Principles of Economics – Chapters 15-20 BUS499(2011A)
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CHAPTER 15: MEASURING A NATION’S INCOME
CHAPTER SYNOPSIS
Chapter 15 is the third chapter in a five-chapter sequence dealing with firm behavior
and the organization of industry. Chapter 13 developed the cost curves on which firm
behavior is based. These cost curves were employed in Chapter 14 to show how a
competitive firm responds to changes in market conditions. In Chapter 15, these cost
curves are again employed, this time to show how a monopolistic firm chooses the
quantity to produce and the price to charge. Chapters 16 and 17 will address the
decisions made by monopolistically competitive, and oligopolistic firms.
The purpose of this chapter is to provide students with an understanding of the
measurement and the use of gross domestic product (GDP). GDP is the single most
important measure of the health of the macro-economy. Indeed, it is the most widely
reported statistic in every developed economy.
CHAPTER OBJECTIVES
� why an economy’s total income equals its total expenditure.
� how gross domestic product (GDP) is defined and calculated.
� the breakdown of GDP into its four major components.
� the distinction between real GDP and nominal GDP.
� whether GDP is a good measure of economic well-being.
REVIEW AND DISCUSSION
A) Gross Domestic Product (GDP) is the market value of all final goods and
services produced by the factors of production located in a country in one year’s
time.
B) GDP can be divided into four final use categories:
1. Personal Consumption Expenditures are the goods and services purchased
by households for their consumption.
2. Government Expenditures for Goods and Services are the goods and
services purchased by the government at all levels (federal, state and local).
Government Transfer Payments are not included because they do not
(directly) purchase a good or service.
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3. Investments are the goods purchased, mainly by business firms, to add to the
nation’s capital stock. Depreciation is the value of the existing capital stock
that has been used up in the process of producing output.
4. Net Exports are the domestically produced goods purchased by foreigners
minus domestic purchases of foreign produced goods.
C) Real GDP measures the volume of real goods and services produced by the
economy by removing the effect of changing prices from nominal GDP. Nominal
GDP is the value of the output of final goods and services expressed using
prevailing prices;
D) Gross National Product (GNP) measures the production of the factors of
production supplied by residents of the country, whether that production took
place at home or abroad. It is calculated as GDP plus income generated by
U.S.-owned factors located in other nations minus income paid in the United
States to foreign-owned factors of production.
E) National Income equals GNP minus depreciation and indirect business taxes
(such as sales taxes). National income also equals the sum of payments made to
the factors of production.
F) Personal Income equals the sum of all income people actually receive. Personal
Disposable Income equals personal income minus personal income tax payments.
Thus, personal disposable income is all the income people actually have to spend
or save.
G) Since GDP equals the sum of total expenditures on consumption investment,
government spending, and net exports, and also equals the amount of income that
can be spent on consumption, savings and taxes investment must be equal to
saving. The amount of investment is limited by both household saving and public
saving.
H) The Natural Level of Real GDP is the output associated with the natural rate of
unemployment
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PRACTICE QUIZ
Students are encouraged to complete the following practice quiz prior to reviewing
the provided answers.
True/False
If the statement is correct, write true in the space provided; if it is wrong, write false.
Below the question give a short statement that supports your answer.
_____ 1. Extensive economic growth can occur if more people decide to work rather
than retire early or continue in school.
_____ 2. A government policy that encourages investment in human capital, such as
providing below cost of college educations, can help increase a nation’s growth rate.
_____ 3. Intensive growth refers to economic growth that is the result of increases in
the amount of a nation’s productive inputs.
_____ 4. Real GDP can fall even if nominal GDP rises.
Multiple Choice Questions
Circle the letter corresponding to the correct answer.
5. The stage of the business cycle during which output is at its lowest point is
(a) the recession.
(b) when the stock market is falling.
(c) the peak.
(d) the recovery.
(e) the trough.
6. Which of the following is not a final use of GDP?
(a) Consumption expenditures
(b) Government expenditures for goods and services
(c) Government expenditures for transfer payments to individuals
(d) Investment
(e) Net exports of goods and services
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7. Which of the following is an example of intensive growth?
(a) Growth caused by an increase in technology that allows more output to be
produced without any change in the inputs utilized
(b) Growth caused by an expansion of the nation’s capital stock that takes place as
a result of changes in the nation’s tax laws
(c) Growth caused by an increase in the nation’s labor force
(d) All of the above
(e) None of the above
8. The amount of goods and services produced by an economy is measured by
(a) national income.
(b) depreciation.
(c) consumption.
(d) the business cycle.
(e) real GDP.
9. At the natural rate of unemployment, real GDP _________ the natural level of real
GDP and the inflation rate is _________.
(a) is greater than; rising
(b) is greater than; rising
(c) is equal to; rising, constant, or falling, depending on other factors
(d) is equal to; not changing
(e) is less than; falling
10. The production function says that
(a) real GDP depends on the economy’s capital stock..
