Blanchard Solucionario

128
ANSWERS TO END-OF-CHAPTER PROBLEMS

CHAPTER 1
Quick Check
1. a. b. c. d. True. True. False. False/uncertain. The rate of growth was higher during the decade beginning in 1996 than
during the previous two decades, but it is probably unrealistic to expect productivity to continue to grow at such a fast pace. e. False. There are problems with the statistics, but the consensus is that growth in hina has been high. f. False. The !uropean "unemployment miracle# refers to the relatively low !uropean unemployment rate in the 196$s and the early 19%$s. g. True. h. True. &. a. )uestions restructured its labor mar(et institutions to resemble more closely *.,. institutions and now has a lower unemployment rate than before the restructuring. -n the other hand, .enmar( and the /etherlands have relatively low unemployment rates while maintaining relatively generous social insurance programs for wor(ers. 0n addition, some economists argue that tight monetary policy has at least something to do with the high unemployment rates in !urope. b. country will be forced to give up its own monetary policy. 1lthough the !uro will remove obstacles to free trade between !uropean countries, each 'ore flexible labor mar(et institutions may lead to lower unemployment, but there are about how precisely to restructure these institutions. The *nited +ingdom has
Dig Deeper
2. a. The hinese government has encouraged foreign firms to produce in hina. ,ince foreign firms are typically more productive than hinese firms, the presence of foreign firms has lead to an increase in hinese productivity. The hinese government has also encouraged 3oint ventures between foreign and hinese firms. These 3oint ventures allow hinese firms to learn from more productive foreign firms. b. The recent increase in *.,. productivity growth has been a result of the development and widespread use of information technologies.
c. The *nited ,tates is a technological leader. 'uch of *.,. productivity growth is related to the development of new technologies. hina is involved in technological catch4up. 'uch of hinese productivity growth is related to adopting existing technologies developed abroad.
opyright 5 &$$9 6earson !ducation, 0nc. 6ublishing as 6rentice 7all.
126 d. 0t9s not clear to what extent hina provides a model for other developing countries. 7igh investment seems a good strategy for countries with little capital, and encouraging foreign firms to produce :and participate in 3oint ventures; at home seems a good strategy for countries trying to improve productivity. -n the other hand, the degree to which hina9s centrali<ed political control has been important in managing the pace of the transition and in protecting property rights of foreign firms remains open to )uestion. =. a. 1$ years> :1.$1?;1$@1.198 or 19.8 A higher &$ years> =&.9A higher 8$ years> 1==A higher 1$ years> 21.? A higher &$ years> %2.% A higher 8$ years> &9%.?A higher Ta(e output per wor(er as a measure of the standard of living. 1$ years> 1.198/1.21?@1.1$2, so the standard of living would be 1$.2A higherB &$ years> &1.6 A higher 8$ years> 62A higher
b.
c.
d. /o. Cabor productivity growth fluctuates a lot from year to year. The last few years may represent good luc(. 0t is too soon to tell whether there has been a change in the trend observed since 19%$. 8. a. 12.&:1.$2=;t@&.?:1.$??;t t @ ln:12.&/&.?;/Dln:1.$??/1.$2=;E t F 2$.8 yrs This answer can be confirmed with a spreadsheet, for students unfamiliar with the use of logarithms. b. hinese output per person :the hinese standard of living; will still be less than *.,. output per person. /o. 1t current growth rates, hinese output will exceed *.,. output within 21 years, but
Expl re Fur!her
6. since a/c. 1s of February &$$?, there had been 8 recessions :according to the traditional definition; 196$. ,easonally4ad3usted annual percentage growth rates of G.6 :in chained &$$$ dollars; are given below. 1969>= 19%$>1 19%=>2 19%=>= 19%8>1 41.9 4$.% 42.? 41.6 4=.% 19?1>= 19?&>1 199$>= 1991>1 4=.9 46.= 42.$ 4&.$
12% 19?$>& 19?$>2 4$.% Hith respect to the note on &$$1, the growth rates for &$$1 are given below. &$$1>1 4$.8A &$$1>& 1.&A &$$1>2 41.=A &$$1>= 1.6A A point increase in the unemployment rate for the 8 recessions 19694%$ $.% 19?14?& 1.1 19%=4%8 2.1 199$491 $.9 19?$ $.6 The unemployment rate increased by 1.8 percentage points between Ianuary &$$1 and Ianuary &$$&. 4%.?
%.
a4b.
CHAPTER "
Quick Check
1. a. b. c. d. e. f. g. &. a. b. c. d. e. 2. a. b. c. True. True/*ncertain. Jeal G.6 increased by a factor of &8B nominal G.6 increased by a factor of &1. Jeal G.6 per person increased by a factor of =. False. True. False. The level of the 60 means nothing. The rate of change of the 60 is one measure of inflation. *ncertain. Hhich index is better depends on what we are trying to measureKinflation faced by consumers or by the economy as a whole. False. The underground economy is large, but by far the ma3ority of the measured unemployed in ,pain are not employed in the underground economy. /o change. This transaction is a purchase of intermediate goods. LM1$$> personal consumption expenditures LM&$$ million> gross private domestic fixed investment LM&$$ million> net exports /o change. The 3et was already counted when it was produced, i.e., presumably when .elta :or some other airline; bought it new as an investment. The value of final goods @M1,$$$,$$$, the value of the silver nec(laces. 1st ,tage> M2$$,$$$. &nd ,tage> M1,$$$,$$4M2$$,$$$@M%$$,$$$. G.6> M2$$,$$$LM%$$,$$$@M1,$$$,$$$. Hages> M&$$,$$$ L M&8$,$$$@M=8$,$$$. 6rofit> :M2$$,$$$4M&$$,$$$;L:M1,$$$,$$$4M&8$,$$$42$$,$$$;
12? @M1$$,$$$LM=8$,$$$@M88$,$$$. G.6> M=8$,$$$LM88$,$$$@M1,$$$,$$$. =. a. &$$6 G.6> 1$:M&,$$$;L=:M1,$$$;L1$$$:M1;@M&8,$$$ &$$% G.6> 1&:M2,$$$;L6:M8$$;L1$$$:M1;@M=$,$$$ /ominal G.6 has increased by 6$A.
b.
&$$6 real :&$$6; G.6> M&8,$$$ &$$% real :&$$6; G.6> 1&:M&,$$$;L6:M1,$$$;L1$$$:M1;@M21,$$$ Jeal :&$$6; G.6 has increased by &=A. &$$6 real :&$$%; G.6> 1$:M2,$$$;L=:M8$$;L1,$$$:M1;@M22,$$$ &$$% real :&$$%; G.6> M=$,$$$. Jeal :&$$%; G.6 has increased by &1.&A. The answers measure real G.6 growth in different units. /either answer is incorrect, 3ust as measurement in inches is not more or less correct than measurement in centimeters. &$$6 base year> .eflator:&$$6;@1B .eflator:&$$%;@M=$,$$$/M21,$$$@1.&9 0nflation@&9A &$$% base year> .eflator:&$$6;@M&8,$$$/M22,$$$@$.%6B .eflator:&$$%;@1 0nflation@:14$.%6;/$.%6@.2&@2&A 1nalogous to =d. &$$6 real G.6 @ 1$:M&,8$$; L =:M%8$; L 1$$$:M1; @ M&9,$$$ &$$% real G.6 @ 1&:M&,8$$; L 6:M%8$; L 1$$$:M1; @ M28,8$$ :28,8$$4&9,$$$;/&9,$$$ @ .&&= @ &&.=A .eflator in &$$6@M&8,$$$/M&9,$$$@.?6 .eflator in &$$%@M=$,$$$/M28,8$$@1.12 0nflation @ :1.12 4.?6;/.?6 @ .21 @ 21A. Nes, see appendix for further discussion. a. The )uality of a routine chec(up improves over time. hec(ups now may include !+Gs, for example. 'edical services are particularly affected by this problem since there are continual improvements in medical technology.
c.
d.
8.
a.
b.
c. 6. a. b. c.
d.
Dig Deeper
%.
b.
The new method represents a 1$A )uality increase.
129 c. There is a 8A true price increase. The other 1$A represents a )uality increase. The )uality4ad3usted price of chec(ups using the new method is only 8A higher than chec(ups using the old method last year. Nou need to (now the relative value of pregnancy chec(ups with and without ultra4 sounds in the year the new method is introduced. ,till, since everyone chooses the new method, we can say that the )uality4ad3usted price of chec(ups has risen by less than 18A. ,ome of the observed 18A increase represents an increase in )uality. a. 'easured G.6 increases by M1$LM1&@M&&. :,trictly, this involves mixing the final goods and income approaches to G.6. 1ssume here that the M1& per hour of wor( creates a final good worth M1&.; b. /o. The true value of your decision to wor( should be less than M&&. 0f you choose to wor(, the economy produces the value of your wor( plus a ta(eout meal. 0f you choose not to wor(, presumably the economy produces a home4coo(ed meal. The extra output arising from your choice to wor( is the value of your wor( plus any difference in value between ta(eout and home4coo(ed meals. 0n fact, however, the value of home4coo(ed meals is not counted in G.6. :-f course, there are other details. For example, the value of groceries used to produce home4coo(ed meals would be counted in G.6. 6utting such details aside, however, the basic point is clear.; Ouarters &$$$>000, &$$1>0, and &$$1>000 had negative growth. The unemployment rate increased after &$$$, pea(ed in &$$2, and then began to fall. The participation rate fell steadily over the periodKfrom 6%.1A in &$$$ to 66A in &$$=. 6resumably, wor(ers unable to find 3obs became discouraged and left the labor force. !mployment growth slowed after &$$$. !mployment actually fell in &$$1. The employment4to4population ratio fell between &$$$ and &$$=. 0t several years after the recession for the labor mar(et to recover.
d.
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Expl re Fur!her
9. a. b.
c. d.
CHAPTER #
Quick Check
1. a. b. c. d. e. f. g. a. b. True. False. Government spending excluding transfers was 19A of G.6. False. The propensity to consume must be less than one for our model to ma(e sense. True. False. False. The increase in output is one times the multiplier. False. Y@16$L$.6:Y41$$;L18$L18$ Y@1$$$ YD@Y4T@1$$$41$$@9$$
&.
1=$ c. 2. b. C@16$L$.6:9$$;@%$$ a. !)uilibrium output is 1$$$. Total demand@ CLILG@%$$L18$L18$@1$$$. Total demand e)uals production. He used this e)uilibrium condition to solve for output. -utput falls by :=$ times the multiplier; @ =$/:14.6;@1$$. ,o, e)uilibrium output is now 9$$. Total demand@CLILG@16$L$.6:?$$;L18$L11$@9$$. 1gain, total demand e)uals production. 6rivate saving@Y4C4T@9$$416$4$.6:?$$;41$$@16$. 6ublic saving @T4G@41$. /ational saving :or in short, saving; e)uals private plus public saving, or 18$. /ational saving e)uals investment. This statement is mathematically e)uivalent to the e)uilibrium condition, total demand e)uals production. 0n other words, there is an alternative :and e)uivalent; e)uilibrium condition> national saving e)uals investment.
c.
Dig Deeper
=. a. b. c. d. e. Y increases by 1/:14c1; Y decreases by c1/:14c1; The answers differ because spending affects demand directly, but taxes affect demand indirectly through consumption, and the propensity to consume is less than one. The change in Y e)uals 1/:14c1; 4 c1/:14 c1;@1. Palanced budget changes in G and T are not macroeconomically neutral. The propensity to consume has no effect because the balanced budget tax increase aborts the multiplier process. Y and T both increase by one unit, so disposable income, and hence consumption, do not change. Y@c$Lc1YDLILG implies Y@D1/:14c1Lc1t1;EDc$4c1t$LILGE The multiplier@1/:14c1Lc1t1;Q1/:14c1;, so the economy responds less to changes in autonomous spending when t1 is positive. 1fter a positive change in autonomous spending, the increase in total taxes :because of the increase in income; tends to lessen the increase in output. 1fter a negative change in autonomous spending, the fall in total taxes tends to lessen the decrease in output. Pecause of the automatic effect of taxes on the economy, the economy responds less to changes in autonomous spending than in the case where taxes are independent of income. ,ince output tends to vary less :to be more stable;, fiscal policy is called an automatic stabili<er. Y@D1/:14c1Lc1t1;EDc$4c1t$LILGE T @ t$ L t1D1/:14c1Lc1t1;EDc$4c1t$LILGE Poth Y and T decrease.
8.
a. b.
c.
6.
a. b. c.
1=1 d. %. a. b. c. d. 0f G is cut, Y decreases even more. 1 balanced budget re)uirement amplifies the effect of the decline in c$. Therefore, such a re)uirement is destabili<ing. 0n the diagram representing goods mar(et e)uilibrium, the ZZ line shifts up. -utput increases. There is no effect on the diagram or on output. The ZZ line shifts up and output increases. !ffectively, the income transfer increases the propensity to consume for the economy as a whole. The propensity to consume is li(ely to be higher for low4income taxpayers. Therefore, tax cuts will be more effective at stimulating output if they are directed toward low4 income taxpayers. Y@CLILG Y@D1/:14c14b1;ERDc$4c1TLb$LGE 0ncluding the b1N term in the investment e)uation increases the multiplier. 0ncreases in autonomous spending now create a multiplier effect through two channels> consumption and investment. For the multiplier to be positive, the condition c 1Lb1Q1 is re)uired. -utput increases by b$ times the multiplier. 0nvestment increases by the change in b $ plus b1 times the change in output. The change in business confidence leads to an increase in output, which induces an additional increase in investment. ,ince investment increases, and saving e)uals investment, saving must also increase. The increase in output leads to an increase in saving. -utput will fall. ,ince output falls, investment will also fall. 6ublic saving will not change. 6rivate saving will fall, since investment falls, and investment e)uals saving. ,ince output and consumer confidence fall, consumption will also fall. -utput, investment, and private saving would have risen. learly this logic is faulty. Hhen output is low, what is needed is an attempt by consumers to spend more. This will lead to an increase in output, and thereforeKsomewhat paradoxicallyKto an increase in private saving. /ote, however, that with a linear consumption function, the private saving rate :private saving divided by output; will fall when c$ rises.
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a. b.
c.
Expl re Fur!her
9. a. b.
c. d.
1$.
1nswers will vary depending on when students visit the website.
CHAPTER $
Quick Check
1. a. b. False. False.
1=& c. d. e. f. g. h. &. a. b. c. d. e. 2. a. b. c. =. a. b. False. 'oney demand describes the portfolio decision to hold wealth in the form of money rather than in the form of bonds. The interest rate on bonds is relevant to this decision. True. False. False. True. True. i@$.$8> money demand @ M1?,$$$ i@$.1$> money demand @ M18,$$$ 'oney demand decreases when the interest rate increases because bonds, which pay interest, become more attractive. The demand for money falls by 8$A. The demand for money falls by 8$A. 1 1A increase :decrease; in income leads to a 1A increase :decrease; in money demand. This effect is independent of the interest rate. i@1$$/MPB S1B i@22AB 1?AB 8A when MPB @M%8B M?8B M98. Hhen the bond price rises, the interest rate falls. MPB @1$$/:1.$?; F M92 M&$@MD@M1$$:.&84i; i@8A M@M1$$:.&84.18; M@M1$ BD @ 8$,$$$ 4 6$,$$$ :.284i; 0f the interest rate increases by 1$ percentage points, bond demand increases by M6,$$$. 1n increase in wealth increases bond demand, but has no effect on money demand, which depends on income :a proxy for transactions demand;. 1n increase in income increases money demand, but decreases bond demand, since we implicitly hold wealth constant. First of all, the use of "money# in this statement is collo)uial. "0ncome# should be substituted for "money.# ,econd, when people earn more income, their wealth does not change right away. Thus, they increase their demand for money and decrease their demand for bonds.
Dig Deeper
8. a. b. c. d.
1=2 6. !ssentially, the reduction in the price of the bond ma(es it more attractive. 1 bond promises fixed nominal payments. The opportunity to receive these fixed payments at a lower price ma(es a bond more attractive. a. M16 is withdrawn on each trip to the ban(. 'oney holdings are M16 on day oneB M1& on day twoB M? on day threeB and M= on day four. 1verage money holdings are :M16LM1&LM?LM=;/=@M1$. M? is withdrawn on each trip to the ban(. 'oney holdings are M?, M=, M?, and M=. d. e. f. g. ?. a. b. c. 1verage money holdings are M6. M16 is withdrawn on each trip to the ban(. 'oney holdings are M$, M$, M$, and M16. 1verage money holdings are M=. Pased on these answers, 1T's and credit cards have reduced money demand. 1ll money is in chec(ing accounts, so demand for central ban( money e)uals demand for reserves. Therefore, demand for central ban( money@$.1:MN;:.?4= i;. M1$$P @ $.1:M8,$$$P;:.?4=i; i@18A ,ince the public holds no currency, money multiplier @ 1/reserve ratio @ 1/.1@1$. M@:1$;M1$$P@M1,$$$P M@ Md at the interest derived in part :b;. 0f H increases to M2$$P the interest rate falls to 8A. The interest rate falls to 8A, since when 7 e)uals M2$$P, M@:1$;M2$$P@M2,$$$P.
