END-OF-CHAPTER QUESTIONS

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1 NSWERS TO END-OF-CHPTER QUESTIONS for THE MCROECONOMY Private Choices, Public ctions, and ggregate Outcomes by Michael McElroy Prentice Hall, Englewood Cliffs, New Jersey 07632

2 CHPTER 1 NSWERS TO QUESTIONS CHPTER 1 NSWERS TO END-OF-CHPTER QUESTIONS 2. Explain how the production possibility frontier (PPF) illustrates scarcity and, especially, the fact that in a world of scarcity, choices are unavoidable. e specific. Scarcity decrees that we cannot produce beyond the PPF, so in order to get more of one kind of output we must produce less of another. This is captured in the downward slope of the PPF. ny decision we make about what goods and services to produce (or consume) is also a decision not to use our resources in any other way. This is the "opportunity cost" that accompanies our every economic move. 3. Explain what it means to say that economic growth is primarily a matter of choice, not luck or good fortune. Many factors can affect the growth of real output -- anything that alters the rate of growth of the inputs (labor, capital, institutional structure). ut a crucial one is the choice between producing consumption goods (benefits now) or investment goods (benefits later). s we trade consumption for investment, the capital stock grows more rapidly and the PPF shifts outward. Unless a country is at a minimum, subsistence level of consumption it always has the option to reduce consumption now in favor of investment, faster economic growth, and therefore more consumption later. 4. Use the PPF diagram to illustrate the following events. a. Joseph Stalin institutes the "Five-Year Plan," asking citizens to sacrifice now in order to promote industrialization, which will usher in a new era of prosperity and economic justice in the near future. (Why do you think this was followed by a series of Five-Year Plans?) The idea behind the Five-Year Plan is to enlist support for a limited period of reduced consumption and increased investment with the promise of a "better world" in the near future. It is a political manifestation of the economic fact that the benefits of economic growth (more later) also have their cost (less now). These economic plans reduced the amount of resources going into consumer goods in order to channel them into investment activities. b. poor country borrows externally as part of an ambitious plan of economic development. Somehow, these new resources get diverted from their intended use and end up as consumption by a few top members of the government and their close friends and families. External borrowing allows us to have all the goods we can produce (on our PPF) plus additional ones produced in other nations. We can be temporarily beyond our domestic PPF. ut when the

3 CHPTER 1 NSWERS TO QUESTIONS 2 loan ends and must be repaid (with interest), it comes out of our own production. Though we continue to produce on the PPF, part of those goods must be sent abroad. Since they are unavailable to us, our domestic consumption and investment must move to a point inside our PPF. If we used the borrowed funds for consumption ( to C) then we have to pay back from a "pie" that hasn't grown. We have to give back the "slice" we borrowed plus interest. If we used the borrowed funds for investment ( to I) then the size of the pie will have grown, making it easier to repay. C c. "The U.S. economy was devastated by the severe unemployment of the Great Depression. fter such an ordeal and such damage, it is surprising that the country was able to mobilize for World War II with relatively little hardship." Use the PPF to evaluate this statement and, especially, the contention that it was surprising. If the Great Depression had been simply a period of negative economic growth, then our PPF would have shifted inward, and mobilization for World War II would have required us to sacrifice civilian goods for military goods. ut the Great Depression was primarily a period in which the economy operated far inside its PPF. The initial production of military output could, therefore, come from the use of previously unemployed workers and idle capital as the economy experienced economic recovery. 5. Illustrate each of the concepts listed below using the PPF diagram. For example, for a negative supply shock, you would show the PPF shifting inwards. For scarcity, you would show a movement along the PPF. Note that some of these events may leave no trace whatsoever in terms of the PPF. a. Unemployment. b. orrowing externally to finance an increase in government spending. c. n increase in taxes to finance an increase in government spending. d. orrowing internally to finance an increase in government spending. e. n equal cut in both government spending and taxes. f. tax cut with no change in government spending. g. n increase in net investment spending. h. continued increase in the average rate of time preference. i. major breakdown in the ability of government to carry out its basic functions.