(b) real GDP should increase when labor inputs increase.
(c) real GDP rises when there are technological improvements.
(d) (a), (b), and (c).
(e) None of the above
Essay Questions
Write a short essay or otherwise answer each question.
11. What is the difference between real and nominal GDP?
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12. What are the four final use categories of GDP?
13. Suppose an economy’s production function is given by:
Y = 0.75 L + 0.25 K + T, where the italics denote annual growth rates.
Output grows at 5% per year, labor grows at 4% per year, and capital grows at 6%
per year. How much of the growth in output is explained by technology?
14. Suppose that you have the following information for the U.S. economy:
Item Amount
Consumption Expenditure $67 million
Depreciation $10 million
Exports $22 million
Government Expenditure $31 million
Imports $25 million
Investment $35 million
Transfer Payments $8 million
(a) What is the value of GDP?
(b) Is there a trade surplus of deficit? By how much?
ANSWERS TO PRACTICE QUIZ
True/False
1. True. Extensive growth occurs when productive inputs increase. By retiring later
or leaving school earlier, people increase the nation’s labor force and so labor, a
productive resource, increases.
2. True. This sort of productivity-enhancing policy can raise intensive growth.
3. False. The definition of intensive growth is growth caused by more output per
input, not growth caused by possessing more inputs.
4. True. Even if the number of goods and services produced in an economy declines
(so that real GDP falls), it is possible for the inflation rate to be high enough so
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that nominal GDP, which includes both the effects of higher prices and lower
output, rises.
Multiple Choice Questions
5. (e) The trough is the moment when the economy is at the bottom of the business
cycle, passing from the recession phase into the recovery phase.
6. (c) The final use breakdown of GDP depends on who or what purchases the goods
and services. Transfer payments are given to people, but nothing—that is, no good
or service—is received in exchange. Thus, transfer payments are not part of the
government expenditure on goods and services. (Transfer payments can be spent
by the recipients to help finance some of the consumption part of GDP.)
7. (a) This is virtually the definition of intensive growth: Growth that occurs when
more output can be produced from the same amount of inputs.
8. (e) Real GDP measures the number of goods and services produced by an
economy.
9. (d) When the economy is at the natural rate of unemployment, employment is not
changing and so there is no wage pressure either upwards or downwards. Because
employment does not change, the economy is producing at the natural level of real
GDP. And, because there is no wage pressure, the inflation rate is constant.
10. (d) The production function says output depends on labor, capital, and technology.
Essay Questions
11. Real GDP measures the number of goods and services produced by an economy.
Nominal GDP is the market value of these goods and services. Nominal GDP
depends on the quantities produced as well as on their prices. Real GDP depends
on only the quantities.
12. The four final use categories of GDP depend on the sector that purchases the
good.
(a) Consumption: Goods purchased by the household sector.
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(b) Government purchases of goods and services: Goods purchased by the
government sector.
(c) Investment: Goods purchased by firms to add to their capital stock.
(d) Net exports of goods and services: Goods purchased by foreign residents
less the purchase of foreign goods by domestic residents.
13. Plugging the information into the growth formula:
5% = 0.75 X 4% + .25 X* 6% + T
5% – 3% – 1.5% = T
T = 0.5%
14. (a) GDP = C + I + G + X – M = 67 + 35 + 31 +
22 – 25 = $130 million
(b) There is a trade deficit since imports are larger than exports. The deficit is $3
million.
Principles of Economics – Chapters 15-20 BUS499(2011A)
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CHAPTER 16: MEASURING THE COST OF
LIVING
CHAPTER SYNOPSIS
Chapter 16 introduces students to two vital statistics that economists use to monitor
the macroeconomy—GDP and the consumer price index (CPI).
The purpose of Chapter 16 is twofold: first, to show students how to generate a price
index and, second, to teach them how to employ a price index to compare dollar
figures from different points in time and to adjust interest rates for inflation. In
addition, students will learn some of the shortcomings of using the consumer price
index as a measure of the cost of living.
CHAPTER OBJECTIVES
� how the consumer price index (CPI) is constructed.
� why the CPI is an imperfect measure of the cost of living.
� how to compare the CPI and the GDP deflator as measures of the overall price
level.
� how to use a price index to compare dollar figures from different times.
� the distinction between real and nominal interest rates.
REVIEW AND DISCUSSION
1. A 10% increase in the price of chicken has a greater effect on the consumer price
index than a 10% increase in the price of caviar because chicken is a bigger part of
the average consumer's market basket.
2. The three problems in the consumer price index as a measure of the cost of living
are: (1) substitution bias, which arises because people substitute toward goods that
have become relatively less expensive; (2) the introduction of new goods, which
are not reflected quickly in the CPI; and (3) unmeasured quality change.
3. If the price of a Navy submarine rises, there is no effect on the consumer price
index, because Navy submarines are not consumer goods. But the GDP price
index is affected, because Navy submarines are included in GDP as a part of
government purchases.