%.
b. c.
d. e. 9.
The money multiplier is 1/DcL:14c;E, where c is the ratio of currency to deposits and is the ratio of reserves to deposits. Hhen c increases, as in the Great .epression, the money multiplier falls. 1nswers will vary depending on when students visit the F-' website.
Expl re Fur!her
1$.
CHAPTER %
Quick Check
1. a. b. c. True. True. False.
1== d. e. f. g. &. a. b. False. The balanced budget multiplier is positive :it e)uals one;, so the 0, curve shifts right. False. *ncertain. 1n increase in government spending leads to an increase in output :which tends to increase investment;, but also to an increase in the interest rate :which tends to reduce investment;. True. Y@D1/:14c1;EDc$4c1TLILGE The multiplier is 1/:14c1;. Y@D1/:14c14b1;EDc$4c1TLb$4b&iLGE The multiplier is 1/:14c14b1;. ,ince the multiplier is larger than the multiplier in part :a;, the effect of a change in autonomous spending is bigger than in part :a;. 1n increase in autonomous spending now leads to an increase in investment as well as consumption. ,ubstituting for the interest rate in the answer to part :b;, Y@D1/:14c14b1Lb&d1/d&;EDc$4c1TLb$L:b&/d&;:M/P;LGE. The multiplier is 1/:14c14b1Lb&d1/d&;. The multiplier is greater :less; than the multiplier in part :a; if : b14b&d1/d&; is greater :less; than <ero. The multiplier as measured in part :c; measures the marginal effect of an increase in autonomous spending on equilibrium output. 1s such, the multiplier is the sum of two effects> a direct effect of output on demand and an indirect effect of output on demand via the interest rate. The direct effect is e)uivalent to the hori<ontal shift of the IS curve. The indirect effect depends on the slope of the LM curve :since the e)uilibrium moves along the LM curve in response to a shift of the IS curve; and the effect of the interest rate on investment demand. The direct effect is captured by the sum c1Lb1, which measures the marginal effect of an increase in output on the sum of consumption and investment demand. 1s this sum increases, the multiplier gets larger. The indirect effect is captured by the expression b&d1/d& and tends to reduce the si<e of the multiplier. The ratio d1/d& is the slope of the LM curve, and the parameter b& measures the marginal effect of an increase in the interest rate on investment. /ote that the slope of the C' curve becomes larger as money demand becomes more sensitive to income :i.e., as d1 increases; and becomes smaller as money demand becomes more sensitive to the interest rate :i.e., as d& increases;. 2. a. The IS curve shifts left. -utput and the interest rate fall. The effect on investment is ambiguous because the output and interest rate effects wor( in opposite directions> the fall in output tends to reduce investment, but the fall in the interest rate tends to increase it. b. c From the answer to &:c;, Y@D1/:14c14b1Lb&d1/d&;EDc$4c1TLb$L:b&/d&;:M/P;LGE. From the LM relation, i@Y:d1/d&;S:M/P;/d&. To obtain the e)uilibrium interest rate, substitute for e)uilibrium Y from part :b;.
c.
d.
1=8 d. e. I@ b$Lb1Y4b&i@b$L:b14b&d1/d&;YL:b&/d&;:'/6; To obtain e)uilibrium investment, substitute for e)uilibrium Y from part :b;. From part :b;, holding M/P constant, e)uilibrium Y decreases by D1/:14c14b1Lb&d1/d&;E when G decreases by one unit. From part :d;, holding M/P constant, I decreases by :b14 b&d1/d&;/:14c14b1Lb&d1/d&; when G decreases by one unit. ,o, if G decreases by one unit, investment will increase when b1Qb&d1/d&. 1 fall in G leads to a fall in output :which tends to reduce investment; and to a fall in the interest rate :which tends to increase investment;. Therefore, for investment to increase, the output effect :b1; must be smaller than the interest rate effect :b&d1/d&;. /ote that the interest rate is the product of two factors> :i; d1/d&, the slope of the LM curve, which gives the effect of a one4unit change in e)uilibrium output on the interest rate, and :ii; b&, which gives the effect of a one4unit change in the e)uilibrium interest rate on investment. Y@CLILG@&$$L.&8:Y4&$$;L18$L.&8Y41$$$iL&8$ Y@11$$4&$$$i M/P@16$$@&Y4?$$$i i@Y/=$$$41/8 ,ubstituting from part :b; into part :a; gives Y@1$$$. ,ubstituting from part :c; into part :b; gives i@8A. C@=$$B I@28$B G@&8$B CLILG@1$$$ Y@1$=$B i@2AB C@=1$B I@2?$. 1 monetary expansion reduces the interest rate and increases output. onsumption increases because output increases. 0nvestment increases because output increases and the interest rate decreases. Y@1&$$B i@1$AB C@=8$B I@28$. 1 fiscal expansion increases output and the interest rate. onsumption increases because output increases. 0nvestment is affected in two ways> the increase in output tends to increase investment, and the increase in the interest rate tends to reduce investment. 0n this example, these two effects exactly offset one another, and investment does not change.
f.
=.
a. b. c. d. e. f.
g.
Dig Deeper
8. Firms deciding how to use their own funds will compare the return on bonds to the return on investment. Hhen the interest rate on bonds increases, bonds become more attractive, and firms are more li(ely to use their funds to purchase bonds, rather than to finance investment pro3ects. a. 0f the interest rate were negative, people would hold only money, and not bonds. 'oney would be a better store of value than bonds. b. c. ,ee hint. ,ee hint.
6.
1=6 d. e. %. a. b. c. The increase the money supply has little effect on the interest rate. 0f the interest rate is actually <ero, than the increase in the money supply literally has no effect. /o. 0f there is no effect on the interest rate, which affects investment, monetary policy cannot affect output. The reduction in T shifts the IS curve to the right. The increase in M shifts the LM curve down. -utput increases. The linton4Greenspan policy mix was :loosely; contractionary fiscal policy : IS left; and expansionary monetary policy :LM down;. 0n &$$1, there was a recession, which was triggered by a fall in investment spending following the decline in the stoc( mar(et. The events of ,eptember 11, which came after the recession had begun, had only a limited effect. 0n fact, the economy had positive growth in the fourth )uarter of &$$1. The expansionary monetary and fiscal policies tended to wea(en the recession, but the policies came too late to avoid a recession. 0ncrease G :or reduce T;, which shifts the IS curve to the right, and increase M, which shifts the LM curve down. Jeduce G :or increase T;, which shifts the IS curve to the left, and increase M, which shifts the LM curve down. The interest rate falls. 0nvestment increases, since the interest rate falls while output remains constant. The IS curve shifts left. -utput and the interest rate fall. onsumption falls. The change in investment is ambiguous> the fall in output tends to reduce investment, but the fall in the interest rate tends to increase investment. The change in private saving e)uals the change in investment. ,o, private saving could rise or fall in response to a fall in consumer confidence. The fall in G and the increase in T shift the IS curve to the left. The increase in M shifts the C' curve down. The interest rate falls, and investment increases. Jeceipts rose, outlays fell, and the budget deficit fell. c. -n ,eptember =, 199&, the F-' reduced the federal funds rate by &8 basis points. ,ubse)uent changes in federal funds rate over the period 19924&$$$ are given below. hanges in the Federal Funds Jate ,eptember =, 199& 2 February =, 199= 2.&8 'arch &&, 199= 2.8 1pril 1?, 199= 2.%8 'ay 1%, 199= =.&8 1ugust 16, 199= =.%8 /ovember 18, 199= 8.8 February 1, 1998 6 'arch &8, 199% ,eptember &9, 199? -ctober 18, 199? /ovember 1%, 199? Iune 2$, 1999 1ugust &=, 1999 /ovember 16, 1999 February &, &$$$ 8.8 8.&8 8 =.%8 8 8.&8 8.8 8.%8
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a. b.
9.
a. b.
Expl re Fur!her
1$. a. b.
1=% Iuly 6, 1998 .ecember 19, 1998 Ianuary 21, 1996 8.%8 8.8 8.&8 'arch &1, &$$$ 'ay 16, &$$$ 6 6.8
d. 0nvestment was 1&.1A of G.6 in 199& and increased every year over the period to reach 1%.%A of G.6 in &$$$. e. -ver the period 19924&$$$, the average annual growth rate of G.6 per person was &.=9A. -ver the period first four years of the period, the average annual growth rate was 1.9?AB over the second four years, the average annual growth rate was 2A. Growth was negative in &$$$>000, &$$1>0, and &$$1>000. 0nvestment had a bigger percentage change, and unli(e consumption, growth in investment was negative for every )uarter in &$$$ and &$$1, except &$$$>00. -verall investment was generally more variable than nonresidential fixed investment in &$$$ and &$$1. 'oreover, nonresidential fixed investment had positive growth during &$$$, but negative growth in &$$1. 0nvestment had a substantially larger decline in its contribution to growth in &$$$ and &$$1. The proximate cause of the recession of &$$1 was a fall in investment demand. 0nvestment fell in the last two )uarters of &$$1, but began growing again in the first )uarter of &$$1. onsumption growth was slow for the first three )uarters of &$$1, but grew rapidly in the fourth )uarter. 1s mentioned in the text, the Fed reduced the federal funds rate several times during the fourth )uarter of &$$1. 'oreover, automobile manufacturers offered large discounts. These actions may have helped to generate strong consumer spending. 0n any event, it is clear that the events of ,eptember 11 did not cause the recession of &$$1. The recession had started well before these events.
11.
a. b.
c. d.
CHAPTER &
Quick Check
1. a. b. c. d. e. f. g. h. &. a. b. c. d. False. The participation rate has increased over time. False. False. True. False. *ncertain/False. The degree of bargaining power depends on the nature of the 3ob and the employee9s s(ills. True. False. :'onthly hires L monthly separations;/monthly employment @:=.=L=.6;/1&&@%A 1.=/6.&@&2A :1.=L1.=;/6.&@=8A. .uration is 1/.2% or &.& months. :2L&.?L1.=L1.=;/8%.2@18A.
1=? e. 2. a. b. c. new wor(ers> $.=/:2L1.=;@9A. H/6@1/:1L;@1/1.$8@.98& Hage setting> u@14H/6@=.?A H/6@1/1.1@.91B u@14.91@9A. The increase in the mar(up lowers the real wage. 1lgebraically, from the wage4setting e)uation, the unemployment rate must rise for the real wage to fall. ,o the natural rate increases. 0ntuitively, an increase in the mar(up implies more mar(et power for firms, and therefore less production, since firms will use their mar(et power to increase the price of goods by reducing supply. Cess production implies less demand for labor, so the natural rate rises. 1nswers will vary. 'ost li(ely, the difference between your actual wage and your reservation wage will be higher for the 3ob you will have ten years later. The later 3ob is more li(ely to re)uire training, which means you will be costly to replace, and will probably be a much harder 3ob to monitor, which means you may need an incentive to wor( hard. !fficiency wage theory suggests that your employer will be willing to pay a lot more than your reservation wage for the later 3ob, to ma(e the 3ob valuable to you, so you will stay at it and wor( hard. a. The computer networ( administrator has more bargaining power. ,he is much harder to replace. b. The rate of unemployment is the most important indicator of labor mar(et conditions. Hhen the rate of unemployment increases, it becomes easier for firms to find replacements, and wor(er bargaining power falls. 0n our model, the real wage is always given by the price4setting relation> W/P@1/:1L;. ,ince the price4setting relation depends on the actual price level and not the expected one, this relation holds in the short run and the medium run of our model Hhen the unemployment rate is very low, it is very difficult for firms to find wor(ers to hire and very easy for wor(ers to find 3obs. 1s a result, the bargaining power of wor(ers is very high when the unemployment rate is very low. Therefore, the wage gets very high as the unemployment rate gets very low. 6resumably, the real wage would grow without bound as the unemployment rate approached <ero. ,ince a wor(er could always find a 3ob, there would be nothing to constrain aggressive wage bargaining. 1t any positive rate of unemployment, however, there is some constraint on wor(er bargaining power. a. !at0n 6opulation Cabor Force !mployment 1$$ %8 8$ !at out 6opulation Cabor Force !mployment 1$$ 1$$ %8
Dig Deeper
=. a. b4c. d.
8.
c.
6.
a.
b.
%.
1=9 *nemployment *nemployment Jate 6articipation Jate b. &8 22A %8A *nemployment *nemployment Jate 6articipation Jate &8 &8A 1$$A
The measured labor force and participation rate rise. 'easured employment rises. 'easured unemployment does not change, but the measured unemployment rate falls. 'easured G.6 will rises.
c. To ad3ust the labor mar(et statistics, you would have to estimate the number of wor(ers informally employed at home and add them to the measured employed. To the extent that wor(ers employed informally at home were measured as unemployed, you would have to reduce measured unemployment accordingly. To the extent that wor(ers employed informally at home were considered out of the labor force, counting these wor(ers as employed would increase the si<e of the labor force. To ad3ust the G.6 statistics, you would have to estimate the value4added of final goods produced at home. Nou could ma(e comparisons to similar goods produced outside the home, or ma(e comparisons to wor(ers involved in similar industries outside the home, estimate the relevant wage and hours wor(ed, and calculate value4added as the cost of labor, as is done for government services. 0n either case, you need to calculate value4 added, since intermediate goodsKgroceries, cleaning supplies, child care supplies, and so onKinvolved in the production of at4home goods are already counted in G.6 as final goods in the formal sector.
Expl re Fur!her
?. a. b. c. d. 88AB :$.88;&@ 2$AB :$.88;6 @ &A 88A second month> :$.88;&@2$AB sixth month> :$.88;6 @ &A 1verage proportion &% wee(s or more over 199$41999@ 16.1A 1996> 1%A &$$$> 11A 199%> 16A &$$1> 1&A 199?> 1=A &$$&> 1?A 1999> 1&A &$$2> &&A The long4term unemployed exit unemployment less fre)uently than the average unemployed wor(er. 9. a4b. c. 1nswers will depend on when the page is accessed. The decline in unemployment does not e)ual the increase in employment, because the labor force is not constant.
CHAPTER '
Quick Check
1. a. True.
18$ b. c. d. e. f. g. True. 0n the AS relation, if P@Pe, Y@Yn. /ote that Pe must be (nown to graph the AS curve. False. The 1. curve slopes down because an increase in P leads to a fall in M/P, so the nominal interest rate increases, and I and Y fall. False. There are changes in autonomous expenditure and supply shoc(s, both of which cause output to deviate from the natural level in the short run. True. False. Fiscal policy affects the interest rate in the medium run and therefore affects investment. False. The natural level of output changes in response to a permanent supply shoc( :other than a change in Pe;. The price level changes in the medium run in response to either a demand or a supply shoc(. IS shifts right, and LM shifts up. AD shifts right, and AS shifts up. Y returns to its unchanged natural level. The interest rate and the price level increase. SR> short run MR> medium run H, up same as ,J WS> wage4setting curve PS> price4setting curve 6, no change no change 1, up up further 1. no change no change 0, no change no change C' up up further
&.
a. b.
2.
a.
,J 'J
WS b. ,J 'J i
PS
AS
AD
LM
IS
N falls falls further 6
i rises rises further
6 rises rises further
=.
a. 'oney is neutral in the sense that the nominal money supply has no effect on output or the interest rate in the medium run. -utput returns to its natural level. The interest rate is determined by the position of the IS curve and the natural level of output. .espite the neutrality of money in the medium run, an increase in the money supply will increase output and reduce the interest rate in the short run. Therefore, expansionary monetary policy can be used to speed up the economyTs return to the natural level of output when output is low.
