Study Plan

Ch. 7: GDP: Measuring Total Production and Income

7.1 Gross Domestic Product Measures Total Production

1. Why in microeconomics can we measure production in terms of quantity, but in macroeconomics we measure production in terms of market value?

• All of the above: If, in macroeconomics, we measured production using

quantities, we would add tons of wheat grown by U. S. farmers to the number of iPods produced by Apple, to gallons of milk, and so on. When we measure total production, we can’t just add together the quantities of every good and service because the result would be meaningless. Measuring production using market value in dollar terms allows us to add together many different goods and services. Both A and C.

2. If the U.S. Bureau of Economic Analysis (BEA) added up the values of every good and service sold during the year, would the total be larger or smaller than measured gross domestic product (GDP)?

• Larger: The value of all goods and services sold would include intermediate

goods.

3. In the circular flow of expenditure and income, why must the total value of production in an economy equal the total value of income?

• Every penny spent on a good or service must end up as someone’s income.

4. Which equation represents the relationship between GDP and the four major expenditure components?

• Y=C+I+G+NX

• What are the four major components of expenditures in GDP?

• Consumption, investment, government purchases, and net exports.

5. What is the difference between the value of a firm’s final product and the value added by the firm to the final product?

• The value of a firm’s final product is the sale price; value added is the difference

between the sale price and the price of intermediate goods.

6. Is the value of intermediate goods and services produced during the year included in Gross Domestic Product (GDP)? For example, is cotton used to produce a new shirt included in GDP?

• Yes. The value of the cotton is not directly counted in GDP, but the production of

cotton is included in the value-added method of measuring GDP.

7. Indicate whether each of the following transactions represents the purchase of a final good.

• The purchase of steel from a steel mill by an automobile manufacturer. Is no the

purchase of a final good.

• The purchase of an aircraft carrier by the federal government. Is the purchase of

a final good.

• The purchase of domestic wine by a French consumer. Is the purchase of a final

good.

• The purchase of a new machine tool by the Ford Motor Company. Is the

purchase of a final good.

8. Indicate whether you agree or disagree with the following statement: “In years when people buy few shares of stock, investment will be low and, therefore, so will gross domestic product (GDP).”

• Disagree: Investment as a component of GDP refers to the purchase of physical

and human capital and inventory, not stock purchases.

9. Indicate which component of GDP will be affected by each of the following transactions involving the Ford Motor Company.

• You purchase a new Ford Escape Hybrid from a Ford dealer. Consumption

Expenditure

• You purchase a 2008 (pre-owned) Ford Escape Hybrid from a friend. Not

included in GDP calculation.

• Ford purchases door handles for the Escape from an auto parts manufacturer in

Indiana. Not included in GDP calculation.

• Ford produces 1,000 Escapes in a factory in Missouri and ships them to a car

dealer in Shanghai, China. Not Export Expenditure

• Ford purchases new machine tools to use in its Missouri Escape factory.

Investment Expenditure

• The state of Missouri builds a new highway to help improve access to the Ford

Escape plant. Government Expenditure

10. Suppose a house is built and sold in the year 2000. If the house is resold in the year 2011, is the value of the house included in Gross Domestic Product (GDP) for 2011?

• No. GDP for 2011 includes only production that occurs during 2011.

• Would the services of a real estate agent who helped sell (or helped buy) the

house be included in GDP for 2011?

• Yes. GDP for 2011 includes the market value of final goods and services.

This includes real estate services.

11. An article in the Wall Street Journal observed: “Plenty of companies, both in the U. S. and abroad, came to depend on U.S. consumers for their growth. They may have to peddle their wares elsewhere.” U.S. and foreign firms will need to depend less on U.S. consumers in the future because

• U.S. consumers are saving more and spending less.

12. Suppose that a simple economy produces only the following four goods and services: textbooks, hamburgers, shirts, and cotton. Further, assume that all of the cotton used in the production of shirts. Use the information in the following table to calculate Nominal Gross Domestic Product (NGDP) for 2011. Production and Price Statistics for 2011

• The NGDP for the year 2011 is $7,450.

13. For the total value of expenditures on final goods and services to equal the total value of income generated from producing those final goods and services, all the money that a business receives form the sale of its product must be paid out as income to the owners of the factors of production. How can a business make a profit if it pays out as income all the money it receives?

• Profit is the income that remains after a firm has paid wages, rent, and interest.

14. Review the following events: 1. A farmer sells $200 worth of wheat to an agricultural products distributor. 2. The distributor trims, packages, and sells the wheat to a state-owned bakery for $300. 3. The state-owned bkaery uses all of the wheat to make bread and then sells it for $250.

• If, for simplicity, we ignore the value of inputs used to grow the wheat-such as

seeds, labor, and fertilizer, then the farmer’s value added is $200. (Enter your response as an integer and include a minus sign if necessary.)

• The value added for the distributor is $100.

• The value added for the state-owned bakery is $-50.

• Would a state-owned firm that adds a negative value added to its products

operate differently than a free market firm that adds negative value added to its products?

• Yes. Under the circumstances, the private, free-market firm would quickly

shut down, the state-owned could continue operating, ceteris paribus.

15. An artist buys scrap metal from a local steel mill as a raw material for her sculptures. Last year, she purchased $6,000 worth of scrap metal. With the steel she produced 10 authentic sculptures that she sold for $900 each to a local art dealer. The art dealer then sold all of the sculptures to art collectors for an average of $1,100 each.

• The total value added of the artist is $3,000. (Enter your response as an integer.)

7.2 Does GDP measure what we want it to measure?

1. How does the size of a country’s GDP affect the quality of life of the country’s people?

• Generally, the more goods and services people have, the better off they are.

2. GDP is an imperfect measure of economic well-being because it fails to measure what types of production?

• Household production and the underground economy.

• Even if GDP included these types of production, why would it still be an imperfect

measure of economic well-being?

• All of the above: The value of leisure is not included in GDP. GDP is not

adjusted for crime or other social problems. GDP is not adjusted for pollution and it does not account for unequal income distribution.

3. Which of the following are likely to increase the measured level of GDP and which are likely to reduce it?

• When the number of people working outside the home decreases, the measured

level of GDP decreases.

• When there is a sharp increase in the crime rate, the measured level of GDP

may increase or decrease.

• If higher tax rates cause more people to hide the income they earn, the

measured GDP decreases.

4. Michael Burda of Humboldt University in Germany and Daniel Hamermesh of the University of Texas examined how workers in the United States who lost their jobs

between 2003 and 2006 spent their time. They discovered that during the period when they were unemployed, the reduction in the number of hours paid work was almost completely replaced by an increase in the number of hours spend on household production. Based on these findings, what can we predict about total production-whether or not that production is included in the calculation of GDP-in the economy when these workers became unemployed?

• If the workers had been paying other people to perform the household activities

prior to unemployment, then total production will fall.

5. We often use real GDP per capita as a measure of a country’s well-being. Review the definition of real GDP per capita before answering the following questions. Today, the typical American works fewer than 40 hours per week. In 1890, the typical American worked 60 hours per week. Would the difference between the real GDP per capita in 1890 and the real GDP per capita today understate or overstate the difference in the population’s economic well-being?

• The increase in real GDP per capita between 1890 and today understates well-

being because the value of leisure is not included in GDP.

6. A report of the World Bank, an international organization devoted to increasing economic growth in developing countries, includes the following statement: “Informal economic activities pose a particular measurement problem [in calculating GDP], especially in developing countries, where much economic activity may go unrecorded.” What does the World Bank mean by “informal economic activities”?