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4. Because the overall price level doubled, but the price of the candy bar rose
six-fold, the real price (the price adjusted for inflation) of the candy bar tripled.
5. The nominal interest rate is the rate of interest paid on a loan in dollar terms. The
real interest rate is the rate of interest corrected for inflation. The real interest rate
is the nominal interest rate minus the rate of inflation.
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CHAPTER 17: PRODUCTION AND GROWTH
CHAPTER SYNOPSIS
Chapter 17 is the first chapter in a four-chapter sequence on the production of output
in the long run. Chapter 17 addresses the determinants of the level and growth rate of
output. We find that capital and labor are among the primary determinants of output.
In Chapter 18, we address how saving and investment in capital goods affect the
production of output, and in Chapter 19, we learn about some of the tools people and
firms use when choosing capital projects in which to invest. In Chapter 20, we address
the market for labor.
The purpose of Chapter 17 is to examine the long-run determinants of both the level
and the growth rate of real GDP per person. Along the way, we will discover the
factors that determine the productivity of workers and address what governments
might do to improve the productivity of their citizens.
CHAPTER OBJECTIVES
� how much economic growth differs around the world.
� why productivity is the key determinant of a country’s standard of living.
� the factors that determine a country’s productivity.
� how a country’s policies influence its productivity growth.
REVIEW AND DISCUSSION
I. The level of a nation’s GDP measures both the total income earned in the
economy and the total expenditure on the economy’s output of goods and
services. The level of real GDP is a good gauge of economic prosperity, and
the growth of real GDP is a good gauge of economic progress. You would
rather live in a nation with a high level of GDP, even though it had a low
growth rate, than in a nation with a low level of GDP and a high growth rate,
because the level of GDP is a measure of prosperity.
A) A Price Index shows the current year’s cost of buying a particular basket of
goods as a percentage of the cost of the same basket of goods bought in some
year earlier. Two common indices are:
1. The Consumer Price Index (CPI) measures the change in consumer
prices; the price of a market basket of goods purchased by an average
urban household.
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2. The GDP Deflator measures the change in prices of all goods and services
produced in the economy.
B) Since WWII, there has been a continuing increase in prices (inflation) but at
different rates. This is different that prior to 1930 when prices were just as
likely to rise as they were to fall.
C) There are three general effects of inflation:
1. When inflation is unanticipated it redistributes income.
2. Inflation can reduce economic efficiency since agents search for ways to
beat inflation.
3. Rapid inflation diverts resources from productive to non productive
investments and reduces an economy’s productive capacity.
II. Productivity
A) The four determinants of productivity are: (1) physical capital, which is the
stock of equipment and structures that are used to produce goods and services;
(2) human capital, which consists of the knowledge and skills that workers
acquire through education, training, and experience; (3) natural resources,
which are inputs into production that are provided by nature; and (4)
technological knowledge, which is society’s understanding of the best ways to
produce goods and services.
B) A college degree is a form of human capital. The skills learned in earning a
college degree increase a worker's productivity.
C) Higher saving means fewer resources are devoted to consumption and more to
producing capital goods. The rise in the capital stock leads to rising
productivity and more rapid growth in GDP for a while. In the long run, the
higher saving rate leads to a higher standard of living. A policymaker might be
deterred from trying to raise the rate of saving because doing so requires that
people reduce their consumption today and it can take a long time to get to a
higher standard of living.
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PRACTICE QUIZ
Students are encouraged to complete the following practice quiz prior to reviewing
the provided answers.
Essay Questions
Write a short essay or otherwise answer each question.
1. If a worker is offered a wage of $12/hour, and if the average price of goods is
$4/good, how many goods can be purchased for an hour’s work? Suppose the
worker has underestimated the inflation rate so that the worker believes the
average price is $3/good. How many goods does the worker believe an hour’s
work will buy? Is the worker more likely to accept the job if he or she believes the
prices of goods are $3/good or $4/good?
2. Suppose people’s inflationary expectations are formed adaptively. What would be
the immediate effect on inflationary expectations if the government announced
that it was going to lower the growth rate of the money supply?
3. If people’s inflationary expectations are formed rationally, what would be the
immediate effect on inflationary expectations if the government announced that it
was going to lower the growth rate of the money supply? Does your answer
depend on whether the public believes the government’s announcement?
4. Explain using the evidence at the end of this chapter why some experts think we
have entered a new era of low inflation and low unemployment in the 1990s?
5. Suppose the market basket used to calculate a price index contains five CD’s,
twenty hamburgers and twenty beers. The table below list the price of these goods
in 2003 and 2004.
Good 2003 Prices 2004 Prices
CD’s $16.00 $15.00
Hamburger $2.00 $2.50
Beer $3.00 $3.25
(a) What is the 2004 price index?
(b) What is the inflation rate from 2003 to 2004?
