Complete Instructor Resource Manual

Transcription

1 Complete Instructor Resource Manual

2 Macroeconomics In Context, 2e INSTRUCTOR RESOURCE MANUAL by Patrick Dolenc, Mariano Torras, and Joshua Uchitelle-Pierce Copyright 2014 Global Development And Environment Institute, Tufts University. Copyright release is hereby granted to instructors for educational purposes. This manual is intended for instructor use only. Please do not distribute to students or post widely in your department. Students may download the Student Study Guide from Comments and feedback are welcomed: Global Development And Environment Institute Tufts University Medford, MA

3 Chapter 1 ECONOMIC ACTIVITY IN CONTEXT Macroeconomics in Context (Goodwin, et al.), 2 nd Edition Note to the Instructor This chapter presents standard macroeconomic topics such as the macroeconomic goals of growth and stability and a basic roadmap of the most significant events and theories of the last century. We place these subjects, however, into a broader context of concern for well-being. Many texts define economics as the study of choice in the face of scarcity, and focus on economic growth as a (if not the) goal of macroeconomic policy. In this chapter, however, we take the view that growth in GDP, while important to understand for the study of macroeconomics, may or may not contribute to the general goal of human well-being. We define the well-being goals of macroeconomics as (1) living standards growth, (2) stability and security, and (3) financial, social, and ecological sustainability. Objectives After reading and reviewing this chapter, the student should be able to: 1. Distinguish the concerns of macroeconomics from microeconomics. 2. Define the difference between normative and positive questions. 3. Discuss the relationship between economics and well-being. 4. Identify and describe the three main macroeconomic goals. 5. Identify and distinguish the major historical traditions of economic thought. Key Terms economics microeconomics macroeconomics recession unemployment inflation macroeconomy global economy economic actor (agent) positive questions normative questions assets well-being good living standards, stability and security, and environmental sustainability living standards growth economic growth economic development labor productivity business (trade) cycle restorative development Chapter 1 Economic Activity in Context 1

4 precautionary principle classical economics division of labor specialization laissez-faire economy Say s Law aggregate demand Keynesian economics fiscal policy monetarist economics monetary policy Notes on Discussion Questions 1.1 The purpose of this question is to help engage students by linking the subject matter of the course to their personal goals. Making more money and satisfying my parents by staying in school are a couple goals that will likely show up, if students are honest. But becoming an informed citizen and voter, learning things that can be put to use in fighting poverty or environmental degradation, or just getting intellectual stimulation might also be mentioned. If they aren t mentioned spontaneously, you might ask students if they have ever considered such goals. 1.2 This is a good question for gauging the overall level of preparation of your students. You might have them write down their answers (anonymously) and turn them in, or have them discuss this question in small groups. Sooner or later you will probably need to stress to students that economists tend to use certain terms in a very different way than they are used in popular conversation, and you might consider using this question as an occasion to that sooner, or at least to raise the issue. Money is the stock of very liquid assets in an economy, not the same thing as income. Investment means investing in non-financial assets (such as business spending on structures and equipment), not buying a stock or bond. 2.1 This question is designed to just let students pause and reflect on the goals, their connection to their lives, and the rationales they might give for their concerns. Regarding missing goals, you might be able to help the class decide whether they are potentially within the realm of macroeconomics or not. This discussion might also help you discover if you don t know already how many people in your class take a rather conventional macroeconomic view (growth and stability) versus a view that includes broader social and environmental concerns. 2.2 This question could lead to debate, since students may have different views on the importance of economic growth and sustainability. Try to encourage them to go beyond stereotypes to examine the arguments underlying both then perceived need for economic growth and its problems and environmental limitations. 3.1 Historical events named important in macroeconomics include the Industrial Revolution, the booms ( and 1920 s) and bank panics (1907 and ) of the early 20 th century, the Great Depression, World War II, and the simultaneous inflation and unemployment (also called stagflation though this term is not used at this point in the book) of the early1970 s. Scientific findings about global climate Chapter 1 Economic Activity in Context 2