4 CHPTER 1 NSWERS TO QUESTIONS 3 X2 PPF Public a. b. ' +)g X1 -)(c+i) Private Public Public c. +)g d. +)g -)(c+i) Private -)(c+i) Private Public Public e. -)g f. g 0 No Change +)(c+i) Private (c+i) 0 Private

5 CHPTER 1 NSWERS TO QUESTIONS 4 Investment Investment g. +)i h. -)i -)c Consumption +)c Consumption X2 -)i nst i. PPF PPF' X1 6. Suppose a country puts all its resources into consumption and doesn't even undertake replacement investment as its capital stock wears out. How can you portray this situation of negative net investment (i<0) and its aftermath in terms of the PPF curve? Negative net investment means a declining capital stock and, hence, negative economic growth. This can be put into the PPF framework by adding a quadrant for investment negative values of net investment. Just as positive values of net investment shift the PPF out (since i>0 Y +)k), negative net investment shifts it inwards (via i<0 Y-)k). y "consuming its capital" (+)c coming from -)i such that i<0), an economy or individual is choosing a declining consumption path over time. (Such "consumption-draining" behavior is discussed carefully in the context of the government deficit in Chapter 5.) +i -i 0 PPF' consumption PPF 7. Evaluate and explain the following statements. a. "The best way to finance any government spending is through taxes." Students need to be cautioned to watch out whenever they see the word "best." Economic analysis tells us that there

6 CHPTER 1 NSWERS TO QUESTIONS 5 are three broad ways for a government to pay for the goods and services provided through the public sector -- taxes, deficits, and money creation. Each can accomplish the goal of transferring resources from private to public sector use. ut since they affect different people at different times (who pays? & when?), there will be differences of opinion about which is "best." b. "The only way to finance government spending is by taxes -- direct or indirect, now or later." This statement is certainly not true if we define "taxes" in the usual sense as the revenues raised by the government through current tax collections. The government can also pay for current goods and services by deficits or, in some countries, printing money. Neither of those requires current taxes. ut if we think of "taxes" in the more general sense of coerced transfers from private to public sector, then all government spending is always paid through taxes -- now or later, direct or indirect (e.g., the "inflation tax"). This latter notion has the advantage of making us aware that substantive talk of tax "cuts" (as opposed to "postponements") must include talk of spending cuts as well. 8. "The problem with borrowing outside the U.S. is that we end up making interest payments outside our economy. If we've got to borrow, it's best to do it internally because then we make the interest payments to ourselves and keep more total resources inside the country." Evaluate and explain. This statement makes it sound like it's a net loss if we borrow outside our economy. The error here, a common one, is to fail to note that when we borrow internally (keeping interest payments "inside") this means that some of "us" are foregoing current spending in order to lend to others. ut when we borrow externally, it enables us to collectively have more now, since none of "us" are doing the lending. In other words: internal borrowing keeps interest payments internal but also requires an internal transfer from lenders to borrowers. External borrowing postpones this transfer (a net gain to "us") at the cost of making interest payments outside the economy. This issue is revisited in Chapter 7 (International Trade), but this is a good time to get students thinking about it. Those who are puzzled at this level of abstraction may find it helpful to think of internal and external borrowing in terms of their family. If they borrow from their parents, they have more resources and their parents have less. ut if they borrow from a bank, they have more and their parents have the same as before. The cost for their parents not having to reduce their resources is an interest payment outside the family. 9. In the Civil War, the North began the war with the greater amount of resources. oth sides attempted to transfer production to military output as quickly as possible. In the North, this was accomplished in good part through taxes and borrowing. The Southern states had no established system or even tradition of taxation and were able to raise relatively little money in taxes. The South was also unable to find many buyers for its bonds. y the end of the war, the North had experienced total inflation over four years of about 180%, the South over 9000%. a. Portray as much of the above information as you can in terms of the Production Possibility

7 Frontier. ssume full employment and put military spending on the vertical axis, all other spending on the horizontal. CHPTER 1 NSWERS TO QUESTIONS 6 b. ssuming that potential lenders had no idea who would eventually win the war, why do you think the South found it so difficult to borrow funds? (Obviously, there could be many factors, but consider just the information given above to keep this simple.) With relatively poor prospects of being able to repay current borrowing through future taxes, the South scared away potential lenders who feared that their loans might not be repaid (default) or would be repaid with currency that had greatly reduced purchasing power (if they repaid by simply printing more money). c. Why do you think the transformation of resources was accomplished with so much inflation on the one side, but relatively little on the other? The North was able to use taxes and borrowed funds to make the transformation, while the South had to resort primarily to the printing press. The increased supply of Confederate dollars without additional goods and services to match (from economic growth) meant a loss of value of those dollars and the resulting "inflation tax." 10. n oil-rich nation discovers that its usable petroleum will be virtually depleted in 20 years. a. Use the PPF framework to portray what will happen to it over the next 20 years if it simply ignores this information and keeps with "business as usual." b. If you were chief economic adviser to the Prime Minister, what policies would you advocate to avoid the scenario in part "a"? Explain. The loss of oil is a decline in the nation's capital stock and the resulting negative growth will bring falling levels of consumption in the future. To avoid this, they would have to offset the loss of oil with an increase in some other component of their capital stock, so that the PPF remained at its present level. For example, they could use current oil revenues to create alternative industries or to pay for education that would replace petroleum capital with human capital skills. They can prevent the loss of future consumption only by sacrificing current consumption in favor of investment. CHPTER 2 NSWERS TO END-OF-CHPTER QUESTIONS

