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Understanding Economic Growth, Inflation, and Interest Rates - Prof. Prathibha V. Joshi, Assignments of Introduction to Macroeconomics

An overview of economic growth, its impact on living standards, and the role of various supply factors. It also discusses inflation, its relationship with interest rates, and how it affects different economic agents such as workers, farmers, and executives. The document further explores the concept of deflation and its negative effects on the economy. Lastly, it touches upon the determinants of investment and the relationship between real interest rates and investment spending.

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MACROECON 2105: ANSWER-KEY
Chapter 8: 1,5,11, &14
1. Economic growth means a higher standard of living, provided population does not grow even
faster. And if it does, then economic growth is even more important to maintain the current
standard of living. Economic growth allows the lessening of poverty even without an outright
redistribution of wealth.
If population is growing at 2.5 percent a year—and it is in some of the poorest nations—then a
2.5 percent growth rate of real GDP means no change in living standards. A 3.0 percent growth
rate means a gradual rise in living standards. For a wealthy nation, such as the United States,
with a GDP in the neighborhood of $10 trillion, the 0.5 percentage point difference between 2.5
and 3.0 percent amounts to $50 billion a year, or more than $150 per person per year.
Using the “Rule of 70,” it would take 28 years for output to double with a 2.5 percent growth
rate, and just over 23 years with 3.0 percent growth.
5. The four supply factors are the quantity and quality of natural resources; the quantity and
quality of human resources; the stock of capital goods; and the level of technology. The demand
factor is the level of purchases needed to maintain full employment. The efficiency factor refers
to both productive and allocative efficiency. Figure 8.2 illustrates these growth factors by
showing movement from curve AB to curve CD.
11. The rate of productivity growth has grown substantially due to innovations using microchips,
computers, new telecommunications devices and the Internet. All of these innovations describe
features of what we call information technology, which connects information in all parts of the
world with information seekers. New information products are often digital in nature and can be
easily replicated once they have been developed. The start-up cost of new firms and new
technology is high, but expanding production has a very low marginal cost, which leads to
economies of scale – firms’ output grows faster than their inputs. Network effects refer to a type
of economy of scale whereby certain information products become more valuable to each user as
the number of buyers grows. For example, a fax machine is more useful to you when lots of
other people and firms have one; the same is true for compatible word-processing programs.
Global competition is a feature of the New Economy because both transportation and
communication can be accomplished at much lower cost and faster speed than previously which
expands market possibilities for both consumers and producers who are not very limited by
national boundaries today.
14. Over the past 25 years U.S. real GDP has grown about 3 percent per year; China’s real GDP
has grown about 9 percent per year. China’s annual income per capita is around $2500. China’s
coastal areas are more industrialized, with greater access to international markets. Some of these
areas have been designated “special economic zones,” with greater freedom and support to
engage in high productivity economic activity. The poorer interior regions are heavily
agricultural.
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MACROECON 2105: ANSWER-KEY

Chapter 8: 1,5,11, &

1. Economic growth means a higher standard of living, provided population does not grow even

faster. And if it does, then economic growth is even more important to maintain the current

standard of living. Economic growth allows the lessening of poverty even without an outright

redistribution of wealth.

If population is growing at 2.5 percent a year—and it is in some of the poorest nations—then a

2.5 percent growth rate of real GDP means no change in living standards. A 3.0 percent growth

rate means a gradual rise in living standards. For a wealthy nation, such as the United States,

with a GDP in the neighborhood of $10 trillion, the 0.5 percentage point difference between 2.

and 3.0 percent amounts to $50 billion a year, or more than $150 per person per year.

Using the “Rule of 70,” it would take 28 years for output to double with a 2.5 percent growth

rate, and just over 23 years with 3.0 percent growth.

5. The four supply factors are the quantity and quality of natural resources; the quantity and

quality of human resources; the stock of capital goods; and the level of technology. The demand

factor is the level of purchases needed to maintain full employment. The efficiency factor refers

to both productive and allocative efficiency. Figure 8.2 illustrates these growth factors by

showing movement from curve AB to curve CD.