5 change might also be included. The second part of the question is open ended. Perhaps some students will say things like the power of multinational corporations, excessive regulatory burdens on business, or rising health care costs. Knowing that these are their top concerns may help you tailor the course to take advantage of their motivation to learn more about these issues. 3.2 Whether this question is a good one for your class depends on their level of ability in critical thinking. To intellectually sophisticated students, the idea that there are controversies is no surprise. They may find this question to be a no brainer. But many young college students are used to a more passive learning style just learning an accepted set of facts and these may find controversy unsettling. They need to know that they are learning the right thing, or they will become frustrated with the class and with you. You may be able to assuage this emotional discomfort while still presenting a range of views by aiming to confidently present a relatively authoritative account of the controversies! That is, teaching macro as a sort of history of thought course can give the students a sense of confidence and continuity in what they are learning in spite of the fact that the theory they learn one week may contradict the theory they learned the week before. Answers to Review Questions 1. Economics is the study of the way in which people organize themselves to sustain life and enhance its quality. 2. Macroeconomics is the study of how economic activity at all levels create a national (and global) economic environment, while microeconomics deals with the economic activities and interactions of individuals, households, businesses, and other groups at the sub-national level. 3. Positive questions concern issues of fact (how things are, while normative questions deal with goals and values (how things should be). 4. Living standards growth means improvements in people s diet, housing, medical attention, education, working conditions and access to care, transportation communication entertainment and the like, that can allow people to have long and enjoyable lives and have the opportunity to accomplish the things that give their life meaning. It is not the same as economic growth, which refers only to growth in production (gross domestic product). 5. Economic development is the process of moving from a situation of poverty and deprivation to a situation of increased production and plenty, through investments and changes in the organization of work. To benefit the population of a country as a whole, economic development must keep pace with population growth, produce goods that increase well-being (the what? question), use methods of production that increase well-being (the how? question), and the gains must be distributed across the population (the for whom question). 6. Economic fluctuations make it hard for people to plan for the future. High unemployment is associated with many signs of social stress, including suicide, domestic violence, stress-related illnesses and crime. Chapter 1 Economic Activity in Context 3

6 7. Financial sustainability has become a concern in poor countries due to the debt crisis, and in rich countries due to fears about future tax burdens. Social sustainability has become a concern, as people have come to question whether traditional development will ever solve the problem of global disparities in living standards, and whether more-is-better values are good for people. Environmental sustainability has become a concern as scientists have pointed out the effects of economic activities on global climate and other natural systems. 8. The precautionary principle says that we should err on the cautious side, preferring to cooperate with natural systems rather than assuming we can safely replace them, especially when major health or environmental damage could result. 9. The classical economists were motivated by observing the Industrial Revolution, and believed that the division of labor, specialization, capital accumulation and self-interested actions in markets led to the creation of wealth. They also assumed that monetary issues affected only prices. John Maynard Keynes was motivated by observing the Great Depression, and believed that the key to getting out of slumps was to raise aggregate demand through government control of investment. Keynesian economists followed J.M. Keynes, but believed that fiscal policy (not government control of investment) should be used to get an economy out of a slump. The monetarists were also motivated by observing the Great Depression, but believed that it was caused by bad government monetary policies. The synthesizers of the classical and Keynesian schools were motivated by observing the combination of rising unemployment and rising inflation that occurred in the early 1970s. They believed that Keynesian theory explained the short run (the course of the economy before markets have time to adjust) while classical theory explained the long run (after the economy has had time to adjust). 10. The recognition of the environmental impact of fossil-fuel based economic growth (particularly global warming) and of the persistence of global poverty will likely shape the development of macroeconomics in the 21 st century. Issues of debt management, the merits/hazards of austerity, growing income inequality in the advanced economies, and intergenerational fairness are additional topics that could shape macroeconomics in this century. Answers to Exercises 1. Students should be able to easily come up with an article that mentions GDP, the Federal Reserve, unemployment, etc. You should also accept articles that look at sustainability, such as articles on international debt issues, education spending, or environmental damage. 2. a. positive b. normative c. positive d. normative e. normative 3. Examples of correct answers: a. False. Macroeconomics is about the national or global economic environment created by all actors, including but not limited to government agencies. b. False. Economic growth may not lead to living standards growth if the questions of what, how and for whom are not well-addressed. c. False..financial, social, and ecological Chapter 1 Economic Activity in Context 4

