(Test Bank) Macroeconomics

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Instructor’s Manual for Macroeconomics Fifth Edition Stephen D. Williamson Washington University in St. Louis ©2014 Pearson Education, Inc. Chapter 1 I ntroduction ◼ Teaching Goals Macroeconomics primarily studies economic growth and business cycles. Over time, there is a prevailing upward trend in the standard of living. However, such growth can be rather erratic. There are some periods of very rapid growth, some periods of rather anemic growth, and also some periods of temporary economic decline. Explanations for the overall upward trend in standards of living are the subject of economic growth analysis. Explanations of variations in growth over shorter time horizons are the subject of business cycle analysis. Students should be able to distinguish between microeconomic topics and macroeconomic topics. Students should understand the distinction between growth analysis and business cycle analysis. Although microeconomics and macroeconomics are separate branches of study, both branches are guided by the same set of economic principles. Standard economic theory is guided by the assumption of maximizing behavior. As a first approximation, we therefore view the macroeconomy as a co llection of markets with maximizing participants. These participants are price -taking agents and the economy is closely approximated by a competitive equilibrium. Because the economy as a whole is extremely complex, macroeconomists must rely on somewhat a bstract models. Although the structure of such models does not correspond to all of the details of life in a complex society, these models offer the best hope of providing simple, yet accurate descriptions of how the macroeconomy works, and how government policies may affect macroeconomic outcomes. Economists are in broad consensus about the mechanisms of economic growth. There is less agreement about the causes and consequences of business cycles. While there are strong regularities in macroecon omic data, competing theories have been developed that each have a claim to explaining those regularities. There are Keynesian and non -Keynesian models of the business cycle. Examples of the former are Keynesian coordination failure models and New Keynesia n sticky price models. Examples of the latter are the Lucas -Friedman money surprise model, the real business cycle model, and new monetarist models. ◼ Classroom Discussion Topics One good way to get the ball rolling is to list some macroeconomic concerns like stagnant economic growth, unemployment, inflation, the recent recession, government budget deficits, tax burdens, balance of trade deficits, financing of Social Security, and the like. Draw on current news or look at various policy proposals discussed in Washington. Ask or poll students as to whether they are personally concerned about such problems and what original prejudices they might have about causes and effects. Sometime s students express concerns about topics that are perhaps more microeconomic in nature, like inequality in the distribution of income and environmental concerns. Emphasize that economic growth may provide enough extra resources to help deal with these issues. Chapter 1 Introduction 2 Students often have conflicting ideas about the current state of the economy. Sometimes their perspectives may be governed by their individual circumstances, what they read in the paper, what they see on TV and the like. Ask them whether they believe that times are currently good or bad. Ask them why they think the way that they do. Ask them how they can more objectively back up or check out their casual impressions about the current state of the economy. ◼ Outline I. . What Is Macroeconomics? II. . Gross National Product, Economic Growth, and Business Cycles I I I . Macroeconomic M odels IV. Microeconomic Principles V. Disagreement in M acroeconomics VI. What Do We Learn from M acroeconomic Analysis? A. Fundamentals: Preferences and Productive Capacity B. The Efficiency of Market Outcomes C. The Implications of Unemployment D. The Source of Long -run Improvements in the Standard of Living E. A Tax Cut is not a Free Lunch F. Credit Markets G. Expectations about the Future H. The Role of Money I. Business Cycles J. International Trade in Goods and Assets K. Money Growth and Inflation L. The Phillips Curve VII. Understanding Current and Recent Macroeconomic Events A. Aggregate Productivity B. Unemployment and Vacancies C. Taxes, Government Spending, and the Government Deficit D. Inflation E. Interest Rates F. Business Cycles in the United States G. Credit Markets and the Financial Crisis H. The Current Account Surplus ◼ Solutions to End-of-Chapter Problems 1. Calculating percentage growth rates, and log approximations to percentage growth rates, we obtain: Year Percentage Growth Rate Log Approximation 2003 1.597484 1.584858 2004 2.466649 2.436718 Chapter 1 Introduction 3 2005 2.073992 2.052778 2006 1.667763 1.654008 2007 1.162146 1.155445 2008 -1.13738 -1.14389 2009 -4.41241 -4.51272 2010 2.257293 2.232193 2011 0.997377 0.992436 In this case, calculating the change in the natural logarithm from one year to the next gives a good approximation to the percentage growth rate, as the growth rates are small. But if we do the same thing for growth rates over ten -year periods, as below, t he approximation is poor, as the growth rates are relatively large. Ten-year percentage growth rate Log Approximation 1960 19.09544 17.4755 1970 33.10087 28.59371 1980 22.66362 20.42756 1990 25.33007 22.57806 2000 23.14175 20.81659 2. Some obvious possibilities include Federal Reserve open market purchases to keep the money supply from shrinking, instituting bank reforms before the Depression started, avoiding high tariff rates, etc. 3. Newton’s model of falling bodies. Ignores air resist ance. Works well for most dense objects, doesn’t work well for feathers. Diagrams of plays in football and basketball. Ignores the characteristics of individual players, and opponent reactions. Works well for evenly matched teams. Chapter 1 Introduction 4 Scale models of new aircraft designs. Ignores working engines and interior contents. Wind tunnel testing approximates aerodynamics of actual aircraft. 