GDP) (% of GDP)

1981-1990 -0.1% -0.1%1990-2000 5.1% -3.1%2000-2004 -0.1% -1.5%

Only in the 1990s was the fall in NX matched by an increase in investment.

d. Yes. An increase in investment leads to more capital accumulation and more output in the future, and therefore to a greater ability to repay foreign debt.

CHAPTER 20

Quick Check1. a. True.

b. False. c. True.d. True.e. Uncertain. If expected appreciation on the yen is greater than the interest rate in other

countries, than foreign investors will hold yen bonds.f. False. The money stock will change in response to shocks (including policy shocks) so

that the home interest rate equals the foreign interest rate.

2. The appropriate mix is a monetary expansion to depreciate the currency (and improve the trade balance) and a fiscal contraction to prevent output from increasing.

3. a. Consumption increases because output increases. Investment increases because output increases and the interest rate falls.

b. A monetary expansion has an ambiguous effect on net exports. The nominal (and real) depreciation tends to increase net exports, but the increase in output tends to reduce net exports.

4. a. IS shifts right, because NX tend to increase.

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b. IS shifts right, because the increase in i* tends to create a depreciation of the home currency and an increase in NX. The interest parity line also shifts up.

c. A foreign fiscal expansion is likely to increase Y* and increase i*. A foreign monetary expansion is likely to increase Y* and reduce i*.

d. A foreign fiscal expansion is likely to increase home output. A foreign monetary expansion has an ambiguous effect on home output. The increase in Y* tends to increase home output. The fall in i* tends to reduce home output.

Dig Deeper5. a. An increase in Y* shifts IS to the right. The incipient rise in the home interest rate

creates a monetary expansion as the home central bank purchases foreign exchange reserves to prevent the domestic currency from appreciating. So, LM shifts right. Output and NX increase.

b. The interest parity line shifts up and LM shifts left as the central bank sells foreign exchange to prevent the domestic currency from depreciating. Output falls, which leads to an increase in NX).

c. A fiscal expansion in the Leader country, which increases Y* and i*, reduces home output, if the effect of Y* on output is small. A monetary expansion in the Leader country, which increases Y* and reduces i*, increases domestic output.

6. a. IS shifts to the left. Output falls, the interest rate falls, and the currency depreciates. The exchange rate change tends to increase output by increasing NX. Therefore, the exchange rate movement dampens the effect of the fall in business confidence.

b. IS shifts left and LM shifts left (because the money supply falls) as the central bank sells foreign exchange reserves to prevent the domestic currency from appreciating. The fall in output is greater than in part (a).

c. When the exchange rate is flexible, movements of the exchange rate tend to dampen the output effects of IS shocks. The currency depreciates when IS shifts left and appreciates when IS shifts right.

Explore Further7. a. The pound generally depreciated during the period. It was more stable while the United

Kingdom participated in the ERM, and depreciated immediately after the United Kingdom left the ERM.

b. The interest rates should be equal.

c. U.K. Interest Rate minus German Interest RateJan. 1985 – Sep. 1990: 5.22Oct. 1990 – Sep. 1992: 1.14Oct: 1992 – Dec. 2004: 1.72

d. The spread dropped from 4% to 2.2% in the first three months that the United Kingdom was part

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of the ERM. It appears that financial markets believed that the United Kingdom would continue to participate in the ERM.

e. The spread changed from positive to negative immediately after the United Kingdom left the ERM. Lower interest rates (than they would have been otherwise) were beneficial to the United Kingdom’s economy.

CHAPTER 21

Quick Check1. a. True. Britain returned to the gold standard at too appreciated a parity.

b. True.c. False.d. False.e. False.

2. b. AD shifts right in the short run. AS shifts left in the medium run. In the medium run, output is unchanged, but the price level is higher.

c. Consumption is unchanged in the medium run.

d. The real exchange rate appreciates, since the price level rises. NX fall in the medium run, as a result of the real appreciation.

e. i=i*. The nominal interest rate is unaffected by government spending. Since expected inflation is constant, the real interest rate is also unaffected. Investment is unchanged in the medium run.

f. In a closed economy, an increase in government spending reduces investment in the medium run.

g. The statement is true. Under fixed exchange rates, the interest rate is anchored to foreign interest rate. Since the interest rate does not change, there is no mechanism for government spending to crowd out investment.

