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Mankiw solutions: Principles of economics solutions, Exercises of Economics

Principles of economics solutions

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Solutions to Quick Quizzes
1
Chapter 1
1. There are many possible answers.
2. There are many possible answers.
3. The three principles that describe
how the economy as a whole
works are: (1) a country’s standard
of living depends on its ability
to produce goods and services;
(2) prices rise when the govern-
ment prints too much money; and
(3) society faces a short-run trade-
off between inflation and unem-
ployment. A country’s standard
of living depends largely on the
productivity of its workers, which
in turn depends on the education
of its workers and the access its
workers have to the necessary
tools and technology. Prices rise
when the government prints too
much money because more money
in circulation reduces the value of
money, causing inflation. Society
faces a short-run trade-off between
inflation and unemployment that
is only temporary. Policymakers
have some short-term ability to
exploit this relationship using vari-
ous policy instruments.
Chapter 2
1. Economics is like a science because
economists devise theories, collect
data, and analyze the data in an
attempt to verify or refute their
theories. In other words, eco-
nomics is based on the scientific
method.
Figure 1 shows the production
possibilities frontier for a society
that produces food and clothing.
Point A is an efficient point (on
the frontier), point B is an inef-
ficient point (inside the frontier),
and point C is an infeasible point
(outside the frontier).
B
A
Quantity of Food Produced
Quantity of Clothing Produced
C
Figure 1
The effects of a drought are
shown in Figure 2. The drought
reduces the amount of food that
can be produced, shifting the
production possibilities frontier
inward.
Quantity of Food Produced
Quantity of Clothing Produced
PPF2PPF1
Figure 2
Microeconomics is the study of
how households and firms make
decisions and how they interact in
markets. Macroeconomics is the
study of economy-wide phenom-
ena, including inflation, unem-
ployment, and economic growth.
2. An example of a positive state-
ment is “a higher price of coffee
causes me to buy more tea.” It is
a positive statement because it is
a claim that describes the world
as it is. An example of a norma-
tive statement is “the government
should restrain coffee prices.” It
is a normative statement because
it is a claim that prescribes how
the world should be. Many other
examples are possible.
Parts of the government that
regularly rely on advice from
economists are the Department
of the Treasury in designing tax
policy, the Department of Labor
in analyzing data on the employ-
ment situation, the Department of
Justice in enforcing the nation’s
antitrust laws, the Congressional
Budget Office in evaluating policy
proposals, and the Federal Reserve
in analyzing economic develop-
ments. Many other answers are
possible.
3. Economic advisers to the president
might disagree about a question
of policy because of differences in
scientific judgments or differences
in values.
Chapter 3
1. Figure 1 shows Robinson Crusoe’s
production possibilities frontier
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1

Chapter 1

  1. There are many possible answers.
  2. There are many possible answers.
  3. The three principles that describe how the economy as a whole works are: (1) a country’s standard of living depends on its ability to produce goods and services; (2) prices rise when the govern- ment prints too much money; and (3) society faces a short-run trade- off between inflation and unem- ployment. A country’s standard of living depends largely on the productivity of its workers, which in turn depends on the education of its workers and the access its workers have to the necessary tools and technology. Prices rise when the government prints too much money because more money in circulation reduces the value of money, causing inflation. Society faces a short-run trade-off between inflation and unemployment that is only temporary. Policymakers have some short-term ability to exploit this relationship using vari- ous policy instruments.

Chapter 2

  1. Economics is like a science because economists devise theories, collect data, and analyze the data in an attempt to verify or refute their theories. In other words, eco- nomics is based on the scientific method. Figure 1 shows the production possibilities frontier for a society that produces food and clothing. Point A is an efficient point (on

the frontier), point B is an inef- ficient point (inside the frontier), and point C is an infeasible point (outside the frontier).

B

A

Quantity of Food Produced

Quantity of Clothing Produced

C

Figure 1

The effects of a drought are shown in Figure 2. The drought reduces the amount of food that can be produced, shifting the production possibilities frontier inward.

Quantity of Food Produced

Quantity of Clothing Produced PPF2 PPF

Figure 2

Microeconomics is the study of how households and firms make decisions and how they interact in markets. Macroeconomics is the study of economy-wide phenom- ena, including inflation, unem- ployment, and economic growth.

  1. An example of a positive state- ment is “a higher price of coffee causes me to buy more tea.” It is a positive statement because it is a claim that describes the world as it is. An example of a norma- tive statement is “the government should restrain coffee prices.” It is a normative statement because it is a claim that prescribes how the world should be. Many other examples are possible. Parts of the government that regularly rely on advice from economists are the Department of the Treasury in designing tax policy, the Department of Labor in analyzing data on the employ- ment situation, the Department of Justice in enforcing the nation’s antitrust laws, the Congressional Budget Office in evaluating policy proposals, and the Federal Reserve in analyzing economic develop- ments. Many other answers are possible.
  2. Economic advisers to the president might disagree about a question of policy because of differences in scientific judgments or differences in values.