4. The time series for unemployment exhibits an asymmetry . The unemployment rate typically increases at a much higher rate than the rate at which it decreases. Thus, when the unemployment rate is unusually high, it takes a long time to fall to “normal” levels. After the 2001 recession, the unemployment rate took about 7 years to fall by about 1.8 points. In 2 000, the unemployment rate was 4%, and the peak unemployment rate in 2010 was about 10%. Based on previous experience, it may take until 2033 for the unemployment rate to fall to 4%. 5. The deficit is large in 2011 because taxes have fallen and spending has risen. However, the contribution of increased spending to the deficit is larger than the contribution of decreased taxation. 6. In Figure 1.10, the money growth rate is more variable afte r 1980 than before 1980, but the inflation rate is more variable before 1980 than after 1980. These observations seem to contradict the view that there is a tight link between money growth and inflation. Possibly an active monetary policy that makes money growth more variable in the short run is necessary to make the inflation rate stable. 7. In Figure 1.12, there have been some sharp movements in the real interest rate. Before late 2008, those movements in the real interest rate were due both to variability in inflation, and to variability in the nominal interest rate. The latter movements in the nominal interest rate were driven primarily by the Federal Reserve System. However, in late 2008, the Fed adopted a policy of essentially zero nominal interest rates , and so after late 2008, movements in the real rate are due entirely to fluctuations in the inflation rate. 8. The recent recession, in 2008 -09, in figure 1.13, was more severe than the previous two recessions, but slightly less severe than the 1981 -82 recession, and about as severe as the 1974 - 75 recession. An issue here is how we determine the deviation from tre nd, and what the trend is. Given the way the trend is calculated here, there is a sense in which the recent recession does not look so bad, but that may be because of a long -term deterioration in the US economy, i.e. there was a downward level adjustment to the trend. 9. When there are spikes in the interest rate spread, those tend to occur during recessions, i.e. periods when real GDP is below trend. Further, large (small) spikes in the interest rate spread tend to be associated with large (small) negative deviations from trend in real GDP. However, in the 1990 -91 recession, there is only a small spike in the inter est rate spread, which looks like other random spikes in the spread that have occurred which are not associated with recessions. 10. The three previous declines in housing prices occurred beginning in 1970, 1980, and 1990. In those cases, the percentage declin es in relative price of housing were about 15%, 12%, and 15%, respectively. These declines were large, but the decline beginning in 2006 was larger in percentage terms. ©2014 Pearson Education, Inc. Chapter 2 M easurement ◼ Teaching Goals Students must understand the importance of measuring aggregate economic activity. Macroeconomists produce theories that provide useful insights and policy conclusions. To be credible, such theories must produce hypotheses that evidence could possibly refut e. Macroeconomic measurement provides such evidence. Without macroeconomic measurements, macroeconomics could not be a social science, and would rather consist of philosophizing and pontificating. Market transactions provide the most simple and direct meas urements. Macroeconomists’ most basic measurement is Gross Domestic Product (GDP), the value of final, domestically market output produced during a given period of time. In the United States, the Commerce Department’s National Income and Product Accounts p rovide official estimates of GDP. These accounts employ their own set of accounting rules to ensure internal consistency and to provide several separate estimates of GDP. These separate estimates are provided by the product accounts, the expenditure accoun ts, and the income accounts. The various accounting conventions may, at first glance, be rather dry and complicated. However, students can only easily digest the material in later chapters if they have a good grounding in the fundamentals. GDP changes thr ough time because different amounts of goods and services are produced, and such goods and services are sold at different prices. Standards of living are determined by the amounts of goods and services produced, not by the prices they command in the market. While GDP is relatively easy to measure, the decomposition of changes in real GDP into quantity and price components is much more difficult. It is easy to separately measure the number of apples sold and the price of each apple. Because macroeconom ics deals with aggregate output, the differentiation of price and quantity is much less easily apparent. It is important to emphasize that while there may be more or less reasonable approaches to this problem, there is no unambiguous best approach. Since m any important policy discussions involve debates about output and price measurements, it is very important to understand exactly how such measurements are produced. ◼ Classroom Discussion Topics Much of this material is best learned by example. Rather than simply working through the examples from the text or making up your own, the material may resonate better if the students come up with their own examples. They can start by picking a single good , and by the choice of their numbers they provide their own implied decomposition of output into wage and profit income. Later on, encourage them to suggest intermediate input production, inventory adjustments, international transactions, a government sect or, and so on. Such an exercise may help assure them that the identities presented in the text are more than simply abstract constructions. Chapter 2 Measurement 6 If many of your students are familiar with accounting principles, it may also be useful to present the National Income and Product Account with the “T” accounts, and highlighting how all income is an expense elsewhere. Make one account for each of the firm s, one for the household and one for the government. Add another account for the rest of the world when discussing the example with international trade. This procedure can highlight how some entities can be inferred from