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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).