Chapter 3

  1. Figure 1 shows Robinson Crusoe’s production possibilities frontier

for gathering coconuts and catch- ing fish. If Crusoe lives by himself, this frontier limits his consump- tion of coconuts and fish, but if he can trade with natives on the island, he will possibly be able to consume at a point outside his production possibilities frontier.

Coconuts Gathered

Fish Caught

Figure 1

  1. Crusoe’s opportunity cost of catching one fish is 10 coconuts, since he can gather 10 coconuts in the same amount of time it takes to catch one fish. Friday’s oppor- tunity cost of catching one fish is 15 coconuts, since he can gather 30 coconuts in the same amount of time it takes to catch two fish. Friday has an absolute advantage in catching fish, since he can catch two per hour, while Crusoe can catch only one per hour. But Cru- soe has a comparative advantage in catching fish, since his opportu- nity cost of catching a fish is less than Friday’s.
  2. If the world’s fastest typist hap- pens to be trained in brain sur- gery, she should hire a secretary because the secretary will give up less for each hour spent typing. Although the brain surgeon has an absolute advantage in typing, the secretary has a comparative advantage in typing because of the lower opportunity cost of typing.

Chapter 4

  1. A market is a group of buyers (who determine demand) and a

group of sellers (who determine supply) of a particular good or service. A perfectly competitive market is one in which there are many buyers and many sellers of an identical product so that each has a negligible impact on the market price.

  1. Here is an example of a monthly demand schedule for pizza:

Price of Number of Pizza Pizza Slice Slices Demanded

$0.00 10 0.25 9 0.50 8 0.75 7 1.00 6 1.25 5 1.50 4 1.75 3 2.00 2 2.25 1 2.50 0

The demand curve is graphed in Figure 1.

Price of Pizza Slice

0

$2.

2 4 6 8 10

Demand

Number of Pizza Slices Demanded Figure 1

Examples of things that would shift the demand curve include changes in income, prices of related goods like soda or hot dogs, tastes, expectations about future income or prices, and the number of buyers. A change in the price of pizza would not shift this demand curve; it would only lead to a movement from one point to

another along the same demand curve.

  1. Here is an example of a monthly supply schedule for pizza:

Price of Number of Pizza Pizza Slice Slices Supplied

$0.00 0 0.25 100 0.50 200 0.75 300 1.00 400 1.25 500 1.50 600 1.75 700 2.00 800 2.25 900 2.50 1000

The supply curve is graphed in Figure 2.

Price of Pizza Slice

0

$2.

200 400 600 800 1000

Supply

Number of Pizza Slices Supplied Figure 2

Examples of things that would shift the supply curve include changes in prices of inputs like tomato sauce and cheese, changes in technology like more efficient pizza ovens or automatic dough makers, changes in expectations about the future price of pizza, or a change in the number of sellers. A change in the price of pizza would not shift this supply curve; it would only lead to a movement from one point to another along the same supply curve.

  1. If the price of tomatoes rises, the supply curve for pizza shifts to the left because there has been an increase in the price of an input

If the tax is imposed on car sellers, as shown in Figure 2, the sup- ply curve shifts upward by the amount of the tax ($1,000) to S 2. The upward shift in the supply curve leads to a rise in the price paid by buyers to P 2 and a decline in the equilibrium quantity to Q 2. The price paid by buyers increases by P 2 – P 1 , shown in the figure as ΔPB. Sellers receive P 2 – 1,000, a decrease in what they receive by P 1 – (P 2 – $1,000), shown in the figure as ΔPS.

P 2  $1,

P 1

P 2

Quantity of Cars

Price of Cars

Q 2 Q 1

 P B  P S

S 2

S 1

D

Figure 2

Chapter 7

  1. Figure 1 shows the demand curve for turkey. The price of turkey is P 1 and the consumer surplus that results from that price is denoted CS. Consumer surplus is the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it. It measures the benefit to buyers of participating in a market.

Quantity of Turkey

Price of Turkey

Demand

P 1

CS

Figure 1

  1. Figure 2 shows the supply curve for turkey. The price of turkey is P 1 and the producer surplus that results from that price is denoted PS. Producer surplus is the amount sellers are paid for a good minus the sellers’ cost of provid- ing it (measured by the supply curve). It measures the benefit to sellers of participating in a market.

Quantity of Turkey

Price of Turkey

Supply

PS

P 1

Figure 2

  1. Figure 3 shows the supply and demand for turkey. The price of turkey is P 1 , consumer surplus is CS, and producer surplus is PS. Producing more turkeys than the equilibrium quantity would lower total surplus because the value to the marginal buyer would be lower than the cost to the marginal seller on those additional units.