7 d. True. e. False : now many of them face a debt crisis and pay more in interest than they receive in grants and loans. 4. Examples of correct answers: a. False. Monetary policy b. True. c. False. Keynesian economists d. True e. False. Classical economists or Keynesian economists believe that an economy that experiences a high rate of unemployment requires fiscal policy (and perhaps monetary policy) actions to recover. 5. a-5; b-8; c-6; d-1; e-9; f-7;g-11; h-2; i-3; j-10; k-4 Extensions 1. A Numerical Problem on Growth : The textbook uses many numerical comparisons that seem very familiar to us instructors, as economists, but may, in actual application, baffle a new economics student. This exercise gives students practice calculating the level of increase of GDP, per capita GDP, and the factor by which a variable has increased--all concepts used in Chapter 1 (The GDP figures given are real GDP, a concept that will be formally defined in Chapter 5). Watch out for issues such as per capita GDP being erroneously expressed in billions, and expect questions about constant (year 2000) dollars and the appropriate use of rounding and levels of precision. For discussion, note the phenomenal rate of growth in China, but the remaining poverty in three of the four most populous countries. An answer key is provided. 2. Interpreting Data on Sustainability : This problem does not involve math, but simply being able to read a table and apply the results to issues of concern. An answer key is provided. The data source is available online at 3. Ideas for In-Class Exercises : Two group exercises submitted by a user of this textbook. Chapter 1 Economic Activity in Context 5

8 A Numerical Problem on Growth The following data for the world s four most populous nations are taken from the World Bank World Development Indicators Online: Country GDP 1960 (billions of 2000 U.S. $) GDP 2006 (billions of 2000 U.S. $) Population 1960 (billions) Population 2006 (billions) China 70 2, India U.S. 2,546 11, Indonesia GDP figures given are corrected for inflation (this is called real GDP, which will be defined in detail in Chapter 20). Answer the following questions for India, the United States, or Indonesia. China is done as an example, below. a. For your assigned country, how much greater was GDP in 2006 compared to 1960, in constant U.S. dollars? (The increase is calculated as the 2006 number minus the 1960 number.) b. GDP increased by a factor of how much? (That is, GDP in 2006 is equal to GDP in 1960 multiplied by what number?) c.. Calculate GDP per capita in 1960 and in d. How much greater was GDP per capita in 2006 compared to 1960? e. Per Capita GDP increased by a factor of how much? c. Write a brief paragraph describing economic growth over this period in one of the countries using the statistics in the table above and your calculations. Example: a. For China, the increase in GDP is $ 2,096 billion - $ 70 billion = $ 2,026 billion. b. In China, GDP increased by a factor of $2,096/$70 = 29.9, or about 30. c. Per capita GDP for China in 1960 is $70 billion/.667 billion people = $ per person. In 2006 it is $ 2,096 billion/1.3 billion people = $1,612.3 per person. d. In China, per capita GDP was $1, $104.9 = $1,507.4 per person higher. e. In China, per capita GDP rose by a factor of 1,612.3/104.9 = 15.4, or about 15. f. GDP in China (expressed in 2000 U.S. dollars) increased by a factor of 30 from 1960 to It rose $2,026 billion, from a 1960 level of $70 billion to a 2006 level of $2,096 billion. Because the population was growing as well, however, per capita GDP in 2006 was only 15 times higher in 2006 than in Per capita GDP rose $1,507.4, from $104.9 per person in 1960 to $1,612.3 per person in Chapter 1 Economic Activity in Context 6