11. The rate of productivity growth has grown substantially due to innovations using microchips,

computers, new telecommunications devices and the Internet. All of these innovations describe

features of what we call information technology, which connects information in all parts of the

world with information seekers. New information products are often digital in nature and can be

easily replicated once they have been developed. The start-up cost of new firms and new

technology is high, but expanding production has a very low marginal cost, which leads to

economies of scale – firms’ output grows faster than their inputs. Network effects refer to a type

of economy of scale whereby certain information products become more valuable to each user as

the number of buyers grows. For example, a fax machine is more useful to you when lots of

other people and firms have one; the same is true for compatible word-processing programs.

Global competition is a feature of the New Economy because both transportation and

communication can be accomplished at much lower cost and faster speed than previously which

expands market possibilities for both consumers and producers who are not very limited by

national boundaries today.

14. Over the past 25 years U.S. real GDP has grown about 3 percent per year; China’s real GDP

has grown about 9 percent per year. China’s annual income per capita is around $2500. China’s

coastal areas are more industrialized, with greater access to international markets. Some of these

areas have been designated “special economic zones,” with greater freedom and support to

engage in high productivity economic activity. The poorer interior regions are heavily

agricultural.

Chapter 9: 1,7, & 11

1. The four phases of a typical business cycle, starting at the bottom, are trough, recovery, peak,

and recession. As seen in Table 9.1, the length of a complete cycle varies from about 2 to 3

years to as long as 15 years.

There is a pre-Christmas spurt in production and sales and a January slackening. This normal

seasonal variation does not signal boom or recession. From decade to decade, the long-term trend

(the secular trend) of the U.S. economy has been upward. A period of no GDP growth thus does

not mean all is normal, but that the economy is operating below its trend growth of output.

Because capital goods and durable goods last, purchases can be postponed. This may happen

when a recession is forecast. Capital and durable goods industries therefore suffer large output

declines during recessions. In contrast, consumers cannot long postpone the buying of

nondurables such as food; therefore recessions only slightly reduce non-durable output. Also,

capital and durable goods expenditures tend to be “lumpy.” Usually, a large expenditure is

needed to purchase them, and this shrinks to zero after purchase is made.

7. The CPI is constructed from a “market basket” sampling of goods that consumers typically

purchase. Prices for goods in the market basket are collected each month, weighted by the

importance of the good in the basket (cars are more expensive than bread, but we buy a lot more

bread), and averaged to form the price level.

To calculate the rate of inflation for year 5, the BLS subtracts the CPI of year 4 from the CPI of

year 5, and then divides by the CPI of year 4 (percentage change in the price level).

Inflation reduces the purchasing power of the dollar. Facing higher prices with a given number of

dollars means that each dollar buys less than it did before.

The rate of inflation in the CPI approximates the difference between the nominal and real interest

rates. A nominal interest rate of 10% with a 6% inflation rate will mean that real interest rates are

approximately 4%.

Deflation means that the price level is falling, whereas with inflation overall prices are rising.

Deflation is undesirable because the falling prices mean that incomes are also falling, which

reduces spending, output, employment, and, in turn, the price level (a downward spiral). Inflation

in modest amounts (<3%) is tolerable, although there is not universal agreement on this point.

11. (a) Assuming the pensioned railway worker has no other income and that the pension is not

indexed against inflation, the retired worker’s real income would decrease every year by

approximately 10 percent of its former value.

(b) Assuming the clerk was unionized and the contract had over a year to run, the clerk’s real

income would decrease in the same manner as the pensioner. However, the clerk could

expect to recoup at least part of the loss at contract renewal time. In the more likely event of

the clerk not being unionized, the clerk’s real income would decrease, possibly by as much as

the pensioned railroad worker. Although with prices increasing, the store hiring the clerk

may be able to pay the clerk better (and need to in order to retain his or her services).

(c) Since the UAW worker is unionized, the loss in the first year would be the same as in (b) but

it is likely—barring a deep recession—that the loss will be made up at contract renewal time

plus the usual real increase that may or may not be related to increased productivity. If the

contract had a cost-of-living allowance clause in it, the wage would automatically be raised at

the end of the year to cover the loss in purchasing power. Next year’s wage would rise by 10

percent.

(d) If the inflation is also in the price the farmer gets for his products, he could gain. But more

likely the price increases are mostly in what he buys, since farm machinery, fertilizer, etc.,

(g) Because this reduces disposable income, consumption will decline in proportion to the

marginal propensity to consume. Consumption will be less at each level of real output, and

so the curve shifts down. The saving schedule will also fall because the disposable income

has decreased at each level of output, so less would be saved.