Price of Turkey

P 1

Quantity of Turkey

Supply

Demand

PS

CS

Figure 3

Chapter 8

  1. Figure 1 shows the supply and demand curves for cookies, with equilibrium quantity Q 1 and equi- librium price P 1. When the govern- ment imposes a tax on cookies, the price to buyers rises to P B, the price received by sellers declines to P S, and the equilibrium quantity falls to Q 2. The deadweight loss is the triangular area below the demand curve and above the supply curve between quantities Q 1 and Q 2. The deadweight loss shows the fall in total surplus that results from the tax.

PB

DWL DWL

P 1

Quantity of Cookies

Q 2

Price ofCookies

PS

Q 1

Demand

Supply

Figure 1

  1. The deadweight loss of a tax is greater the greater is the elasticity of demand. Therefore, a tax on beer would have a larger deadweight loss than a tax on milk because the demand for beer is more elastic than the demand for milk.
  2. If the government doubles the tax on gasoline, the revenue from the gasoline tax could rise or fall depending on whether the size of the tax is on the upward or down- ward sloping portion of the Laffer curve. However, if the government doubles the tax on gasoline, you can be sure that the deadweight loss of the tax rises because dead- weight loss always rises as the tax rate rises.

Chapter 9

  1. Since wool suits are cheaper in neighboring countries, Autarka would import suits if it were to allow free trade.
  2. Figure 1 shows the supply and demand for wool suits in Autarka. With no trade, the price of suits is 3 ounces of gold, consumer sur- plus is area A, producer surplus is area B + C, and total surplus is area A + B + C. When trade is allowed, the price falls to 2 ounces of gold, consumer surplus rises to A + B + D (an increase of B + D), producer surplus falls to C (a decline of B), so total surplus rises to A + B + C + D (an increase of D). A tariff on suit imports would reduce the increase in consumer surplus, reduce the decline in pro- ducer surplus, and reduce the gain in total surplus.

C

B (^) D

A

Price of Wool Suits

3

Quantity of Wool Suits

Domestic supply

Domestic demand

2 World price

Imports

Figure 1

  1. Lobbyists for the textile industry might make five arguments in favor of a ban on the import of wool suits: (1) imports of wool suits destroy domestic jobs; (2) the wool-suit industry is vital for national security; (3) the wool-suit industry is just starting up and needs protection from foreign competition until it gets stronger; (4) other countries are unfairly subsidizing their wool-suit indus- tries; and (5) the ban on the impor- tation of wool suits can be used as

a bargaining chip in international negotiations. In defending free trade in wool suits, you could argue that: (1) free trade creates jobs in some industries even as it destroys jobs in the wool-suit industry and allows Autarka to enjoy a higher standard of living; (2) the role of wool suits for the military may be exagger- ated; (3) government protection is not needed for an industry to grow on its own; (4) it would be good for the citizens of Autarka to be able to buy wool suits at a subsidized price; and (5) threats against free trade may backfire, leading to lower levels of trade and lower economic welfare for everyone.

Chapter 10

  1. Examples of negative externalities include pollution, barking dogs, and consumption of alcoholic beverages. Examples of positive externalities include restoring historic buildings, research into new technologies, and education. (Many other examples of nega- tive and positive externalities are possible.) Market outcomes are inefficient in the presence of exter- nalities because markets produce a larger quantity than is socially desirable when there is a negative externality and a smaller quantity than is socially desirable when there is a positive externality.
  2. The town government might respond to the externality from the smoke in three ways: (1) regula- tion; (2) corrective taxes; or (3) tradable pollution permits. Regulation prohibiting pollu- tion beyond some level is good because it is often effective at reducing pollution. But doing so successfully requires the govern- ment to have a lot of informa- tion about the industries and the alternative technologies that those industries could adopt. Corrective taxes are a useful way to reduce pollution because the tax can be increased to get

pollution to a lower level and because the taxes raise revenue for the government. The tax is more efficient than regulation because it gives factories economic incentives to reduce pollution and to adopt new technologies that pollute less. The disadvantage of corrective taxes is that the government needs to know a lot of information to pick the right tax rate. Tradable pollution permits are similar to corrective taxes but allow the firms to trade the right to pollute with each other. As a result, the government does not need as much information about the firms’ technologies. The gov- ernment can simply set a limit on the total amount of pollution, issue permits for that amount, and allow the firms to trade the permits. This reduces pollution while allow- ing economic efficiency. Those opposed to pollution permits argue that it is wrong to put a price on pollution and wrong to allow even low levels of pollution, but economists have little sympa- thy with these arguments.

  1. Examples of private solutions to externalities include moral codes and social sanctions, charities, and relying on the interested par- ties entering into contracts with one other. The Coase theorem is the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own. Private economic partici- pants are sometimes unable to solve the problems caused by an externality because of transac- tions costs or because bargaining breaks down. This is most likely when the number of interested parties is large.

Chapter 11

  1. Public goods are goods that are neither excludable nor rival in consumption. Examples include

because at low levels of output, marginal cost is below average total cost, so average total cost is falling. But after the two curves cross, marginal cost rises above average total cost, and average total cost starts to rise. So the point of intersection must be the mini- mum of average total cost.