• In many developing countries, informal economic activities refer to activities in

the underground economy.

• Why do these activities make it harder to measure GDP and, as a result, the

standard of living?

• If a large portion of an economy’s production is done in the underground

economy, measured GDP will underestimate production and economic well-being.

7. Each year, the United Nations publishes the Human Development Report, which provides information on the standard of living in nearly every country in the world. The report includes data on real GDP per capita and also contains a broader measure of the standard of living called the Human Development Index (HDI). The HDI combines data on real GDP per capita with data on life expectancy at birth, adult literacy, and school enrollment. The table below shows values for real GDP per capita and the HDI for several countries. 1) Rank each country from highest real GDP per capita to lowest real GDP per capita (1 for highest, 2 for next highest, etc.). 2) Next, rank each country from

highest HDI to lowest HDI.

• Why are there differences between the two lists?

• All of the above: The value of leisure is not included in GDP. GDP is not

adjusted for crime or other social problems. GDP does not account for income distribution. GDP is not adjusted for pollution or other negative effects of production.

8. Think about the increase in spending for the Department of Homeland Security and the wars in Afghanistan and Iraq. These all represent government expenditures that have increased GDP yet the typical person might not necessarily be better off as a result. Why?

• All of the above: GDP is not adjusted for pollution or other negative effects of

production. The value of leisure is not included in GDP. GDP is not adjusted for crime or other social problems. GDP does not account for income distribution.

7.3 Real GDP versus Nominal GDP

1. Why does inflation make nominal GDP a poor measure of the increase in total production from one year to the next?

• When nominal GDP increase from year to year, the increase is due partly to

changes in prices and partly to changes in quantities.

• How does real GDP deal with the problem inflation causes with nominal GDP?

• All of the above: Real GDP uses the prices of goods and services in the

base year to calculate the value of goods in all other years. Real GDP separates prices changes from quantity changes. By keeping prices constant, we know that changes in real GDP represent changes in the quantity of output produced.

2. How is the GDP deflator calculated?

•

3. Suppose the information in the following table is for a simple economy that produces only the following four goods: textbooks, hamburgers, shirts, and cotton. Further, assume that all of the cotton is used to produce shirts.

If the base year is the year 2005, then real GDP for 2010 equals $8375.00 (round your answer to the nearest penny). and the real GDP for 2011 equals $8862.50 (round your answer to the nearest penny).

• What is the (annual) growth rate of real GDP in 2011? 5.82% (enter your

response as a percentage rounded to two decimal places).

4. Assuming that inflation has occurred over time, what is the relatioinship between nominal GDP and real GDP in each of the following situations?

• In years after the base year, nominal GDP is greater than real GDP.

• In the base year, nominal GDP is equal to real GDP.

• In years prior to the base year, nominal GDP is less than real GDP.

5. Indicate whether you agree or disagree with the following statements. “Whenever real GDP declines, nominal GDP must also decline.”

• Disagree. Real GDP falls if output falls. Nominal GDP can increase if output fall

and prices rise.

• “If a recession is so severe that the price level declines, then we know that both

real GDP and nominal GDP must decline.”

• Agree. If both output and prices are falling, then both real GDP and

nominal GDP will fall.

6. Use the data in the following table to calculate the GDP deflator for each year (values are in billions of dollars, enter your response rounded to 1 decimal place—remember to multiply by 100).

Which year from 1998 to 2001 saw the largest percentage increase in the price level, as measured by changes in the GDP deflator? 2001 (enter a 4-digit year: 1998, 1999, 2000, or 2001.)

7.4 Other Measures of Total Production and Total Income

1. U.S. Gross National Product (GNP) differs from U.S. Gross Domestic Product (GDP) in which of the following ways? (Mark all that apply.)

• GNP considers production that occurs outside the U.S. GNP is the value of final

goods and services produced by residents of the U.S.

• In the United States, the difference between GNP and GDP is smaller than that

of many other countries.

2. Consider the following table:

• National income (NI) equals $11,680 billion. (Enter your response as an integer.)

• Personal income (PI) equals $11,180 billion.

• Disposable personal income (DPI) equals $9,930 billion.

3. In the U.S., gross domestic product (GDP) and gross national product (GNP) are close in value. Under what circumstances would GNP be much longer than GDP?

• All of the above would push GNP above GDP: Few foreign firms maintain

facilities in the U.S. while many U.S. firms are currently opeating abroad. Many U.S. citizens currently work in foreign countries while few foreign citizens currently work in the U.S. Few foreign citizens currently work in the U.S. and foreign firms maintain facilities in the U.S.

4. Suppose the amount the federal government collects in personal income taxes decreases, while the level of GDP remains the same. What will happen to the values of national income, personal income, and disposable personal income?

• National income will remain the same.

• Personal income will remain the same.

• Disposable personal income will increase.

5. If you were attempting to forecast the level of consumer spending by households, which measure of total production or total income might be most helpful in making your forecast?

• Disposable personal income

6. Indicate whether the following statement is correct or incorrect. “Corporate profits are much too high: most corporations make profits equal to 50 percent of the price of the products they sell.”

• Incorrect: The largest component of gross domestic income is wages, which are

about three times as large as profit.

7. N: Economics in the News

1. Is This Another Great Depression? A depression is defined as a severe recession. But what constitutes severe? Since the Great Depression of the 1930s we have had short-lived and relatively shallow downturns in economic activity. But many forecasters and pundits are throwing the term ‘depression’ around this time. While economic conditions do appear to be dire they are not yet of the same magnitude as the Great Depression.

GDP fell 27 percent bewteen 1929 and 1933. IN the current downturn we are only down 2.5 to 3 percent. The stock market lost 90 percent of its value in the Great Depression and we are only down 35 to 40 percent now. One thired of all banks vailed in the Great Depression. And, while the current bank failures are large, they are numbered in the dozens. By any metric we are not in a depression. However, the period leading up to the Great Depression has some similarities that are alarming. A period of prosperity in the 1920s led to asset price bubbles and a faltering banking system. However, the current belief is that we learend from our policy mistakes of the 1930s. The Fed has been aggressive in addressing the liquidity crisis. In addition the government appears to be near additional massive fiscal stimulus. Only time will tell whether we have better tools today to keep this downturn classified as a recession. Analyzing the News. Where are we on the business cycle? Unfortunately we won’t know until later. Did the aggressive monetary and fiscal stimulus work? I’ll let you know in a few years but until then we will all be speculating. Was it enough? Was it too much? Will it get better or worse? It apperas we have not been able to prevent downturns nor predict their magnitude. Economic interventino is still more art than science. Thinking Critically Questions. What is the business cycle?

• A period of economic growth followed by decline. HIstoricaly business cycles

range from 3 to 15 years long.

• Why are we concerned about this particular decline?

• The current rapid deterioration as shown by corporate profitablity failing

and layoffs has many wroried we may continue to spiral down.

• What is the opint of the fiscal and monetary stimulus?

• To stop the downward trend and revers it, riscal policy will be designed to

get consumers spending again and working again. The monetary stimulus is desgined to shore up banks and enable them to lend money again.