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6. Since the late 1980’s what one factor was contributed to periods of high inflation?
What type of inflation is this? Explain.
7. Suppose that from 2003 to 2004 the money supply increased by 6% and real GDP
increased by 4%. If velocity was constant over the year, what was the inflation
rate according to the equation of exchange? If velocity actually fell by 2%, what
would the inflation rate have been?
8. Suppose a person forms their expectations of inflation adaptively. In the simplest
case assume that they expect the inflation rate today to be the same as it was
yesterday. The following table shows the actual inflation rates over 7 years.
Year Actual Inflation Rate Expected Inflation Rate Forecast
Error
1 0% — —
2 2%
3 3%
4 5%
5 4%
6 2%
7 1%
(a) Complete the table. The forecast error is the difference between what you
expected and what actually occurred. Pay careful attention to the sign of
your error (positive or negative).
(b) Do you notice a pattern with the relationship between the sign of you
forecast error and whether inflation is rising or falling? What does this say
about adaptive expectations?
ANSWERS TO PRACTICE QUIZ
1. An hour’s work actually purchases 3 goods. The worker expects that an hour’s
work buys 4 goods. Clearly the worker is more likely to accept the job if he or she
thinks an hour’s work is worth 4 goods. This example shows how unexpected
inflation can cause workers to more readily accept jobs. If the worker were aware
of how much the actual inflation rate had increased the price of goods, the worker
would be less inclined to accept the job offer.
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2. Adaptive expectations depend on only past experiences. Thus, there would be no
immediate effect on people’s expectations.
3. Rational expectations depend on all available information. So, if people believe
the government’s announcement, they would promptly lower their inflationary
expectations. If they did not believe the government, they would not alter their
inflationary expectations.
4. The new era of low inflation and low unemployment of the 1990s has supposedly
been caused by increased foreign competition, low energy prices, and the
deflationary effects of the crisis in Asia.
5. (a) The cost of the market basket in 2003 is $180 (5 X $16 20 X $2 20 X $3). The cost of the market basket in 2004 is $190 (5 X $15 20
X $2.50 20 X $3.25). The 2004 price index is 105.56.
(b) 5.56%.
6. Since the late 1980’s increases in energy prices have given rise to periods of high
inflation three times: the Iran-Iraq War in the late 1980’s, the first Gulf War in
1991, and the second Gulf War. Each time the price of crude oil increased
significantly. When the price of crude oil increases, production costs increase as
well, which causes the aggregate supply curve to shift to the left. Therefore, oil
price shocks lead to supply-side inflation.
7. The equation of exchanges (in growth rates) is:
%∆M + %∆ V = %∆ P + %∆ Y.
If velocity is constant the %∆V = 0, and %∆ P = 6% – 4% = 2%. If velocity fell by 2%, then %∆P = 6% – 2% – 4% = 0%.
Therefore, there was no inflation.
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8. (a)
Year Actual Inflation Rate Expected Inflation Rate Forecast
Error
1 0% — —
2 2% 0 –2
3 3% 2 –1
4 5% 3 –2
5 4% 5 1
6 2% 4 2
7 1% 2 1
(b) When the inflation rate is increasing (from year 1 to year 4) the forecast error
is negative. When the inflation rate is falling (from year 5 to year 7) the
forecast error is positive. There is a consistent pattern to the errors you make.
More formally, you make systematic errors. This is one of the things that is
troubling about adaptive expectations. If you know you are making a mistake
and you know how you are making the mistake, shouldn’t you correct for it?
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CHAPTER 18: SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM
APTER SYNOPSIS
Chapter 18 is the second chapter in a four-chapter sequence on the production of
output in the long run. In Chapter 17, we found that capital and labor are among the
primary determinants of output. For this reason, Chapter 18 addresses the market for
saving and investment in capital, and Chapter 19 addresses the tools people and firms
use when choosing capital projects in which to invest. Chapter 20 will address the
market for labor.
The purpose of Chapter 18 is to show how saving and investment are coordinated by
the loanable funds market. Within the framework of the loanable funds market, we are
able to see the effects of taxes and government deficits on saving, investment, the
accumulation of capital, and ultimately, the growth rate of output.
CHAPTER OBJECTIVES
� some of the important financial institutions in the U.S. economy.
� how the financial system is related to key macroeconomic variables.
� the model of the supply and demand for loanable funds in financial markets.
� how to use the loanable-funds model to analyze various government policies.
� how government budget deficits affect the U.S. economy.
REVIEW AND DISCUSSION
I. Consumption and Savings
A) Household Savings (or personal savings) is what we have left over from our
income after buying goods and services and paying our income taxes.
B) We can save only by reducing consumption. When we save, we add to our
assets by increasing funds in savings accounts, by purchasing bonds, stocks,
etc.
C) How much of our income we consume depends on the income we earn after
taxes and the interest rate.
D) The Consumption Function shows how much a household wishes to
consume at each level of income and interest rate: C =f (Y, r).