9 Interpreting Data on Sustainability The following data is taken from the United Nations Development Program Human Development Report 2007/8, Table 24: Carbon dioxide emissions and stocks : CO 2 emissions, total (millions of tons), 2004 CO 2 emissions, (% of world total, 2004) CO 2 emissions per capita (tons, 2004) U.S. 6, China 5, India 1, Russian Federation 1, CO 2 emissions, average annual change in (%), a. Which country contributed the largest share of the world s CO 2 emissions in 2004? b. Which country emitted the most CO 2 per capita in 2004? c. Which two countries had the fastest rates of growth of CO 2 emissions from ? d. What are some of the implications of these data for the question of who should take responsibility for actions to assure ecological and social sustainability? Chapter 1 Economic Activity in Context 7

10 Numerical Problem on Growth: Answer Key 1. a and b: Country Increase in GDP GDP per capita (2000 U.S. $) Increase in GDP Per Capita billions of 2000 U.S. $ factor of U.S. $ factor of China India U.S Indonesia c. For example: GDP in Indonesia (expressed in 2000 US dollars) increased by a factor of 12 from 1960 to 2006, rising $201 billion, from $18 billion to $ 219 billion. Because of population growth, however, per capita GDP in 2006 was only five times higher than in 1960, rising by $791 per person, from $192 per person to $982 per person. Interpreting Data on Sustainability: Answer Key a) U.S. (somewhat more than China) since 2004 China has overtaken the U.S. in total emissions. b) U.S. (by a very large margin) c) China and India. d) For ecological sustainability, the high global levels of CO 2 emissions must be brought down. This could be done in part by reducing the extremely high rates of per capita consumption in the U.S. (and other industrialized countries). The rapid rate of growth of emissions in China and India, however, is also of environmental concern. Social sustainability is an issue because, while emissions in China and India are growing very fast, they are growing from a very low level. The great inequality between per capita emissions in the U.S. and per capita emissions in China and India reflects a great inequality in living standards that could be socially destabilizing. Chapter 1 Economic Activity in Context 8

11 Ideas for In-Class Exercises 1. Have students get in to groups of about 4, and ask them to draw a picture of the economy. (Bring some large drawing paper and colored markers). Then have one spokesperson from each group present and explain their picture to the rest of the class. Tape the pictures up on the whiteboard, and then as a class, discuss the different themes that appear in the pictures. Sometimes students who have taken economics before draw pictures with some kind of circular flow diagram, or pictures with supply and demand graphs. But students who haven t taken economics before come up with quite creative pictures. Some kind of roller-coaster theme often appears, or a bubble bursting. For such a picture, the instructor can highlight the theme of instability, a theme which doesn t appear in the circular flow diagram, where everything seems to flow around smoothly in a circle. Another theme that often appears is the theme of inequality (of income, wealth, or power). 2. Print out the statistical tables from the United Nations Development Program Human Development Report, available on-line at Have students get in to groups of 4, and distribute one or two tables to each group. Ask them to compare some of the richest countries to the poorest countries, on one or two of the indicators in the table. (e.g. GDP per capita, GDP growth rates, # of people living below $1 a day, population growth rate, health expenditures, education spending, life expectancy, HIV prevalence, etc.). Then have each group report back one or two things that stood out when comparing the data among the countries. Chapter 1 Economic Activity in Context 9