8 CHPTER 2 NSWERS TO QUESTIONS 7 2. Using the classical model of the overall economy, what impact would the following events have on the equilibrium values of the price level and total real output? a. n increase in government spending financed by higher taxes. No impact since fiscal policy is "powerless" (to shift D) when velocity is constant. b. n increase in government spending financed by printing money. Though the +)g has no impact, the +)M will shift D out and raise the equilibrium price level accordingly. It will have no impact on real output ("money is a veil"). c. substantial increase in the nation's stock of capital. This is a supply-side event that shifts out S *, reducing the equilibrium price level as it raises real output. d. simultaneous increase in the capital stock and in the money supply. The increase in the capital stock and resulting +)S * tells us that real output will rise (as in part 2c). The increase in the money supply means that we will also have +)D. If, by accident or design, both curves grew at the same rate, the price level would remain constant. 3. In Chapter 1 we used the PPF to profile an economy that raised government spending but refused to raise taxes to pay for it. Using the classical D/S * framework, what impact would such a policy have on the price level and real output? (Remember that there are two ways to finance the increase in government spending.) n increase in government spending not paid out of current taxes must be either deficit-financed (+)g=+)b) or by money creation (+)g=+)m). The latter will shift out D and push up the price level (as in 2b above). ut since the deficit-financed increase in spending does not involve any change in the money supply, there can be no shift in D (the same as in 2a above). 4. Use the classical macroeconomic model to evaluate the likely impact of a substantial negative supply shock on output and the price level if the government: a. does nothing in response. b. runs an expansionary monetary policy. c. runs an expansionary fiscal policy. d. runs a contractionary monetary policy.

9 CHPTER 2 NSWERS TO QUESTIONS 8 price level b. P2 P1 S*' S* price level c. S*' S* P1 P0 P0 D D y*' y* real output y*' y* real output price level d. S*' S* P0 D y*' y* D' real output

10 CHPTER 2 NSWERS TO QUESTIONS 9 5. Explain how each of the three important slogans below describes an implication of the classical model. In other words, describe the meaning behind the slogan and demonstrate that it is a logical consequence of the assumptions of the classical model. a. Money is a Veil. This phrase is used to mean that changes in the supply of money have only nominal impacts on the economy. Specifically, it means that although the price level will be affected, there will be no impact on the equilibrium levels of output, employment or any of the so-called "real" variables of the system that determine our standard of living. This implication comes from the assumption of wage flexibility and market-clearing in the labor market and price flexibility and market-clearing in the output market. The resulting vertical aggregate supply curve means that no matter how much changes in the money supply may shift aggregate demand, it can intersect aggregate supply only at the full employment level of real output (y * ). b. Supply creates its own demand. This is called Say's Law and is another way of saying that demand plays an entirely passive role in the macroeconomy when it comes to output (and employment). s long as there is wage and price flexibility and market-clearing, there will always be enough demand to purchase the full employment level of production. c. Inflation is everywhere and always a monetary phenomenon. This is Milton Friedman's way of saying that the monetary authority is always (and everywhere) to blame for the rate of inflation. The continued rises in the price level that represent inflation are observed to be the result of demand growing more rapidly than supply (%)D>%)S * ). The classical assumption of constant velocity of money means that there is only one thing left that can shift the aggregate demand curve -- changes in the supply of money. 6. Each graduation sees a flood of new job hopefuls entering the labor force. nd while there are also retirements, they are usually many fewer. How can the economy keep absorbing this growing labor force, year-after-year? Where will the new jobs come from? Have we just been lucky or is there some systematic process going on which guarantees, more or less, that a market system will be able to handle a growing labor force? Use the classical framework to analyze this in terms of both the demand and supply sides of the model. That is, will the new jobs be created and, if they are, will there be enough spending to support this additional production? Explain. This is just another way to look at Say's Law and the Classical prediction that "full employment prevails." It happens so long as wages and prices are flexible, allowing both labor and output markets to clear. 7. Suppose the economy finds itself in a situation in which aggregate demand is well below aggregate supply, resulting in unsold goods and real output below its full employment level. How does the classical model explain the existence of such a situation and what remedy, if any, would it propose? The classical model that we have discussed presumes market-clearing and, therefore,