181 b. c. 0n the medium run, fiscal policy affects the interest rate and investment, so fiscal policy is not considered neutral. False. Cabor mar(et policies, such as the degree of unemployment insurance, can affect the natural level of output. SR> short run MR> medium run 0, left same as ,J C' down down further 1. left same as ,J 1, no change down
Dig Deeper
8. a.
,J 'J
WS
PS
AS
AD
LM
IS
b4c. ,J 'J N falls bac( to original Nn i falls falls further 6 falls falls further
,J 'J
falls bac( to original level
0 ambiguous rises :above original level;
6rivate , ambiguous rises :above original level;
18& The short4run change in investment is ambiguous, because the interest rate falls, which tends to increase investment, but output also falls, which tends to reduce investment. 0n the medium run, investment must rise :as compared to its short4run and original levels;, because the interest rate falls but output returns to its original level. ,ince the budget deficit does not change in this problem, the change in private saving e)uals the change in investment. 0t is possible that private saving will fall in the short run, but private saving must rise :above its short4run and original levels; in the medium run. 6. b. c. d. e. a. -pen answer. Firms may be so pessimistic about sales that they do not want to borrow at any interest rate. The IS curve is verticalB the interest rate does not affect e)uilibrium output. The LM curve is unaffected. The AD curve is verticalB the price level does not affect e)uilibrium output. The increase in z reduces the natural level of output and shifts the AS curve up. ,ince the AD curve is vertical, e)uilibrium output does not change, but the price level increases. /ote that output is above its natural level. ,ince YUYn, PUPe. Therefore, Pe rises and theAS curve shifts up. 0n fact, the AS curve shifts up forever, and the price level increases forever. -utput does not changeB it remains above its natural level forever. The LM has a flat segment at i@$ and then slopes up. The IS slopes down as before. There is no flat segment at i@$. 1rguably, the IS curve is undefined for nominal interest rates below <ero. 1s P falls, M/P rises, and the nominal interest rate falls. !ventually, when P falls far enough, the nominal interest reaches <ero. The AD curve slopes down until P reaches the level consistent with i@$. For levels of P below this threshold, the AD curve is vertical. There is no effect on output in the short run or the medium run. ,ince the money stoc( does not affect the interest rate, it does not affect output. The 1. curve shifts left in the short run. -utput and the price level fall in the short run. 0n the medium run, the expected price level falls, and 1, shifts right, returning the economy to the original natural level of output, but at a lower price level. The unemployment rate rises in the short run, but returns to its original level :the natural rate, which is unchanged; in the medium run. The Fed should increase the money supply, which shifts the AD curve right. 1 monetary expansion of the proper si<e exactly offsets the effect of the decline in business confidence on the AD curve. The net effect is that the AD curve does not move in the short run or medium run, and neither does the AS curve.
f.
%.
a. b. c.
d. ?. a.
b. c.
182 d. *nder the policy option in part :c;, output and the price level are higher in the short run. 0n the medium run, output is the same in parts :a; and :c;, but the price level is higher in part :c;. The unemployment rate is lower in the short run in part :c;. 0n the medium run, the unemployment rate is the same in parts :b; and :c;. a. The AS curve shifts up in the short run and shifts up further in the medium run. -utput falls in the short run and falls further in the medium run. The price level rises in the short run and rises further in the medium run. b. c. to the right. The AS curve would shift up over time. d. same in the medium run in parts :a; and :c;, but the price level is higher in part :c;. e. medium run in parts :a; and :c;. 1$. The Fed9s 3ob is not so easy. 0t has to distinguish changes in the actual rate of unemployment from changes in the natural rate of unemployment. The Fed can use monetary policy to (eep the unemployment rate near the natural rate, but it cannot affect the natural rate. 11. The a. The unemployment rate rises in the short run and rises further in the medium run. real wage falls immediately to its new medium4run level. b. The unemployment rate falls in the short run but returns to the original natural rate in the medium run. The real wage is unaffected. 7owever, after tax income rises. c. 0n our model, the real wage depends only upon the mar(up. 1 fall in the mar(up increases the real wage. 6olicy measures that improve product mar(et competitionKfor example, more vigorous anti4trust enforcementKcould increase the real wage. d. The fall in income taxes tended to increase the after4tax real wage. The increase in oil prices tended to reduce the after4tax real wage. 0ntuitively, the immediate effect of an oil price increase is to reduce the real wage by increasing gas prices. Thus, the increase in gas prices tends to absorb the extra after4tax income provided by the tax cut. The unemployment rate in the short run is lower in part :c;, but the same in the -utput and the price level are higher in the short run in part :c;. -utput is the The unemployment rate rises in the short run and rises further in the medium run. The Fed could increase the money supply in the short run and shift the AD curve
e. 9.
18=
Expl re Fur!her
1&. a. b.
P@:1L;:Pe; :!:u,z;; :P";14 P@:1L;:Pe; :!:u,z;; :P#;14 P@ Pe:1L;1/ !:u,z;x:14 ;/
c. d. when u rises.
The AS curve slopes up in Y4P space. 0f P@ Pe, then 1@:1L;1/ !:u,z;x:14 ;/ . 1n increase in # implies that ! must fall to maintain the e)uality. ! falls
,o, an increase in the relative price of energy resources leads to an increase in the natural rate of unemployment. e. The unemployment rate and the price level rise in the short run and rise further in the medium run. -utput falls in the short run and falls further in the medium run. f. 1n increase in the relative price of energy resources causes the AS curve to shift up in the short run. 0f Pe remains constant, the AS curve will not shift further after the initial, short4run shift. 0n order for Pe to remain constant, wage setters must be expecting the Fed to reduce the money supply, thereby shifting the AD curve left. This monetary policy moves output to its new, lower natural level right away, and maintains the original price level, so there will be no price ad3ustment in the transition to the new medium4run e)uilibrium. 12. a. 1989>0V S 1969>0V 8&.9A 1969>0V S 19%9>0V 19%9>0V S 19?9>0V 19?9>0V S 1999>0V 1999>0V S &$$%>0V 2?.&A 28.1A 2%.6A &$.%A The AS curve shifts up in the short run and shifts up further in the medium run.
b. growth.
The %$s, ?$s, and 9$s loo( remar(ably similar. The 6$s had by far the highest learly, the first decade of the &1st century will have the lowest growth.
/ote, although the problem did not as( for the growth rates of G.6 per person, the ran(ing of the decades would be similar. The growth rates of G.6 per person are given below.
1989>0V S 1969>0V 1969>0V S 19%9>0V 19%9>0V S 19?9>0V 19?9>0V S 1999>0V 1999>0V S &$$%>0V
2=.=A &=.$A &2.$A &1.?A 11.%A
188
CHAPTER (
Quick Check
1. a. b. c. d. e. f. True. False. False. True. False. True. a. /o. 0n the 19%$s, we experienced high inflation and high unemployment. The expectations4augmented 6hillips curve is a relationship between inflation and unemployment conditional on the natural rate and inflation expectations. Given inflation expectations, when the natural rate of unemployment increases :i.e., when there is an increase in z or ;, there is also an increase in both the actual unemployment rate and the inflation rate. 0n addition, increases in inflation expectations imply higher inflation for any level of unemployment. 0n the 19%$s, both the natural rate and expected inflation increased, so both unemployment and inflation were relatively high. /ote that increases in inflation expectations also tend to increase the unemployment rate in the short run from the supply sideKthin( of an increase in the expected price level, given last period9s price, in the 1.41, framewor(. 7owever, increases in inflation expectations may tend to increase short run output from the demand side, because of the real interest rate effect. The real interest rate is introduced in hapter 1=. b. /o. The expectations4augmented 6hillips curve implies that maintaining a rate of unemployment below the natural rate re)uires not merely high inflation but increasing inflation. This is because inflation expectations continue to ad3ust to actual inflation. un@$.1/& @8A Wt @$.14&:$.$2; @ =A every year beginning with year t. Wet@ $ and Wt@=A forever. 0nflation expectations will be forever wrong. This is unli(ely. might increase because inflation expectations adapt to persistently positive inflation. The increase in has no effect on un. W8@ W =L$.14&:$.$2;@=AL=A@?A For tU8, W t@ ?A L :t 4 8;:=A;. ,o, W 1$@&?AB W 18@=?A. 0nflation increases by four percentage points every year. 0nflation expectations will again be forever wrong. This is unli(ely. a. 1 higher cost of production means a higher mar(up of the price level over wages. 0n the simple model of the text, the mar(up reflects all nonwage components of the price of a good. un@:$.$?L$.1;/&
&.
2.
a. b. c. d. e.
f. =.
b.
186 The natural rate of unemployment increases from 8A to 6A as increases from &$A to =$A.
Dig Deeper
8. a. un@$1./&@.$8 W t @ W t41 4 &:ut 4 .$8; @ W t41 L &A@&A W t @ &AB W tL1 @ =AB W tL& @ 6AB W tL2 @ ?A. b. c. d. 6. b. %. a. W t @ $.8 W t L $.8 W t41 4 &:ut 4 .$8; or, W t @ W t41 4 =:ut 4 .$8; W t @ =AB W tL1 @ ?AB W tL& @ 1&AB W tL2 @ 16A 1s indexation increases, inflation becomes more sensitive to the difference between the unemployment rate and the natural rate. a. Nes. The average rate of unemployment was lower in the 199$s. 0ndeed, even though the unemployment rate was at a historical low, inflation rose very little. The natural rate of unemployment probably decreased. @1> uu@6AB @&> uu@2A 1s wages become more flexible, more of the effect of supply shoc(s :changes in and z; is transmitted to changes in wages and less to changes in the natural rate of unemployment. @1> uu@9AB @&> uu@=.8A 0n an environment with more wage flexibility :higher ;, the natural rate of unemployment rises less in response to an increase in the price of oil. 1s of &$$6, the e)uation that seems to fit well is Wt S Wt41 @ =.=A S$.%2ut, which implies a natural rate of approximately 6A.
b.
Expl re Fur!her
?. 9. a4d.
The relationships imply a lower natural rate in the more recent period.
CHAPTER )
Quick Check
1. a. b. c. d. False. The unemployment rate rises when output growth is less than the normal rate and rises when output growth is greater than the normal rate. True. True. False. The 6hillips curve relates the change in inflation to the difference between the unemployment rate and the natural rate. -(un9s law relates the change in the unemployment rate to the difference between output growth and the normal rate. The aggregate demand relation e)uates inflation to real money growth. 0t is true that the aggregate demand relation implies that inflation e)uals ad3usted money growth, which is
18% the difference between money growth and output, but this is only a relation between inflation and output growth c$nditi$n l on money growth. False. 0n the medium run, inflation e)uals ad3usted money growth, which is the difference between nominal money growth and output growth. True. *ncertain. 0n principle, the statement is true, but nominal rigidities may ma(e even fully credible policy costly. True. True. a. The unemployment rate will increase by 1A per year when g@$.8A. 1bsent output growth, productivity growth tends to increase the unemployment rate, since fewer wor(ers are re)uired to produce a given )uantity of goods. 1bsent output growth, labor force growth also tends to increase the unemployment rate, since more wor(ers are competing for the same number of 3obs. Therefore, unemployment will increase unless the growth rate exceeds the sum of productivity growth and labor force growth. b. c. 2. a. b. c. t41> t> tL1> tL&> tL2> =. For the unemployment rate to decrease by $.8A per year for the next four years, output must grow at =.&8A per year for each of the next four years. -(un9s law is li(ely to become ut4ut%&@4$.=R:'(t48A; un@ 8A 1ssume the economy has been at the natural rate of unemployment for two years :this year and last year;. Then, '(t @ 2AB 'mt @ '(t L )t @ 11A. ) ?A =A =A =A =A u 8A 9A 8A 8A 8A '(t 2A 4%A 12A 2A 2A 'mt 11A 42A 1%A %A %A
e. f. g. h. i. &.
a. ,ee text for full answer. Gradualism reduces the need for large policy swings, with effects that are difficult to predict, but immediate reduction may be more credible and encourage rapid, favorable changes in inflation expectations. /evertheless, the staggering of wage decisions suggests that a gradual disinflationKas long as it is credible Kis the option consistent with no change in the unemployment rate. b. c. The answer is not clear. Pased in PallTs evidence, a fast disinflation probably results in a lower sacrifice ratio, depending on the features listed in part :c;. Jelevant features include the degree of indexation, the nature of the wage4setting process, and the initial rate of inflation. 0nflation will start increasing. 0t should let unemployment increase to its new, higher, natural rate.
8.
a. b.
18?
Dig Deeper
6. a. b. c. d. sacrifice ratio@1 Wt @ 11AB WtL1 @ 1$AB WtL& @ 9AB WtL2 @ ?AB WtL= @ %AB . . . B WtL9 @ &A 1$ yearsB sacrifice ratio@ :1$ point years of excess unemployment;/:1$ percentage point reduction in inflation;@1 Wt @ ?.8AB WtL1 @ 8.9AB WtL& @ 2.9AB WtL2 @ &.=AB WtL= @ 1.2A Cess than 8 years are re)uired. sacrifice ratio@8/:1&41.2;@$.=% The sacrifice ratio is lower because people are somewhat forward4loo(ing and incorporate the target inflation rate into their expectations. The central ban( can let the unemployment rate return to the natural rate beginning at time tL1. The ex post sacrifice ratio from this scenario @ :1 point year of excess unemployment;/:1$ point reduction of inflation; @ $.1 Ta(e measures to enhance credibility. Wt4Wt41@ 4:ut4.$8; ut4 ut%&@ 4$.=:'mt4Wt4.$2; 1ssuming 'm*t41@12A, Wt41@ 1$A, ut41@8A, and beginning in year t, 'm@2A, the economy evolves as follows. t> tL1> tL&> tL2> tL=> tL8> tL6> tL%> tL?> tL9> tL1$> c. W %.1A 2.1A 4$.%A 42.&A 4=.1A 42.8A 4&.1A 4$.8A $.?A 1.8A 1.6A u %.9A 9.1A ?.?A %.8A 8.9A =.=A 2.6A 2.=A 2.%A =.2A =.9A
e.
f. %. a. b.
0nflation does not decline smoothly. 0n the early years, the large unemployment rates :relative to the natural rate; reduce inflation to negative values. 0n this example, money growth e)uals the normal growth rate of output, so negative inflation drives re l money growth :and hence output growth; b$+e the normal output growth rate, and unemployment falls. !ventually, when unemployment falls below the natural rate, inflation begins to increase again. These cycles continue, with decreasing amplitude. u@8A and W@$A in the medium run. Nes.
d. ?. a.
Expl re Fur!her
189 b. The unemployment rate increased from 8.%A in Ianuary &$$& to 6.2A in Iune &$$2.
c. 1lthough growth was positive, it well below the normal rate of 2A for most of the period. Therefore, growth was too low to prevent the unemployment rate from rising. d. e. f. !mployment fell. Nes. 6roductivity grew.
9. a. 1ctually, according to non4seasonally ad3usted data, the level of unemployment fell in five months of &$$1, although it rose over the entire year. /evertheless, in several months in which the level of unemployment rose :e.g., Iuly;, the level of employment also rose, which is the point of the problem. b. participation rate increases. The levels of employment and unemployment can both rise if the
CHAPTER 1*
Quick Check
1. a. b. c. d. e. f. g. True. True. False. False. True. False. True.
&.
The table should read as follows.