12 Chapter 2 USEFUL TOOLS AND CONCEPTS Macroeconomics in Context (Goodwin, et al.), 2 nd Edition Note to the Instructor This chapter introduces standard concepts of economic modeling, efficiency, scarcity, opportunity cost, the Production Possibilities Frontier, and the advantages of market systems, and includes a review of graphing techniques. However, we set these into a broader context of concern for well-being. We discuss the institutional requirements of markets and introduce the concepts of externalities, public goods, market power, transaction costs, information and expectations and concern for human needs and equity in order to demonstrate why markets, while useful, are not on their own sufficient for organizing economic life in service of well-being. Objectives After reading and reviewing this chapter, the student should be able to: 1. Distinguish and differentiate among the different methods of investigation: empirical investigation, theoretical investigation, and historical investigation. 2. Understand the concept of economic tradeoffs (or opportunity costs) in the face of abundance or scarcity. 3. Interpret and apply the Production Possibilities Frontier. 4. Distinguish the different meanings of the term market, and describe how the market is understood in the basic neoclassical model. 5. Describe the institutional requirements of markets. 6. Identify the advantages and limitations of markets. Key Terms empirical investigation time series data negative (or inverse) relationship positive (or direct) relationship theoretical investigation model ceteris paribus historical investigation abundance scarcity 2-1 production possibilities frontier opportunity cost efficiency technological progress market (three meanings) institutions basic neoclassical (traditional microeconomic) model private property implicit contract

13 explicit contract physical infrastructure public goods free riders externalities transactions costs market power static analysis dynamic analysis market failure Notes on Discussion Questions 1.1 a. empirical b. theoretical c. empirical d. historical e. theoretical 1.2 This question should illustrate that any model must leave certain things out and only concentrate on a subset of relevant factors. The map analogy works well because maps can serve many different purposes. A road map would obviously differ from a soils map, a geology map, a political map, or water system map in terms of what is included and excluded. A map that aims to include everything would obviously be unusable because it would be too complicated. Similarly, a model must exclude certain factors that are irrelevant. Just as a road map need not include information about soil types, an economic model need not include factors that are irrelevant to the issue under study. (As a philosophical stance, this chapter suggests that traditional macroeconomic models are like very specific kinds of maps that may be useful for some purposes but not for others, thus avoiding the extremes of either adopting them wholly or discarding them entirely.) 2.1 Given a limited amount of time available to study for either economics or another subject, most likely a production function for knowledge of either subject would have the shape of Figure 5. You could devote all your time and resources to studying just economics, producing a maximum of economic knowledge. You could also devote all your resources to the other subject, learning no economics but a maximum of the other subject. The concave shape will likely result because studying will tend to produce diminishing returns. The first hour of studying economics will probably produce more knowledge that the 20 th hour of studying. If the same relationship holds for studying the other subject, then a concave PPF will result. 2.2 Several of these activities present potential controversies regarding whether they increase or decrease society s PPF. Points to consider for each include: a) Increasing education will increase the pool of human capital available for production in the future. However, realize that increasing education involves an opportunity cost. The benefits of an increase in education must be compared to what must be given up. b) Expanding oil production can be considered as increasing society s PPF to the extent that our economy is reliant on fossil fuel energy sources. In the long run 2-2

14 this nonrenewable fuel is not a sustainable energy source and therefore society s PPF could potentially face a reverse shift if alternatives are not developed and implemented in a timely manner. c) Building a new power facility will increase society s PPF based on a potential increase in the supply of electricity (assuming that additional electricity is needed). d) Restoring wetlands will increase society s supply of natural resources, including wildlife, water quality, and recreational opportunities. Similar to increasing education, restoring wetlands also requires costs. Whether society s PPF expands or contracts depends on the comparison of the costs and benefits. e) A new interstate highway increases society s ability to transport goods, recreate, and travel for business. In this respect, it expands society s PPF. However, it can also lead to decreased air quality, possibly paving over natural areas, and damaging the quality of life of residents along the highway. Once again, disagreement can exist over whether this activity expands or contracts society s PPF. f) Using larger trawlers to catch more fish will increase society s PPF in the short run because a larger catch could foster greater consumption. In the long run, however, fishing in an unsustainable manner could lead to the further collapse of fisheries and result in an inward shift in the PPF. 3.1 Go to the market and get some bananas. a place to buy and sell The market is the best invention of humankind. pure exchange The labor market for new Ph.D. s is bad this year. social institution The advance of the market leads to a decline in social morality. pure exchange The market performance of IBM stock weakened last month. social institution 3.2 Students may need some help to get the point of the Churchill quote can something have a lot of disadvantages, and still be the best one can get? Popular critics of market-oriented economic systems often point out that, for example, such economies have neglected the poor, are damaging the environment, and are being increasingly populated by large global corporations. The students should be encouraged to translate such statements into the terms used in this reading: neglect of human needs and equity, neglect of public goods and externalities, and market power. Those who take a view that markets are the worst form for an economy except for all those other forms would say that, in spite of these limitations, markets are better than, say, central planning or tradition. Those who oppose this view would think that some other system perhaps of locally controlled cooperatives and distribution based on need--might be superior. Others may argue for a middle ground, letting markets operate but within social constraints. 2-3