Consumption increases with income and decreases with the interest rate.
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E) The Saving Function shows how much a household wishes to save at each
level of income and interest rate: S = F (Y, r). Saving increases with
income and increases with the interest rate.
II. The financial system
A) The financial system's role is to help match one person's saving with another
person's investment. Two markets that are part of the financial system are
the bond market, through which large corporations, the federal government,
or state and local governments borrow, and the stock market, through which
corporations sell ownership shares. Two financial intermediaries are banks,
which take in deposits and use the deposits to make loans, and mutual funds,
which sell shares to the public and use the proceeds to buy a portfolio of
financial assets.
B) It is important for people who own stocks and bonds to diversify their
holdings because then they will have only a small stake in each asset, which
reduces risk. Mutual funds make such diversification easy by allowing a
small investor to purchase parts of hundreds of different stocks and bonds.
C) National saving is the amount of a nation's income that is not spent on
consumption or government purchases. Private saving is the amount of
income that households have left after paying their taxes and paying for their
consumption. Public saving is the amount of tax revenue that the
government has left after paying for its spending. The three variables are
related because national saving equals private saving plus public saving.
D) Investment refers to the purchase of new capital, such as equipment or
buildings. It is equal to national saving.
E) A change in the tax code that might increase private saving is the expansion
of eligibility for special accounts that allow people to shelter some of their
saving from taxation. This would increase the supply of loanable funds,
lower interest rates, and increase investment.
F) A government budget deficit arises when the government spends more than
it receives in tax revenue. Because a government budget deficit reduces
national saving, it raises interest rates, reduces private investment, and thus
reduces economic growth.
G) For an example, when the Russian government defaulted on its debt,
investors perceived a higher chance of default (than they had before) on
similar bonds sold by other developing countries. Thus, the supply of
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loanable funds shifted to the left, as shown in Figure 1. The result was an
increase in the interest rate.
Figure 1
PRACTICE QUIZ
Students are encouraged to complete the following practice quiz prior to reviewing
the provided answers
True/False
If the statement is correct, write true in the space provided; if it is wrong, write false.
Below the question give a short statement that supports your answer.
_____ 1. The consumption function is the same as the saving function since both are
determined by a household income and interest rate.
_____ 2. Given a constant rate of interest, both consumption and saving increase as
the income increases.
_____ 3. Given an unchanging level of income, consumption falls and saving rises as
the rate of interest increases.
_____ 4. The life-cycle theory of consumption states that people base their
consumption and saving decisions on their current level of income.
Principles of Economics – Chapters 15-20 BUS499(2011A)
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Multiple Choice Questions
5. Which of the following is correct? Savings can be made by
(a) government.
(b) households.
(c) businesses.
(d) (b) and (c).
(e) all of the above.
6. People are able to smooth out fluctuations in their consumption because they can
(a) borrow over entire lifetimes.
(b) save over entire lifetimes.
(c) borrow when they expect their income to rise and save when they expect their
income to decline.
(d) borrow and/or save depending on the real rate of interest.
(e) borrow and/or save depending on the nominal rate of interest.
ANSWERS TO REVIEW QUESTIONS
True/False
1. False. Although both functions have similar form, their meanings are different: the
consumption function shows how much a household wishes to consume at each
level of income and interest rate, and the saving function deals with that portion of
income that is left over after consumption.
2. True. If the interest rate holds constant, a household will normally spend and save
more as its income increases.
3. True. The interest rate is the reward for saving. When our income does not change,
we usually choose to save more and spend less as the interest rate increases.
4. False. The life-cycle theory of consumption predicts that people tend to smooth
out fluctuations in consumption over time by anticipating future changes in their
incomes. Young people borrow, expecting future rises in their incomes, while
mature people consume less and save more, expecting their income to shrink as
they become old.
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Multiple Choice Questions
5. (e) Not all saving in the economy is the personal saving. Businesses save by
retaining profits that are not distributed to owners as dividends and by setting
aside funds to replace capital that is depreciating. Also the government saves by
spending less than it collects in taxes.
6. (c) According to the life-cycle theory of consumption, in order to avoid swings in
consumption, people borrow when they are young, expecting that their incomes
will eventually rise; and people save as they become mature, expecting that their
incomes will fall when they are old.
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CHAPTER 19: THE BASIC TOOLS OF FINANCE
CHAPTER SYNOPSIS
Chapter 19 is the third chapter in a four-chapter sequence on the level and growth of
output in the long run. In Chapter 17, we discuss how capital and labor are among the
primary determinants of output and growth. In Chapter 18, we addressed how saving
and investment in capital goods affect the production of output. In Chapter 20, we will
show some of the tools people and firms use when choosing capital projects in which
to invest. Because both capital and labor are among the primary determinants of
output, Chapter 20 will address the market for labor.