Tr,-.p r!,!i F Price + Quantity 400 1,000 Ser/ice. Price 20 pesos $2 Quantity 200 2,000
'exico *nited ,tates a. b. c.
5 pesos $1
*.,. consumption per person @ M1:1$$$; L M&:&,$$$;@M8$$$ 'exican consumption per person@8:=$$; pesos L &:&$$$; pesos @ 6$$$ pesos From the *.,. point of view, the exchange rate :!;@1$ pesos/M. 'exican consumption per person in dollars @ 6$$$ pesos/!@M6$$
16$ d. e. 'exican consumption per person :M666;@M1:=$$;LM&:&$$;@M?$$ 'exican standard of living relative to the *nited ,tates !xchange rate method> 6$$/8$$$ @$.1& 666 method> ?$$/8$$$@$.16 Y@62 Y doubles. Nes. Y/,@:-/,;1/& -/,@= implies Y/,@&. -/,@? implies Y/,@&.?2. -utput less than doubles. /o. /o. 0n part :f;, we are essentially loo(ing at what happens to output when we increase capital only, not capital and labor in e)ual proportion. There are decreasing returns to capital. Nes. Y/Y @ .8 :-/-; growth rate of output @ 1/& growth rate of capital =A per year -/Y increases. /o. ,ince capital is growing faster than output, the saving rate will have to increase to maintain the same pace. !ventually, the re)uired saving will exceed output. apital must grow faster than output because there are decreasing returns to capital in the production function.
2.
a. b. c. d. e. f. g.
h.
Dig Deeper
=. a. b. c. d.
8.
!ven though the *nited ,tates was ma(ing the most important technical advances, the other countries were growing faster because they were importing technologies previously developed in the *nited ,tates. 0n other words, they were reducing their technological gap with the *nited ,tates. The figures on G.6 per person are chained :M&$$$; 666 numbers. a. Version 6.& of the 6enn Horld Table through &$$2 yields the following average growth rates. 1981419%2 19%=4&$$2 19914&$$2
Expl re Fur!her
6.
161 *.,. Iapan b. &.19A =.%$A 1.9%A 1.9?A 1.9%A $.?$A
7ad the *nited ,tates and Iapan maintained the growth rates they achieved over the period 1981 to 19%2, Iapanese real output per person would have surpassed *.,. output per person by &$$2. 0nstead, in &$$2 *.,. real output per person :M2=,?%8; was substantially higher than Iapanese real output per person :M&=,$2%;.
%.
The figures on G.6 per person are chained :M&$$$; 666 numbers. a. There was substantial convergence for the France, Pelgium, and 0taly through 1991. ,ince then, the standard of living of these countries relative to the *.,. standard of living has fallen somewhat. b. 1rgentina, had, 'adagascar, and Vene<uela have not converged to the *nited ,tates. 0n fact, they have grown steadily poorer relative to the *nited ,tates.
?.
The figures on G.6 per person are chained :M&$$$; 666 numbers. a. 1$ Jichest ountries in 19%$ Oatar M66, %62 +uwait M6=,91= Prunei M2$,%=9 Permuda M&1,=9& ,wit<erland M&1,111 *nited ,tates M1%,2&1 Pahamas M16,911 Cuxembourg M16,?$6 .enmar( M16,8?= ,weden M18,%?8 b. 1$ Jichest ountries in &$$2 Cuxembourg M=9,&6& Oatar M26,18% Permuda M28,%2? *nited 1rab !mirates M28,68? *nited ,tates M2=,?%8 /orway M2=,$11 'acao M2$,=&$ ,wit<erland M&?,%9& 0reland M&?,&=? .enmar( M&%,9%$
c.
1$ Jichest ountries in 19%$> 6roportional 0ncrease in the ,tandard of Civing 19%$4&$$2 Cuxembourg &.92 *nited ,tates &.$1 .enmar( 1.69
16& Permuda ,weden ,wit<erland Pahamas Prunei Oatar +uwait d. 1.66 1.66 1.26 1.$9 $.?8 $.8= $.=$
The dataset includes 18& countries with observations for both 19%$ and &$$2. biggest proportional increase in standard of living> smallest proportional increase in standard of living> fraction with negative growth> hina 9.9= Ciberia $.1% 1?/18&@1?A
CHAPTER 11
Quick Check
1. b. c. a. True, if saving includes public and private saving. False. True. 0n the model without depreciation, there is no steady state. 1 constant saving rate produces a positive but declining rate of growth. 0n the infinite4time limit, the growth rate e)uals <ero. -utput per wor(er rises forever without bound. 0n the model with depreciation, if the economy begins with a level of capital per wor(er below the steady4 state level, a constant saving rate also produces a positive but declining rate of growth, with a limit of <ero. 0n this case, however, output per wor(er approaches a fixed number, defined by the steady4state condition of the ,olow model. /ote that depreciation is not needed to define a steady state if the model includes labor force growth or technological progress. *ncertain. ,ee the discussion of the golden4rule saving rate. *ncertain/False. 0t is li(ely the *.,. rate is below the golden rule rate and that transforming ,ocial ,ecurity to a pay4as4you4go system would ultimately increase the *.,. saving rate. These premises imply that such a transformation would increase *.,. consumption in the future, but not necessarily in the present. 0ndeed, if the only effect of such a transformation is to increase the saving rate, we (now that consumption per wor(er will fall in the short run. 'oreover, moving to a pay4as4you4go system re)uires transition costs. 0f these costs are borrowed, then the reduction in public saving will offset the increase in private saving during the transition. 0f these costs are not borrowed, then transitional generations must suffer either a reduction in promised benefits or an increase in taxes to finance their own retirement :at least to some degree; in addition to the retirement of a previous generation. Thus, whether the *.,. "should# move to a pay4 as4you4go system depends on the li(ely resolution of intergenerational distributional issues and your view about the e)uity of such a resolution. *ncertain. The *.,. capital stoc( is below the golden rule, but that does not necessarily imply that there should be tax brea(s for saving. !ven if the tax brea(s were effective in stimulating saving, the increase in future consumption would come at the cost of current consumption. False. !ven if you accept the premise :that educational investment increases output, as would be implied by the 'an(iw, Jomer, Heil paper;, it does not necessarily follow that countries should increase educational saving, since future increases in output will come at
d. e.
f.
h.
162 the expense of current consumption. -f course, there are other arguments for subsidi<ing education, particularly for low4income households. &. .isagree. 1n increase in the saving rate does not affect growth in the long run, but does increase growth in the short run. 0n addition, an increase in the saving rate leads to an increase in the long4 run level of output per wor(er. Finally, since the evidence suggests that the *.,. saving rate is below the golden4rule rate, an increase in the saving rate would increase steady4state consumption per wor(er. 1ssume that the economy begins in steady state. -ne decade after an increase in the saving rate, the growth rate of output per wor(er will be higher than it was in its initial steady state. Five decades after an increase in the saving rate, the growth rate of output per wor(er will be close to its value in the initial steady state :this value is <ero in the absence of technological progress;. The level of output per wor(er will be higher, however, than it was in the initial steady state. a. b. This would li(ely lead to a higher saving rate, so output per wor(er and output per person will be higher in the long run. Treat an increase in female participation as a one4time increase in employed labor. 0n this case, an increase in female participation would have no effect on the level of output per wor(er, but would lead to a higher level of output per person, since a greater fraction of the population is employed.
2.
Dig Deeper
=.
8.
1 transformation to a fully funded system leads to an increase in the saving rate. 0gnoring any short4run transition costs, in the long run an increase in the saving rate leads to a higher level of output per wor(er, but has no effect on the growth rate of output per wor(er. a. b. c4e. -/,@:./:&;;&B Y/,@s/:=; C/,@:14.;Y/,@.:14.;/:=; Y/, increases with .. C/, increases until .@$.8, then decreases. Nes. Nes. Nes. Y/, @ :-/,;1/2 0n steady state, .Y/// @ -/,, which, given the production function in part :d;, implies -/,@:./;2/& Y/, @:./;1/& Y/, @ &
6.
%.
a. b. c. d. e. f. g.
16= h. ?. a. b. c. d. t tL1 tL& tL2 9. b. c. Y/, @ &1/& ,ubstituting from problem % part :e; implies -/,@1. ,ubstituting from problem % part :f;, Y/,@1. -/,@$.28B Y/,@$.%1 -/, 1.$$ $.9$ $.?$ $.%1 Y/, 1.$$ $.9% $.92 $.?9
-/, @ :$.18/.$%8;& @ = Y/,@ :=;1/&@& -/,@:$.&/$.$%8;& @%.11 Y/,@:%.11;1/&@&.6% apital per wor(er and output per wor(er increase. For &$$6, the national saving rate was approximately 1=.1A. 0n steady state, -/, @ :$.1=1/$.$%8;& @2.86, and Y/,@:2.&8;1/& @1.?9. For &$$6, the budget deficit :including the off budget items; was 1.9A of G.6. !liminating the deficit increases the national saving rate to 16A :1=.1A L 1.9A;. 1s a result, in steady state, -/, @ :$.16/.$%8;&@=.88, and Y/,@:=.88;1/& @&.12. ,teady4state output per wor(er increases by 1&.%A.
Expl re Fur!her
1$. a. b.
CHAPTER 1"
Quick Check
1. a. b. c. d. e. f. g. h. True. True. False. 0n steady state, there is no growth of output per effective wor(er. True. False. The steady4state rate of growth of output per effective wor(er is <ero. 1 higher saving rate leads to higher steady4state level of capital per effective wor(er, but has no effect on the steady4state rate of growth of output per effective wor(er. True. False. False/*ncertain. !ven pessimists about technological progress typically argue that the rate of progress will decline, not that it will be <ero. ,trictly, however, the truth of this statement is uncertain, because we cannot predict the future. a. 'ost technological progress seems to come from JX. activities. ,ee discussion on fertility and appropriability in hapter 1&.&. b. This proposal would probably lead to lower growth in poorer countries, but higher
&.
168 growth in rich countries. c. d. e. This proposal would lead to an increase in JX. spending. 0f fertility did not fall, there would be an increase in the rates of technological progress and output growth. 6resumably, this proposal would lead to a :small; decrease in the fertility of applied research and therefore to a :small; decrease in growth. This proposal would reduce in the appropriability of drug research. 6resumably, there would be a reduction in the development of new drugs, a reduction in the rate of technological progress, and a reduction in the growth rate. The economic leaders typically achieve technological progress by generating new ideas through research and development. .eveloping countries can import technology from the economic leaders by copying this technology or by receiving a transfer of technology as a result of 3oint ventures with firms head)uartered in the economic leaders. !ven in the absence of technology transfer, foreign direct investment can increase technological progress in the host country by substituting more productive foreign production techni)ues for less efficient domestic ones. 6oor patent protection may facilitate a more rapid adoption of new technologies in developing countries. The costs of such a policy are relatively small, since developing countries generate relatively few new technologies. The growth rate of output per wor(er falls in the short run and continues to fall over time. 0n the long run, the growth rate approaches a new steady state with a permanently lower :but still positive; growth rate. -utput per wor(er continues to rise over time, 3ust at a slower rate. 1 permanent reduction in the saving rate has no affect on the steady4state growth rate of output per wor(er. The growth rate of output per wor(er falls :but remains positive; in the short run but in the long run it approaches its original steady4state rate. /ominal G.6 Near 1> 1$:1$$;L1$:&$$;@2$$$ Near &> 1&:1$$;L1&:&2$;@296$ Near & Jeal G.6 :Near 1 6rices;@1$:1$$;L1$:&2$;@22$$ growth rate of real G.6@22$$/2$$$ S 1 @ 1$A G.6 deflator Near 1@1B Near &@296$/22$$@1.& inflation@&$A Jeal G.6/Hor(er Near 1 @ 2$$$/1$$@2$B Near & @ 22$$/11$@2$
2.
a. b.
c.
Dig Deeper
=. a.
b.
8.
a.
b. c.
d.
166 Cabor productivity growth is <ero. e. f. Near & Jeal G.6 :Near 1 6rices;@1$:1$$;L12:&2$;@299$ output growth@299$/2$$$ S 1 @ 22A. G.6 deflator Near 1@1B Near &@296$/299$@$.99& inflation@$.99&/1 S 1 @ 4$.?A Jeal G.6/wor(er@26.2 in year &. Cabor productivity growth is 26.2/2$@&1A. This statement is true, assuming there is progress in the ban(ing services sector. i. ii. iii. iv. v. i. ii. iii. iv. v. -/:A,; @ :./:L'AL',;;& @ 1 Y/:A,;@ :-/A,;1/&@1 'Y/:A,; @ $ 'Y/, @ 'A@=A 'Y @ 'AL',@6A -/:A,; @ :./:L'AL',;;& @ $.6= Y/:A,;@ :-/A,;1/&@$.? 'Y/:A,; @ $ 'Y/, @ 'A@?A 'Y @ 'AL',@1$A
g. h. 6. a.
b.
1n increase in the rate of technological progress reduces the steady4state levels of capital and output per e//ecti+e wor(er, but increases the rate of growth of output per wor(er. c. i. ii. iii. iv. v. -/:A,; @ :./:L'AL',;;& @ $.6= Y/:A,;@ :-/A,;1/&@$.? 'Y/:A,; @ $ 'Y/, @ 'A@=A 'Y @ 'AL',@1$A
:+/:1/;; @ :=/8;&B :N/:1/;; @ :=/8;B gN/:1/; @ $B gN// @ =AB gN @ 1$A 6eople are better off in case a. Given any set of initial values, the level of technology is the same in cases :a; and :c;, but the level of capital per effective wor(er is higher at every point in time in case :a;. Thus, since Y/,@AY/:A,;@A:-/:A,;;1/&@A1/&:-/,;1/&, output per wor(er is always higher in case :a;. %. a. b. c. d. 6robably affects A. Thin( of climate. 1ffects H and possibly A, if better education improves the fertility of research. 1ffects A. ,trong protection tends to encourage more JX. but also to limit diffusion of technology. 'ay affect A through diffusion.
16% e. f. g. 'ay affect -, H, and A. Cower tax rates increase the after4tax return on investment, and thus tend to lead to more accumulation of - and H and to more JX. spending. 0f we interpret - as private capital, than infrastructure affects A :e.g., better transportation networ(s may ma(e the economy more productive by reducing congestion time;. 1ssuming no technological progress, a reduction in population growth implies an increase in the steady4state level of output per wor(er. 1 reduction in population growth leads to an increase in capital per wor(er. 0f there is technological progress, there is no steady4state level of output per wor(er. 0n this case, however, a reduction in population growth implies that output per wor(er will increase at every point in time, for any given path of technology. ,ee the answer to problem 6:c;. The )uantity 'Y S ', is the growth rate of output per wor(er. The )uantity '- S ', is the growth rate of capital per wor(er. '- S ', @ 2:'Y S ',; S &'A *.,. France Iapan *+ 'Y S ', 1.?A 2.&A =.&A &.=A 'A &.$A 2.1A 2.?A &.6A '- 0 ', 1.=A 2.=A 8.$A &.$A