others because accounting identitie s must hold. It makes it also easier to determine consumption for some student Social Security benefits are indexed to the Consumer Price Index. Explain with an example exactly how these adjustments are made. Ask the students if they think that this proced ure is “fair.” Another topic for concern is the stagnation in the growth of measured real wages. Real wages are measured by dividing (for example) average hourly wages paid in manufacturing by the consumer price index. Ask students if measured changes in r eal wages confirm or conflict with their general beliefs about whether the typical worker is better or worse off than 10 or 20 years ago. How does possible mis -measurement of prices reconcile any apparent differences between casual impressions and statisti cal evidence? The text discusses why unemployment may or may not be a good measure of labor market tightness. Another interpretation of the unemployment rate is as a measure of economic welfare – welfare goes down as unemployment goes up. Ask the students if they agree with this interpretation. Does the unemployment rate help factor in considerations like equal distribution of income? How can the unemployment rate factor in considerations like higher income per employed worker? Discuss possible pros and con s of using unemployment rather than per capita real GDP as a measure of well-being. Can unemployment be too low? Why or why not? ◼ Outline I. . M easuring GDP: The National Income and Product Accounts A. What Is GDP and How Do We Measure It? B. The Product Approach C. The Expenditure Approach D. The Income Approach E. Gross National Product (GNP) F. What Does GDP Leave Out? G. Expenditure Components 1. Consumption 2. Investment 3. Net Exports 4. Government Expenditures II. . Nominal and Real GDP and Price Indices A. Real GDP B. Measures of the Price Level 1. Implicit GDP Price Deflator 2. Consumer Price Index (CPI) C. Problems Measuring Real GDP and the Price Level III. I . Savings, Wealth, and Capital A. Stocks and Flows B. Private Disposable Income and Private Sector Saving 1. Y d = Y + NFP + TR + INT − T Chapter 2 Measurement 7 2. Sp = Y d − C C. Government Surpluses, Deficits, and Government Saving 1. Sg = T − TR − INT − G 2. D = −Sg D. National Saving: S = Sp + Sg = Y + NFP − C − G E. Saving, Investment, and the Current Account 1. S = I + NX + NFP 2. CA = NX + NFP  S = I + CA F. Capital Stock 1. S  Wealth 2. I  K 3. CA  Claims on Foreigners I V . Labor Market M easurement A. BLS Categories 1. Employed 2. Unemployed 3. Not in the Labor Force B. The Unemployment Rate Unemployment Rate = Number unemployed Labor force C. The Participation Rate Participation Rate = Labor force Total working age population D. The Employment/Population Ratio Employment/Population Ratio = Total employment Total working age population E. Unemployment and Labor Market Tightness ◼ Solutions to End-of-Chapter Problems 1. Product accounting adds up value added by all producers. The wheat producer has no intermediate inputs and produces 30 million bushels at $3/bu. for $90 million. The bread producer produces 100 million loaves at $3.50/loaf for $350 million. The bread produ cer uses $75 million worth of wheat as an input. Therefore, the bread producer’s value added is $275 million. Total GDP is therefore $90 million + $275 million = $365 million. Expenditure accounting adds up the value of expenditures on final output. Consumers buy 100 million loaves at $3.50/loaf for $350 million. The wheat producer adds 5 million bushels of wheat to inventory. Therefore, investment spending is equal to 5 million bushels of wheat valued Chapter 2 Measurement 8 at $3/bu., which costs $15 million. Total GDP is therefore $350 million + $15 million = $365 million. 2. Coal producer, steel producer, and consumers. (a) (i) Product approach: Coal producer produces 15 million tons of coal at $5/ton, which adds $75 million to GDP. The steel producer produces 10 million tons of steel at $20/ton, which is worth $200 million. The steel producer pays $125 million for 25 million tons of coal at $5/ton. The steel producer’s value added is therefore $75 million. GDP is equal to $75 million + $75 million = $150 million. (ii) Expenditure approach: Consumers buy 8 million tons of steel at $20/ton, so consumption is $160 million. There is no investment and no government spending. Exports are 2 million tons of steel at $20/ton, w hich is worth $40 million. Imports are 10 million tons of coal at $5/ton, which is worth $50 million. Net exports are therefore equal to $40 million −$50 million = −$10 million. GDP is therefore equal to $160 million + (−$10 million) = $150 million. (iii) Income approach: The coal producer pays $50 million in wages and the steel producer pays $40 million in wages, so total wages in the economy equal $90 million. The coal producer receives $75 million in revenue for selling 15 million tons at $15/ton. The coal producer pays $50 million in wages, so the coal producer’s profits are $25 million. The steel producer receives $200 million in revenue for selling 10 million tons of steel at $20/ton. The steel producer pays $40 million in wages and pay s $125 million for the 25 million tons of coal that it needs to produce steel. The steel producer’s profits are therefore equal to $200 million − $40 million − $125 million = $35 million. Total profit income in the economy is therefore $25 million + $35 mi llion = $60 million. GDP therefore is equal to wage income ($90 million) plus profit income ($60 million). GDP is therefore $150 million. (b) There are no net factor payments from abroad in this example. Therefore, the current account surplus is equal to net exports, which is equal to (−$10 million). (c) As originally formulated, GNP is equal to GDP, which is equal to $150 million. Alternatively, if foreigners receive $25 million in coal industry profits as income, then net factor payments from abroad are (−$25 million), so GNP is equal to $125 million. 