The purpose of Chapter 19 is to introduce the students to some tools that people use
when they participate in financial markets. We will show how people compare
different sums of money at different points in time, how they manage risk, and how
these concepts combine to help determine the value of a financial asset, such as a
share of stock.
CHAPTER OBJECTIVES
� the relationship between present value and future value.
� the effects of compound growth.
� how risk-averse people reduce the risk they face.
� how asset prices are determined.
REVIEW AND DISCUSSION
I. Interest Rates and Savings
A) Consumption today is preferable over consumption tomorrow: by consuming
our income today, we get instant satisfaction.
B) The Interest Rate constitutes the reward for postponing consumption into
the future.
C) Interest rates determine saving decisions: an increase in the rate of interest,
holding other factors constant, encourages us to save more (to postpone more
consumption).
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II. Interest Rates and Investment
A) The term Investment refers to business investment in new plants, equipment,
and inventories.
B) The key determinants of investment are
1. the expectations of the future profits.
2. the costs of borrowing.
C) Businesses compare the rate of return of an investment to the cost of
acquiring additional capital.
Firms carry out additional investments as long as their rate of return exceeds
the market rate of interest. The last investment project should yield a rate of
return equal to the market interest rate.
D) The firm’s Investment Demand Curve shows the amount of investment
desired at different interest rates, and the investment demand curve is
negatively sloped: the amount of desired investment increases as the interest
rate falls. The investment demand curve of the economy shows the amount of
investment desired at different interest rates by the economy as a whole.
III. The Structure of the Interest Rates
A) There are many types of borrowers in credit markets: businesses who wish to
launch new projects, households who wish to finance home purchase or new
cars, governments whose budgets are in deficit. The interest rate is not the
same for all borrowers, and different interest rates are paid on different
financial assets.
B) Interest rates vary with the conditions of Risk, Liquidity, and Maturity
associated with a loan.
1. Lenders must be compensated for the extra risk of lending to borrowers
with poor credit ratings. The greater the risk associated with the loan, the
higher the interest rate. The risk premium is the additional interest paid
by high risk borrowers.
2. Financial assets are called liquid if they can be turned into cash quickly
or with a small penalty. Interest rates vary inversely with liquidity.
3. Interest rates vary with the term of maturity, that is, the length of the
borrowing period.
Principles of Economics – Chapters 15-20 BUS499(2011A)
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PRACTICE QUIZ
Students are encouraged to complete the following practice quiz prior to reviewing
the provided answers
True/False
If the statement is correct, write true in the space provided; if it is wrong, write false.
Below the question give a short statement that supports your answer.
_____ 1. The nominal rate of interest is crucial in making saving decisions since it
adjusts for inflation.
_____ 2. The real interest rate equals the nominal rate of interest when there is no
inflation.
_____ 3. The greater the real interest rate, the more people are encouraged to save.
_____ 4. Demand for investment by the entire economy increases as the business
expectations become more optimistic.
Multiple Choice Questions
Circle the letter corresponding to the correct answer.
5. Suppose a $20 million investment project promises to add $1 million to profits
each year for an almost infinite period. What is the rate of return on this
investment project?
(a) 5 percent
(b) 10 percent
(c) 19 percent
(d) 20 percent
(e) 21 percent
6. The market interest rate is the rate of interest that equates
(a) the real rate of interest with the rate of return on an investment project.
(b) the quantity of investment with the quantity of saving.
(c) the amount of savings with consumption expenditures.
(d) the real rate of interest with the nominal interest rate.
Principles of Economics – Chapters 15-20 BUS499(2011A)
Page 24
(e) present and future consumption.
7. In the situation when lenders cannot find enough borrowers, the interest rate
(a) increases.
(b) drops.
(c) remains the same until the businesses find profitable projects, and then
increases.
(d) remains the same until the businesses find profitable projects, and then
drops.
(e) all of the above is possible.
8. The real interest rate formula includes
(a) the nominal rate of interest and the actual rate of inflation.
(b) the nominal rate of interest and the anticipated rate of inflation.
(c) the market interest rate and the expected demand for investment.
(d) the nominal rate of interest and market prices.
(e) all of the above.
9. Under which of the following conditions will the interest rate on a loan tend to be
the highest?
(a) High risk, high liquidity, short term of maturity
(b) High risk, low liquidity, long term of maturity
(c) Low risk, high liquidity, long term of maturity
(d) Low risk, low liquidity, long term of maturity
(e) Both a and d
ANSWERS TO REVIEW QUESTIONS
True/False
1. False. It is the real interest rate that anticipates inflation and affects saving
decisions.
2. True. The real interest rate is defined as the nominal rate of interest minus
anticipated inflation.
Principles of Economics – Chapters 15-20 BUS499(2011A)
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3. True. Changes in the real interest rate affect the terms on which we can exchange
current and future consumption. Thus, a higher interest rate translates into cheaper
future consumption.
4. False. Demand for investment by the entire economy increases as the interest rate
declines.