Expl re Fur!her
?. a. b. c.
CHAPTER 1#
Quick Check
1. a. b. c. d. e. f. g. &. a. b. c. False. 6roductivity growth is unrelated to the natural rate of unemployment. 0f the unemployment rate is constant, employment grows at same rate as the labor force. False. True. True. True. True. False. u @ 14:1/:1L;;:A/Ae; u @ 14:1/:1L$.$8;; @ =.?A /o. ,ince wages ad3ust to expected productivity, an increase in productivity eventually leads to e)uiproportional increases in the real wage implied by wage setting and the real wage implied by price setting, at the original natural rate of unemployment. Thus, e)uilibrium can be maintained without any change in the natural rate of unemployment.
2.
1n increase in labor productivity has no effect on the natural rate of unemployment, because the wage ultimately rises to capture the added productivity. The increase in the wage also implies that an increase in labor productivity has no permanent effect on inflation. From the price setting
16? e)uation, P@:1L;W/A. 0f the wage :W; increases by the same proportion as productivity : A;, the price level will not change. =. a. b. c. d. Jeduce the gap, if this leads to an increase in the relative supply of high4s(ill wor(ers. Jeduce the gap, since it leads to a decrease in the relative supply of low4s(ill wor(ers. Jeduce the gap, if it leads to an increase in the relative supply of high4s(ill wor(ers. 0ncrease the gap, if it leads *.,. firms hire low4s(ill wor(ers in this reduces the relative demand for *.,. low4s(ill wor(ers. entral 1merica, since
Dig Deeper
8. 6. Technological change has led to a reduction in agricultural employment, but evidently has had no effect on the natural rate of unemployment. a. P @ Pe:1L;:Ae/A;:Y/AL; The new variables are technology variables, A and Ae. 1n increase in A has two effects. i. For a given level of Y, an increase in A reduces Y/A, which implies a reduction in , and in increase in u. The increase in u tends to reduce W and therefore to reduce P. This is the effect that tends to increase the actual rate of unemployment in the short run. To the extent that Ae lags behind A, Ae/A falls. 0n effect, wor(ers do not receive as much of an increase in wages as warranted by the increase in productivity. This is the effect that tends to reduce the actual and natural rates of unemployment for a time.
ii.
The effects in :i; and :ii; both shift the AS curve down, so output increases in the short run. The effect on short4run unemployment depends on the relative strength of the effects in :i; and :ii;. b. c. %. a. b. c. d. e. AS shifts down. Given Ae/A@1, only effect :i; is relevant. 0n this case, effects :i; and :ii; from part :a; are relevant. ompared to part :b;, the AS curve shifts down further. W/P@!:14,/L,z; Cabor supply slopes up. 1s , increases, u falls for given L, so W/P increases. W/P@MPL/:1L; Cabor demand slopes down. 1s , increases, the MPL falls, so W/P falls. 1n improvement in technology increases the MPL, so the labor demand curve shifts right. The real wage increases when technology improves.
169 ?. a. b. The real wage of high4s(ill labor increases. The real wage of low4s(ill labor falls. ,ince there is a binding minimum real wage, a fall in labor demand has no effect on the real wage of low4s(ill wor(ers. !mployment of low4s(ill wor(ers falls, however, and the unemployment rate increases. Hage ine)uality will increase by a greater amount in the *nited ,tates. *nemployment will increase by a greater amount in !urope. The *nited ,tates has had a large increase in wage ine)uality over the past 2$ years, and !urope has had a large increase in the unemployment rate. 6ro3ections for 3ob decline from &$$64&$16 ,ome examples> ,toc( cler(s and order fillers S technological change !lectrical and electronic e)uipment assemblers S perhaps foreign competition 6ro3ections for 3ob growth from &$$64&$16 Some examples: Home health aides aging of the population Computer systems analysts technological change More occupations that are forecast to grow require degrees as opposed to ontraining. 1$. a. b. c. For a given mar(up, the real wage grows at the rate of technological progress. there has been technological progress since 19%2. 19%2> M?.9?B &$$6> M?>&= The real wage of low4s(ill wor(ers has fallen mar(edly, which suggests that the relative demand for low s(ill wor(ers has fallen mar(edly. -ther benefits, particularly health care benefits, might be missing from this calculation. learly,
c. d.
Expl re Fur!her
9. a.
b.
c. the-job
d.
CHAPTER 1$
Quick Check
1. a. b. c. d. e. f. g. h. i. True. True. True. False. True. False. True. True. The nominal interest rate is always positive. False. The real interest rate can be negative.
1%$ &. a. b. c. 2. a. b. c. =. Jeal. /ominal profits are li(ely to move with inflationB real profits are easier to forecast. /ominal. The payments are nominal. /ominal. ar lease and car loan payments are usually stated in nominal terms.
exact> r @ :1L.$=;/:1L.$&;41 @ 1.96AB approximation> r .$=4.$& @ &A 2.6$AB =A 8.=?AB ?A a. /o. 0f the nominal interest rate were negative, nobody would hold bonds. 'oney would be more appealing since it could be used for transactions and would earn <eroKas opposed to negativeKinterest.
b.
Nes. The real interest rate is negative if expected inflation exceeds the nominal interest rate. !ven in this case, the real interest rate on bonds :which pay nominal interest; exceeds the real interest rate on money :which does not pay nominal interest; by the nominal interest rate. 1 negative real interest rate ma(es borrowing very attractive and leads to a large demand for investment. 1nswers will vary. a. The discount rate is the interest rate. ,o, in case :i;, the !6.V is M&,$$$:14$.&8; under either interest rate, and in case :ii; the !6.V is :14$.&;M&,$$$ under either interest rate.
c. d. 8.
b.
The interest rate does not enter the calculation. 7ence, you prefer :ii; to :i; since &$AQ&8A. /ote that the answer to part :a; does not imply that saving will not accumulate. Py retirement, the initial investment will have grown by a factor of :1Li; =$ in nominal terms and :1Lr;=$ in real terms. 1s long as r is positive, the purchasing power of the initial investment will grow. 'oreover, this problem assumes that the tax rate you will pay upon retirement :&8A; is higher than the tax rate you pay when you establish the 0J1 :&$A;. This assumption may be false for some taxpayers.
6.
a. b.
M1@M1$$/$.1@M1$$$ ,ince the first payment occurs at the end of the year, M1 @ MzD14 1/:1Li;nE/D14:1Li;E 4 Mz. 1$ years> M8%8.9$B &$ years> M?26.=9B 2$ years> M926.96B 6$ years> M996.29 i @ &A> 6V of consol@M8$$$B 1$ years> M?16.&&B &$ years> M186%.?8B 2$ years> M&1?=.==B 6$ years> M2==8.61
c.
1%1 i @ 8A> 6V of consol@M&$$$B 1$ years> M%1$.%?B &$ years> M1&$?.82B 2$ years> M181=.11B 6$ years> M1??%.8? %. a. The Fisher hypothesis is that in the medium run, changes in inflation are reflected one4 for4one in changes in the nominal interest rate. 0n other words, in the medium run, changes in inflation have no effect on the real interest rate. b. c. d. ,upport. The line should not go through the origin, because the real interest rate is positive> when inflation e)uals <ero, the nominal interest rate is positive. /o. !ven if monetary policy does not affect output or the real interest rate in the medium run, it can be used in the short run. a. The IS shifts right. 1t the same nominal interest rate, the real interest rate is lower, so output is higher. b. The LM curve shifts down because the increase in money growth leads to an increase in the real money stoc(. The increase in expected inflation has no effect on the LM curve, because money demand depends on the nominal interest rate, not the real interest rate. -utput increases. The nominal interest rate is higher than in Figure 1=48. Hhether the nominal interest rate is lower or higher than before the increase in money growth is ambiguous. Thin(ing in terms of the money mar(et e)uilibrium, the increase in the nominal money supply tends to reduce the nominal interest rate, but the increase in nominal money demand :because of the increase in output; tends to increase the nominal interest rate. -utput is higher than in Figure 1=48. Jeasoning from the 0, relation, the real interest rate must be lower, since no exogenous variables in the 0, relation have changed. :0n other words, while the nominal interest rate may increase relative to Figure 1=48, it increases by less than the increase in expected inflation, so the real interest rate decreases.;
Dig Deeper
?.
c.
d.
Expl re Fur!her
9. 1nswers will vary depending upon when the website is accessed.
CHAPTER 1%
Quick Check
1. a. b. c. d. e. f. g. False. True. True. False. True. True. False.
1%& h. *ncertain/False. ,ome of the increase in the stoc( mar(et was probably 3ustified. 7owever, most economists believe that there was a bubble in the stoc( mar(et as well. 1 stoc( mar(et correction followed. :1Li;n@M!/MP 1Li @:M!/MP;1/n i @:1$$$/?$$;1/241 @ %.%A 8.%A =.1A
&.
a.
b. c. 2.
The yield is approximately the average of the short4term interest rates over the life of the bond. a. b. c. 8A. 8.&8A 8.8A a. The LM curve shifts down unexpectedly. There is unexpected fall in the interest rate and an unexpected increase in output. Poth of these changes lead to an increase in the stoc( price. b. c. There is no change in the stoc( price. The effect on the stoc( price is ambiguous. *nexpected expansionary fiscal policy means the interest rate is higher than expected :after the expected expansionary monetary policy; but so is output. The interest rate effect tends to reduce the stoc( priceB the output effect to increase them. ,ee Figure 1=48 in hapter 1=. 0nitially after the increase, the yield curve will slope down out to one4year maturities, then slope up. 1fter one year, the yield curve will slope up. 1fter three years, the yield curve will be flat. a. This )uestion should have read> "!xplain why an inverted :downward4sloping; yield curve may indicate that a recession is coming.# 1n inverted yield curve implies that the expected future interest rate is lower than the current interest rate. These expectations could arise from a belief that the IS curve is going to shift to the left in the future, say because future investment is expected to fall. 0f the IS curve shifts left in the future, output will fall. b. Given the Fisher effect, a steep yield curve probably implies that financial mar(et participants believe that future inflation will be substantially higher than current inflation.
=.
Dig Deeper
8. a. b.
6.
%.
Cet r be the real interest rate, ' the growth rate of dividends, and # the ris( premium. The price is given by the following expression.
1%2 2@1$$$/:1 L r L #; L 1$$$:1 L ';/:1 L r L #;& L 1$$$:1 L ';&/:1 L r L #;2 . . . @ D1$$$/:1 L r L #;ED1 L :1 L ';/:1 L r L #; L :1 L ';&/:1 L r L #;& L . . .E @ 1$$$/:r L # 4 '; a. b. c. d. M8$,$$$B M&$,$$$ M1$,$$$B M%69&.21 M16,666.6%B M11,111.11 The stoc( price increases when the ris( premium falls. 1 fall in the ris( premium is li(e a fall in the real interest rate. a. The Fed can reduce the growth rate of money. increases in the short run, but falls in the medium run. The nominal interest rate
Expl re Fur!her
?.
b. 0nflation was highest in early 19?$. The 1&4month inflation rate pea(ed at 1=.6A in 'arch and 1pril of 19?$. d. 1 positive spread means that expected future interest rates are higher than current interest rates. 1 declining spread means that the expected increase in future short4term interest rates is falling. The one4year T4bill rate increased from %.&?A to 1&.6A between Ianuary 19%? and Ianuary 19?$, but the spread declined from $.9 percentage points to S 1.=6 percentage points over the same period. Financial mar(et participants were not expecting short4term interest rates to continue to increase. 0ndeed, by the end of the 19%$s, the negative spread indicates that short4term interest rates were expected to decline in the future. e. f. g. There spread declined by almost one percentage point in -ctober 19%9. The decline is consistent with expectations of lower inflation in the future. The one4year interest rate fell. .uring the rate cut in the recession, spreads went up, as short4term rates declined. 7owever, long4term rates did not increase, which suggests that inflation expectations did not increase. 0nstead, the increase in spreads is consistent with the expectation that the anti4inflationary policy would continue with high short4term interest rates after the recession. This is indeed what happened.
9. 1$.
1nswers will vary. 1nswers will vary.
CHAPTER 1&
Quick Check
1. a. b. c. False. False. False.
1%= d. e. f. g. &. a. b. c. False. False. True. True. $.%8:1L1.$8L1.$8&;M=$,$$$@M9=,8%8 M19=,8%8 The consumer wor(s for three more years and will be retired for seven years, so there are 1$ more years of consumption. ,o, since the real interest rate is <ero, the consumer can consume one4tenth of her total wealth, or 19,=8%.8$, this year. onsumption could increase by M&,$$$ annually. Penefits imply extra annual consumption of $.6:1.$8&;M=$,$$$:%/1$;@M1?,8&&.
d. e. 2.
The !6.V of purchasing the machine is /:rL; @ M1?,$$$/:rL$.$?; a. b. c. Puy. !6.V@M12?,=6&UM1$$,$$$ Prea(4even. !6.V@M1$$,$$$ .o not buy. !6.V@M%?,&61QM1$$,$$$ M==,$$$:14$.=;264M=$,$$$:14$.=;2?@M2?,=$$ M==,$$$:14$.2;264M=$,$$$:14$.2;2?@M==,?$$ !6.V of future labor income @ M2$. youth> 48B middle age> 18B old age> 41$ Total saving @n:48L1841$;@$ $ S 8n L 1$n @ 8n youth> 8B middle age> 1&.8B old age> 1&.8 The consumer cannot borrow against future income when young. $ L 1&.8n 4 1&.8n @ $ $ L $ L 1&.8n @ 1&.8n Py allowing people to borrow to consume when young, financial liberali<ation may lead to less overall accumulation of capital. !xpected value of earnings during middle age is $.8:M=$,$$$LM1$$,$$$;@M%$,$$$. !6.V of lifetime earnings @ M&$,$$$ L M%$,$$$@M9$,$$$. onsumption@M1$ in all three periods.
=.
a. b.
Dig Deeper
8. a. b. c. d. 6. a.. b. c. d. %. a.