Quantity

Costs^ Marginal Cost

Average Total Cost

Figure 3

  1. The long-run average total cost of producing 9 planes is $9 million / 9 = $1 million. The long-run average total cost of producing 10 planes is $9.5 million / 10 = $0.95 million. Since the long-run average total cost declines as the number of planes increases, Boe- ing exhibits economies of scale.

Chapter 14

  1. When a competitive firm doubles the amount it sells, the price remains the same, so its total rev- enue doubles.
  2. A profit-maximizing competitive firm sets price equal to its mar- ginal cost. If price were above mar- ginal cost, the firm could increase profits by increasing output, while if price were below marginal cost, the firm could increase profits by decreasing output. A profit-maximizing competi- tive firm decides to shut down in the short run when price is less than average variable cost. In the long run, a firm will exit a market

when price is less than average total cost.

  1. In the long run, with free entry and exit, the price in the market is equal to both a firm’s marginal cost and its average total cost, as Figure 1 shows. The firm chooses its quantity so that marginal cost equals price; doing so ensures that the firm is maximizing its profit. In the long run, entry into and exit from the industry drive the price of the good to the minimum point on the average-total-cost curve.

Q Quantity

P

Price

Marginal Cost Average Total Cost

Chapter 15

  1. A market might have a monopoly because: (1) a key resource is owned by a single firm; (2) the government gives a single firm the exclusive right to produce some good; or (3) the costs of produc- tion make a single producer more efficient than a large number of producers. Examples of monopolies include: (1) the water producer in a small town, who owns a key resource, the one well in town; (2) a pharmaceutical company that is given a patent on a new drug by the government; and (3) a bridge, which is a natural monopoly because (if the bridge is uncon- gested) having just one bridge is efficient. Many other examples are possible.
  2. A monopolist chooses the amount of output to produce by finding

the quantity at which marginal revenue equals marginal cost. It finds the price to charge by find- ing the point on the demand curve that corresponds to that quantity.

  1. A monopolist produces a quan- tity of output that is less than the quantity of output that maximizes total surplus because it produces the quantity at which marginal cost equals marginal revenue rather than the quantity at which marginal cost equals price. This lower production level leads to a deadweight loss.
  2. Examples of price discrimina- tion include: (1) movie tickets, for which children and senior citizens get lower prices; (2) airline prices, which are different for business and leisure travelers; (3) discount coupons, which lead to different prices for people who value their time in different ways; (4) financial aid, which offers college tuition at lower prices to poor students and higher prices to wealthy students; and (5) quantity discounts, which offer lower prices for higher quan- tities, capturing more of a buyer’s willingness to pay. Many other examples are possible. Compared to a monopoly that charges a single price, perfect price discrimination reduces consumer surplus, increases producer sur- plus, and increases total surplus because there is no deadweight loss.
  3. Policymakers can respond to the inefficiencies caused by monopo- lies in one of four ways: (1) by trying to make monopolized industries more competitive; (2) by regulating the behavior of the monopolies; (3) by turning some private monopolies into public enterprises; or (4) by doing noth- ing at all. Antitrust laws prohibit mergers of large companies and prevent large companies from coordinating their activities in ways that make markets less competitive, but such laws may

keep companies from merging and generating synergies that increase efficiency. Some monopolies, especially natural monopolies, are regulated by the government, but it is hard to keep a monopoly in business, achieve marginal-cost pricing, and give the monopo- list an incentive to reduce costs. Private monopolies can be taken over by the government, but the companies are not likely to be well run. Sometimes doing nothing at all may seem to be the best solu- tion, but there are clearly dead- weight losses from monopoly that society will have to bear.

Chapter 16

  1. Oligopoly is a market structure in which only a few sellers offer similar or identical products. Examples include the market for tennis balls and the world mar- ket for crude oil. Monopolistic competition is a market structure in which many firms sell products that are similar but not identical. Examples include the markets for novels, movies, restaurant meals, and computer games.
  2. The three key attributes of monopolistic competition are: (1) there are many sellers; (2) each firm produces a slightly different product; and (3) firms can enter or exit the market freely. Figure 1 shows the long-run equilibrium in a monopolisti- cally competitive market. This equilibrium differs from that in a perfectly competitive market because price exceeds marginal cost and the firm does not produce at the minimum point of average total cost but instead produces at less than the efficient scale.

Q Quantity

Price, Cost, Revenue

P

Demand

Marginal Revenue

Average Total Cost

Marginal Cost

Figure 1

  1. Advertising may make markets less competitive if it manipulates people’s tastes rather than being informative. Advertising may give consumers the perception that there is a greater difference between two products than really exists. That makes the demand curve for a product more inelastic, so the firms can then charge greater markups over marginal cost. However, some advertising could make markets more competitive because it some- times provides useful information to consumers, allowing them to take advantage of price differ- ences more easily. Advertising also facilitates entry because it can be used to inform consumers about a new product. In addition, expen- sive advertising can be a signal of quality.