3. Wheat and Bread (a) Product approach: Firm A produces 50,000 bushels of wheat, with no intermediate goods inputs. At $3/bu., the value of Firm A’s production is equal to $150,000. Firm B produces 50,000 loaves of bread at $2/loaf, which is valued at $100,000. Firm B pays $60,000 to firm A for 20,000 bushels of wheat, which is an intermedi ate input. Firm B’s value added is therefore $40,000. GDP is therefore equal to $190,000. Chapter 2 Measurement 9 (b) Expenditure approach: Consumers buy 50,000 loaves of domestically produced bread at $2/loaf and 15,000 loaves of imported bread at $1/loaf. Consumption spending is therefore equal to $100,000 + $15,000 = $115,000. Firm A adds 5,000 bushels of wheat to inventory. Wheat is worth $3/bu., so investment is equal to $15,000. Firm A exports 25,000 bushels of wheat for $3/bu. Exports are $75,000. Consumers import 15,000 loaves of bread at $1/loaf. Imports are $15,000. Net exports are equal to $75,000 − $15,000 = $60,000. There is no government spending. GDP is equal to consumption ($115,000) plus investment ($15,000) plus net exports ($60,000). GDP is therefore equal to $190,000. (c) Income approach: Firm A pays $50,000 in wages. Firm B pays $20,000 in wages. Total wages are therefore $70,000. Firm A produces $150,000 worth of wheat and pays $50,000 in wages. Firm A’s profits are $100,000. Firm B produces $100,000 worth of bread. Firm B pays $20,000 in wages and pays $60,000 to Firm A for wheat. Firm B’s profits are $100,000 − $20,000 − $60,000 = $20,000. Total profit income in the economy equals $100,000 + $20, 000 = $120,000. Total wage income ($70,000) plus profit income ($120,000) equals $190,000. GDP is therefore $190,000. 4. Price and quantity data are given as the following. Year 1 Good Quantity Price Computers 20 $1,000 Bread 10,000 $1.00 Year 2 Good Quantity Price Computers 25 $1,500 Bread 10,000 $1.00 (a) Year 1 nominal GDP = 20  $1,000 + 10,000  $1.00 = $30,000 . Year 2 nominal GDP = 25  $1,500 + 12,000  $1.10 = $50,700 . With year 1 as the base year, we need to value both years’ production at year 1 prices. In the base year, year 1, real GDP equals nominal GDP equals $30,000. In year 2, we need to value year 2’s output at year 1 prices. Year 2 real GDP = 25  $1,000 + 12,000  $1.00 = $37,000 . Chapter 2 Measurement 10 The percentage change in real GDP equals ($37,000 − $30,000)/$30,000 23.33%. We next calculate chain -weighted real GDP. At year 1 prices, the ratio of year 2 real GDP to year 1 real GDP equals g1 = ($37,000/$30,000) = 1.2333. We must next compute real GDP using year 2 prices. Year 2 GDP valued at year 2 prices equals year 2 nominal GDP = $50,700. Year 1 GDP valued at year 2 prices equals (20  $1,500 + 10,000  $1.10) = $41,000. The ratio of year 2 GDP at year 2 prices to year 1 GDP at year 2 prices equals g2 = ($50,700/$41,000) = 1.2367. The chain - weighted ratio of real GDP in the two years therefore is equal to gc = = 1.23496 . The percentage change chain -weighted real GDP from year 1 to year 2 is therefore approximately 23.5%. If we (arbitrarily) designate year 1 as the base year, then year 1 chain -weighted GDP equals nominal GDP equals $30,000. Year 2 chain -weighted real GDP is equal to (1.23496  $30,000) = $37,048.75. (b) To calculate the implicit GDP deflator, we divide nominal GDP by real GDP, and then multiply by 100 to express as an index number. With year 1 as the base year, base year nominal GDP equals base year real GDP, so th e base year implicit GDP deflator is 100. For the year 2, the implicit GDP deflator is ($50,700/$37,000)  100 = 137.0. The percentage change in the deflator is equal to 37.0%. With chain weighting, and the base year set at year 1, the year 1 GDP deflator equals ($30,000/$30,000)  100 = 100. The chain -weighted deflator for year 2 is now equal to ($50,700/$37,048.75)  100 = 136.85. The percentage change in the chain -weighted def lator equals 36.85%. (c) We next consider the possibility that year 2 computers are twice as productive as year 1 computers. As one possibility, let us define a “computer” as a year 1 computer. In this case, the 25 computers produced in year 2 are the equivale nt of 50 year 1 computers. Each year 1 computer now sells for $750 in year 2. We now revise the original data as: Year 1 Good Quantity Price Year 1 Computers 20 $1,000 Bread 10,000 $1.00 Year 2 Good Quantity Price Chapter 2 Measurement 11 Year 1 Computers 50 $750 Bread 12,000 $1.10 First, note that the change in the definition of a “computer” does not affect the calculations of nominal GDP. We next compute real GDP with year 1 as the base year. Year 2 real GDP in year 1 prices is now 50  $1,000 + 12,000  $1.00 = $62,000. The percentage change in real GDP is equal to ($62,000 − $30,000)/$30,000= 106.7%. We next revise the calcul ation of chain -weighted real GDP. From above, g 1 equals ($62,000/$30,000) = 206.67. The value of year 1 GDP at year 2 prices equals $26,000. Therefore, g2 equals ($50,700/$26,000) = 1.95. 200.75. The percentage change chain -weighted real GDP from year 1 to year 2 is therefore 100.75%. If we (arbitrarily) designate year 1 as the base year, then year 1 chain -weighted GDP equals nominal GDP equals $30,000. Year 2 chain -weighted real GDP is equal to (2.0075  $30,000) $60,225. The chain -weighted deflator for year 1 is automatically 100. The chain -weighted deflator for year 2 equals ($50,700/$60,225)  100 = 84.18. The percentage rate of change of the chain - weighted deflator equals −15.8%. When there is no quality change, the difference between using year 1 as the base year and using chain weighting is relatively small. Factoring in the increased performance of year 2 computers, the production of computers rises dramatically while its relati ve price falls. Compared with earlier practices, chain weighting provides a smaller estimate of the increase in production and a smaller estimate of the reduction in prices. This difference is due to the fact that the relative price of the good that increa ses most in quantity (computers) is much higher in year 1. Therefore, the use of historical prices puts more weight on the increase in quality -adjusted computer output. 