Chapter 15 (1, 2, 4, 6, 8)

 

15-1 Distinguish between the short run and the long run as they relate to macroeconomics.

For macroeconomists the short run is a period in which wages (and other input prices) do not respond to price level changes. There are at least two reasons why nominal wages may remain constant for a while even though the price level has changed.

1. Workers may not be aware of price level changes, and thus have not adjusted their demands.

2. Many employees are hired under fixed wage contracts.

Once sufficient time has elapsed for contracts to expire and nominal wage adjustments to occur, the economy enters the long run, a period in which nominal wages are fully responsive to changes in the price level.

15-2 Which of the following statements are true? Which are false? Explain why the false statements are untrue.

a. Short-run aggregate supply curves reflect an inverse relationship between the price level and the level of real output.

b. The long-run aggregate supply curve assumes that nominal wages are fixed.

c. In the long run, an increase in the price level will result in an increase in nominal wages.

(a) False, short-run aggregate supply curves reflect a direct relationship between the price level and the level of real output. If there is an increase in the price level, the higher product prices bring an increase in revenue from sales to business firms. Since the nominal wages they are paying are fixed, their profits rise. In response, firms collectively increase their output. Producers respond to a decrease in the price level by cutting output. When product prices fall with nominal wages constant, firms will discover their revenue and profits have diminished.

(b) False, by definition, nominal wages in the long run are fully responsive to changes in the price level.

(c) True, as above.

 

15-4 (Key Question) Use graphical analysis to show how each of the following would affect the economy first in the short run and then in the long run. Assume that the United States is initially operating at its full-employment level of output, that prices and wages are eventually flexible both upward and downward, and that there is no counteracting fiscal or monetary policy.

a. Because of a war abroad, the oil supply to the United States is disrupted, sending oil prices rocketing upward.

b. Construction spending on new homes rises dramatically, greatly increasing total U.S. investment spending.

c. Economic recession occurs abroad, significantly reducing foreign purchases of U.S. exports.

(a) See Figure 16-4 in the chapter, less AD 2. Short run: The aggregate supply curve shifts to the left, the price level rises, and real output declines. Long run: The aggregate supply curve shifts back rightward (due to declining nominal wages), the price level falls, and real output increases.

(b) See Figure 16-3. Short run: The aggregate demand curve shifts to the right, and both the price level and real output increase. Long run: The aggregate supply curve shifts to the left (due to higher nominal wages), the price level rises, and real output declines.

(c) See Figure 16-5. Short run: The aggregate demand curve shifts to the left, both the price level and real output decline. Long run: The aggregate supply curve shifts to the right, the price level falls further, and real output increases.

 

 

15-6 (Key Question) Suppose the government misjudges the natural rate of unemployment to be much lower than it actually is, and thus undertakes expansionary fiscal and monetary policy to try to achieve the lower rate. Use the concept of the short-run Phillips Curve to explain why these policies might at first succeed. Use the concept of the long-run Phillips Curve to explain the long-run outcome of these policies.

In the short run there is probably a trade-off between unemployment and inflation. The government’s expansionary policy should reduce unemployment as aggregate demand increases. However, the government has misjudged the natural rate and will continue its expansionary policy beyond the point of the natural level of unemployment. As aggregate demand continues to rise, prices begin to rise. In the long run, workers demand higher wages to compensate for these higher prices. Aggregate supply will decrease (shift leftward) toward the natural rate of unemployment.

In other words, any reduction of unemployment below the natural rate is only temporary and involves a short-run rise in inflation. This, in turn, causes long-run costs to rise and a decrease in aggregate supply. The end result should be an equilibrium at the natural rate of unemployment and a higher price level than the beginning level. The long-run Phillips curve is thus a vertical line connecting the price levels possible at the natural rate of unemployment found on the horizontal axis. (See Figure 16-9.)

 

    • (Key Question) What is the Laffer Curve and how does it relate to supply-side economics? Why is determining the location where the economy is on the curve so important in assessing tax policy?

Economist Arthur Laffer observed that tax revenues would obviously be zero when the tax rate was either at 0% or 100%. In between these two extremes would have to be an optimal rate where aggregate output and income produced the maximum tax revenues. This idea is presented as the Laffer Curve shown in Figure 16-10.

The difficult decision involves the analysis to determine the optimum tax rate for producing maximum tax revenue and the related maximum economic output level. Laffer argued that low tax rates would actually increase revenues because low rates improved productivity, saving, and investment incentives. The expansion in output and employment and thus, revenue, would more than compensate for the lower rates.

 

Chapter 16 (1, 2, 3, 5, 6, 9)

 

16-1

(Key Question) What are the four supply factors of economic growth? What is the demand factor? What is the efficiency factor? Illustrate these factors in terms of the production possibilities curve.