Brand names may be beneficial because they provide information to consumers about the quality of goods. They also give firms an incentive to maintain high quality, since their reputations are impor- tant. But brand names may be criticized because they may simply differentiate products that are not really different, as in the case of drugs that are identical with the brand-name drug selling at a much higher price than the generic drug.

Chapter 17

  1. If the members of an oligopoly could agree on a total quantity to produce, they would choose to produce the monopoly quantity, acting in collusion as if they were a monopoly. If the members of the oligopoly make production decisions individually, self-interest induces them to produce a greater quantity than the monopoly quantity.
  2. The prisoners’ dilemma is the story of two criminals suspected of committing a crime, in which the sentence that each receives depends both on his or her deci- sion whether to confess or remain silent and on the decision made by the other. The following table shows the prisoners’ choices:

Bonnie’s Decision

Confess Remain Silent

Confess Bonnie gets eight years Bonnie gets 20 years Clyde’s Clyde gets eight years^ Clyde goes free Decision (^) Remain Silent Bonnie goes free Bonnie gets one year Clyde gets 20 years Clyde gets one year

increase the total utility of society. A liberal would want to maximize the utility of the least well-off per- son in society, so a liberal would favor even greater redistribution. A libertarian would not want to redistribute income from Pam to Pauline as long as the process of earning income was a fair one.

  1. Policies aimed at helping the poor include minimum-wage laws, wel- fare, a negative income tax, and in-kind transfers. Minimum-wage laws can help the working poor without any cost to the govern- ment but have the disadvantage of causing unemployment among some workers. Welfare assists the poor with direct aid but creates incentives for people to become needy. The negative income tax is a good way to implement a pro- gram of financial aid for the poor and does not distort incentives as much as some other programs do, but it may support those who are lazy and unwilling to work. In-kind transfers provide goods and services directly to the poor, ensuring that the poor get neces- sities such as food and shelter, but the government may not know what the poor need the most.

Chapter 21

  1. A person with an income of $1, could purchase $1,000/$5 = 200 pints of Pepsi if she spent all of her income on Pepsi or she could purchase $1,000/$10 = 100 pizzas if she spent all of her income on pizza. Thus, the point representing 200 pints of Pepsi and no pizzas is the vertical intercept and the point representing 100 pizzas and no Pepsi is the horizontal intercept of the budget constraint, as shown in Figure 1. The slope of the budget constraint is the rise over the run, or –200/100 = –2.

100 Quantity of Pizza

Quantity of Pepsi

0

200

Budget constraint

Figure 1

  1. Figure 2 shows indifference curves between Pepsi and pizza. The four properties of these indifference curves are: (1) higher indifference curves are preferred to lower ones because consumers prefer more of a good to less of it; (2) indiffer- ence curves are downward sloping because if the quantity of one good is reduced, the quantity of the other good must increase in order for the consumer to be equally happy; (3) indifference curves do not cross because if they did, the assumption that more is preferred to less would be violated; and (4) indifference curves are bowed inward because people are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little.

Quantity of Pizza

Quantity of Pepsi

Figure 2

  1. Figure 3 shows the budget con- straint ( BC 1 ) and two indifference curves. The consumer is initially at point A, where the budget constraint is tangent to an indif- ference curve. The increase in the price of pizza shifts the budget constraint to BC 2 , and the con- sumer moves to point C where the new budget constraint is tangent to a lower indifference curve. To break this move down into income and substitution effects requires drawing the dashed budget line shown, which is parallel to the new budget constraint and tangent to the original indifference curve at point B. The movement from A to B represents the substitution effect, while the movement from B to C represents the income effect.

Substitution Effect Income Effect Quantity of Pizza

Quantity of Pepsi A

BC 1

I 1 I 2

BC 2

B C

Substitution Effect

Income Effect

Figure 3

  1. An increase in the wage can poten- tially decrease the amount that a person wants to work because a higher wage has an income effect that increases both leisure and consumption and a substitution effect that increases consumption and decreases leisure. Because less leisure means more work, a person will work more only if the substi- tution effect outweighs the income effect.

Chapter 22

  1. Buyers of life insurance will likely have higher than average death rates. Two reasons for this are moral hazard and adverse selection. Moral hazard is the tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behav- ior. After purchasing insurance, an insured person may engage in riskier behavior than do people who are not insured. Adverse selection is the ten- dency for the mix of unobserved attributes to become undesirable from the standpoint of an unin- formed party. In this case, those with higher risk of death are more likely to want to buy insurance. As a result, the price of life insurance will reflect the costs of a riskier- than-average person. Buyers with low risk of death may find the price of life insurance too high and may choose not to purchase it. A life insurance company can mitigate moral hazard by trying to monitor behavior better and charging higher rates to those who engage in risky behavior (such as smoking). It can mitigate adverse selection by trying to collect bet- ter information on applicants; for example, it may require that all applicants submit to a medi- cal examination before issuing insurance.
  2. According to the median voter theorem, if each voter chooses a point closest to his preferred point, the district vote will reflect the preferences of the median voter. Therefore, the district will end up with a student-teacher ratio of 11:1.
  3. Human decision making can differ from the rational human being of conventional economic theory in three important ways: (1) people aren’t always rational, (2) people care about fairness, and (3) people are inconsistent over time.