Multiple Choice Questions
5. (a) The rate of return on a $20 million investment project is 5 percent—the annual
addition to profit divided by the cost of the project.
6. (b) The credit market is in equilibrium at an interest rate that equates the desired
amount of investment with the desired amount of saving.
7. (b) If the amount of desired investment exceeds the amount of desired saving, and
lenders cannot find enough borrowers, the interest rate drops until the credit
market reaches an equilibrium.
8. (b) The real interest rate is the nominal rate minus anticipated inflation. This
formula does not claim that we correctly anticipate inflation. Actual inflation can
be different from expected. After the fact, however, we can look back and observe
the actual interest rate earned by savers by deducting the actual inflation rate from
the nominal rate.
9. (b) Interest rates vary with the conditions of risk, liquidity, and maturity
associated with a loan. Higher risk, lower liquidity, and longer term of maturity
make the loans less profitable for the lenders. To compensate, lenders will charge
higher interest rates on loans if one or more of these conditions are met.
Principles of Economics – Chapters 15-20 BUS499(2011A)
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CHAPTER 20: UNEMPLOYMENT AND ITS NATURAL RATE
CHAPTER SYNOPSIS
Chapter 20 is the fourth chapter in a four-chapter sequence on the level and growth of
output in the long run. In Chapter 17, we learned that capital and labor are among the
primary determinants of output and growth. In Chapter 18, we addressed how saving
and investment in capital goods affect the production of output. In Chapter 19, we
learned about some of the tools people and firms use when choosing capital projects
in which to invest. In Chapter 20, we see how full utilization of our labor resources
improves the level of production and our standard of living.
The purpose of Chapter 20 is to introduce students to the labor market. We will see
how economists measure the performance of the labor market using unemployment
statistics. We will also address a number of sources of unemployment and some
policies that the government might use to lower certain types of unemployment.
CHAPTER OBJECTIVES
� the data used to measure the amount of unemployment.
� how unemployment can result from minimum-wage laws.
� how unemployment can arise from bargaining between firms and unions.
� how unemployment results when firms choose to pay efficiency wages.
REVIEW AND DISCUSSION
1 The unemployment rate is the percentage of those who would like to work but do
not have jobs. The Bureau of Labor Statistics calculates this statistic monthly
based on a survey of thousands of households.
2 The unemployment rate is an imperfect measure of joblessness. Some people who
call themselves unemployed may actually not want to work, and some people who
would like to work have left the labor force after an unsuccessful search and
therefore are not counted as employed.
3 In the U.S. economy, most people who become unemployed find work within a
short period of time. Nonetheless, most unemployment observed at any given time
is attributable to the few people who are unemployed for long periods of time.
Principles of Economics – Chapters 15-20 BUS499(2011A)
Page 27
4 One reason for unemployment is the time it takes for workers to search for jobs
that best suit their tastes and skills. This frictional unemployment is increased as a
result of unemployment insurance, a government policy designed to protect
workers’ incomes.
5 A second reason why our economy always has some unemployment is
minimum-wage laws. By raising the wage of unskilled and inexperienced workers
above the equilibrium level, minimum-wage laws raise the quantity of labor
supplied and reduce the quantity demanded. The resulting surplus of labor
represents unemployment.
6 A third reason for unemployment is the market power of unions. When unions
push the wages in unionized industries above the equilibrium level, they create a
surplus of labor.
7 A fourth reason for unemployment is suggested by the theory of efficiency wages.
According to this theory, firms find it profitable to pay wages above the
equilibrium level. High wages can improve worker health, lower worker turnover,
raise worker quality, and increase worker effort.
8 The Bureau of Labor Statistics (BLS) categorizes each adult (16 years of age and
older) as either employed, unemployed, or not in the labor force. The labor force
consists of the sum of the employed and the unemployed. The unemployment rate
is the percentage of the labor force that is unemployed. The labor-force
participation rate is the percentage of the total adult population that is in the labor
force.
9 Unemployment is typically short term. Most people who become unemployed are
able to find new jobs fairly quickly. But some unemployment is attributable to the
relatively few workers who are jobless for long periods of time.
10 Frictional unemployment is inevitable because the economy is always changing.
Some firms are shrinking while others are expanding. Some regions are
experiencing faster growth than other regions. Transitions of workers between
firms and between regions are accompanied by temporary unemployment.
The government could help to reduce the amount of frictional unemployment
through public policies that provide information about job vacancies in order to
match workers and jobs more quickly, and through public training programs that
Principles of Economics – Chapters 15-20 BUS499(2011A)
Page 28
help ease the transition of workers from declining to expanding industries and
help disadvantaged groups escape poverty.
11 Minimum-wage laws are a better explanation for unemployment among teenagers
than among college graduates. Teenagers have fewer job-related skills than
college graduates do, so their wages are low enough to be affected by the
minimum wage. College graduates' wages generally exceed the minimum wage.