11 CHPTER 2 NSWERS TO QUESTIONS 10 is silent about situations in which output/income remain far below their full employment level. It can only suggest that price and wage flexibility will eventually and automatically lead us back to full employment. So the only remedy for unemployment is whatever "time" is needed for the market-clearing process to do its work. 8. key assumption in the classical model is that wages and prices are perfectly flexible, responding quickly to any changes in market conditions. Suppose, instead, that the money wage (W) can move upward but not downward while the price level (P) remains flexible. real wage W/P1 U n price level S* W/P0 n d P0 P1 U D D' n u n* employment y u y real output a. With the addition of this minimum nominal wage assumption, derive the corresponding aggregate supply curve for this economy. llowing the money wage (W) to rise, but not fall (a "minimum wage") alters a key assumption of the classical model and changes some implications as well. If we start at point in the graph and suppose D shifts out, then the price level will rise and everything is as usual in the classical model (the rising P initially lowers W/P but the resulting excess demand for labor causes +)W until we're back at the original real wage, etc.). ut if aggregate demand falls, the lower price level pushes up the real wage, and the difference is that W cannot fall to get rid of the excess supply of labor. The result is that quantity demanded of labor falls and the economy comes to rest below full employment at point U. b. Using this new supply curve, what impact would a decrease in the money supply have on real output and the price level in this economy? contractionary monetary policy would shift D to the left, causing the equilibrium value of real output and the price level to fall as the economy moved from point to U in the graph on the preceding page. c. Some of the major implications of the classical model are listed below. Would the addition of this minimum-wage assumption change any of these results? Explain your reasoning.

12 CHPTER 2 NSWERS TO QUESTIONS 11 Money is a veil. s 8b shows, money is no longer a "veil" since it can alter real output if we're on the kinked portion of the aggregate supply curve. Full employment prevails. Similarly, full employment no longer prevails unless we're above the kink caused by the downward rigid nominal wage. Only money matters. We haven't changed anything on the demand side, so "only money matters" still holds. We can't print our way to prosperity. We can "print our way to prosperity" if we're on the kinked part of the S curve. ut this means only economic recovery (return to full employment), not economic growth (increase in full employment level of output itself). Economic growth can come only from the supply side. It is still true that economic growth can come only from the supply side which would shift the entire S curve to the right. If we're on the kinked part of S, an increase in aggregate demand can bring about economic recovery, but it doesn't alter the full employment level of output. Inflation is everywhere and always a monetary phenomenon. Since nothing has changed on the demand side, it is still true that inflation can come only from a too rapid increase in the money supply. 9. Suppose that flexible wages and prices hold, but that "constant velocity of money" is dropped from the classical assumptions. Which of the implications listed in the question above will remain true? Explain your reasoning. If we allow velocity to be a variable, this now means that something other than money (M) can now shift D, since V can now change as well. So it will no longer be a prediction of the model that "only money matters," and inflation would not necessarily be the result of too-rapid growth of the money supply. It might come from whatever it is that can now change velocity. ut all the other implications still hold (money is a veil, full employment prevails, we can't print our way to prosperity, and economic growth comes from the supply side) as long as we have flexible wages and prices to bring about bring market clearing in labor and output markets. 10. Suppose we discover that the economy's aggregate supply curve is actually horizontal in the "short run." Which, if any, of the four basic implications of the classical macroeconomic model would be affected by this change in one of the underlying assumptions of that model? Explain your reasoning. If it turns out that aggregate supply, for some as yet unstated reason, were horizontal rather than vertical, then the economy could come to rest at any level of output,

13 CHPTER 2 NSWERS TO QUESTIONS 12 depending on where D happened to intersect the now horizontal S. It would no longer be true that full employment prevails; nor would it be true that shifts in aggregate demand have no real effects. Growth of demand could now cause real output to grow so it is no longer true that growth is a supply-side phenomenon. If aggregate supply is truly horizontal, then this would say that the price level is a constant, so the model would predict that we can't have inflation.

ANSWERS TO END-OF-CHAPTER QUESTIONS

CHAPTER 1 ANSWERS TO QUESTIONS CHAPTER 1 ANSWERS TO END-OF-CHAPTER QUESTIONS 2. Explain how the production possibility frontier (PPF) illustrates scarcity and, especially, the fact that in a world of scarcity,