Chapter 23

  1. Gross domestic product measures two things at once: (1) the total income of everyone in the economy and (2) the total expenditure on the economy’s output of final goods and services. It can measure both of these things at once because all expenditure in the economy ends up as someone’s income.
  2. The production of a pound of caviar contributes more to GDP than the production of a pound of hamburger because the contribu- tion to GDP is measured by mar- ket value and the price of a pound of caviar is much higher than the price of a pound of hamburger.
  3. The four components of expen- diture are: (1) consumption, (2) investment, (3) government purchases, and (4) net exports. The largest component is consumption, which accounts for more than two- thirds of total expenditure.
  4. Real GDP is the production of goods and services valued at con- stant prices. Nominal GDP is the production of goods and services valued at current prices. Real GDP is a better measure of economic well-being because changes in real GDP reflect changes in the amount of output being produced. Thus, a rise in real GDP means people have produced more goods and services, but a rise in nominal GDP could occur either because of increased production or because of higher prices.
  5. Although GDP is not a perfect measure of well-being, policymak- ers should care about it because a larger GDP means that a nation can afford better healthcare, better educational systems, and more of the material necessities of life.

Chapter 24

  1. The consumer price index mea- sures the overall cost of the goods and services bought by a typical consumer. It is constructed by

surveying consumers to determine a basket of goods and services that the typical consumer buys. Prices of these goods and services are used to compute the cost of the basket at different times, and a base year is chosen. To compute the index, we divide the cost of the market basket in the current year by the cost of the market basket in the base year and multiply by 100. The CPI is an imperfect measure of the cost of liv- ing because of (1) substitution bias, (2) the introduction of new goods, and (3) unmeasured quality changes.

  1. Since Henry Ford paid his workers $5 a day in 1914 and the consumer price index was 10 in 1914 and 218 in 2010, then the Ford paycheck was worth $5 × 218 / 10 = $109 a day in 2010 dollars.

Chapter 25

  1. The approximate growth rate of real GDP per person in the United States is 1.83 percent (based on Table 1) from 1870 to 2006. Coun- tries that have had faster growth include Japan, Brazil, Mexico, China, Germany, Canada, and Argentina; countries that have had slower growth include India, United Kingdom, Indonesia, Paki- stan, and Bangladesh.
  2. The four determinants of a coun- try’s productivity are: (1) physical capital, which is the stock of equip- ment and structures that are used to produce goods and services; (2) human capital, which is the knowledge and skills that work- ers acquire through education, training, and experience; (3) natural resources, which are inputs into production that are provided by nature, such as land, rivers, and mineral deposits; and (4) technolog- ical knowledge, which is society’s understanding of the best ways to produce goods and services.
  3. Ways in which a government policymaker can try to raise the growth in living standards in a society include: (1) investing

WE

Quantity of Labor

LE

unemployment

S

D

Wage W

LD LS

Figure 1

  1. A union in the auto industry raises the wages of workers employed by General Motors and Ford by threatening to strike. To prevent the costs of a strike, the firms generally pay higher wages than they would if there were no union. However, the higher wages reduce employment at General Motors and Ford. The unemployed autoworkers seek jobs elsewhere, reducing wages and increasing employment in the nonunion sector.
  2. There are four reasons that firms might find it profitable to pay wages above the level that balances the quantity of labor supplied and the quantity of labor demanded: (1) to ensure that work- ers are in good health so they will be more productive; (2) to reduce worker turnover because it is costly to hire new workers; (3) to make workers eager to keep their jobs, thus discouraging them from shirk- ing; and (4) to attract a better pool of workers.

Chapter 29

  1. The three functions of money are: (1) medium of exchange; (2) unit of account; and (3) store of value. Money is a medium of exchange because money is the item people use to purchase goods and ser- vices. Money is a unit of account

because it is the yardstick people use to post prices and record debts. Money is a store of value because people use it to transfer purchasing power from the pres- ent to the future.

  1. The primary responsibilities of the Federal Reserve are to regulate banks, to ensure the health of the banking system, and to control the quantity of money that is made available in the economy. If the Fed wants to increase the supply of money, it usually does so by creating dollars and using them to purchase government bonds from the public in the nation’s bond markets.
  2. Banks create money when they hold a fraction of their deposits in reserve and lend out the remain- der. If the Fed wanted to use all three of its tools to decrease the money supply, it would: (1) sell government bonds from its port- folio in the open market to reduce the number of dollars in circula- tion; (2) increase reserve require- ments to reduce the money created by banks; and (3) increase the discount rate to discourage banks from borrowing reserves from the Fed.