2. ‘Made in the USA’ Still Means Something. The news media paints a dire picture of U.S. manufacturing. We often hear that most goods are now manufactured overseas using cheaper sources of labor and more modern facilities. While this may be true for many goods the U.S. is still “the world’s leading manufacturer.” However, the mix of goods has changed signifcantly. Instead of dress shirts, microwave ovesn, and boom boxes we now produce chemicals and aircraft. We have shifted production to high-value fields such as medical technologies where we manufacture more than half of the $174 billion of these products purchased annually worldwide. The focus on the jobs lost in manufacturing often overshadows the job gains due to visibility. Many of the more common consumer goods such as clothing are now made outside the U.S. In contrast optimists point out that the U.S. focuses on high value capital goods as Ricardo’s comparative advantage predicts. Analyzing the News. Much has been written about the U.S. falling behind in manufacturing. However, it depends on what metric you use to evaluate manufacturing. While we may have lost jobs in this sector it appears that dollars of products produced have increased significantly. According to this metric the U.S. still leads the world in manufacturing. Thinking Critically Questions. Why have we lost some manufacturing jobs?

• Many labor-intesnive items are much less costly to produce overseas where

labor is much less expensive than in the U.S.

• Why does the U.S. continue to manufacture high-end products?

• Only A and B: Job-related training is more readily availble in the U.S. than

in many foreign countries. Many of these products require a more educated work force.

3. April Retail Sales Fall, Raising Recovery Doubts. Retail Sales were down for the second straight month and would have been substantially lower without the increase in auto sales. Many analysts believe the data points to a more prolonged recession and now believe that second quarter consumption numbers will show a decline. Businesses were hopeful that the stimulus package would begin to entice consumers to spend again. However, with the unemployment rate at 8.9 percent there are many that no longer have an income to spend. The news cast a damper on the stock market and pushed stocks lower overall. While most retailers saw sales fall, the nation’s largest retailer Wal-Mart Stores Inc., posted gains of 5 percent. Consumers are flocking to the discount retail giant and shunning high-end stores. Furniture, appliances, and electronics all continue to suffer as consumers postpone those purchases. Analyzing the News. Consumers appear to be continuing their tightfisted ways. Keep in mind that many consumers have lost their jobs, have high levels of debt, or both. Other consumers are saving just in case they find themselves out of work. This recession may be more drawn out than originally

forecasted because of these factors. Why is consumer spending critical to recovering from the recession?

• Consumer spending is by far the largest component of the economy.

Consumption typically represents about 70 percent of the GDP.

• How could the release of falling retail sales impact the length of the recession?

• Consumers may use this information as additional evidence the recession

is lingering and curtail spending even more.

• Besides consumption, what are the other major components of the gross

domestic product? (select all that apply)

• Net Exports, Business Investment, Government spending.

4. Economy Seems to be stuck in Neutral. National numbers indicate that the economy has moved into a recovery phase, yet many states and metropolitan areas continue to suffer. While the economic free-fall has stopped, the pace of recovery is agonizingly slow. Unemployment remains high and consumers continue to pinch pennies.

The anemic recovery has been driven by the government sector and some business inventory rebuilding. The housing market continues to struggle in many regions, but it is picking up slightly in 17 states versus this time last year. About one-third of metro areas are showing signs of economic life, while the remaning two-thirds are still in contraction phase. Those regions still in decline are at least doing so at a moderate pace. The primary challenge for every region remains job creation so that consumers will have the wherewithal to aid the recovery. Analyzing the News. Many economists are predicting unemployment will remain high for several years.

The primary reason is that consumers, who represent about 70 percent of our economy, are still not spending. The reliance on consumer ddebt and home equity fueled the previous ten years of consumer spending, and now the party is over. Job loss, declining home values and tighter credit standards all lessen the liklihood of a strong consumer spending rebound for years. Thinking Critically Questions. Which of the following accurately describes the behavior of home values, credit, and consumption over the last decade?

• Home values were rising, credit was easy, and many homeowners extracted

equity from their home sto finance consumption.

• Even with the economy revocering, there is evidence that firms are reluctant to

hire. Which of the following may explain this?

• Some firms have learened to get by with fewer employees.

• Which of the following correctlyl defines “double dip recession”?

• a situation in which an economy in recession recovers to seom degree

but then experiences another downward trend.

5. Housing Real-Estate Recovery Signaled as Fed Unwinds. Economists belive that the housing market has recovered enough to continue growing even after the expiration of the home buyer tax credits and the Fed’s withdrawal from the mortgage market. The consensus estimate is that new home sales will contribute around 25 basis points of the expected 3.6 percentage growth. Some are even forecasting a rate increase by the Fed as early as June. The stock market appears to share optimism, with home builder stocks at a five month high on the expectation of new housing starts. Job groth, much of it from the government sector, appears to be the primary drive of the optimism with a little boost from lower home prices. Oddly, home builders do not seem to share this positive sentiment. Most builders view conditions as poor, and prospective buyer traffic also fell to a one-year low. In spite of these negative indicators, many economists maintain that easier credit and the new Senate bill extending unemployment benefits are both positive signs and that the economy is well on the way to recover. Time will tell who is right. Analyzing the News. It’s not usually economists who are optimists in any group of people. However, this appears to be the case now, according to the article. Is the recovery strong enough to withstand a gradual withdrawal by the Fed and the expiration of tax credits? We should know in a few months, but there is room for skepticism, given the persistent pessimism of builders and the drop in buyer traffic. Thinking Criticallly Questions. What is the current state of home buyer traffic, and how does this influence the housing market?

• It is currently low, and home buyer traffic affects the demand for housing.

• Economists often place special emphasis on the sentiments of home builders,

because they deal with the housing market rather intensivelly. Which is true

about the information available to home builders and the side of the housing market about which this information gives them insight?

• Their knowledge of credit conditions and lenders gives them insight into

the supply side of the housing market, while their current inventory gives them insight into the demand side of the market.

• Why might the Fed want to pull out of the mortgage-backed securities market

and increase interest rates once the receovery has fully taken root? What type of monetary policy would this be?

• The Fed would do so to avoid excessive inflation; this would be

contractionary monetary policy.

6. U.S. Orders Ex-Transportation Jump by Most Since ’07. March durable goods orders, minus transportation, increased by the largest amount since December 2007. The 2.8 perecent increase was also four times the consensus forecast of .7 of a percent expected by economists. Analytsts touted the results as evidence that the recovery was gaining strength. Durable goods are those goods expected to last at least three years and are often postponed purchases when economic uncertainty reigns. Last month’s increase was particularly good news since the orders included a broad cross section of industries. Computers, machinery, electrical equipment and metals all posted gains. Non-defense industry capital goods were up 4 percent, providing further evidence that the recovery is not soley driven by government spending. Analyzing the News. Durable goods orders are considered a good barometer of economic health since they are often postponable purchases. For example, a consumer may elect to postpone the purchase of a new washer and dryer as long as the old units are still functioning when the economic outlook is uncertain. However, when times are good there is a higher probability of making the purchase even when the old units still have some useful life. Consumers and businesses appear to be finally willing to spend some money. Thinking Critically Questions. Which of the following correctly describes and gives an example of durable good?

• Durable goods last more than three years; one example is a car.

• Which of the following is an example of a non-durable good?

• Fuel

• Which of the following is most likely to be true about durable and non-durable

goods?

• Non-durable goods purahses are less likely than durable goods to be

postponed because of recession.

