ANSWERS TO END-OF-CHAPTER QUESTIONS

Transcription

1 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, choices are unavoidable. Be 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. Any 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). But a crucial one is the choice between producing consumption goods (benefits now) or investment goods (benefits later). As 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. A 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 currently purchase more goods than we produce domestically -- via a trade deficit -- at the cost of repaying those borrowed resources plus interest at a later date. What determines whether borrowing can be sustained over time is the manner in which the borrowed funds are used. If they are used to produce investment goods that yield a rate of return at least equal to the rate of interest on the loan, then the outcome will be a favorable one for both borrowers and lenders. But if the borrowed funds are diverted from investment (benefits later) to consumption (benefits now), then we will be forced to repay principal and interest out of a pie that has not grown in size.

2 CHAPTER 1 ANSWERS TO QUESTIONS 2 External borrowing gave us an initial increase in consumption equal to the amount of the loan. When we pay it back, we ll have to cut our consumption by the amount of the loan plus interest. The net result is a binge of consumption spending, financed from the outside, followed by a larger contraction of consumption as we pay the price for our failure to use the borrowed funds productively. c. "The U.S. economy was devastated by the severe unemployment of the Great Depression. After 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. But 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 or statements below in terms of the appropriate PPF diagram. Note that some of these events may leave no trace whatsoever in terms of the PPF, in which case you should explain why. a. Scarcity: Shows up as a movement along a given PPF, revealing that the opportunity cost of an increase in one good is always a reduction in the potential output of another. b.unemployment: Shows up as an economy operating at a point inside the boundaries defined by its PPF. In such circumstances we can increase the output of both goods (or of one without decreasing another) by putting the unemployed resources to work and moving to a point on our PPF. c. Borrowing externally to finance an increase in government spending: Putting public output (g) on the vertical axis and private output (c+i+x) on the horizontal, this would show up as a movement along the PPF as the +)g is offset by a rising trade deficit (-)x). d. An increase in taxes to finance an increase in government spending: As in part c above, a +)g must show up as a movement along the curve, causing a drop in one or more components of (c+i+x). We d have to have more information about the kind of tax to be able to determine whether it will mostly fall on consumption or investment or, perhaps, on net exports. e. Borrowing internally to finance an increase in government spending: Once again, what the PPF tells us is that the resources to produce +)g must come from one of the three categories of private spending. When we borrow internally we are not increasing the trade deficit, so it would not show up as -)x. We d have to have a more detailed model to determine the extent to which this internallyfinanced +)g will come from reduced consumption or reduced investment. As you ll see in a later chapter, the concern is that this increased borrowing by government will just divert saving from private investment (-)i) to public spending (+)g). This phenomenon is called the crowding out of private investment by public spending. f. An equal cut in both government spending and taxes: We haven t looked at how tax changes

3 CHAPTER 1 ANSWERS TO QUESTIONS 3 spread their way through the system yet. But we can still say something quite definite here. Assuming the economy remains at full employment, this -)g will free up resources that will support a +)(c+i+x). We d need more information (and a more detailed model) to say exactly which of the three components would be affected. g. A tax cut with no change in government spending: This may seem a bit puzzling because your attention is drawn to trying to figure out how the tax cut will affect private spending. But if we stick with the PPF with public vs. private spending, we can say that there will be no net change in private spending because there has been no change in public spending. Since we haven t freed up any resources from government output, we can t increase private output. Depending on the kind of tax, there may be a change in the composition of private spending. But the total will remain unchanged because public spending is unchanged. h. An increase in net investment spending: Assuming that this increase in net investment spending reflects a decrease in spending on consumption, it will show up as an initial movement up the Investment PPF (as shown in the graph), followed by an outward shift in the PPF as the increased capital stock increases productive capacity. g. B +)i A -)c Consumption i. A major breakdown in the ability of government to carry out its basic functions: A loss of nst institutional efficiency (-)i ) reduces the overall productivity of the economy and shows up as a negative supply shock an inward shift of the PPF.

4 CHAPTER 1 ANSWERS TO QUESTIONS 4 6. Suppose a country puts all its resources into consumption and doesn't even undertake investment replacement investment as its capital stock wears out. How can you portray this situation +i of negative net investment (i<0) and its aftermath in terms of the PPF curve? Negative net investment means a declining capital stock PPF and, hence, negative economic growth. This can be put into the PPF framework by adding a PPF' quadrant for negative values of net investment. A 0 Just as positive values of net investment shift consumption the PPF out (since i>0 Y +)k), negative net investment shifts it inwards (via i<0 Y-)k). By B -i "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.) 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 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. But 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. But 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 inevitably a net loss if we borrow outside our economy. The error here, a common one, is the failure 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. But 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

5 CHAPTER 1 ANSWERS TO QUESTIONS 5 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. But 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. Both 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. By 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 Frontier. Assume full employment and put military spending on the vertical axis, all other spending on the horizontal. b. Assuming 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."

6 CHAPTER 1 ANSWERS TO QUESTIONS An 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 continues 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.