Chapter 30

  1. When the government of a country increases the growth rate of the money supply from 5 percent per year to 50 percent per year, the average level of prices will start rising very quickly, as predicted by the quantity theory of money. Nominal interest rates will increase dramatically as well, as predicted by the Fisher effect. The government may be increasing the money supply to finance its expenditures.
  2. Six costs of inflation are: (1) shoe- leather costs; (2) menu costs; (3) relative-price variability and the misallocation of resources;

(4) inflation-induced tax dis- tortions; (5) confusion and inconvenience; and (6) arbi- trary redistributions of wealth. Shoeleather costs arise because inflation causes people to spend resources going to the bank more often. Menu costs occur when people spend resources changing their posted prices. Relative-price variability occurs because as general prices rise, a fixed dol- lar price translates into a declin- ing relative price, so the relative prices of goods are constantly changing, causing a misallocation of resources. The combination of inflation and taxation causes distortions in incentives because people are taxed on their nominal capital gains and interest income instead of their real income from these sources. Inflation causes confusion and inconvenience because it reduces money’s ability to function as a unit of account. Unexpected inflation redistributes wealth between borrowers and lenders.

Chapter 31

  1. Net exports are the value of a nation’s exports minus the value of its imports, also called the trade balance. Net capital outflow is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. Net exports equal net capital outflow.
  2. The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another. They are related through the expression: real exchange rate equals nominal exchange rate times domestic price divided by foreign price.

If the nominal exchange rate goes from 100 to 120 yen per dollar, the dollar has appreciated because a dollar now buys more yen.

  1. Because Spain has had high inflation and Japan has had low inflation, the number of Spanish pesetas a person can buy with Japanese yen has increased.

Chapter 32

  1. The supply of loanable funds comes from national saving. The demand for loanable funds comes from domestic investment and net capital outflow. The supply in the market for foreign-currency exchange comes from net capital outflow. The demand in the mar- ket for foreign-currency exchange comes from net exports.
  2. The two markets in the model of the open economy are the market for loanable funds and the market for foreign-currency exchange. These markets determine two relative prices: (1) the market for loanable funds determines the real interest rate and (2) the market for foreign-currency exchange deter- mines the real exchange rate.
  3. If Americans decided to spend a smaller fraction of their incomes, the increase in saving would shift the supply curve for loanable funds to the right, as shown in Figure 1. The decline in the real interest rate increases net capital outflow and shifts the supply of dollars to the right in the market for foreign-currency exchange. The result is a decline in the real exchange rate. Since the real inter- est rate is lower, domestic invest- ment increases. Since the real exchange rate declines, net exports increase and the trade balance moves toward surplus. Overall, saving and domestic investment increase, the real interest rate and

real exchange rate decrease, and the trade balance moves toward surplus.

Real Interest Rate Real Interest Rate

Quantity of Dollars

Quantity of Loanable Funds Net Capital Outflow

Real Exchange Rate

r 2

E 2

E 1

Demand

Demand

r 1

Net capital outflow

S 1 S 2

S 1 S 2

Figure 1

Chapter 33

  1. Three key facts about economic fluctuations are: (1) economic fluc- tuations are irregular and unpre- dictable; (2) most macroeconomic quantities fluctuate together; and (3) as output falls, unemployment rises. Economic fluctuations are irreg- ular and unpredictable, as you can see by looking at a graph of real GDP over time. Some recessions are close together and others are far apart. There appears to be no recurring pattern. Most macroeconomic quantities fluctuate together. In recessions, real GDP, consumer spending, investment spending, corporate profits, and other macroeconomic variables decline or grow much more slowly than during eco- nomic expansions. However, the variables fluctuate by different amounts over the business cycle, with investment varying much more than other variables. As output falls, unemploy- ment rises, because when firms want to produce less, they lay off

workers, thus causing a rise in unemployment.

  1. The economy’s behavior in the short run differs from its behav- ior in the long run because the assumption of monetary neutrality applies only to the long run, not the short run. In the short run, real and nominal variables are highly intertwined. Figure 1 shows the model of aggregate demand and aggregate supply. The horizontal axis shows the quantity of output, and the vertical axis shows the price level.

Equilibrium output

Quantity of Output

Price Level

Equilibrium price level

Aggregate supply

Aggregate demand

Figure 1

  1. The aggregate-demand curve slopes downward for three rea- sons. First, when prices fall, the value of dollars in people’s wallets and bank accounts rises, so they are wealthier. As a result, they spend more, thereby increasing the quantity of goods and services demanded. Second, when prices fall, people need less money to make their purchases, so they lend more out, which reduces the inter- est rate. The lower interest rate encourages businesses to invest more, increasing the quantity of goods and services demanded. Third, since lower prices lead to a lower interest rate, some U.S. investors will invest abroad, supplying dollars to the foreign-

Chapter 35

  1. The Phillips curve is shown in Figure 1.

Unemployment Rate

Inflation Rate

Phillips curve

Figure 1

To see how policy can move the economy from a point with high inflation to a point with low infla- tion, suppose the economy begins at point A in Figure 2. If policy is used to reduce aggregate demand (such as a decrease in the money supply or a decrease in govern- ment purchases), the aggregate- demand curve shifts from AD 1 to AD 2 , and the economy moves from point A to point B with lower inflation, a reduction in real GDP, and an increase in the unemploy- ment rate.