15 Answers to Review Questions 1. Empirical investigation means observing and recording the specific phenomena of concern. Theoretical investigation is analysis based on abstract thought. Historical investigation is the study of past events. 2. A model is an analytical tool that highlights some aspects of reality while ignoring others. The ceteris paribus assumption simplifies creation of a model because it allows the research to hold constant some factors. 3. Abundance creates the possibility of decision-making, by supplying resources that are in plentiful supply for meeting various goals. Scarcity creates the necessity of decision-making, since not all goals can be accomplished at once. 4. Along a production possibilities frontier, production meets the requirements of no involuntary unemployment or undesired idle productive capacity; application of optimal technology and social organization; and efficient resource allocation. 5. Figure 2.5 presents a production possibilities frontier (for guns and butter). The frontier defines the necessary tradeoff between the two goods more of one can only be obtained by giving up some of the other good. In other words, moving along the frontier from, say, point A to point B, the opportunity cost of more guns is less butter. All points within and along the PPF are attainable, including points A, B, and D. All points beyond the PPF are currently unattainable, such as point C. We are efficiently allocating resources when we are operating along a PPF (such as points A and B) because no resources are idle; point D illustrates an inefficient use of resources. 6. A PPF will expand over time through technological progress and improvements in capital (including human, natural, and social capital). A PPF may shrink over time if resources are depleted or degraded. 7. First, markets are physical places where there is a reasonable expectation of finding both buyers and sellers for the same product or service. Second, markets are institutions that bring buyers and sellers into communication with each other, structuring and coordinating their actions. Third, the market is an abstract situation of pure exchange, or a global system of exchange. 8. The basic neoclassical models assumes that there are only two kinds of actors, households who consume and maximize utility and firms who produce and maximize profit. These two actors engage in exchange on perfectly competitive markets. Markets are said to be efficient in this case because price signals coordinate individual decision-making, the profit motive makes firms produce efficiently, consumers maximize utility and the market value of production is assumed to be a reasonable proxy for well-being. 9. Individualist institutions include private property, the ability to make decisions on an individual basis, and having prices set through the interaction of market participants. Social institutions of trust reduce the risk of transactions, and include factors of relationships, reputation, norms, implicit and explicit contracts, and institutions such as credit bureaus and government agencies that enforce regulations. Infrastructure institutions include buildings, equipment, transportation systems, and information technology. Money is also an institution 2-4