7. Orders for U.S. Durable Goods Likely Climbed, Boosting Growth. U.S. durable goods orders appear to be leading the economic recovery, according to some economists. Bookings for durable goods, those products expected to last more than three years, increased by two percent. Conversely housing sales continue to hover “near a record low.” Improving sales overseas for companies like Boeing and Intel are pushing profits higher as businesses renew spending on “machinery and software.” The transportation category was the biggest gainer, with Boeing alone booking orders for 117 aircraft in the past month. The company raised its profit forecast accordingly. Other durable goods saw improvement as well, mobbing up by 0.5 percent. While the Fed expects a “less vigorous” recovery than desired, the durable goods numbers were a welcome improvement. Analyzing the News. Economic recovery must be driven by something other than government spending. That’s why this data on increased business investments is a very positive sign for the economy. Businesses will likely have to add employees to fill orders if the trend continues. Thinking Critically Questions. Which of the following equations would get you the correct figure for an open economy in terms of spending (aggregate demand)? Assume that any government spending does not include spending on transfer payments, so you to not need to consider these in your answer.

• Consumption + Investment + Government Spending + Exports – Imports

• When businesses start buying durable investment goods after a recession,

economists take this as a very positive sign. Which of the following helps explain this?

• Businesses tend to postpone these purchases as long as possible.

• Which of the following industries experienced the most growth as described in

the article?

• Transportation

8. Economy in U.S. Grew 1.8% in First Quarter, Less Than Forecast. The U.S. economy posted first quarter growth of only 1.8 percent annualized. According to the article, the primary culprit was a reduction in government spending which fell by the most since 1983. Most economists expected a growth rate of about 2.0 percent for the first quarter. The news prompted the Federal Reserve to reiterate that it intends to complete the remainder of the current $600 billion in monetary stimulus. Some experts had speculated the Fed might end the program early due to strength in the economy. However, jobless claims also rose and consumer confidence fell due to higher gas and food prices. In addition, the Fed pared back its forecast of 2011 GDP growth to 3.1 percent. Federal government spending fell by 5.2 percent annually and residential construction was also down by 4.1 percent. Both of these sectors contributed to the lower overall growth but were partially offset by inventory buildups and increases in software and equipment spending. Analyzing the News. The U.S. economy is growing but not fast enough. Higher growth rates will be necessary in order to spur domestic hiring. While some experts are optimistic growth will “pick up” later in the year, it will be dampened by the

higher cost of food and fuel. Consumer budgets are being stretched to pay for increases in food and energy, which reduces their ability to buy other goods and services. Thinking Critically Questions. What is the definition of real gross domestic product or real GDP?

• The inflation-adjusted market value of all final goods and services produced

domestically during a period of time.

• How is real GDP used to determine the strength of the economy?

• An increase in the growth rate of real GDP indicates an increase in the

level of economic activity.

• What does the 1.8 percent increase indicate to policymakers?

• Most policymakers nod analysts would like to see growth exceed 3

percent in order to create the jobs necessary to significantly reduce U.S. unemployment rates.

9. Trade Deficit in U.S. Probably Little Changed in May From Four-Month Low. Most economies expect the trade deficit to remain stable for some time and, in fact, the May 2011 deficit of $44.1 billion was little different from the $43.7 billion trade deficit posted in April 2011. While the U.S. continues to import more than it exports, the current weak dollar helped to make U.S. goods more attractive to foreign buyers. In addition, “growing economies overseas may keep bolstering demand for American-made goods.” The U.S. economy expanded at an annual rate of 1.9 percent for the first quarter of the year according to Commerce Department data. However, the dollar is currently down 9.5 percent over the past 12 months against a market basket of currencies and should continue to contribute to export growth and add a few basis points to overall economic growth. Imports are also lower as U.S. consumers continue to remain tightfisted with their money. Analyzing the News. The U.S. economy remains mired in stagnant growth mode and the current budget battle in Washington DC leaves litter room for fiscal policy action. For now, the Fed remains the primary source of policy designed to stimulate the economy. The falling dollar may be one of the few bright spots in the overall economic recovery. Thinking Critically Questions. How can a weaker dollar help the U.S. economy?

• U.S. exports become cheaper to the rest of the world.

• How can a weaker dollar harm U.S. consumers?

• Imports to the U.S. become more expensive.

• What is a possible reason for the weaker dollar?

• Huge national debt.

Ch. 8: Unemployment and Inflation

8.1 Measuring the Unemployment Rate and the Labor Force Participation Rate

1. The unemployment rate is calculated as follows:

•

• Consider the following chocies. Which oen is not accurate?

• Black teenagers as a group have lower unemployment rates than white

teenagers.

2. The labor force particpation rate is calculated by

•

•

• Use the Graph to the right ot help determine which of the following statements

regarding the labor force participation rates of adult men and women since 1950 is false.

• The labor force participation rates of adult men and adult women were

equal in 1990.

3. Which of the following depicts an accurate description of the household survey and the establishment survey?

• The household survey interviews households and measures the unemployment

rate whereas the establishment survey interviews businesses and measures the employment rate.

• Many economists prefer

• The establishment survey because it is determined by actual payroll

records than unverified answers.

4. Fill in the missing values in the table of data collected in the household survey for the year 2009 (enter all values rounded to one decimal place).

•

5. A firm may lay off a substantial number of workers because of

• A business cycle recession during which the firm cuts back its production in

response to a fall in demand for its products.

6. Currently, the Bureau of Labor Statistics does not inlcude homemakers in its employment and labor force totals. What would happen to the unemployment rate and the labor force participation rate if homemakers were included in these numbers?

• The unemployment rate would decrease and the labor force participation rate

would increase.

7. Complete the table below. (Enter your responde rounded to one deciaml place.)

•

• Note: The sum of employed and unemployed may not equal the labor force due

to rounding. How is it possible for both the number of employed AND the unemployment rate to decline?

• A and B: A decrease in the labor force. An increase in discouraged

workers.

8. During the 2007-2009 recession, employment declined sharply in the construction, manufacturing, and financial services sectors. Suppose that employment in these sectors becomse a permanently smaller fraction of total employment in the United States. Thish shift will increase the average unemployment rate of male workers relative to female workers.

• Would it make a difference if you are considering the situation 2 years from now

or 15 years from now?

• It will make a difference if there is a shift in the proportions of mena dn

women in industries that are currently disproportionately male or female.

9. Between December 2001 and January 2002, the total number of people employed and the unemployment rate both fell. How is this possible?

• It is possible if labor force participation rates also fall.

10. In an article in the New York Times in 2009 on the signs of a potential recovery from the recession, the author makes the following statement: “And whenever the economy begins growing again, it won’t feel good for a while. The unemployment rate may continue to rise into 2010-and not come down to a healthy level until even later.” Why would the unemployment rate continue to rise if the economy has begun to grow again?

• As firms expand, discouraged workers may enter the labor force but not

immediately find jobs.

11. An article published in the Wall Street Journal in December of 2008 remarks that, “Employers eliminated nearly two million jobs this year, and no relief is in sight.” Is two million likely to be an accurate estimate of the number of jobs eliminated in the United States in 2008-or any other year?

• No. The U.S. economy creates and destroys millions of jobs every year, so the

creation of new jobs offsets many of the jobs eliminated in the economy.

12. Real-Time Data Analysis Exercise Click the following link to view unemployment data form FRED*. *Real-time data provided by Federal Reserve Economic Data (FRED), Federal Reserve Bank of Saint Louis. The data in the table below shows employment data for August 01, 2011. Using the link above, correctly identify the title for each series listed in the table below.

Using FRED, the series above are reported monthly, and the values are in thousands of persons.