The four supply factors are the quantity and quality of natural resources; the quantity and quality of human resources; the stock of capital goods; and the level of technology. The demand factor is the level of purchases needed to maintain full employment. The efficiency factor refers to both productive and allocative efficiency. Figure 17-1 illustrates these growth factors by showing movement from curve AB to curve CD.

16-2 Suppose that Alpha and Omega have identically sized working-age populations, but that annual hours of work are much greater in Alpha than in Omega. Provide two possible explanations.

One explanation might be that Omega’s labor force is underemployed, producing at a point inside the production possibilities curve. Another explanation could be that the two populations have different attitudes and preferences about work and leisure, with Omega workers placing a higher value on leisure than those in Alpha.

16-3 Suppose that work-hours in New Zombie are 200 in year 1 and productivity is $8. What is New Zombie’s real GDP? If work-hours increase to 210 in year 2 and productivity rises to $10, what is New Zombie’s rate of economic growth?

NZ’s GDP in year 1 is $1600; GDP in year 2 is $2100.

The rate of growth is (2100-1600)/1600 or .3125 =31.25% (assumes constant prices).

16-5 (Key Question) Between 1990 and 2002 the U.S. price level rose by about 38 percent while its real output increased by about 41 percent. Use the aggregate demand-aggregate supply model to illustrate these outcomes graphically.

In the graph shown, both AD and AS expanded over the 1990-2002 period. Because aggregate supply increased as well as aggregate demand, the new equilibrium output rose at a faster pace than did the price level. P 2 is 38% above P 1 and GDP 2 is 41% greater than GDP 1.

 


Price AS 1

Level AS 2

 

P 2

P 1

 

 

AD 1 AD 2

GDP 1 GDP 2 Real GDP

 

 

16-6 (Key Question) To what extent have increases in U.S. real GDP resulted from more labor inputs? From higher labor productivity? Rearrange the following contributors to the growth of real GDP in order of their quantitative importance: economies of scale, quantity of capital, improved resource allocation, education and training, technological advance.

The U.S. labor force grew by an average of about 1.7 million workers per year for each of the past 25 years, and this explains much of the growth in real GDP. From 1990-2002, higher labor productivity accounted for 68 percent of the 3 percent average annual growth Other factors have also been important. Refer to Table 17-1. Factor importance in descending order: (1) Technological advance—the discovery of new knowledge that results in the combining of resources in more productive ways. (2) The quantity of capital. (3) Education and training. (4) Economies of scale. (5) Improved resource allocation.

 

    • (Key Question) Relate each of the following to the New Economy:
  • The rate of productivity growth
  • Information technology
  • Increasing returns
  • Network effects
  • Global competition

Each of the above is a characteristic of the New Economy. The rate of productivity growth has grown substantially due to innovations using microchips, computers, new telecommunications devices and the Internet. All of these innovations describe features of what we call information technology, which connects information in all parts of the world with information seekers. New information products are often digital in nature and can be easily replicated once they have been developed. The start-up cost of new firms and new technology is high, but expanding production has a very low marginal cost, which leads to economies of scale – firms’ output grows faster than their inputs. Network effects refer to a type of economy of scale whereby certain information products become more valuable to each user as the number of buyers grows. For example, a fax machine is more useful to you when lots of other people and firms have one; the same is true for compatible word-processing programs. Global competition is a feature of the New Economy because both transportation and communication can be accomplished at much lower cost and faster speed than previously which expands market possibilities for both consumers and producers who are not very limited by national boundaries today.

 

Chapter 17 (1-6, 12, 13)

 

17-1 (Key Question) Use the aggregate demand-aggregate supply model to compare the “old” classical and Keynesian interpretations of (a) the aggregate supply curve and (b) the stability of the aggregate demand curve. Which of these interpretations seems more consistent with the realities of the Great Depression?

(a) Classical economists envisioned the AS curve as being perfectly vertical. When prices fall, real profits do not decrease because wage rates fall in the same proportion. With constant real profits, firms have no reason to change the quantities of output they supply. Keynesians viewed the AS curve as being horizontal at outputs less than the full-employment output and vertical only at full employment. Declines in aggregate demand do not change the price level because wages and prices are assumed to be inflexible downward.

  • Classical economists viewed AD as stable so long as the monetary authorities hold the money supply constant. Therefore inflation and deflation are unlikely. Keynesians viewed the AD curve as unstable—even if the money supply is constant—since investment spending is volatile. Decreases in AD can cause a recession; rapid increases in AD can cause demand-pull inflation.

(c) The Keynesian view seems more consistent with the facts of the Great Depression; in that period, real output declined by nearly 40 percent in the United States and remained low for a decade.

17‑2 According to mainstream economists what is the usual cause of macroeconomic instability? What role does the spending-income multiplier play in creating instability? How might adverse aggregate supply factors cause instability, according to mainstream economists?

The mainstream view of macroeconomic instability is Keynesian-based and focuses on aggregate spending and its components. Particularly significant are changes in investment spending, which change aggregate demand and, occasionally, adverse supply shocks, which change aggregate supply.