16 that people must trust to hold its value and have minimal storage and handling costs. 10. A public good is one for which (1) use by one person does not diminish usefulness to others, and (2) it would be difficult to exclude anyone from benefiting. Individuals can generally not be prevented from benefiting from public goods. Thus, a business could not exclude those who haven t paid from enjoying a public good. Once the good is provided, commonly anyone can benefit with or without paying. This tends to create free riders, people who benefit but do not pay. As everyone has an incentive to be a free rider, business generally cannot make a profit through the provisioning of public goods. 11. A negative externality is a harmful side-effect, or unintended consequence, of economic activity which affects persons, or entities such as the environment, that are not among the economic actors directly responsible for the activity. An example would be the air pollution created by a factory. A positive externality is a beneficial effect of economic activity that rebounds largely on persons or entities that are not among the economic actors directly involved in the activity. An example would be the positive impacts on passersby from a private garden. 12. (a) Transaction costs are the costs of arranging economic activities. The idealized model of markets assumes a frictionless state, but as soon as we recognize that coordinating market activities involves time and effort (and often additional expenses) we depart from this fictional world. (b) Market power is the ability to control, or at least affect, the terms and conditions of exchanges in which one participates. The idealized model assumes perfect competition and the complete absence of any market power by individual agents. Such a scenario is the exception in the real world rather than the norm. (c) Information and expectations issues mean that people are not sure of the future when they make their decisions. The idealized model assumes that all affected economic agents have perfect and complete information. As soon as we relax this unrealistic assumption we introduce imperfections that compromise the efficiency of markets. (d) Concerns for human needs and equity are not fully reflected in market models, since the only demands that count are those backed up by ability to pay. Markets are blind to fairness, and instead focus exclusively on whether or not consumers are willing and able to pay for the product. Why consumers want the product is generally NOT a consideration for facilitating transactions in the marketplace. 2-5

17 Inflation (percent per year) Answers to Exercises 1. a. Yes, unemployment steadily falls, while inflation is constant or falling in all but the last year. b Unemployment c Unemployment Rate (percent) d. Seem to have a relationship. The empirical relationship is direct (except for the last year). e. It is direct, instead of inverse. Instead of a trade off, both good objectives seemed to be increasingly accomplished. NOTE: You could modify this to more recent data (and/or to being a web exercise for the students) by giving them (or having them find) data for the most recent few years in the Economic Report of the President on line. End-of-chapter exercise 6 in Chapter 12 describes how to do this. 2. This question is designed to serve two purposes. First, students are sometimes confused by the notion of general scarcity, as economists use it, and confuse it with more specific, prosaic situations of shortage (quantity supplied exceeding quantity demanded at a given price) or inadequacy (such as inadequate food leading to hunger). This question gives you a chance to clear up such confusion at an early 2-6

18 Pizzas stage. Scarcity exists whenever there are competing uses for a resource that is, in a global sense, fixed in supply. If there is not enough of something around to meet all goals, then it is scarce, in the economist s sense, and decision have to be made. On the other hand, if there is more than enough to meet all desires, so that the notion of having to make decisions about allocating its use does not apply, then it is not scarce. The global supply of desert sand, for example, is big enough, relative to foreseeable human needs, that sand is not scarce (even though people may sometimes experience specific local shortages e.g., when urgently needing to fill sandbags to protect a town from a flood). Second, at a deeper level, students could also question whether scarcity is, in fact, a universal existential condition for many important, but intangible, resources. Decisions about allocation of scarce resources can be compared to dividing up of a fixed pie of resources, among different uses or different people. But it is not clear that the pie analogy fits well with things like enjoying a piece of music or enjoying something coming over radio waves, where one person s consumption does not deplete another person s opportunities. Nor is it clear that allocating more trust or respect in one direction means that you then have less of it to allocate somewhere else. Resources such as trust may be increased, rather than decreased, by their common use! 3. As long as a resource is not scarce, there is no need to use it efficiently. For example, one does not generally need to be concerned about the quantity of air one breathes because it is not scarce (disregarding the issue of air quality). When more demands are put on a resource, the importance of efficiency increases. Most people would try to use their time more efficiently when they are pressed for time. Thus, one would use time efficiently when studying for exams but perhaps be less efficient during a vacation. 4. a) A B Books 2-7 C D E F