12 Unions may affect the natural rate of unemployment via the effect on insiders and
outsiders. Because unions raise the wage above the equilibrium level, the quantity
of labor demanded declines while the quantity supplied of labor rises, so there is
unemployment. Insiders are those who keep their jobs. Outsiders, workers who
become unemployed, have two choices: either get a job in a firm that is not
unionized, or remain unemployed and wait for a job to open up in the union sector.
As a result, the natural rate of unemployment is higher than it would be without
unions.
13 Advocates of unions claim that unions are good for the economy because they are
an antidote to the market power of the firms that hire workers and they are
important for helping firms respond efficiently to workers' concerns.
14 Four reasons why a firm's profits might increase when it raises wages are: (1)
better paid workers are healthier and more productive; (2) worker turnover is
reduced; (3) the firm can attract higher quality workers; and (4) worker effort is
increased.
PRACTICE QUIZ
Students are encouraged to complete the following practice quiz prior to reviewing
the provided answers.
True/False
If the statement is correct, write true in the space provided; if it is wrong, write false.
Below the question give a short statement that supports your answer.
_____ 1. Labor is a unique factor of production because its price is not determined by
the supply and demand for it.
Principles of Economics – Chapters 15-20 BUS499(2011A)
Page 29
_____ 2. The supply curve for a factor of production typically shows that the higher
the factor’s price, the greater the quantity that will be supplied.
_____ 3. Firms purchase factor inputs because the inputs directly yield satisfaction.
_____ 4. Human capital refers to people who lend funds to firms for their investment
in capital equipment.
_____ 5. Noncompeting groups are groups of jobs that are very different.
_____ 6. The two goals of unions, higher pay and greater employment, are not in
conflict with each other.
_____ 7. The notion of compensating wage differentials shows that, everything else
equal, the wages paid for less desirable jobs will be higher than those paid for more
desirable jobs.
Multiple Choice Questions
Circle the letter corresponding to the correct answer.
8. All of the following increase the wage paid to carpenters except
(a) an increase in the demand for new houses.
(b) a new belief among workers that carpentry is a less desirable job.
(c) a fall in the price and marginal revenue of new houses.
(d) the introduction of new saws that increase the marginal productivity of
carpenters.
(e) an increase in the demand for carpenters.
9. If the supply curve for a factor shifts to the right, the price of the factor will
_________ while the quantity employed will _________.
(a) rise; rise
(b) rise; fall
(c) not change; not change
(d) fall; rise
(e) fall; fall
Principles of Economics – Chapters 15-20 BUS499(2011A)
Page 30
10. The labor market is different from other factor markets for all of the following
reasons except that
(a) slavery is against the law.
(b) people care about the jobs at which they work.
(c) workers can engage in alternative activities such as household production.
(d) unions may be formed.
(e) the number of people willing to work does not depend on their wage.
11. Other things equal, wages in less desirable jobs are _________ wages in more
desirable jobs.
(a) more than
(b) equal to
(c) less than
(d) sometimes more than and sometimes less than
(e) not comparable to
ANSWERS TO PRACTICE QUIZ
True/False
1. False. As with any factor, the price of labor (its wage) is determined by the supply
and demand for it.
2. True. The higher the factor’s price, the larger is the opportunity cost of failing to
supply the factor.
3. False. Firms purchase factors because they can sell the output produced by the
factors. This means
(a) the demand for factors is derived from the demand for the products
produced.
4. False. Human capital refers to the productivity-boosting investments people make
in themselves.
5. False. Noncompeting groups are groups of workers whose talents are so different
they do not compete with each other for jobs.
Principles of Economics – Chapters 15-20 BUS499(2011A)
Page 31
6. False. If the union gains higher pay, firms reduce their employment of the
unionized workers.
7. True. Essentially, in order to attract workers to less desirable jobs, these jobs must
pay higher wages to compensate for their unpleasantness.
Multiple Choice Questions
8. (c) The fall in the price of new houses lowers the additional revenue gained by
hiring an extra carpenter (the marginal revenue product of the carpenter), so the
demand for carpenters falls.
9. (d) This is precisely the same result we get in product markets when the supply of
a commodity shifts to the right.
10. (e) The number of people willing to work generally, but not always, increases as
the wage they can receive rises.
11. (a) The difference is a compensating wage differential.
UNIT EXAM
For assessment purposes this course is divided into various units for which you will
be required to take unit exams. Please carefully read all chapters in the given unit and
try to understand their contents.
It is important to note here that the unit exams are open book exams and you may use
your textbooks and other supporting material for your reference and assistance. Please
note that you must strive to score highest grades at unit exams and as such you must
only attempt your unit exams after you are confident that you can answer most of the
questions correctly. Please also note that there is no time constraint and you may open
each unit exam in multiple times. However this does not mean that you unnecessarily
delay the course completion rather that the completion of your course should always
remain higher on your academic agenda.
YOU MAY NOW START UNIT EXAM 3!
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