Investment spending is subject to wide variations, and a “multiplier effect” magnifies these changes into even greater changes in aggregate demand, which can cause demand-pull inflation in the forward direction or a recession if investment spending falls.

In the mainstream view, a second source of instability could arise on the supply side. Wars or an artificial supply restrictions boost may increase per-unit production costs. The result is a sizable decline in a nation’s aggregate supply, which could destabilize the economy by simultaneously causing cost-push inflation and recession.

17‑3 State and explain the basic equation of monetarism. What is the major cause of macroeconomic instability, as viewed by monetarists?

The fundamental equation of monetarism is the equation of exchange. MV = PQ. The left side, MV, represents the total amount spent [M, the money supply x V, the velocity of money, (the number of times per year the average dollar is spent on final goods and services)]. The right side, PQ, equals the nation’s nominal GDP [P is the price level or more specifically, the average price at which each unit of output is sold. Q is the physical volume of all goods and services produced].

Monetarists believe changes in the money supply, in particular, inappropriate monetary policy, is the single most important cause of macroeconomic stability.

 

17‑4 (Key Question) Suppose that the money supply and the nominal GDP for a hypothetical economy are $96 billion and $336 billion, respectively. What is the velocity of money? How will households and businesses react if the central bank reduces the money supply by $20 billion? By how much will nominal GDP have to fall to restore equilibrium, according to the monetarist perspective?

Velocity = 3.5 or 336/96. They will cut back on their spending to try to restore their desired ratio of money to other items of wealth. Nominal GDP will fall to $266 billion (= the $76 billion remaining money supply x 3.5) to restore equilibrium.

 

 

17-5 Briefly describe the difference between a so-called real business cycle and a more traditional “spending” business cycle.

In the real-business-cycle theory, business fluctuations result from significant changes in technology and resource availability. These changes affect productivity and thus the long-run growth trend of aggregate supply. The changes in aggregate supply then induce changes in the demand for money, which in this controversial scenario then leads to a change in the money supply, which allows adjustment in output without changes in the price level. The conclusion of the real-business-cycle theory is that macro instability arises on the aggregate supply side of the economy, not on the aggregate demand side as both mainstream economists and monetarists generally say.

17‑6 Craig and Kris were walking directly toward each other in a congested store aisle. Craig moved to his left to avoid Kris, and at the same time Kris moved to his right to avoid Craig. They bumped into each other. What concept does this example illustrate? How does this idea relate to macroeconomic instability?

This example illustrates a coordination failure that occurs in macroeconomics when people do not reach a mutually beneficial equilibrium because they lack some way to jointly coordinate their actions.

Expectations of households and business firms can create an undesirable outcome. If individuals expect others to cut spending and anticipate excess capacity, they will cut their own investment and consumption as well. Aggregate demand will decline and the economy will experience a recession due to a self-fulfilling prophecy. Once the economy is depressed, producers and households have no individual incentive to increase spending. If all participants would agree to simultaneously increase spending, then aggregate demand would rise and real output and real income would expand. Each producer and consumer would be better off. But this mutually beneficial outcome will not occur because there is no mechanism by which to coordinate their actions.

 

17‑12 Explain the difference between “active” discretionary fiscal policy advocated by mainstream economists and “passive” fiscal policy advocated by new classical economists. Explain: “The problem with a balanced-budget amendment is that it would, in a sense, require active fiscal policy—but in the wrong direction—as the economy slides into recession.”

Active discretionary fiscal policy entails the use of deficit spending during recessions, that is, increasing government spending, and/or cutting taxes to expand aggregate demand, and to use contractionary fiscal policy, running a budget surplus, all to ward off inflationary pressures when necessary.

New classical economists, monetarists, and rational expectationists see the economy as automatically self-correcting when disturbed from its full-employment level of real output. They are opposed to using discretionary fiscal policy to create budget deficits or budget surpluses.

Mainstream economists vigorously defend the use of both discretionary fiscal and monetary policies. They believe that both theory and empirical data support the use of countercyclical measures. Requiring an annually balanced budget would require the use of fiscal policy that would intensify the swings in the business cycle, rather than help reduce variations in output.

17-13 (Key Question) Place “MON,” “RET,” or “MAIN” beside the statements that most closely reflect monetarist, rational expectations, or mainstream views, respectively.

a. Anticipated changes in aggregate demand affect only the price level; they have no effect on real output.

b. Downward wage inflexibility means that declines in aggregate demand can cause long-lasting recession.

c. Changes in the money supply M increase PQ; at first only Q rises because nominal wages are fixed, but once workers adapt their expectations to new realities, P rises and Q returns to its former level.

d. Fiscal and monetary policy smooth out the business cycle.

e. The Fed should increase the money supply at a fixed annual rate.

(a) RET

(b) MAIN

(c) MON

(d) MAIN

(e) MON