1%8 The consumption plan is M2$,$$$ per year. The consumer will save 4M1$,$$$ :i.e., the consumer will borrow M1$,$$$; in the first period of life. b. 0n the worst case, the !6.V of lifetime earnings @ M6$,$$$. onsumption @ M&$,$$$ and saving@$ in the first period of life. onsumption is lower than part :a;, and saving is higher. onsumption in youth is M&$,$$$B in middle age is M8$,$$$B and in old age is M8$,$$$. onsumption will not be constant over the consumer9s lifetime. The uncertainty leads to higher saving by consumers in the first period of life. a4c. Petween 1989 and &$$6, consumption accounted for 66A of G.6 on average and investment for about 12A, so consumption is about five times bigger than investment. Jelative to average changes, movements in consumption and investment are of similar magnitude, which implies investment is much more volatile than consumption. a. onsumers may be more optimistic about the future :and spend more; when disposable income is higher, so consumer confidence might be positively related to disposable income. 7owever, consumer confidence should depend on expectations about the future, rather than on current variables per se. 7ence, there are reasons to thin( changes in consumer confidence might not always trac( changes in disposable income. There appears to be positive relationship between the variables, but it is not tight. 6ersonal disposable income increased at an annual rate of 11.8A in &$$1>000 and at an annual rate of 11.6A in &$$&>0. onsumer confidence fell in &$$1>000 but rose in &$$&>0. The events of ,eptember 11, as well as the ongoing recession, probably played a role in the consumer confidence numbers for &$$1>000.
c. d. ?.
Expl re Fur!her
9.
b. c.
CHAPTER 1'
Quick Check
1. a. b. c. d. e. f. g. False. False. False. True/*ncertain. False. True. False.
onsumers can rely on forecasts by others, but somebody has to do it.
&.
a. 7igher real stoc( prices led to an increase real wealth directly, which would tend to increase consumption. 'oreover, the hype about the /ew !conomy, combined with increasing stoc( prices, may have led to favorable expectations about future labor income, which would also tend to increase consumption.
1%6 b. ,ubse)uent declines in the stoc( mar(et decreased wealth and may have led consumers to revise :downward; expectations about future labor income, effects that would tend to reduce consumption. The IS curve shifts right. The LM curve shifts right. There are three effects. First, an increase in expected future taxes tends to reduce expected future after4tax income :for any given level of income;, and therefore to reduce consumption. This effect tends to shift the IS curve to the left. ,econd, the increase in future taxes :a deficit reduction program; tends to reduce real interest rates in the future. The fall in the expected future interest rate tends to shift the IS curve to the right. Third, the fall in future real interest rates leads to an increase in investment in the medium run and to an increase in output in the long run. The increase in expected future output tends to shift the IS curve to the right. The net effect on the IS curve is ambiguous. /ote that the model of the text has lump sum taxes. 0n taxes are not lump sum, the tax increase may increase distortions in the economy. These effects tend to reduce output :or the growth rate;. The IS curve shifts to the left.
2.
a. b. c.
d. =.
Jational expectations may be unrealistic, but it does not imply that every consumer has perfect (nowledge of the economy. 0t implies that consumers use the best available informationK models, data, and techni)uesKto assess the future and ma(e decisions. 'oreover, consumers do not have to wor( out the implications of economic models for the future by themselves. They can rely on the predictions of experts on television or in the newspapers. !ssentially, rational expectations rules out systematic mista(es on the part of consumers. Thus, although rational expectations may not literally be true, it seems a reasonable benchmar( for policy analysis. The answers below ignore any effect on capital accumulation and output in the long run. 1ssume the tax cut policy in the future is temporary, so we need only worry about future short4 run effects. a. The effect on current output is ambiguous. The tax cut in the future will lead to a boom. -utput and the real interest rate will increase. The increase in expected future output tends to shift the IS curve to the rightB the increase in the expected future real interest rate tends to shift the IS curve to the left. Finally, the fall in expected future taxes tends to increase expected future after4tax income :for any given level of income;. This effect tends to shift the IS curve to the right. This means that the Fed will increase the interest rate in the future :shift the LM curve to the left in the future;. The expected interest rate will increase more, which tends to to shift the IS curve to the left, but there is still the effect of lower expected taxes on current consumption. The effect today on output is still ambiguous, but more li(ely to be negative than in part :a;. Future output will be higher, the future interest rate will not increase, and future taxes will be lower. The IS curve definitely shifts to the right in the current period, and current output increases.
8.
b.
c.
1%%
Dig Deeper
6. a4b. c. ,ee the discussion in the text. The gesture seemed to indicate that the Fed supported deficit reduction, and was willing to conduct expansionary monetary policy in the future to offset the direct negative effects on output from spending cuts and tax increases. 1 belief that the Fed was willing to act in this way would tend to increase expected future output :relative to the case where the Fed did nothing; and to reduce expected future interest rates. Poth of these effects would tend to increase output in the short4run. a. Future interest rates will tend to rise. Future output will tend to fall. Poth effects shift the IS curve to the left in the present. urrent output and the current interest rate fall. The yield curve gets steeper on the day of the announcement. b. /o.
%.
c. ompared to original expectations, the nominee is expected to follow a more expansionary monetary policy. The yield curve will get flatter on the day of the announcement.
Expl re Fur!her
?. a. The interest rate will increase in the short run, and increase even further in the medium run. The yield curve will get steeper. b. The spread increased over the period. 84Near Nield minus 24'onth Nield 1ugust &$$&> 1.6=A Ianuary &$$2> 1.?6A 1ugust &$$2> &.=A Ianuary &$$=> &.&&A
CHAPTER 1(
Quick Check
1. a. b. c. d. e. True. False. False. False. False. f. The statement should read> "Given the definition of the exchange rate adopted in this chapter, if the dollar is the domestic currency and the euro the foreign currency, a nominal exchange rate of &3&4 means that one dollar is worth &3& euros.# This statement is True. False.
g. &.
Domestic Country Balance of Payments :M; urrent 1ccount !xports
&8
1%? 0mports Trade Palance 0nvestment 0ncome Jeceived 0nvestment 0ncome 6aid /et 0nvestment 0ncome /et Transfers Jeceived urrent 1ccount Palance apital 1ccount 0ncrease in Foreign 7oldings of .omestic 1ssets 0ncrease in .omestic 7oldings of Foreign 1ssets /et 0ncrease in Foreign 7oldings ,tatistical .iscrepancy Foreign Country Balance of Payments :M; urrent 1ccount !xports 0mports Trade Palance 0nvestment 0ncome Jeceived 0nvestment 0ncome 6aid /et 0nvestment 0ncome /et Transfers Jeceived urrent 1ccount Palance apital 1ccount 0ncrease in Foreign 7oldings of .omestic 1ssets 0ncrease in .omestic 7oldings of Foreign 1ssets /et 0ncrease in Foreign 7oldings ,tatistical .iscrepancy 2. a. b. c. d. e. 1$$ 4%8 :@&841$$; $ 18 418 :@$418; 4&8 4118 :@4%84184&8; ?$ :@68L18; 48$ 12$ :@?$4:48$;; 418 :@118412$;
1$$ &8 %8 :@1$$4&8; 18 $ 18 :@184$; &8 118 :@%8L18L&8; 48$ ?$ :@68L18; 412$ :@48$4?$; 18 :@12$4118;
The nominal return on the *.,. bond is 1$,$$$/:9618.2?;S1@=A. The nominal return on the German bond is 6A. *ncovered interest parity implies that the expected exchange rate is given by !:1LiR;/:1Li;@$.%8:1.$6;/:1.$=;@$.%6 !uro/M. 0f you expect the dollar to depreciate, purchase the German bond, since it pays a higher interest rate and you expect a capital gain on the currency. The dollar depreciates by =A, so the total return on the German bond :in M; is 6A L =A @1$A. 0nvesting in the *.,. bond would have produced a =A return. The uncovered interest parity condition is about e)uality of expected returns, not e)uality of actual returns.
Dig Deeper
=. a. G.6 is 18 in each economy. onsumers will spend 8 on each good.
1%9 b. c. d. 8. !ach country has a <ero trade balance. ountry 1 exports clothes to ountry P, ountry P exports cars to ountry , and ountry exports computers to ountry 1. /o country will have a <ero trade balance with any other country. There is no reason to expect that the *nited ,tates will have balanced trade with any particular country, even if the *nited ,tates eliminates its overall trade deficit. a. The relative price of domestic goods falls. Jelative demand for domestic goods rises. The domestic unemployment rate falls in the short run. b. The price of foreign goods in terms of domestic currency is PR/". 1 nominal depreciation :a fall in "; increases the price of foreign goods in terms of domestic currency. Therefore, a nominal depreciation tends to increase the 60. c. The real wage falls.
d. !ssentially, a nominal depreciation stimulates output by reducing the domestic real wage, which leads to an increase in domestic employment.
Expl re Fur!her
6. a. onsidering the evidence through 'ay &$$?, the yen appreciated from mid419?8 to mid41998, depreciated until mid4199?, appreciated through the end of 1999, depreciated through the end of &$$1, appreciated through &$$=, depreciated through mid4 &$$%, and then began to appreciate. From a broader perspective, between the Ianuary 19%9 and 'ay &$$?, the yen appreciated by 9$A. The yen reached its strongest value against the dollar in mid41998. b. c. %. .epreciation of the yen. The yen appreciated from the end of &$$1 to the end of &$$=, and again after mid4&$$%, . This did not help the Iapanese recovery. a. The sum of world current account balances should be <ero. 0n &$$%, the sum was positive, which implies literally that the world as a whole was borrowing. -bviously, this cannot have been true. b. 0n &$$%, the *nited ,tates was the worldTs biggest borrower by far. The rest of the advanced economies as a whole were lenders, although the !uro area as a borrower. The economies of the 'iddle !ast and developing economies in 1sia were other large lendersB the economies of central and eastern !urope were large borrowers. c. 0n &$$%, the saving of the advanced economies other than the *ntied ,tates amounted to only &=A of *.,. borrowing. ,o, the *nited ,tates was borrowing heavily from all regions of the world. d. The pro3ections in the 1pril &$$? Horld !conomic -utloo( suggested no )ualitative change in the answers to parts :a; through :c;. ?. a. Horld saving essentially e)uals world investment, as it must logically.
1?$ b. 0n &$$%. *.,. saving was 12.6A of G.6, but *.,. investment was 1?.?A of G.6. The *nited ,tates financed the difference by borrowing from abroad. The 1pril &$$? Horld !conomic -utloo( pro3ected a gap of similar magnitude for the next two years.
CHAPTER 1)
Quick Check
1. a. b. c. d. e. False. False. 1n increase in the budget deficit will lead to an increase in the trade deficit, but we canTt conclude that from the national income accounting identity. He have to use our model to ma(e that prediction. False. True. False. !conometric evidence suggests that a real depreciation does not lead to an immediate improvement in the trade balance. Typically, the trade balance improves six to twelve months after a real depreciation. only after six to twelve months between only after six to twelve months. True. False. a. b. 2. a. b. c. d. =. 8. There is a real appreciation over time. -ver time, the trade balance worsens.
f. g. &.
The currency depreciates at the rate of 4R. The share of Iapanese spending on *.,. goods relative to *.,. G.6 is :$.$6;:$.11;@$.%A. *.,. G.6 falls by &:.$8;:.$$%;@$.$%A. *.,. G.6 falls by &:.$8;:$.11;@1.1A. This is an overstatement. The numbers above indicated that even if *.,. exports fall by 8A, the effect is to reduce G.6 growth by 1.1A.
1nswers follow the model in the text. a. b. c. d. The ZZ and ,5 lines shift up. .omestic output and domestic net exports increase. .omestic investment will increase because output increases. 1ssuming taxes are fixed, there is no effect on the deficit. ,5@S4ILT4G. ,ince the budget deficit is unchanged, and I and ,5 increase, , must increase. !xcept for G and :for our purposes; T, the other variables in e)uation :19.8; are endogenous. 1n exogenous shoc( such as an increase in foreign output can affect all of the endogenous variables simultaneously.
Dig Deeper
1?1 6. a. b. %. a. There must be a real depreciation. Y@CLILGL,5. 0f ,5 rises while Y remains constant, CLILG must fall. The government can reduce G or increase T, which will reduce C. Y @ C L I L G L 5 S IM Y6c$Lc1:Y4T;Ld$Ld1YLGL#1Y74m1Y Y@D1/:14c14d1Lm1;EDc$Lc1TLd$LGL#1Y7E -utput increases by the multiplier, which e)uals 1/:14 c14d1Lm1;. The condition $Q m1Q c1Ld1Q1 ensures that the multiplier is defined, positive, and less than one. 1s compared to the original multiplier, 1/:1L c1;, there are two additional parameters> d1, which captures the effect of an additional unit of income on investment, and m1, which captures the effect of an additional unit of income on imports. The investment effect tends to increase the multiplierB the import effect tends to reduce the multiplier. Hhen government purchases increase by one unit, net exports fall m1N@ m1/:14c14d1Lm1;. /ote that the change in output is simply the multiplier. by
b.
c. d.
The larger economy will li(ely have the smaller value of m1. Carger economies tend to produce a wider variety of goods, and therefore to spend more of additional unit of income on domestic goods than smaller economies do. small economy :m1@$.8; large economy :m1@$.1; N 1.1 & /Y $.6 $.&
e.
f. ?. a.
Fiscal policy has a larger effect on output in the large economy, but a larger effect on net exports in the small economy. 0t is convenient to wait to substitute for G until the last step. Y @ C L I L G L 5 S IM @ 1$ L $.?:Y 4 1$; L 1$LG L $.2YR4 $.2Y Y @ D1/:1 4 .? L .2;E:1& L G L $.2NR; @ &:1& L G L $.2NR; @ == L $.6NR Hhen foreign output is fixed, the multiplier is & :@1/:14$.?L$.2;;. The closed economy multiplier is 8 :@1/:14$.?;;. 0n the open economy, some of an increase in autonomous demand falls on foreign goods, so the multiplier is smaller.