• Use the data in the table above to calculate two different unemployment rates.

(Round your responses to two decimal places. The civilian unemployment rate is 9.09 perecent.

• The civilian unemployment rate including persons who are

underemployed (part-time for economic reasons) is 12.89 percent.

8.2 Types of Unemployment

1. Which of the following accurately describes the relationship between fictional unemployment and job search?

• People are said to be frictionally unemployed when they are between jobs and

searching for new jobs.

2. The natural rate of unemployment is not equal to zero because

• It is the sum of structural unemployment and frictional unemployment.

3. Macroeconomics conditions affect the decisions firms and families make. After graduation, a college student might enter the job market during an economic expansion but apply for graduate school during a recession because

• The probability of finding a job is higher during economic expansion and lower

during recession.

4. A person who is in between jobs but actively engaged in a job search is considered to be frictionally unemployed.

• Experts in hand-drawn animation who remain unemployed due to the film

industry’s switch to computer-generated animation are considered to be structurally unemployed.

• When a company reduces production and employment during economic

recession, those employees who lose their jobs are generally considered to be cyclically unemployed.

5. Recall the definitions of normal and inferior goods. During a recession, a person would prefer to work in an industry that produces

• An inferior good because the demand for inferior goods should increase with

decreases in income during a recession.

• During an economic expansion, a person would prefer to work in an industry that

produces

• A normal good because the demand for normal goods should increase

with increases in income during economic expansion.

6. If Congress eliminated the unemployment insurance system,

• The level of frictional unemployment would decrease.

• If Congress eliminated the unemployment insurance system,

• The level of real GDP will increase as frictionally unemployed individuals

will take less time to find jobs.

• The elimination of unemployment insurance

• Will reduce the workers’ incomes and their consumption spending and

thus will lower economic well-being.

8.3 Explaining Unemployment

1. Government unemployment insurance tends to

• Increase the unemployment rate by lowering the opportunity cost of job search.

2. Consider the effect of each of the following on the unemployment rate: The minimum wage law

• Has only a small effect on the unemployment rate since only a small part of the

labor force earns the minimum wage.

• The effect of labor unions on overall unemployment is small since only a small

percentage of the labor force outside the government is unionized.

• An efficiency wage

• Increases the unemployment rate since firms pay a higher-than-market

wage that increases the quantity of labor supplied.

3. In 2007, Segolene Royal, who was running unsuccessfully for president of France, proposed that workers who lost their jobs would receive unemployment payments equal to 90 percent of their previous wages during the first year of unemployment. If this proposal were enacted, the unemployment rate in France

• Would have gone up as the opportunity cost of job search would have

decreased.

4. Discuss the likely impact of the following event on the unemployment rate. If more companies make information on job openings easily available on Internet job sites, then the unemployment rate will decrease.

5. The government set the minimum wage at $0.25 per hour in 1938. This wage was

• Higher than the equilibrium wage since minimum wages are biding price floors

and are usually set above the equilibrium wage rate.

6. An economic consultant studies the labor policies of a firm where it is difficult to monitor workers and recommends an increase in wages. At a meeting of the firm’s managers to discuss the report, one manager makes the following argument: “I think the wages we are paying are fine. As long as enough people are willing to work here at the wages we are currently paying, why should we raise them?” If the firm’s managers do not currently face a worker shortage, the consultant should pursue the following argument to justify the wage hike:

• Efficiency wages are designed to increase worker productivity.

7. If Wal-Mart adopted Costco’s compensation policies, the number of workers employed by Wal-Mart

• Will decrease as efficiency wages always create unemployment when cyclical

unemployment is zero.

• If Wal-Mart adopted Costco’s compensation policies, consumers would be

• Worse off as Wal-Mart increases their prices to pay for the higher wage

cost.

8.4 Measuring Inflation

1. Which of the following is not a measure of the price level?

• Government Price Index: an average of the prices paid by the government for

goods and services used only by different government agencies.

• The most frequently used measure of the price level is:

• Consumer Price Index.

2. Which of the following is not considered one of the potential biases in calculating the consumer price index?

• Coverage bias

• Which of the following steps has not been taken by the Bureau of Labor Statistics

(BLS) to reduce the size of the biases in the CPI?

• The BLS has expanded the number of store from which it collects the

price information to reduce the coverage bias.

3. If the Consumer Price Index (CPI) for the year 2008 is 205, does that mean that (the annual rate of) inflation in 2008 was 105%?

• No. The inflation rate is the percentage increase in the price level from the

previous year, not the base year.

4. The following is from an article in the Wall Street Journal: “Apple Inc. refreshed its line of Macintosh desktop computers…The new models generally offer more features and computing power for the same price as previous models.” If Apples new computers offer “more features and computing power for the same price as previous modes,” how will the consumer price index (CPI) be affected?

• The CPI does not change.

5. Consider the simple economy that produced only three products. Use the information in the following table to calculate the (annual rate of) inflation for 2010 as measured by the consumer price index (CPI).

What is the inflation rate for 2010 as measured by the consumer price index (CPI)? 2.53%. (Enter your response rounded to two decimal places.)

6. The Standard and Poor’s?Case-Shiller Home Price Index is one of the leading indicators of housing price trends in the United States. The base year for the index is January

2000. The following table lists index numbers for December 2007 and December 2008

for five cities. Calculate the percentage changes in the price indices during 2007-2008 for the following cities (enter all values as percentages rounded to one decimal place and include a minus sign if

necessary): The rpices of luxury homes changed the most during this year in Phoenix.

• Can you determine on the basis of these numbers which city had the most

expensive luxury homes in December 2008?

• It is not possible to determine this with the information provided.

7. Real-Time Data Analysis Exercise. Click the following link to view CPI data from FRED*. Then use that data to answer the following questions. Using the data from FRED, answer the following questions. The series Id for these CPI data is CPIAUCSL.

• This is monthly data that has been seasonally adjusted.

• From the FRED website, click on the “View Data” link to find the values to enter

below. The CPI for August of 2010 (shown as 2010-08-01 in FRED) was 218.068.

• The CPI for August of 2011 (shown as 2011-08-01 in FRED) was

226.268. (Enter the values exactly as they appear in FRED.)

8. Real-Time Data Analysis Exercise. Click the following like to view the CPI data from FRED*. Then use that data to answer the following questions. This exercise requires you to download data from FRED in an Excel format, and then perform calculations using Excel or some other compatible spreadsheet program such as Openoffice. It is important to follow the instructions carefully. Step 1 Click on the FRED link above. Clicking the link will take you the Consumer Price Index for All Urban Consumers: All Items (CPIAUCSL)

page. Step 2 Click on the “download data” link on that page. From the “download data page,” change the beginning date to 2005-09-01. You can leave the ending date as it is. Then click on the “download” button to download the data and save it on your computer. Finally, open the Excel file. Step 3 Using Excel, calculate the percentage change in CPI from a year ago for each of the observation, beginning with 2006-09-01. To do so, click on the blank cell next to the observation corresponding to the date 2006-09-01, and then

enter the following formula: Step 4 Repeat step 3 for the remaining observations. Step 5 Using Excel, create a time series graph of the percentage change from ayear ago. Then, using the spreadsheet, answer the following questions. Looking at the data for March, 2008 (shown as 2008-03-01 in FRED) to the present, the highest inflation rate, over this period, was 5.53 perecent, which occurred on 7-2008. (Round your numerical response to two decimal places. Enter the data using t he following form: M-YYYY, e.g. 6-2000)

9. Real-Time Data Analysis Exercise. Click anywehre on the graph to the right.

In the diaglog box that appears, select Inflation (CPI) for Y axis1 and Inflation excluding food and energy (CPI) for Y axis2. Then click the “plot” button. Click the “close” button to dismiss the dialog box. Click the magnifying glass in the upper right-hand corner of the graph to enlarge the

graph. Click the following graph icon to view data that can help you complete the following.