3. a. The home real interest rate equals the foreign real interest rate minus expected real appreciation of the home currency. When the home currency is expected to appreciate in real terms, foreign bonds must offer a real interest rate higher than the home real interest rate to compensate international portfolio investors for the expected loss in real value of the foreign currency. When the home currency is expected to depreciate in real terms, home bonds must pay a real interest rate higher than the foreign real interest rate.

b. 10%=6%-expected nominal appreciation, so expected nominal appreciation = - 4% per year. Therefore, expected depreciation is 4% per year.

c. 10%-6%=(6%-3%) - expected real appreciation, so expected real appreciation = -1% per year. Therefore, expected real appreciation is 1% per year.

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d. You would purchase the domestic bond because the foreign bond will only yield 6% and there is a loss on your position in the foreign currency.

4. a. The expected exchange rate is E. The home interest rate is i*.

b. The expected exchange rate is less than E. The home interest rate is greater than i*.

c. The domestic interest rate returns to i*, because expected depreciation is zero.

d. Devalution per se does not lead to higher interest rates. Fear of devaluation does.

Dig Deeper5. a. The price level rises by 10%.

b. The real exchange rate is EP/P*. If P rises by 10%, E falls by 10%. There is a 10% depreciation of the currency in nominal terms.

c. Eet+n falls by 10%.

d. E falls by 10%.

e. E falls by more than 10%. By interest parity, i-i* equals expected depreciation. If i falls below i* in the short run, then there is expected appreciation. This can only happen if E falls by more than 10% in the short run. So, E falls by more in the short run than it does in the medium run.

6. a. Eet+1 falls.

b. The UIP curve shifts up. The domestic interest rate must increase to maintain the fixed exchange rate.

c. The money supply falls as the central bank sells foreign exchange to buy its own currency. LM shifts left.

d. Output falls and the interest rate increases. The government might choose to abandon the fixed exchange rate to avoid the fall in output, even if initially the government had no intention of devaluing. Self-fulfilling crises are possible.

7. a. i=i* before and after the devaluation.

b. The expected exchange rate increases to E. The UIP curve shifts up.

c. The IS shifts right, because devaluation tends to increase NX. The interest rate would increase with no change in the money supply.

d. The money supply must increase. LM shifts right.

e. Output increases.

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f. Fear of further devalution will increase the expected exchange rate above E and increase the interest rate above i*. These effects will tend to reduce the increase in output. If the initial devaluation creates a strong enough fear of further devaluation, the devaluation could lead to a fall in output.

Explore Further8. The answer is given in part (c). The exchange rate is many times more variable than the interest

rate differential.

CHAPTER 22

Quick Check1. a. False.

b. True.c. Uncertain.d. True.e. False.

2. a. The central bank could increase M and shift LM to the right.

b. P falls and M/P rises, so LM shifts right.

c. Expected inflation is likely to fall. The fall in expected inflation tends to increase the real interest rate and shift IS to the left. Output moves further away from the natural level.

d. No. If the Fed does nothing, the economy may not return to the natural level of output, if the effect of the fall in expected inflation is strong enough.

3. b. P falls and M/P rises, so LM shifts right. The adjustment mechanism does not work when i=0. As LM shifts right, output does not change.

c. Monetary policy is ineffective. An increase in M shifts LM to the right, which does not increase output when i=0.

d. Yes. If IS shifts right, output will increase.

e. Not wise advice. In the liquidity trap, the central bank cannot restore the natural level of output.

Dig Deeper4. a. Short-term unemployment has more effect. The long-term unemployed may not be

searching and may not be very employable.

b. u=.05/[1.05*(1-.5 )]

c. If =0, 0.4, 0.8, the natural rate =4.8%, 6.0%, 7.9%. The long-term unemployed put less downward pressure on wages than the short-term unemployed. Thus, from the wage-setting equation, for a given aggregate unemployment rate, an increase in the proportion of long-term unemployed would tend to increase the real wage. Since the real wage is

175

fixed from the price-setting equation, however, the aggregate unemployment rate must increase to offset the upward pressure on the real wage from the increase in the share of long-term unemployed. Intuitively, if the weight on the long-term unemployed were zero instead of 0.5, then the wage-setting and price-setting equations would determine the natural short-term rate of unemployment. Additional long-term unemployed would simply increase the aggregate unemployment rate. The same kind of reasoning applies here, but the effect is less strong because the weight on long-term unemployed in the wage-setting equation is not zero.

5. a. Higher unemployment implies lower wages given expected prices. This implies lower prices given expected prices. Equivalently, it implies lower inflation given expected inflation, which here equals past inflation.

b. t - πt-1 = - (uS + uL – un)

c. π - πt-1 = - (uS – un)

d. π - πt-1 = - ((1 - ) ut – un)

e. The curve will shift to the right.

f. More overall unemployment is needed to achieve the same decrease in inflation. The cost of disinflation increases.

g. Larger increase. In the Great Depression, perhaps the long-term unemployed did not exert much pressure on wages and prices, so deflation ended despite high unemployment.