b.
,ince the countries are identical, Y@YR@11$. Ta(ing into account the endogeneity of foreign income, the multiplier e)uals D1/:14$.? 4$.2R$.6 L$.2;E@2.1&8. The multiplier is higher than the open economy multiplier in part :a; because it ta(es into account the fact that an increase in domestic income leads to an increase in foreign income :as a result of an increase in domestic imports of foreign goods;. The increase in foreign income leads to an increase in domestic exports. 0f Y@1&8, then YR@==L$.6:1&8;@119. *sing these two facts and the e)uation Y@&:1&LGL$.2YR; yields 1&8@&=L&GL$.6:119;, which implies G@1=.?. 0n the domestic
c.
1?& economy, ,5@$.2:119;4$.2:1&8;@41.? and T4G@1$41=.?@4=.?. 0n the foreign economy, ,5R@1.? and TR4GR@$. d. e. 0f Y@YR@1&8, then 1&8@&=L&GL$.6:1&8;, which implies G@GR@12. 0n both countries, net exports are <ero, but the budget deficit is 2. 0n part, fiscal coordination is difficult to achieve because of the benefits of doing nothing and waiting for another economy to underta(e a fiscal expansion, as indicated from part :c;. ,5@/ational ,aving 4 I. b. 1s a A of G.6, gross private domestic investment was 2.6 percentage points higher in &$$6 than in 19?1. /et exports were 8.% percentage points lower. Therefore, the national income identity implies that national saving fell by 2.6S8.% @ &.1 percentage points relative to G.6. c. 19?14199$ 199$4&$$$ &$$$4&$$= hange in 0nvestment :A of G.6; 4$.%A 8.1A 4$.%A hange in /Y :A of G.6; 4$.9A 42.1A 41.%A
Expl re Fur!her
?. a.
-nly in the 199$s was the fall in /Y matched by an increase in investment. d. Nes. 1n increase in investment leads to more capital accumulation and more output in the future, and therefore to a greater ability to repay foreign debt.
CHAPTER "*
Quick Check
1. a. b. c. d. e. f. &. 2. False. True. True. True. *ncertain. 0f expected appreciation of the yen is greater than or e)ual to the interest rate in other countries, than foreign investors will hold yen bonds. False. The money stoc( will change in response to shoc(s :including policy shoc(s; so that the home interest rate e)uals the foreign interest rate.
The appropriate mix is a monetary expansion to lessen the value of the currency :and thereby to improve the trade balance; and a fiscal contraction to prevent output from increasing. a. onsumption increases because output increases. 0nvestment increases because output increases and the interest rate falls. b. 1 monetary expansion has an ambiguous effect on net exports. The nominal depreciation tends to increase net exports, but the increase in output tends to reduce net exports.
1?2 =. a. The IS curve shifts right, because net exports tend to increase. .omestic output increases. b. The IS curve shifts right, because the increase in iR tends to create a depreciation of the domestic currency and therefore an increase in net exports. .omestic output increases. The interest parity line also shifts up. c. 1 foreign fiscal expansion is li(ely to increase YR and to increase iR. 1 foreign monetary expansion is li(ely to increase YR and to reduce iR. d. 1 foreign fiscal expansion is li(ely to increase home output. 1 foreign monetary expansion has an ambiguous effect on home output. The increase in YR tends to increase home output, but the fall in iR tends to reduce home output.
Dig Deeper
8. a. 1n increase in YR shifts the IS curve to the right. The incipient rise in the home interest rate creates a monetary expansion as the home central ban( purchases foreign exchange to prevent the domestic currency from appreciating. ,o, the LM curve shifts right. -utput and net exports increase. b. The interest parity line shifts up, and the LM curve shifts left as the central ban( sells foreign exchange to prevent the domestic currency from depreciating. -utput falls, which leads to an increase in net exports. 1 fiscal expansion in the Ceader country, which increases YR and iR, reduces domestic output, if the effect of YR on domestic output is small. 1 monetary expansion in the Ceader country, which increases YR and reduces iR, increases domestic output. a. The IS curve shifts to the left. -utput falls, the interest rate falls, and the currency depreciates. The currency depreciation tends to increase output by increasing net exports. Therefore, the exchange rate movement dampens the effect of the fall in business confidence. b. The IS curve shifts left and the LM curve shifts left :because the money supply falls; as the central ban( sells foreign exchange to prevent the domestic currency from appreciating. The fall in output is greater than in part :a;. Hhen the exchange rate is flexible, movements of the exchange rate tend to dampen the output effects of IS shoc(s. The currency depreciates when the IS curve shifts left and appreciates when the IS curve shifts right. "t@"etL1:1LitL#;/:1LiRtL1; The IS curve slopes down as before, but with the result in part :a; substituted for the nominal exchange rate in the ,5 function. The IS curve shifts right, because the fall in the expected exchange rate creates a depreciation :which leads to an increase in net exports; at the original interest rate. The
c.
6.
c.
Expl re Fur!her
%. a. b. c.
1?= interest parity line shifts left. -utput increases, net exports increase, and the currency depreciates. d. 1n increase in # tends to increase the value of the domestic currency and therefore to shift the IS curve to the left. 1ccording the assumption of the problem, the IS curve returns to its original position. 1s a result, the combined effect of the increase in the expected exchange rate and the increase in # is no change in output. ,ince there is no change in output, there is no change in net exports or the exchange rate. The increase in # shifts the interest parity line to the right, bac( to its original position. Nes and yes. a4b. 1ccording to data in T8e "c$n$mi.t on 'ay &&, &$$?, the dollar was expected to appreciate against the pound, the euro, and the renminbiB to depreciate by 1A against the anadian dollar over 1$ yearsB and to depreciate by &$A over the yen over 1$ years. c. 0f significant real depreciation of the dollar is re)uired, the results of part :b; imply that *.,. inflation needs to be consistently lower than foreign inflation by a substantial margin. For example, if real depreciation of &$A against the euro is re)uired over a 1$4year hori<on, *.,. inflation must be & percentage points lower than !uropean inflation every year. 0f the dollar appreciates against the euro, as forecast by uncovered interest parity, *.,. inflation would have to be even lower than !uropean inflation to achieve the needed real depreciation. .ifferences in annual inflation of this si<e seem unli(ely to happen for an entire decade. d. 6erhaps the relatively strong demand for dollar assets, irrespective of the interest rate or expected depreciation, has slowed the depreciation of the dollar that might have been expected to result from the enormous *.,. current account deficit.
e. ?.
CHAPTER "1
Quick Check
1. a. b. c. d. e. True. Pritain returned to the gold standard at too appreciated a parity. True. False. False. False. b. The AD curve shifts right in the short run. The AS curve shifts left in the medium run. 0n the medium run, output is unchanged, but the price level is higher. c. onsumption is unchanged in the medium run.
&.
d. The real exchange rate appreciates, since the price level rises. 1s a result of the real appreciation, net exports fall in the medium run. e. The domestic interest rate e)uals the foreign interest rate, iR. The nominal interest rate is unaffected by government spending. ,ince expected inflation is constant, the real interest rate is also unaffected. 0nvestment is unchanged in the medium run.
1?8 f. 0n a closed economy, an increase in government spending reduces investment in the medium run. g. The statement is true. *nder fixed exchange rates, the interest rate is tied to the foreign interest rate. ,ince the interest rate does not change, there is no mechanism for government spending to crowd out investment. 2. a. The home real interest rate e)uals the foreign real interest rate minus expected real appreciation of the home currency. Hhen the home currency is expected to appreciate in real terms, foreign bonds must offer a real interest rate higher than the home real interest rate to compensate international portfolio investors for the expected loss in the real value of the foreign currency. Hhen the home currency is expected to depreciate in real terms, home bonds must pay a real interest rate higher than the foreign real interest rate. b. 1ccording to uncovered interest parity, 1$A@6A4expected nominal appreciation, which implies that expected nominal appreciation e)uals 4=A per year. 0n other words, expected depreciation is =A per year. c. 1ccording to real interest parity, 1$A46A@:6A42A; 4 expected real appreciation, which implies that expected real appreciation e)uals 41A per year. Therefore, expected real depreciation is 1A per year. Nou would purchase the domestic bond because the foreign bond will pay less interest than the domestic bond, and the domestic currency is expected to gain in value relative to the foreign currency. The expected exchange rate is !. The home interest rate is iR. The expected exchange rate is less than!. The home interest rate is greater than iR. The domestic interest rate returns to iR, because expected depreciation is <ero. .evaluation per se does not lead to higher interest rates. Fear of devaluation does. The price level rises by 1$A. The real exchange rate is "P/PR. 0f P rises by 1$A, " falls by 1$A. There is a 1$A depreciation of the currency in nominal terms. "etLn falls by 1$A. " falls by 1$A. " falls by more than 1$A. Py interest parity, i4iR e)uals expected depreciation. 0f i falls below iR in the short run, then there is expected appreciation. This can only happen if " falls by more than 1$A in the short run. ,o, " falls by more in the short run than it does in the medium run.
d.
=.
a. b. c. d.
Dig Deeper
8. a. b. c. d. e.
1?6 6. a. b. c. d. "etL1 falls. The 9IP curve shifts up. The domestic interest rate must increase to maintain the fixed exchange rate. The money supply falls as the central ban( sells foreign exchange to buy its own currency. The LM curve shifts left. -utput falls and the interest rate rises. The government might choose to abandon the fixed exchange rate to avoid the fall in output, even if initially the government had no intention of devaluing. ,elf4fulfilling crises are possible. The domestic interest rate e)uals the foreign interest rate before and after the devaluation. The expected exchange rate falls to!. The *06 curve shifts up. The IS curve shifts right, because the devaluation tends to increase net exports. The interest rate would increase with no change in the money supply. The money supply must increase. The LM curve shifts right. -utput increases. Fear of further devaluation will increase the expected exchange rate above ! and increase the interest rate above iR. These effects will tend to reduce the increase in output. 0f the initial devaluation creates a strong enough fear of further devaluation, the devaluation could lead to a fall in output.
%.
a. b. c. d. e. f.
Expl re Fur!her
?. The answer is given in the comments after part :c;. The exchange rate is many times more variable than the interest rate differential.
CHAPTER ""
Quick Check
1. a. b. c. False. True. *ncertain/False. !ven though the unemployment rate declined, it remained high until Horld Har 00. Traditional 6hillips curve analysis suggests that deflation should have continued. ,omething more is needed to explain the end of deflation. The text explores several possible explanations. True. False. a. The central ban( could increase M and shift the LM curve to the right.
d. e. &.
b. ,ince the unemployment rate is above the natural rate, PUPe. 1s a result, Pe falls, the AS curve shifts down, and P falls. 0n the IS%LM diagram, the fall in P implies an increase in M/P, so the LM curve shifts right.
1?% c. !xpected inflation is li(ely to fall. The fall in expected inflation tends to increase the real interest rate and shift 0, to the left. -utput moves further away from the natural level. d. /o. 0f the Fed does nothing, the economy may not return to the natural level of output, if the effect of the fall in expected inflation is strong enough. 2. b. P falls and M/P rises, so the LM curve shifts right. The ad3ustment mechanism does not wor( when the nominal interest rate e)uals <ero. 1s the LM curve shifts right, output does not change. c. 'onetary policy is ineffective. 1n increase in M shifts the LM curve to the right, which does not lead to an increase in output when the nominal interest rate e)uals <ero. d. Nes. 1n increase in G or a reduction in T would shift the IS curve to the right. 1s a result, output would increase. e. This is not wise advice. 0f the economy is in a li)uidity trap, the central ban( cannot restore output to its natural level.
Dig Deeper
=. b. c. a. ,hort4term unemployment has a greater effect on wages. The long4term unemployed may not be searching for employment and may not be very employable. u@D.$8/1.$8:14$.8;E 0f @$, $.=, $.?, the natural rate @=.?A, 6.$A, %.9A. 0ntuitively, if the weight on long4 term unemployed were <ero instead of $.8, the wage4setting and price4setting e)uations would determine the natural short4term rate of unemployment. The long4term unemployed would simply increase the aggregate unemployment rate. Thus, as the proportion of long4term unemployed increased, the natural rate of unemployment would increase. The same (ind of reasoning applies here, but the effect is less strong because the weight on long4term unemployed in the wage4setting e)uation is not <ero. 0n terms of the logic of the labor mar(et, the long4term unemployed put less downward pressure on wages than the short4term unemployed. ,o, increasing the proportion of long4term unemployed tends to increase the real wage. !ffectively, this implies that the labor supply curve :the wage4setting e)uation; shifts up. 0f the labor demand curve were downward4sloping, employment would fall as the real wage rose since wor(ers would be less attractive to firms. 0n this problem, labor demand :the price4setting e)uation; is flat at a fixed real wage, which implies that all of the ad3ustment from an increase in the proportion of long4term unemployment ta(es the form of less employment :and a higher unemployment rate; and none of the ad3ustment ta(es the form of a higher real wage. 8. a. 7igher unemployment implies lower wages given expected prices. This implies lower prices given expected prices. !)uivalently, it implies lower inflation given expected inflation, which here e)uals past inflation. b. t 4 Wt41 @ 4 :uS L uL S un;