5. Price and quantity data are given as the following: Year 1 Good Quantity (million lbs.) Price (per lb.) Broccoli 1,500 $0.50 Cauliflower 300 $0.80 Year 2 Good Quantity (million lbs.) Price (per lb.) Chapter 2 Measurement 12 Broccoli 2,400 $0.60 Cauliflower 350 $0.85 (a) Year 1 nominal GDP = Year 1 real GDP = 1,500 million  $0.50 + 300 million  $0.80 = $990 million. Year 2 nominal GDP = 2, 400 million  $0.60 + 350 million  $0.85 = $1,730.5 million Year 2 real GDP = 2, 400 million  $0.50 + 350 million  $0.80 = $1, 450 million. Year 1 GDP deflator equals 100. Year 2 GDP deflator equals ($1,730.5/$1,450)  100 = 119.3. The percentage change in the deflator equals 19.3%. (b) Year 1 production (market basket) at year 1 prices eq uals year 1 nominal GDP $990 million. The value of the market basket at year 2 prices is equal to 1,500 million  $0.60 + 300 million  $0.85 =$1,050 million. Year 1 CPI equals 100. Year 2 CPI equals ($1,050/$990)  100 106.1. The percentage change in the CPI equals 6.1%. The relative price of broccoli has gone up. The relative quantity of broccoli has also gone up. The CPI attaches a smaller weight to the price of broccoli, and so the CPI shows less inflation. 6. Corn producer, consumers, and government. (a) (i) Product approach: There are no intermediate goods inputs. The corn producer grows 30 million bushels of corn. Each bushel of corn is worth $5. Therefore, GDP equals $150 million. (ii) Expenditure approach: Consumers buy 20 million bushels of corn, so consumption equals $100 million. The corn producer adds 5 million bushels to inventory, so investment equals $25 million. The government buys 5 million bushels of corn, so government spending equals $25 million. GDP equals $150 million. (iii) Income approach: Wage income is $60 million, paid by the corn producer. The corn producer’s revenue equals $150 million, including the value of its addition to inventory. Additions to inventory are treated as purchasing one owns output. The corn producer’s costs include wages of $60 million and taxes of $20 million. Therefore, profit income equals $150 million − $60 million − $20 million = $70 million. Government income Chapter 2 Measurement 13 equals taxes paid by the corn producer, which equals $20 million. Therefore, GDP by income equals $60 million +$70 million + $20 million = $150 million. (b) Private disposable income equals GDP ($150 million) plus net factor payments (0) plus government transf ers ($5 million is Social Security benefits) plus interest on the government debt ($10 million) minus total taxes ($30 million), which equals $135 million. Private saving equals private disposable income ($135 million) minus consumption ($100 million), whi ch equals $35 million. Government saving equals government tax income ($30 million) minus transfer payments ($5 million) minus interest on the government debt ($10 million) minus government spending ($5 million), which equals $10 million. National saving e quals private saving ($35 million) plus government saving ($10 million), which equals $45 million. The government budget surplus equals government savings ($10 million). Since the budget surplus is positive, the government budget is in surplus. The government deficit is therefore equal to (−$10 million). 7. Price controls. Nominal GDP is calculated by measuring output at market prices. In the event of effec tive price controls, measured prices equal the controlled prices. However, controlled prices reflect an inaccurate measure of scarcity values. Nominal GDP is therefore distorted. In addition to distortions in nominal GDP measures, price controls also injec t an inaccuracy in attempts to decompose changes in nominal GDP into movements in real GDP and movements in prices. With price controls, there is typically little or no change in white market prices over time. Alternatively, black market or scarcity value prices typically increase, perhaps dramatically. Measures of prices (in terms of scarcity values) understate inflation. Whenever inflation measures are too low, changes in real GDP overstate the extent of increases in actual production. 8. Underground economy . Transactions in underground economy are performed with cash exclusively, to exploit the anonymous nature of currency. Thus, once we have established the amount of currency held abroad, we know the portion of $2,776 that is held domestically. Remove from it what is used for recorded transactions, say by using some estimate of the proportion of transactions using cash and applying this to observed GDP. Finally apply a concept of velocity of money to the remaining amount of cash to obtain the size of the underground economy. 9. “Questionable financial activity” is essentially theft. If someone steals, there is no contribution to GDP as something is simply transferred from one indiv idual to another. Possibly worse, the time and effort of the thief is pure waste for society, as that time and effort could be used in producing goods and services. Some financial activity could be wasteful in the same way. If workers in financial firms spend their time and effort in designing financial products for the purpose of hiding Chapter 2 Measurement 14 malfeasance, or to convince ill -informed consumers that such products are something they are not, that time and effort is counted as contributing to GDP, when it should not be. 10. The dollar value of a transaction need not all be a contribution to GDP. Inde ed, typically only a fraction of any given transaction in the economy actually represents something we should add to GDP. For example, the production of a given good could involve many stages, with each stage of production done in a different firm. At each stage of production, the intermediate good gets passed on to the next firm in the production process, and a transaction takes place. From this chapter, we know that we only count the value -added at each stage of production toward GDP. Similarly, the finan cial sector contributes to GDP, but the dollar value of every financial transaction is not counted toward GDP, and rightly so. If the Bank of America makes a payment of $10 million to J.P. Morgan Chase, that payment represents the settlement of a debt between the two institutions. What is actually provided, in terms of financial goods and services, could be very small when measured correctly. 11. Sp - 1 = CA + D (a) By definition: S p = Y d − C = Y + NFP + TR + INT − T − C Next, recall that Y = C + I + G + NX. Substitute into the equation above and subtract I to obtain: Sp − I = C + I + G + NX + NFP + INT − T − C − I = (NX + NFP ) + (G + INT + TR − T ) = CA + D (b) Private saving, which is not used to finance domestic investment, is either lent to the domestic government to finance its deficit (D), or is lent to foreigners ( CA). 