By June 2009 inflation, according to the blue line, reached a negative 1.9 percent, while the inflation measured by the red line was approximately 1.75 percent. Which of the following, if true, best explains the data?

• A significant decrease in the global demand for oil, caused the price of oil to fall,

which is reflected on the inflation rate measured using CPI data.

8.5 Using Price Indexes to Adjust for the Effects of Inflation

1. The difference between a nominal variable and a real variable is that

• Nominal variables are calculated in current-year prices and the real variables are

measured in dollars of the base year for the price index to correct the effects of inflation.

2. Which one of the following choices shows how data on nominal wages for 2002 to 2009 and data on the consumer price index for the same years can be used to calculate the real wage for these years?

•

3. IN 1924, the famous novelist F. Scott Fitzgerald wrote an article for the Saturday Evening Post titled “How to live on $36,000 a Year,” in which he wondered how he an d his wife managed to spend all of that very high income without saving any of it. IN 1924, the consumer price index (CPI) was 17, and the CPI in 2008 was 215. The income you would have needed in 2008 to have had the same purchasing that Fitzgerald’s $36,000 had in 1924 is $455294. (Enter your response rounded to the nearest dollar.)

4. Use the information in the following table to determine the percentage changes in the U.S. and French real minimum wages btween 1957 and 2008.

Calculate the percentage change in U.S. real minimum wages between 1957 and 2008: -17.74%. (Enter your response as a percentage rounded to two decimal places). Calculate the precentage chagne in French real minimum wages between 1957 and 2008: 285.23%. Based on the above calculations, we can conclude that

• Although nominal minimum wages increased in the U.S., real minimum wages

fell during this period.

5. The Great Depression was the worst economic disaster in U.S. history in terms of declines in real GDP and increases in the unemployment rate. Use the data in the following table to calculate the percentage decline in real GDP between 1929 and 1933.

Real GDP changed by -27.2% over the 4 year period between 1929 and 1933. (Enter a percentage value rounded to one decimal place. Include a minus sign if necessary.)

6. The following table show the top 10 films of all time through 2008, measured by box office receipts in the United States, as well as several other films farther down the list. The CPI in 2008 was 215. Use this information and the data in the table to calculate the box office receipts for each film in 2008 dollars. Assume that each film generated all of its box office receipts during the year it was released. Use your film results to prepare a new list of the films based on their earnings in 2008 dollars. (Some of the films, such as the first Star Wars film, Gone with the Wind, and Snow White and the Seven Dwarfs, were re-released several times, so their recepits were actually earned during several different years, but we will ignore that comlication.)

Choose the move that earned the most in real terms:

• Gone with the Wind.

8.6 Real Versus Nominal Interest Rates

1. The difference between the nominal interest rate and the real interest rate is

• The nominal interest rate is the stated interest rate whereas the real interest rate

is the nominal interest rate minus the inflation rate.

2. If inflation is expected to increase,

• The nominal interest rate will increase.

3. The following appeared in a newspaper article: “Inflation in the Lehigh Valley during the first quarter of [the year] was less than half the national rate…So, unlike much of the nation, the fear here is deflation-when prices sink so low that the CPI drops below zero.” Do you agree with the reporter’s definition of deflation?

• No. Deflation is defined as a negative inflation rate.

4. Suppose you were borrowing money to buy a car. Consider the following situations. Situation 1: Suppose the interest rate on your car load is 16.00 percent and the inflation rate is 15.00 percent. Calculate the real interest rate. 1.00%. (Enter your response as a percentage rounded to two decimal places.)

• Situation 2: Suppose the interest rate on your car loan is 6.00 percent and the

inflation rate is 3.00 percent. Calculate the real interest rate. 3.00%.

• Situation 1 will be better than Situation 2 because the real interest rate is lower.

5. Describing the situation in England in 1920, the historian Robert Skidelsky wrote the following: “Who would not borrow at 4 percent a year, with prices going up 4 percent a month?” What was the real interest rate paid by borrowers in this situation?

• -56%

6. Suppose that the only good you purchase is hamburgers and that at the beginning of the year, the price of hamburgers is $2.00. Suppose you lend $1,000 for one year at an interest rate of 11.8 percent. At the end of the year, hamburgers cost $2.04. Calculate the real interest rate on the loan. 9.8%. (Enter your response as a percentage rounded to one decimal place.)

8.7 Does Inflation Impose Cost on the Economy?

1. Inflation can affect the distribution of income because

• People with incomes rising faster than the rate of inflation enjoy an increasing

purchasing power, while people with incomes rising more slowly than the rate of inflation are hurt by a decreasing purchasing power.

2. The type of inflation that is a greater problem to society is

• Unanticipation inflation, since it causes greater redistribution of income between

those making payments and those awaiting payments in the future.

3. Menu costs are

• The costs of firms changing prices.

• The Internet has reduced the size of menu costs.

4. Supposed that the inflation rate turns out to be much lower than most people expected. In that case,

• A borrower will lose from the situation while a lender will gain.

5. Suppose James and Frank both retire this year. For income retirement, James will rely on a pension form his company that pays him a fixed $2,500 per month for a long as he lives. James hasn’t saved anything for retirement. Frank has no pension but has saved a considerable amount, which he has invested in certificates of deposit (CDs) at his bank. Currently, Frank’s CDs pay him interest of $2,300 per month. Ten years from now,

• Frank will have a higher real income although he has a lower nominal income

because his interest income is likely to increase with inflation.

• Real income is defined as the following:

•

• Now suppose that instead of being a constant amount, Jame’s pension increases

each year by thte same percentage as the CPI. For example, if the CPI increases by 5 percent in the first year after James retires, then his pension in the secon year equals $2,500 + ($2,500 x 0.05) = $2,625. In this case, 10 years from now,

• James will have a higher real income because he has a higher nominal

income and his income in indexed with the CPI.

6. Suppose that News Corporation, the owner of the Wall Street Journal, and the investors buying the firm’s bonds both expect a 7 percent inflation rate for the year. Further, suppose the nominal interest rate on bonds is 3 percent and the real interest rate is 7 percent. Now suppose that a year after the investors purchase the bonds, the inflation

rate turns out to be 3 percent, rather than the 7 percent that had been expected. In this situation, invest win and borrowers lose.

7. During the late nineteenth century in the United States, many farmers borrowed heavily to buy land. During the most of the period between 1870 and the mid-1890s, the United States experienced mild deflation. Many farmers engaged in political protests during these years, and deflation was often a subject of their prostests. Why would farmers have felt burdened by deflation during t his period?

• During deflationary periods, the real interest rate exceeds the nominal interest

rate, and the real cost of borrowing increases.

Ch. 9: Economic Growth, the Financial System, and Business Cycles

9.1 Long-Run Economic Growth

1. Real GDP per capita in the years 1900 and 2008 are:

Real GDP per capita increased 7.8 times in the United States between 1990 and 2008. (Enter yoyru response roudned to one decimal place.)

• The incraese in real GDP per capita is likely to be smaller than the true increase

in living standards.