1?? c. d. e. f. g. Wt 4 Wt41 @ 4 :u, S un; Wt 4 Wt41 @ 4 D:1 4 ;ut S unE The curve will shift to up, so that any unemployment rate is associated with a greater increase in the inflation rate. 'ore overall unemployment is needed to achieve the same decrease in inflation. The cost of disinflation increases. 1n increase in the proportion of long4term unemployed tends to imply a larger increase in inflation. 0n the Great .epression, perhaps the long4term unemployed did not exert much pressure on wages and prices, so deflation ended despite high unemployment.
Expl re Fur!her
6. 1nswers will vary depending upon when the )uestion is answered.
CHAPTER "#
Quick Check
1. a. b. c. d. e. f. &. a. b. True. False. False. False/*ncertain. 0ncomes policies may be part of a successful stabili<ation program in some cases, but they donTt seem in general to be a prere)uisite for stabili<ation. False. False. 0f money growth @ &8A, 8$A, %8A, seignorage@16&.8, 2&8, =?%.8. 0n the medium run, if money growth @ &8A, 8$A, %8A, seignorage@16&.8, &$$, 11&.8. The fall in real money balances associated with higher ongoing inflation reduces the potential for seignorage. 6art :a; did not allow for this effect. This policy would reduce the effect of inflation on real tax revenues. This policy would reduce the effect of inflation on real tax revenues. This policy would decrease the effect of inflation on real tax revenues, but would also have other effects. The income tax can tax the rich at a higher rate than the poor, but the sales tax rate is the same for rich and poor. a. The end to the crisis depends on shifting the composition of taxes away from the inflation tax and toward other taxes. Hor(ers are already paying the inflation tax. b. The central ban( must ma(e a credible commitment that it will no longer automatically moneti<e the government debt. 1lthough a currency board would do this, it is a drastic and perhaps unnecessary step.
2.
a. b. c.
Dig Deeper
=.
1?9 c. d. 6rice controls may help, but price controls without other policy changes only cause distortions and are a recipe for failure. 1 recession is not needed, but it may happen. 1lthough nominal rigidities are less important during hyperinflationsKa fact that implies that the sacrifice ratio is smallKthe issue of credibility remains. *nless firms and wor(ers believe in the stabili<ation program, a severe recession may be the result. The statement has two components> :i; there is an ongoing fiscal deficit that the government is unable or unwilling to finance from nonmonetary sources, and :ii; the central ban( is willing to moneti<e the debt. The order in which these issues are resolved ultimately depends on the political realities. The fiscal authority could eliminate the deficits. 0f it does not do so, the central ban( could commit not to moneti<e government debt. 7owever, this could drive the government into default on its bonds.
e.
8.
seignorage@:Y/P;:$.94ZM/M;:ZM/M; ,eignorage is maximi<ed when ZM/M@=8A. 1nswers may vary depending upon when the website is accessed, but it is clear that a fall in oil prices would tend to increase the budget deficit in Vene<uala. This would create the possibility of a hyperinflation if the government is unwilling or unable to finance itself and the central ban( finances the deficit through money creation.
Expl re Fur!her
6.
CHAPTER "$
Quick Check
1. a. b. c. d. e. f. False. True/*ncertain. False. False. True. *ncertain. 0t may be wise for a government to commit not to negotiate with hostage ta(ers as a means to deter hi3ac(ings, even recogni<ing that after a hi3ac(ing has ta(en place, there is a strong incentive to negotiate. 7owever, the phrase "under no circumstances# is categorical. There may some circumstances under which a government might wish to violate its commitment. This statement, of course, illustrates the difficulty of precommitment. an a government really commit not to negotiate, no matter what the circumstances, even if these circumstances may not have been imagined at the time the commitment was made[ False. 0nflation will increase in the fourth year. The 6resident should aim for high unemployment early in the administration, to reduce inflation before the fourth year. The policies are not li(ely to achieve the desired the increase in output desired in the fourth year. ,ince people are forward4loo(ing, expected inflation fourth year will
g. &. a. b. c.
19$ account for the intentions of policyma(ers. unemployment e)uals the natural rate. 2. =. 0f inflation e)uals expected inflation,
1nswers will vary, but there is some discussion of this issue in the text. /ew \ealand wants to eliminate fears that the central ban( might try to reduce unemployment below the natural rate with expansionary monetary policy and higher inflation. ,ee hapter &8 for a discussion of inflation targeting. a. b. c. d. e. et@$.8:D L R;
Dig Deeper
8.
The unemployment rate will be less than the natural rate. 0nflation will be higher than expected. The unemployment rate will be greater than the natural rate. 0nflation will be lower than expected. The results fit the evidence in Table &=41 if one loo(s at the first two years of each administration, and not 3ust the first year. The unemployment will e)ual the natural rate, because W @ W e, and there will be high inflation.
6.
The payoffs should be symmetrical, as written below. The table presented in the text leads to the same e)uilibrium, however.
Wel0,re Cu!. 1e. N (R=1, D=1) (R=-2, D=3) (R=3, D=-2) (R=-1, D=-1)
De0e-.e cu!.
1e. N
a. 0f the Jepublicans cut military spending, the .emocrats get 1 if they cut welfare, but 2 if they do not. ,o their best response is to vote against welfare cuts. The Jepublicans will get S& in this case. b. 0f the Jepublicans do not cut military spending, the .emocrats get S& if they cut welfare, but S1 if they do not. ,o their best response is not to cut welfare. The Jepublicans will get S1 in this case. Given the answers above, the Jepublicans will not cut military spending, and the .emocrats will not cut welfare. The two parties are loc(ed in a bad e)uilibrium. They could ma(e a deal> both vote for cuts. 0f they do, they will both be better off.
c.
Expl re Fur!her
%. 1nswers will vary.
191
CHAPTER "%
Quick Check
1. a. b. c. d. e. f. &. b. c. False. False. False. False/*ncertain. !vidence suggests that people have money illusion, when would seem to imply that inflation would distort decision ma(ing. False. True. The capital gains tax is not indexed to inflation. a. .emand for M1 falls while demand for M& is unchanged. 6eople shift funds from savings accounts to time deposits. .emand for M1 increases as people transfer funds from money mar(et funds to chec(ing accounts. .emand for M& remains unchanged. There is a shift in the composition of M1 :and conse)uently M&; as people hold more currency and ma(e fewer trips to the ban( while holding smaller chec(ing account balances. The demand for M& increases as the benefit of holding government securities falls. i. r@=A4$A@=AB ii. r@1=A41$A@=A i. r@=A:14$.&8;4$A@2AB ii. r@1=A:14$.&8;41$A@1$.8A41$A@$.8A Given the deductibility of nominal mortgage interest payments, inflation is good for homeowners in the *nited ,tates. The unemployment rate will remain e)ual to the natural rate. 0t is unli(ely that the central ban( will be able to hit its target every period. There will be surprises, and there are lags and uncertainty in policyma(ing. hanges in the natural rate will ma(e it more difficult for the Fed to hits its target. 0t will be harder to distinguish changes in the actual rate of unemployment from changes in the natural rate of unemployment.
d. 2. a. b. c. =. a. b. c.
Dig Deeper
8. 6. .iscussion )uestion. b. The IS curve slopes down, and the MP relation slopes up.
c. 1n increase in government spending shifts the IS curve right, so output and the real interest rate rise. d. %. a. The MP relation shifts up. -utput falls and the real interest rate increases. The MP relation shifts up. -utput falls and the real interest rate increases.
19& b. c. d. ,ince YQYn, e falls. 0nflation tends to returns to its target level. The MP relation shifts down. -utput increases and the real interest rate falls. ,ince YUYn, e rises. 0nflation tends to move away from its target level. 1 value of Q1 ma(es no sense as part of the policy rule, because inflation would tend to move away from its target
Expl re Fur!her
?. 1nswers will depend upon current Fed policy.
CHAPTER "&
Quick Check
1. a. b. c. d. e. f. g. a. b. c. True. False. *ncertain. False. False. False False 0nterest payments are 1$A of G.6, so the primary surplus is 1$A4=A@6A. Jeal interest payments are :1$A4%A;R1$$A@2A of G.6. ,o the inflation4ad3usted surplus is 6A42A@2A. 1ssume that last period unemployment was at the natural rate, so there has been a two percentage point increase in the unemployment rate over the last period. Py -(un9s law :with a normal growth rate of 2A;, output growth is lower by two percentage points. ,o, output is roughly two percent lower than it would have been. *sing the rule of thumb in the text, the surplus is lower by $.8R&A@1A. ,o the cyclically4ad3usted, inflation4 ad3usted surplus is &A. The change in the debt to G.6 ratio @ :2A4&A;R1$$A 4 2A @ 4&A. The debt to G.6 ratio falls by &A a year. 0n 1$ years, the debt to G.6 ratio will be ?$A. a. The new interest rate is 1$AL$.8R&$A@&$A. ,o assuming that expected depreciation was previously <ero, the domestic interest rate increases from 1$A to &$A. b. c. d. The real interest rate increases from 2A to 12A. The high real interest rate is li(ely to decrease growth. The official deficit increases from =A to 1=A of G.6. The inflation4ad3usted deficit increases from S2A :a surplus; to %A :a deficit;. The change in the debt ratio @ :12A4:4&A;;R1$$A42A@1&A. 0t goes up very )uic(ly.
&.
d. e. 2.
192 e. =. 0n this example, the worries were self4fulfilling.
First, even a temporary deficit leads to an increase in the national debt, and therefore to higher interest payments. This, in turn, implies continued deficits, higher taxes, or lower government spending in the future. ,econd, the evidence does not support the Jicardian e)uivalence proposition. Third, if Jicardian e)uivalence did hold, then government spending would have the same effect on output regardless of whether it was financed by bonds :i.e., with a deficit; taxes. Thus, a deficit, per se, would not be needed to stimulate output. Fourth, war4time economies are already low4unemployment economies. There is no need for further stimulation by using deficits rather than tax finance. The only correct part of the statement is the first sentence. 1 deficit can be preferable to higher taxes during a war, but not for the reasons stated here. .iscussion )uestion. 1lso see the box on ,ocial ,ecurity in hapter 11 :p. &18;. 0f financial mar(et participants discount future dividends at the rate of interest on government bonds, then this economy will exhibit Jicardian e)uivalence. 0f there is a ris(4premium applied to stoc(s, then this economy will not exhibit Jicardian e)uivalence. To see why, let ]t be the dividend tax rate at time t and consider the pre4dividend stoc( price under a fixed se)uence of expected dividends. MOt @ M.t:1 4 ]t; L M.etL1:1 4]tL1;/:1 L i1t;L . . . @ DM.t L M.etL1/:1 L i1t;L . . .E 4 DM.t]t L M.etL1]tL1/:1 L i1t; L . . .E The second term in brac(ets is the present discounted value of tax receipts for the government. To finance a given expenditure policy, the government must (eep the 6.V of tax receipts constant. Thus, for a given se)uence of expected dividends, the timing of dividend taxes will not affect the stoc( price, consumption or investment. 1s a result, this economy will exhibit Jicardian e)uivalence. /ote that, ex post, dividends will vary from their expected values, so taxes may be ad3usted in the future. This new information could affect stoc( prices. 0n addition, note that the level of dividend taxes S the 6.V of tax receipts S could affect stoc( prices. 0f stoc(s are assessed a ris( premium :^;, however, so that they are discounted at rate i L ^, then the timing of dividend taxes will matter, because the government budget constraint will incorporate a different discount rate than the stoc( mar(et price. 1s an example, suppose that i@$ forever but ^ is positive. 0n this case, the government can assess taxes at any time with no conse)uence, but shifting taxes to the future will be favorable to holders of stoc(s. ,ince future dividends are uncertain, so are future tax payments S they might not have to be made if dividends turn out to be low. 0n this scenario, shifting taxes to the future would tend to increase the current stoc( price, and thus increase consumption and investment :if firms are li)uidity constrained;. ,o, Jicardian e)uivalence is violated.
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8. 6.

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128

ANSWERS TO END-OF-CHAPTER PROBLEMS

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The new method represents a 1$A )uality increase.

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1nswers will vary depending on when students visit the website.

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N falls falls further 6

i rises rises further

6 rises rises further

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falls bac( to original level

0 ambiguous rises :above original level;

6rivate , ambiguous rises :above original level;

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The table should read as follows.

'exico *nited ,tates a. b. c.

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161 *.,. Iapan b. &.19A =.%$A 1.9%A 1.9?A 1.9%A $.?$A

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1nswers will vary. 1nswers will vary.

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onsumers can rely on forecasts by others, but somebody has to do it.

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Domestic Country Balance of Payments :M; urrent 1ccount !xports

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