12. The answers to parts (a) and (b) are in the table. Year Capital when initial capital = 80 Capital when initial capital = 100 0 80 100 1 82.0 100 2 83.8 100 3 85.4 100 Chapter 2 Measurement 15 4 86.9 100 5 88.2 100 6 89.4 100 7 90.4 100 8 91.4 100 9 92.3 100 10 93.0 100 In the first case, where the initial quantity of capital was 80, with a constant quantity of investment each period, the quantity of capital increases over time, but at a decreasing rate (note the the increment to the capital stock gets smaller each period ). This happens because, as the capital stock grows, the total amount of capital that depreciates each period increases. The quantity of capital appears to be converging to some quantity, but what is this quantity? When the quantity of capital is initially 100, then the capital stock stays at 100 indefinitely, as long as investment is 10 each period. This is because, when the capital stock is 100, the total quantity of depreciation each period when the depreciation rate is 10% is 10, so new investment just replaces the capital that depreciates each period. Here 100 is what we would call the “steady state” quantity of capital. Steady states are useful when we study economic growth in Chapters 7 and 8. 13. Assume the following: Y d = Sp + C = S + D + C D = 10 INT = 5 T = 40 G = 30 C = 80 NFP = 10 CA = −5 S = 20 (a) (b) = 20 + 10 + 80 = 110 D = G + TR + INT − T TR = D − G − INT + T = 10 − 30 − 5 + 40 = 15 Chapter 2 Measurement 16 (c) (d) (d) S = GNP − C − G GNP = S + C + G = 20 + 80 + 30 = 130 GDP = GNP − NFP = 130 − 10 = 120 (e) Government Surplus = Sg = −D = −10 CA = NX + NFP (f) (f) (g) NX = CA − NFP = −5 − 10 = −15 GDP = C + I + G + NX I = GDP − C − G − NX = 120 − 80 − 30 + 15 = 25 14. First some preliminaries. As the unemployment rate is 5% and there are 2.5 million unemployed, it must be that the labor force is 50 million (2.5/0.05). Thus, the participation rate is 50% (50/100), the labo r force 50 million, the number of employed workers 47.5 million (50 -2.5), and the employment/population ratio is 47.5% (47.5/100). Chapter 3 Business Cycle M easurement ▪ Teaching Goals Chapter 3 stresses the importance of observation as a foundation for scientific exploration in macroeconomics. Because there are mountains of data measurements about the macroeconomy, we need to begin to organize these data in a way that we can begin to lo ok for regularities in the economy — regularities that we hope to explain. The cornerstone of business cycle analysis is deviations from trend in real GDP. Students must first understand the difference between long -run trends and deviations from trend in real GDP. One of the most exciting things about the study of business cycles is the observation that each of these recurring cycles is not unique. Because successive business cycles are more alike than they are different, we have the hope of providing an explanation of business cycles that can consistently be applied to each new cycle we encounter. These business cycle regularities, the “stylized facts” of business cycles, provide us with the first clues about the nature of the typical cycle. Although students may take some time to digest and remember these facts, it is important to be clear about the motivation for cataloging these facts. The plan of study of this text is to view the business cycle as a puzzle that we hope to solve. Our task is much the same as a detective trying to solve a murder mystery. The first task is to collect clues. The clues in the study of business cycles are the regularities chronicled in this chapter. Later on we will begin to encounter “suspect ” causes of business cycles. In order to solve the mystery, we need to deduce the “who,” “what” and “why” of our mystery. We cannot begin the deduction process before first collecting the clues. Students need to understand this detective process. Otherwise , the clues presented in this chapter will be nothing more than a laundry list that they must memorize. ▪ ClassroomDiscussion Topics To get the ball rolling it might be useful to ask the students about whether they have concerns about recessions. Is the econ omy currently in a recession? When was the economy most recently in recession? How do we date recessions – turning points in macroeconomic activity? Should we be paying attention to only real GDP or to other indicators that might be important for economic welfare – e.g. employment or the unemployment rate? Macroeconomics is primarily concerned with business cycles and economic growth. Ask the students which of these two topics is most important. A typical comparison is between the possibility of completely eliminating recessions as opposed to increasing the rate of growth by a half of one percent or so. If they could pick only one of these advances, which would they pick? Some simple calculations reveal the apparent dominance of more growth over eliminating business cycles. Ask them if they believe Williamson • Macroeconomics, Fifth Edition ©2014 Pearson Education, Inc. 18 that there is any other cost of a recession other than the value of lost GDP. In particular, emphasize that GDP fluctuations hide a lot about fluctuations at the household level. Another potential discussion centers on the murder mystery analogy. If the st udents were rounding up the usual suspects of business cycle causes, which suspects would they pick? One part of detective work involves theories and hunches about what might have happened. Another less glamorous part of detective work involves ruling out some of the suspects. How can studying the clues eliminate a suspect from consideration? Emphasize the point that much of the organization of the text revolves about the possible elimination of suspected causes of business cycles based on the evidence. ▪ Outline I. . Regularities in GDP fluctuations I I . Co-movement A. Cyclicality B. Lead/Lag Relationships C. Variability I I I . I . Components of GDP A. Consumption 1. Procyclical 2. Coincident 3. Less Variable Than GDP B. Investment 1. Procyclical 2. Residential and Inventory Investment Lead GDP 3. More Variable Than GDP I V . Nominal Variables A. The Phillips Curve B. Aggregate Price Level 1. Procyclical Since World War II 2. Sometimes Countercyclical 3. Lags GDP C. Money Supply 1. Procyclical 2. Leads GDP V. Labor M arket Variables A. Employment 1. Procyclical 2. Lags GDP B. Real Wage Rates 1. Procyclical 2. Aggregation Problems C. Average Labor Productivity 1. Procyclical 2. Coincident 3. Less Variable Than GDP V I . Seasonal Adjustment Williamson • Macroeconomics, Fifth Edition ©2014 Pearson Education, Inc. 19 A. Seasonal Data ▪ Solutions to End-of-Chapter Problems 1. In Figure 3.13, after 1980 it appears that real GDP and the nominal money supply are negatively correlated, and it is difficult to discern any lead/lag relationship between real GDP and nominal money. Many people, particularly old-school Monetarists (Milton Friedman included) ascribed much importance to the money -output correlation. The fact that this relationship appears to have disappeared in the last 30 years of data is also important. The reason we obse rve this could have something to do with changes in the way monetary policy was conducted after 1980. 