2. The most important factor in explaining increases in real GDP per capita in the long run is increases in productivity.

3. The two key factors that cause labor productivity to increase over time are

• The quantity of capital per hour worked and the level of technology.

4. Potential real GDP is

• The level of GDP attained when all firms are producign at capacity.

• Potential real GDP grows over time.

5. Suppose you had a choice between living in the United States in 1900 with an income of $944,000 per year or in the United States in 2010 with an income of $58,000 per year. Assume the incomes for both years are measured in 2000 dollars. In which year would you have the highest real income? 1900.

• In which year would you have the better standard of living? 2010.

6. Consider the importance of growth in GDP, particularly real GDP per capita, to the quality of life a country’s citizens. Indicate whether you agree or disagree with each of the following statements. Increases in real GDP per capita do not incrase the amount of goods and services available to a country’s citizens. I disagree with this statement.

• Increases in real GDP per capita increase life expectancy at birth.

• I agree with this statement.

• Increases in real GDP per capita mean people will have a lower portion of leisure

time over the course of their lives.

• I disagree wit this statement.

7. Thinkin about the relationship between economic prosperity and life expectancy. The size of the health care sector in a less developed country is smaller than the size of the health care sector of a developed country. In particular, the size of health care sector in a developing country.

• Grows with economic prosperity as life expectancy increases.

8. Use the table to answer the following questions. Calculate the growth rate of real GDP

for each year from 1993 to 1997: Growth rate of real GDP for 1994= 4%. (Enter your response rounded to two decimal places.)

• Growth rate of real GDP for 1995= 2.50%.

• Growth rate of real GDP for 1996= 3.70%.

• Growth rate of real GDP for 1997= 4.50%.

9. Real GDP per capita in the United States, as mentioned in the chapter, grew from about $5, 600 in 1990 to about $43,700 in 2008, which represents an annual growth rate of 1.9 percent. If the United States continues to grow at this rate, how long will it take for real GDP per capita a double? 36.84 years. (Enter your response rounded to two decimal places.)

10. Real GDP per capita in the country of Arcadia grew from about $4,740 in 1990 to about $49,437 in 2008, which represents an annual growth rate of 2.19 precent. If Arcadia

continues to grow at this rate, calculate the number of years when its real GDP per capita will double. 32 years. (Enter your response as an integer.)

11. The economy of China has boomed since the late 1970s, havhing periods of high rates of growth in real GDP. At a 5 percent growth rate in real GDP, calculate how many years it will take this GDP measure in China to double. 14 years. (Enter your response as an integer.)

12. A study conducted by the Moscow-based management consulting firm Strategy Partners found that average labor productivity in Russis is only 17 percent of labor productivity in the United States. What factgors would cause U.S. labor productivity to be nearly six times higher than Russian labor productivity?

• The U.S. has more capital avialable per worker and higher levels of technology.

13. Two reasons for the rapid econmic growth in China over the past two or three decades have been the massive movement of workers from agriculture to manufacturing jobs and the transformation of parts of its economy into a market system. In China, labor productivity and manufacturing substantially exceeds labor productivity over the next decade or so. In 1978, China began to transofrm its economy into a market system, and today nearly 40 percent of Chinese workers are employed in private firms (up from 0 perecent in 1978). In the long run, the movement of workers from agriculture to manufacturing when compared to the transofrmation of the economy into a market system is less important for China’s economic growth.

14. A newspaper story on labor productivity in the United States includes the following observation: “Productivity is the vial element needed to boost living standards.” From the discussion about living standards in the text, are you likely to agree with this statement? Yes.

• Living standards in a country are determined by

• Per capita real GDP, life expectancies, environmental standards, and

labor productivity.

15. The keys to Botswana’s rate of economic growth are not shared by the other countries in the region. The most important contributing factor to Botswana’s recent growth is

• Government policies that protect private property rights, freedom of press and

deomocracy, and avoid political instability and corruption.

16. Real-Time Data Analysis Exercise. Click the following link to view GDP data from FRED*. Then use that data to answer the following questions. For this exercise, you will need to enter data from FRED for potential real GDP, nominal GDP and real GDP. Then you will be asked to compute statistics based on that data. Finally, you will use what you’ve learned to identify the curves in the graph to the right.

Using the data from FRED, enter the values for the second quarter of 2011 (shown as 2011-04-01 in FRED) for the following IDs: (Enter your responses exactly as they appear in FRED.)

Using the data above, calculate the following: (Round your response to two decimal palces.) The GDP deflator is 113.09.

• Relative to potential real GDP, real GDP is 6.92 perecent below potential real

GDP>

• On the graph to the right, potential real GDP is the gray curve, nomina GDP is

the blue curve, and real GDP is the red curve.

9.2 Saving, Investment, and the Financial System

1. The financial System of a country is important for long-run economic growth because

• Firms need the financial system to acquire funds from households.

• It is essential for economic growth that firms have access to adequate sources of

funds, because otherwise firms will not be able to invest in capital, adopt new technologies, and expand.

2. The financial system-either financial markets or financial intermediaries-provides savers and borrowers with all of the following except:

• The financial system provides security to savers by warranting that their funds

are fully insured against loss.

3. The total value of saving in the economy must equal the total value of investment.

Assume a closed economy, where: Which of the following expressions shows the investment-saving equality?

• I=Y+TR-C-G

4. Which of the following is not a “lonable fund”?

• Real estate

• Households supply lonable funds because of the

• Interest income received from the borrowers.

• Business demand loanable funds because

• Firms need to borrow funds for new projects, such as building new

factories or carrying out new research projects.

5. Suppose you can receive an interest rate of 5 percent on a certificate of deposit (CD) at a bank that is charging borrowers 10 percent on new car loans. Which of the following choices does not explain why you might be unwilling to loan money directly to someone who wants to borrow from you to buy a new car, even if that person offers to pay you an interest rate higher than 5 percent?

• You are better at assessing risks than the usually financial institutions.

6. An International Monetary Fund Factsheet makes the following observation regarding stable financial systems: “A sound financial system is…essential for supporting economic growth.” DO you agree with this observation? Briefly explain. A weak financial system might make economic growth difficult, since

• Capital investment, essential for rapid economic growth, is often financed by

borrowed funds and an unstable financial system leads to difficulty attracting loanable funds.

7. The following excerpt is from an article from the Reuters news agency: The White House on Monday raised its forecast for this year’s U.S. budget deficit by $89 billion due to the recession, millions of new unemployed claims and corporate bailouts. The new estimate predicted a deficit of $1.84 trillion, or 12.9 percent of gross domestic product, for the fiscal year ending September 30. It updated the White House’s February forecast of a $1.75 trillion deficit, or 12.3 percent of GDP.

In the adjacent graph, D1 and S1 show the initial demand and supply curves in the lonable funds market in the U.S. and point A, the initial equilibrium point. Use the line drawing tool to shift the demand and/or the supply curve to illustrate the impact of the increase in the budget deficit in the U.S. loanable funds market. Properly label this new line. Using the point drawing tool to locate the new

equilibrium point. Label this point ‘B’. Carefully follow the instructions above, and only

draw the required objects.

• Use the diagram to answer the following question. Asusming that other factors

that affect the demand and supply of loanable funds remain the same, as a result of the larger budget deficit, the equilibrium real interest rate increases and the equilibrium quantity of loanable funds decreases.

• When the budget deficit increases,

• Both saving and investment decrease.