Explore Further6. Answers will vary depending upon when the question is answered.

CHAPTER 23

Quick Check1. a. True.

b. False.c. False.d. False. Although incomes policies may be part of a successful stabilization program in

some cases.e. False.f. False.

2. a. If money growth = 25%, 50%, 75%, seignorage=162.5, 325, 487.5

b. In the medium run, if money growth = 25%, 50%, 75%, seignorage=162.5, 200, 112.5. The fall in real money balances associated with higher ongoing inflation reduces the potential for seignorage. Part (a) did not allow for this effect.

3. a. Would decrease the effect of inflation on real tax revenues.

b. Would decrease the effect of inflation on real tax revenues.

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c. Would decrease the effect of inflation on real tax revenues, but would also have other effects. The income tax can tax the rich at a higher rate than the poor, but the sales tax rate is the same for rich and poor.

Dig Deeper4. i. The end to the crisis depends on shifting the composition of taxes. Workers are already

paying an inflation tax.

ii. The central bank must make a credible commitment that it will no longer automatically monetize the government debt. Although a currency board would do this, it is a drastic and perhaps unnecessary step.

iii. Price controls may help, but price controls without other policy changes only cause distortions and are a recipe for failure.

iv. A recession is not needed, but it may happen. Although nominal rigidities are less important during hyperinflations—which implies that the sacrifice ratio is small—the issue of credibility remains. Unless firms and workers believe in the stabilization program, a severe recession may be the result.

v. The problem has two parts: (i) there is an ongoing fiscal deficit that the government is unable or unwilling to finance from nonmonetary sources and (ii) the central bank is willing to monetize the debt. The order in which these issues are resolved ultimately depends on the political realities. The fiscal authority could eliminate the deficits. If it does not do so, the central bank could commit not to monetize government debt. However, this could drive the government into default on its bonds.

5. max (0.9-∆M/M)(∆M/M)=45%.

Explore Further6. Answers may vary depending upon when the website is accessed, but it is clear that a fall in oil

prices would tend to increase the budget deficit in Venezuala. This would create the possibility of a hyperinflation if the government is unwilling or unable to finance itself and the central bank finances the deficit through money creation.

CHAPTER 24

Quick Check1. a. False.

b. True/Uncertain.c. False.d. False.e. True.f. Uncertain. It may be wise for a government to commit not to negotiate with hostage

takers as a means to deter hijackings, even recognizing that after a hijacking has taken place, there is a strong incentive to negotiate. However, the phrase “under no circumstances” is categorical. There may some circumstances under which a government might wish to violate its commitment. This statement, of course, illustrates the difficulty of precommitment. Can a government really commit not to negotiate, no

177

matter what the circumstances, even if these circumstances may not have been imagined at the time the commitment was made?

g. False.

2. a. Inflation will increase in the fourth year.

b. The President should aim for high unemployment early in the administration, to reduce inflation before the fourth year.

c. The policies are likely to achieve the desired inflation rates, but not the increase in output desired in the fourth year. If inflation equals expected inflation, unemployment equals the natural rate.

3. Answers will vary.

4. New Zealand wants to eliminate fears that the central bank might try to reduce unemploymentbelow the natural rate with expansionary monetary policy and higher inflation. See Chapter 25 for a discussion of inflation targeting.

Dig Deeper5. a. 0.5(D + R)

b. The unemployment rate will be less than the natural rate. Inflation will be higher than expected.

c. The unemployment rate will be greater than the natural rate. Inflation will be lower than expected.

d. Yes, if one looks at the first two years of each administration, not just the first.

e. Unemployment equal to the natural rate, because π = πe, and high inflation.

7. a. If the Republicans cut military spending, the Democrats get 1 if they cut welfare, but 3 if they do not. So their best response is to vote against welfare cuts. The Republicans will get –2 in this case.

b. If the Republicans do not cut military spending, the Democrats get –2 if they cut welfare, but only –1 if they do not. So their best response is not to cut welfare. The Republicans will get –1 in this case.

c. Given the answers above, the Republicans do better when they do not cut military spending, so they will not cut. The Democrats will not cut either. The two parties are locked in a bad equilibrium. They could make a deal: both vote for cuts. If they do, they will both be better off.

Explore Further8. Answers will vary.

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CHAPTER 25

Quick Check1. a. False.

b. False.c. False.d. False/Uncertain. Evidence suggests that people have money illusion, when would seem

to imply that inflation would distort decision making.e. False.f. True/Uncertain. True to the extent the tax code is not indexed to inflation.