2. In Figure 3.16, what we tend to see during the last 3 recessions is a quick recovery of average labor productivity prior to real GDP recovering to the point where it is above trend. This is part of the jobless recovery phenomenon. Employment has been very slow to recover during the last three recessions, which makes for higher growth in average labor productivity coming out of the recession. We get this as average labor productivity is the ratio of real GDP to employment, so if employment is not recovering and real GDP is, then the ratio shows a spurt of growth. 3. Both consumption and investment are procyclical and coincident. The key difference is that investment is much more volatile than consumption. Consumer durables provide services over a horizon greate r than one year. Some consumer nondurable products, like apparel, provide services well beyond the date of purchase. Services, by definition, are fully utilized at the point of sale. The same kinds of timing considerations that affect business investment are likely to come into play with consumer durables, and to a lesser extent, consumer nondurables. Therefore, it is logical that consumer durable purchases should be more volatile than consumer nondurable purchases and that consumer nondurable purchases should be more volatile than consumption of services. 4. After the 1981 -82, the cyclical behavior of the price level varies. From 1980 -2000, the price level appears to be countercyclical, but after 2000 it appears to be procyclical. This is important, as alternative types of macroeconomic shocks will move the price level in different directions. As a result, the cyclicality of the price level may be usful in uncovering what shocks are driving aggregate fluctuations at particular dates. 5. One can see that the amplitude of the deviations from the trend is more moderate for prices, as for GDP. It appears also that the price level is becoming less countercyclical. The fact that both GDP and the price level changed their cyclical behavior indicates that any explanation of the Great Moderation needs to look at more than GDP. ©2014 Pearson Education, Inc. Chapter 4 Consumer and Firm Behavior: The Work -Leisure Decision and Profit M aximization ◼ Teaching Goals The microeconomic approach to macroeconomics stresses the notion that economy -wide events are the result of decisions made by individuals. People work so that they may afford to buy market goods. On the other hand, people generally prefer to work less rath er than working more. Although discussions in the popular press often refer to the idea that spending is what drives the economy, an economy cannot produce unless people are willing to work. Therefore, the most basic macroeconomic decision is the decision to choose whether, and how much, to work. Production and willingness to work are intrinsically interconnected. Students often believe that how much a person works is largely determined by the necessities of their circumstances. Students will report that they have to work to survive and pay tuition. Some might point out that some students need not work much or at all because their parents provide more support. However, circumstances need not dictate exactly how much they may choose to work. They may work les s if they go to a less costly school. They may sometimes decide to switch to part-time student status and full-time work status if they find a high -paying job. A key message of this chapter is that choice is important and that choice is influenced by changes in circumstances. This chapter demands the mastery of a large body of structure and yet provides little in the w ay of immediate insights. Students may need frequent assurances that the mastery of this material eventually pays big dividends in providing hope of understanding the phenomenon of business cycles. This is particularly important as this chapter lays critic al foundations for the rest of the book: the use of microfoundations in macroeconomics. Students need to be able to justify macroeconomic relationships with microeconomic arguments, like in this chapter. This requires to some extent some boring drills that they will come to appreciate only later. If for many textbooks the strategy is to teach one chapter a week, spend more time on this one, especially if students have not yet mastered intermediate microeconomics. Two key points of this chapter are the concepts of income and substitution effects. Often, students are perplexed at the amount of time spent on this material because nothing in practice is purely an income effect or a substitution effect. However, the two most basic insights of microeconomic analysis are that when we become more well -off we generally want more of everything and that we respond to price incentives at the margin. Chapter 4 Consumer and Firm Behavior: The Work -Leisure Decision and Profit Maximization 21 ©2014 Pearson Education, Inc. ◼ Classroom Discussion Topics Ask the students about their work choices and the choices of their parents, friends, and relatives. Does everyone work? Does everyone work the same amount of hours? Then ask the students for examples of the kinds of factors that lead peop le to work more or less. Try to elicit very specific examples. Then ask the students to categorize these factors that lead to more or less work. Some of these factors are actually the by -products of more complex decision making. For example, if they say that they work more or less because they go to school, point out that going to school is a choice. They may also point to circumstances like whether a married couple has