8. Consider the following data for a closed economy: Use the data to calculate the following. (Enter yoour resposnes as integers.)

• Private saving: $4 trillion.

• Public saving: $-1 trillion.

• Government purchases: $3 trillion.

• The government budget balance is $-1 trillion and as result the government

budget is in deficit.

9. Consider the following data for a closed economy: Use the data to calculate the following: (Enter your responses rounded to one decimal place.)

• Price saving is: $3.5 trillion.

• Investmetn spending is: $3.0 trillion.

• Transfer paymets are: $2.5 trillion.

• The government budget balance is: $-0.5 trillion and as a result the government

budget is in deficit.

10. Consider the following data for a closed economy: Now suppose that government purchases increase from $2 trillion to $2.75 trillion but the values of Y and C are unchanged. What must happen to the values of S and I?

• S and I drop by $0.75 trillion.

11. Consider the graph on the right to answer the following questions:

• The shift from S1 to S2 represents a decreas in the supply of loanable funds.

• With the shift in supply, the equilibrium quality of loanable funds decreases.

• With the change in the equilibrium quantity of loanable funds, the quantity of

saving decreases and the quantity of investment decreases.

12. Refer to the graph on the right to answer the following questions:

• With the shift in the demand for loanable funds, the equilibrium real interest rate

increases and the equilibrium quantity of loanable funds increases.

• The fact that the equilibrium quantity of loanable funds may increase along with

an incrase in the real rate of interst

• Assumes that demand for loanable funds increases with supply remaining

unchanged.

• How much would the quantity of loanable funds demanded have increased if the

interest rate had remained at i1?

• From L1 to L3

• How much does the quantity of loanable funds supplied increase with the

increase in the interest rate from i1 and i2?

• From L1 to L2

13. Suppose the economy is currently in a recession and that economic forecasts indicate that the economy will soon enter an expansion. As a result,

• Expected profitability of new investment in plant and equipment increases and

the demand for loanable funds rises.

•

• The initial loanable funds market is described by the demand for loanable funds

curve, D1, and the supply of loanable funds curve, S1. Using the line drawing tool shift the demand of the supply curve if the economic forecasts indicate that the economy, which is currently in recession, will soon enter an expansion. Assume that the borrowers and lenders believe the forecast is accurate. Properly label each line. Note: if you are not prompted for a label, you have used the wrong

drawing tool.

• Use the diagram to the right to answer the following question. When borrowers

and lenders believe that the forecast of economic expansion is accurate, the equilibrium real interest rate increases, the equilibrium quantity of loanable funds increases, and the quantity of saving and investment increases.

14. Firms care about their after-tax rate of return on investment projects. The graph on the right represents the market for loanable funds. The initial demand and supply curves are

D1 and S1, respectively. Using the line drawing tool to shift the demand and or supply curve to illustrate the effect fo an increase in business taxes. (For simplicity, assume no change in the federal budget deficit or budget surplus). Properly label this new line. Carefully follow the instructions above and

onlyl draw the required objects. Use the graph to the right to answer the following questions. When business taxes increase, the equilibrium interest rate decreases and the equilibrium quantity of loanable funds decreases. What will be the effect of an increase in business taxes on the quantity of investment by firms and the economy’s capital stock in the future?

• The quantity of investment will decrease and the economy’s future capital stock

will decrease.

15. The graph on the right represents the market for loanable funds. D1 and S1 are the initial demand and supply curves and A the initial equilibrium point.

Use the line drawing tool to shift the demand for the supply curve to illustrate the effect on the market of the federal budget surpluses of the late 1990s. Properly lable this new line Carefully follow the instructions above, and only draw the required objects.

Use the graph to the right to answer the following questions. A federal budget surplus decreases the equilibrium interest rate and increases the quantity of loanable funds. If the federal government runs a budget surplus,

• Both saving and investment will increase.

16. Savers are taxed on the nominal interest payments they receive rather than the real interest payments. Suppose the government shifted from taxing nominal interest payments to taxing only real interest payments. The graph on the right represents the market for loanable funds. D1 and S1 are the initial demand and supply curves for loanable funds and A the initial equilibrium point.

Use the line drawing tool to shift the demand or supply curve to illustrate the effect on the market if the government changed its tax policy to tax only real interest payments. Properly label this new line. Carefully follow the instructions above, and only draw the required objects.

Use the graph to answer the following questions. If the government changes its tax policy and taxes only real interest payments and not nominal interest payments, the equilibrium real interest rate will decrease and the equilibrium quantity of loanable funds will increase. If the government changes its tax policy and taxes only real interest payments and not nominal interst payments,

• Both saving and investment increase.

17. This Making the Connection claims that Ebenezer Scrooge promoted economic growth more when he was a miser and saved most of his income than when he reformed and began spending freely. Suppose, though, that most of his spending after he reformed involved buying food for the Cratchits and other poor families. Many economists believe there is a close connection between how much very poor people eat and how much they are able to work and how productive they are while working. Does this fact affect the conclusion about whether the pre-reform Scrooge had a more positive impact on economic growth? Uncertain.

9.3 The Business Cycle.

1. What are the names of the following events in a business cycle?

• The high point of economic activity is called

• A peak.

• The low point of economic activity is called

• A trough.

• The period between the high point of economic activity and the following low

point is called

• A recession.

• The period between the low point of economic activity and the following high

point is called

• An expansion

2. The following shows the effect of the business cycle on the inflation rate and the unemployment rate:

• The unemployment rate increases the inflation rate falls during recessions.

3. Consider the following choices. Which of the following choices is correct?

• Recessions were more severe and lasted longer in the first half of the twentieth

century and became shorter and milder in the second half.

• Many economists agree that this difference is due to all of the following reasons

except:

• Since the 1950s, people have become more rational and control their

spending behavior countercyclically.

4. Consider the following goods.

• Ford F-150 trucks. Production of this good is likely to fluctuate more than

fluctuations of real GDP during the business cycle.

• McDonald’s Big Macs. Production of this good is likely to fluctuate less than

fluctuations of real GDP during the business cycle.

• Kenmore refrigerators. Production of this good is likely to fluctuate more than

fluctuations of real GDP during the business cycle.

• Huggies diapers. Production of this good is likely to fluctuate less than

fluctuations of real GDP during the business cycle.

• Caterpillar industrial tractors. Production of this good is likely to fluctuate more

than fluctuations of real GDP during the business cycle.

5. The National Bureau of Economic Research (NBER), a private group, is responsible for declaring when recessions begin and end. The Bureau of Economic Analysis (BEA), part of the federal government, might not want to take on this responsibility. Which one of the following is the most appropriate reason for the BEA’s refusal?

• Because it is part of the government, the BEA could be pulled into politics with

the dating of recessions.

6. “Real GDP in 2008 was $11.7 trillion. This value is a large number. Therefore, economic growth must have been high during 2008.” Do you agree or disagree with this statement? No, I do not agree.

7. The Making the Connection give examples of firms that prospered by expanding during recessions. As we have seen, some firms prosper by expanding during recessions. When firms expand during recessions, they

• Cannot be certain when recovery will occur and know they could experience

prolonged losses.

• A more cautious approach might be advisable in particular industries where

• Sales are particularly cyclical.

8. Imagine you own a business that during the next recession you lay off 20 percent of your workforce. Once economic activity picks up and your sales begin to increase, why might you not immediately start rehiring workers?

• Before rehiring you would like to make sure that this economic expansion lasts.