6. The basic determinants of investment are the expected rate of return (net profit) that businesses hope

to realize from investment spending, and the real rate of interest.

When the real interest rate rises, investment decreases; and when the real interest rate drops,

investment increases—other things equal in both cases. The reason for this relationship is that it

makes sense to borrow money at, say, 10 percent, if the expected rate of net profit is higher than

10 percent, for then one makes a profit on the borrowed money. But if the expected rate of net

profit is less than 10 percent, borrowing the money would be expected to result in a negative rate

of return on the borrowed money. Even if the firm has money of its own to invest, the principle

still holds: The firm would not be maximizing profit if it used its own money to carry out an

investment returning, say, 9 percent when it could lend the money at an interest rate of 10

percent.

Investment is unstable because, unlike most consumption, it can be put off. In good times, with

demand strong and rising, businesses will bring in more machines and replace old ones. In times

of economic downturn, no new machines will be ordered. A firm can continue for years with,

say, a tenth of the investment it was carrying out in the boom. Very few families could cut their

consumption so drastically.

New business ideas and the innovations that spring from them do not come at a constant rate.

This is another reason for the irregularity of investment. Profits and the expectations of profits

also vary. Since profits, in the absence of easy access to borrowed money, are essential for

investment and since, moreover, the object of investment is to make a profit, investment, too,

must vary.

As long as expected rates of return rise faster than real interest rates, investment spending may

increase. This is most likely to occur during periods of economic expansion.

12. (a)

MPC is. 8

(b)

MPS is ( 1 − 8 )=. 2

(c)

C = $ 40 +. 8 ( $ 400 )= $ 40 + $ 320 = $ 360

(d)

APC = $ 360 /$ 400 =. 9

(e)

S = Y − C = $ 400 − $ 360 = $ 40

(f)

APS = $ 40 /$ 400 =. 1 or 1 − APC

Chapter 11: 2, 8, 12 & 13

2. Saving data for completing the table (top to bottom): $-4; $0; $4; $8; $12; $16; $20; $24;

Equilibrium GDP = $340 billion, determined where (1) aggregate expenditures equal GDP (C of

$324 billion + I of $16 billion = GDP of $340 billion); or (2) where planned I = S ( I of $16 billion

= S of $16 billion). Equilibrium level of employment = 65 million; MPC = .8; MPS = .2.

8. The multiplier is 10 or 1/(1-.9) so 10 x -$4 billion = -$40 billion. The new GDP is $400 billion - $40 billion = $360 billion.

12. Before G is added, open private sector equilibrium will be at $350. The addition of government

expenditures of G to our analysis raises the aggregate expenditures (C + Ig +Xn + G) schedule and

increases the equilibrium level of GDP as would an increase in C, Ig, or Xn. Note that changes in

government spending are subject to the multiplier effect. Government spending supplements

private investment and export spending (I g

  • X + G), increasing the equilibrium GDP to $450.

The addition of $20 billion of government expenditures and $20 billion of personal taxes

increases equilibrium GDP from $350 to $370 billion. The $20 billion increase in G raises

equilibrium GDP by $100 billion (= $20 billion x the multiplier of 5); the $20 billion increase in

T reduces consumption by $16 billion at every level. (= $20 billion x the MPC of .8). This $

billion decline in turn reduces equilibrium GDP by $80 billion ($16 billion x multiplier of 5).

The net change from including balanced government spending and taxes is $20 billion (= $

billion - $80 billion).

13. (a) A recessionary gap. Equilibrium GDP is $600 billion, while full employment GDP is

$700 billion. Employment will be 20 million less than at full employment. Aggregate

expenditures would have to increase by $20 billion (= $700 billion -$680 billion) at each

level of GDP to eliminate the recessionary gap. The MPC is .8, so the multiplier is 5.

(b) An inflationary gap. Aggregate expenditures will be excessive, causing demand-pull

inflation. Aggregate expenditures would have to fall by $20 billion (= $520 billion -$

billion) at each level of GDP to eliminate the inflationary gap. The multiplier is still 5 – the

level of full employment GDP does not affect the multiplier.

(c) MPC = .8 (= $40 billion/$50 billion); MPS = .2 (= 1 -.8); multiplier = 5 (= 1/.2).