chi ldren, and if so, the number of children and their ages. Point out that these events are also the results of other choices. Then ask the students to try to categorize the remaining factors as being either primarily an income effect or a substitution effect . Also compare labor choices across countries, as the Macroeconomics in Action feature does. Ask the students to provide examples of factors other than more labor or capital that can allow some countries to be a lot more productive than others. What factor s other than growth in capital and labor allow a given economy to produce more (or less) over time? Explain that these are the kinds of factors that we summarize by the concept of total factor productivity. Insist also on the concept of physical capital an d what it measures and what it does not measure. ◼ Outline I. The Representative Consumer A. Preferences 1. Goods: The Consumption Good and Leisure 2. The Utility Function a. More Preferred to Less b. Preference for Diversity c. Normal Goods 3. Indifference Curves a. Downward Sloping b. Convex to the Origin 4. Marginal Rate of Substitution B. The Representitve Consumer’s Budget Constraint 1. Competitive Behavior, Price -takers, Barter Economy, The Time Constraint 2. Real Disposable Income 3. The Budget Constraint Equations 4. A Graphical Representation C. Optimization 1. Rational Behavior 2. The Optimal Consumption Bundle 3. Marginal Rate of Substitution Relative Price 4. A Graphical Representation D. Comparative Statics Experiments 1. Changes in Dividends and Taxes: Pure Income Effect 2. Changes in the Real Wag e: Income and Substitution Effects Chapter 4 Consumer and Firm Behavior: The Work -Leisure Decision and Profit Maximization 22 ©2014 Pearson Education, Inc. II. The Representative Firm A. The Production Function 1. Constant Returns to Scale 2. Monotonicity 3. Declining MP N 4. Declining MP K 5. Changes in Capital and MP N B. Profit Maximization 1. Profits = Total Revenue − Total Variable Costs 2. Marginal Product of Labor = Real Wage 3. Labor Demand ◼ Solutions to End-of-Chapter Problems 1. Consider the two hypothetical indifference curves in the figure below. Point A is on both indifference curves, I1 and I2. By construction, the consumer is indifferent between A and B, as both points are on I2. In like fashion, the consumer is indifferent between A and C, as both points are on I1. But at point C, the consumer has more consumption and more leisure than at poi nt B. As long as the consumer prefers more to less, he or she must strictly prefer C to A. We therefore contradict the hypothesis that two indifference curves can cross. 2. u = al + bC (a) To specify an indifference curve, we hold utility constant at u. Next rearrange in the form: C = u − a l b b Chapter 4 Consumer and Firm Behavior: The Work -Leisure Decision and Profit Maximization 23 ©2014 Pearson Education, Inc. Indifference curves are therefore linear with slope, a/b, which represents the marginal rate of substitution. There are two main cases, according to whether a/b  w or a/b  w. The top panel of the left figure below shows the case of a/b  w. In this case the indifference curves are flatter than the budget line and the consumer picks point A, at which l = 0 and C = wh +  − T . The right figure shows the case of a/b  w. In this case the indifference curves are steeper than the budget line, and the consumer picks point B, at which l = h and C =  − T . In the coincidental case in which a/b = w, the highest attainable indifference curve coincides with the indifference curve, and the consumer is indifferent among all possible amounts of leisure and hours worked. (b) The utility function in this problem does not obey the property that the consumer prefers diversity, and is therefore not a likely possibility. (c) This utility function does have the property that more is preferred to less. However, the marginal rate of substitution is constant, and therefore this utility function does not satisfy the property of diminishing marginal rate of substitution. 3. (a) Using the formulas in the example from the textbook, one obtains: l = C = (0.75  16 - 0.8 - 6)/(1 + 0.75) = 3.89 Chapter 4 Consumer and Firm Behavior: The Work -Leisure Decision and Profit Maximization 24 ©2014 Pearson Education, Inc. Given the numbers given, we can precisely determine the coordinates of the points in the figure above: A is (0,6.8), B is (3.89,3.89), D is (9,07,0), with the slope of ABD being - 0.75. (b) With the new wage, we obtain: l = C = (1.5  16 - 0.8 - 6)/(1 + 1.5) = 7.52 where A, B and D have the same coordinates as above, and E is (0, 12.8), F is (7.52, 7.52), H is (12.53,0), and the slope of EFH is - 1.5. As there are no substitution effects when goods are perfect complements, the entire move from point B to point F is due to the income effect. 4. When the government imposes a proportional tax on wage income, the consumer’s budget constraint is now given by: C = w(1 − t)(h − l) +  − T , where t is the tax rate on wage income. In the figure below, the budget constraint for t 0, is FGH. When t > 0, the budget constraint is EGH. The slope of the original budget line is –w, while the slope of the new budget line is (1 t)w. Initially the consumer picks the point A on the original budget line. After the tax has been imposed, the consum er picks point B. The substitution effect of the imposition of the tax is to move the consumer from point A to point D on the original indifference curve. The point D is at the tangent point of indifference curve, I1, with a line segment that is parallel to EG. The pure substitution effect induces the consumer to reduce consumption and increase leisure (work less). The tax also makes the consumer worse off, in that he or she can no longer be on indifference curve, I1, but must move to the less preferred indifference curve, I2. This pure income effect moves the consumer to point B, which has less consumption and less leisure than point D, because both consumption and leisure are normal goods. The net effect of the tax is to reduce consumptio n, but the direction of the net effect on leisure is ambiguous. The figure shows the case in which the substitution effect on leisure dominates the income effect. In this case, leisure increases and hours worked fall. Although consumption must fall, hours worked may rise, fall, or remain the same.