Unemployment Rate

Inflation Rate

A

B

Phillips curve

Quantity of Output

AS

B

A

AD 2

AD

Price Level

Figure 2

  1. Figure 3 shows the short-run Phil- lips curve and the long-run Phil- lips curve. The curves are different because in the long run, monetary policy has no effect on unemploy- ment, which tends toward its natural rate. However, in the short run, monetary policy can affect the unemployment rate. An increase in the growth rate of money raises actual inflation above expected inflation, causing firms to produce more since the short-run aggregate supply curve is positively sloped, which reduces unemployment temporarily.

Unemployment Rate

Inflation Rate

Short-run Phillips curve

Long-run Phillips curve

Figure 3

  1. Examples of favorable shocks to aggregate supply include improved productivity and a decline in oil prices. Either shock shifts the aggregate-supply curve to the right, increasing output and reducing the price level, moving the economy from point A to point B in Figure 4. As a result, the Phil- lips curve shifts to the left, as the figure shows.

Unemployment Rate

Inflation Rate A

B

PC 1

PC 2

Quantity of Output

Price Level

P 1

P 2

AD

A

B

AS 1 AS 2

Y 1 Y 2

Figure 4

  1. The sacrifice ratio is the number of percentage points of annual output lost in the process of reduc- ing inflation by 1 percentage point. The credibility of the Fed’s com- mitment to reduce inflation might affect the sacrifice ratio because it affects the speed at which expectations of inflation adjust. If the Fed’s commitment to reduce inflation is credible, people will reduce their expectations of infla- tion quickly, the short-run Phillips curve will shift downward, and the cost of reducing inflation will be low in terms of lost output. But if the Fed is not credible, people will not reduce their expectations of inflation quickly, and the cost of reducing inflation will be high in terms of lost output.

Chapter 36

  1. Monetary and fiscal policies work with a lag. Monetary policy works with a lag because it affects spend- ing for residential and business investment, but spending plans for such investment are often set in advance. Thus, it takes time for changes in monetary policy, working through interest rates, to affect investment. Fiscal policy works with a lag because of the long political process that governs changes in spending and taxes. These lags matter for the choice between active and passive policy because if the lags are long, policy must be set today for conditions far in the future, about which we

can only guess. Since economic conditions may change between the time a policy is implemented and when it takes effect, policy changes may be destabilizing. Thus, long lags suggest a policy that is passive rather than active.

  1. A dollar of additional government spending has a larger effect on GDP than a dollar of tax cuts. This occurs because, in general, some of the dollar tax cut will end up as saving.
  2. There are many possible rules for monetary policy. One example is a rule that sets money growth at 3 percent per year. This rule might be better than discretionary policy because it prevents a political busi- ness cycle and the time inconsis- tency problem. It might be worse than discretionary policy because it would tie the Fed’s hands when there are shocks to the economy. For example, in response to a stock-market crash, the rule would prevent the Fed from easing monetary policy, even if it saw the economy slipping into recession.
  3. The benefits of reducing inflation to zero include: (1) reducing shoe- leather costs; (2) reducing menu costs; (3) reducing the variability of relative prices; (4) preventing unintended changes in tax liabili- ties due to nonindexation of the tax code; (5) eliminating the confu- sion and inconvenience resulting from a changing unit of account; and (6) preventing arbitrary redistribution of wealth associated

with dollar-denominated debts. These benefits are all permanent. The costs of reducing inflation to zero are the high unemployment and low output needed to reduce inflation. According to the natural rate hypothesis, these costs are temporary.

  1. Reducing the budget deficit makes future generations better off because with lower debt, future taxes will be lower. In addition, lower debt will reduce real inter- est rates, causing investment to increase, leading to a larger stock of capital in the future, which means higher future labor produc- tivity and higher real wages. A fis- cal policy that might improve the lives of future generations even more than reducing the budget deficit is increased spending on education, which will also increase incomes in the future.
  2. Our society discourages saving in a number of ways: (1) taxing the return on interest income; (2) tax- ing some forms of capital twice; (3) taxing bequests; (4) having means tests for welfare and Medic- aid; and (5) granting financial aid as a function of wealth. The draw- back of eliminating these disincen- tives is that, in many cases, doing so would reduce the tax burden on wealthy taxpayers. The lost revenue to the government could require raising other taxes, which might increase the tax burden on the poor.