2. a. Demand for M1 falls while demand for M2 is unchanged. People shift funds from savings accounts to time deposits.

b. Demand for M1 increases as people transfer funds from money market funds to checking accounts. Demand for M2 remains unchanged.

c. Shift in the composition of M1 (and consequently M2) as people hold more currency and make fewer trips to the bank while holding smaller checking account balances.

d. The demand for M2 increases as the benefit of holding government securities falls.

3. a. 4%-0%=4%; 14%-10%=4%

b. 4% * (1-0.25)-0%=3%; 14% * (1-0.25)-10%=10.5%-10%=0.5%

c. Yes, given the deductibility of nominal mortgage interest payments in the United States.

4. a. The unemployment rate will remain equal to the natural rate.

b. No, there surprises, lags in policymaking, and uncertainty in policymaking.

c. The changes in the natural rate will make it more difficult for the Fed to hits its target. It will be harder to distinguish changes in the actual rate of unemployment from changes in the natural rate of unemployment.

Dig Deeper5. Discussion question.

6. c. The MP relation slopes up. An increase in government spending shifts IS right, so output and the real interest rate rise.

d. The MP relation shifts up. Output falls and the real interest rate increases.

7. a. The MP relation shifts up. Output falls and the real interest rate increases.

b. Since Y<Yn, e falls. Inflation tends to returns to its target level.

c. The MP relation shifts down. Output increases and the real interest rate falls.

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d. Since Y>Yn, e rises. Inflation tends to move away from its target level. A value of a<1 makes no sense as part of the policy rule, because inflation would tend to move away from its target

Explore Further8. Answers will depend upon current Fed policy.

CHAPTER 26

Quick Check1. a. True.

b. False.c. False.d. False.e. False.f. False

2. First, even a temporary deficit leads to an increase in the national debt, and therefore to higher interest payments. This, in turn, implies continued deficits, higher taxes, or lower government spending in the future. Second, the evidence does not support the Ricardian equivalence proposition. Third, if Ricardian equivalence did hold, then government spending would have the same effect on output regardless of whether it was financed by bonds (i.e., with a deficit) or taxes. Thus, a deficit, per se, would not be needed to stimulate output. Fourth, war-time economies are already low-unemployment economies. There is no need for further stimulation by using deficits rather than tax finance. The only correct part of the statement is the first sentence. A deficit can be preferable to higher taxes during a war, but not for the reasons stated here.

3. a. Interest payments are 10% of GDP, so the primary surplus is 10%-4%=6%.

b. Real interest payments are (10%-7%)*100%=3% of GDP. So the inflation-adjusted surplus is 6%-3%=3%.

c. Output is roughly two percent lower than it would have been. Using the rule of thumb in the text, the surplus is lower by 0.5*2%=1%. So, the cyclically-adjusted, inflation- adjusted surplus is 2%.

d. The change in the debt to GDP ratio = (3%-2%)*100% - 3% = -2%. The debt to GDP ratio falls by 2% a year.

Dig Deeper4. a. The domestic interest rate increases from 10% to 20%.

b. The real interest rate increases from 3% to 13%. The high real interest rate is likely to decrease growth.

c. The official deficit increases from 4% to 14% of GDP. The inflation-adjusted deficit increases from –3% (a surplus) to 7% (a deficit).

d. The change in the debt ratio = (13%-(-2%))*100%-3%=12%. It goes up very quickly.

e. In this example, the worries were self-fulfilling.

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5. a. The IS curve shifts right and output increases in the short run. The increased in government spending is financed by borrowing, i.e., with bonds.

b. IS shifts to the right, because the government spending multiplier is bigger than the tax multiplier. The output effect is smaller than in part (a).

c. The effect is the same as in part (b).

d. The effect is the same as in parts (b) and (c).

e. Government spending affects output, but taxes do not. If taxes are not levied to finance government spending, households will simply save the present value of the required taxes themselves.

Explore Further6. a. The debt-to-GDP ratio is 80% in 10 years.

b. The debt-to-GDP ratio is 93% in 10 years.

c. The answer is the same as in part (b). What matters is r-g, which is the same in parts (b) and (c).

d. The required primary surplus is .5*(r-g)=1% of GDP.

e. The required primary surplus is 2% of GDP per year.

f. The required reduction in the primary deficit will be larger if growth is lower.

g. The policy in part (e) is more dangerous. Waiting to reduce the debt ratio requires a larger change in fiscal policy. Larger policy changes have more uncertainty associated with their outcomes. Thus, the larger change in policy in part (e) is more likely to have extreme effects on output (lower growth), which could set off a vicious cycle. Lower growth means larger surpluses are required to reduce the debt to safe levels, larger surpluses lead to lower growth, which mean larger surpluses, and so on.

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