19 Pizzas b) not possible would require MORE than an efficient use of resources c) possible but inefficient d) 10 e) Lower (only 2 books are foregone). Producing the first few pizzas likely uses resources that are not well suited for book production. f) A B F C D E Books 5. Correct matches are a-9, b-7, c-2, d-11, e-5, f-8, g-3, h-10, i-1, j-6, k-8, l-4, m-7 Web Resources Data on unemployment and inflation from the Economic Report of the President are available on-line at The data measure of inflation used here is the change in the implicit GDP price deflator. Extensions 1. Two additional extra exercises on the Production Possibility Frontier, and answer sheet (suitable for in-class use or homework). (4 pages) 2. Two short questions on the Production Possibility Frontier and answer sheet (suitable for use on an exam) (2 pages) 3. Ideas for Exercises : two suggested exercises submitted by a user of this textbook. 2-8

20 Exercise on the Production Possibility Frontier: CD-Players and Shoes Suppose we see the following table of possible combinations of shoes and CD-players that society could produce (this year): Alternative Shoes (pairs) CD-players (sets) A B C D E a) Using the axes below, draw the production possibilities frontier (PPF) for these numbers. Be as exact and neat as possible. (Assume that the dots define a complete curve.) Leave room for drawing a new PPF (in the same graph) when you get to (e) below. b) If society is currently producing alternative C, then the basis for the opportunity cost of moving to alternative B (and getting 10 more pairs of shoes) equals the value of c) With these production possibilities, producing 18 pairs of shoes and 50 CD sets would be CD-players. d) An example of the principle of increasing marginal opportunity costs that can be seen in this table is that going from C to B costs more CD sets than going from point to point. e) Suppose that the technology used in producing shoes improves, while that for producing CD-players does not. Draw one possible new production possibilities frontier in the graph above which represents the results of this change. Indicate the direction of the change that occurs with a big arrow. _. f) After the change in (e), when 30 CD sets are being produced, we will be able to produce more than g) (Use one word for each) An impossible production mix would be PPF, while a productively or technically efficient production mix would be the the PPF. pairs of shoes. 2-9

21 CD players (sets) Exercise on the Production Possibility Frontier: CD Players and Shoes Answer Sheet Suppose we see the following table of possible combinations of shoes and CD-players that society could produce (in 2003): CD-players Alternative Shoes (pairs) (sets) A 40 0 B C D E 0 65 a) Using the axes below, draw the production possibilities frontier (PPF) for these numbers. Be as exact and neat as possible. (Assume that the dots define a complete curve.) Leave room for drawing a new PPF (in the same graph) when you get to (e) below E D C new PPF 30 B shoes (pairs) A b) If society is currently producing alternative C, then the basis for the opportunity cost of moving to alternative B (and getting 10 more pairs of shoes) equals the value of 20 CD-players. c) With these production possibilities, producing 18 pairs of shoes and 50 CD sets would be productively or technically inefficient. d) An example of the principle of increasing marginal opportunity costs that can be seen in this table is that going from C to B costs more CD sets than going from point D to point C or from point E to point D. e) Suppose that the technology used in producing shoes improves, while that for producing CD-players does not. Draw one possible new production possibilities frontier in the graph above which represents the results of this change. Indicate the direction of the change that occurs with a big arrow. see the graph. f) After the change in (e), when 30 CD sets are being produced, we will be able to produce more than 30 pairs of shoes. g) (Use one word for each) An impossible production mix would be above, to the right of the PPF, while a productively or technically efficient production mix would be inside the PPF. 2-10

22 Exercise on the Production Possibility Frontier: Corn and Wheat The figure below shows a society s Production Possibilities Frontier for production of corn and wheat. Answer the questions below, referring to this figure. A B C D PPF E F Quantity of Wheat a. What is the maximum quantity of corn that can be produced, if the society produces no wheat? b. If the society produces 15 units of wheat, what is the maximum quantity of corn it can produce? c. Does point A represent an efficient use of resources? Explain. d. Which point on the graph represents a combination of outputs that is unattainable? Explain, referring to specific quantities of corn and wheat in your explanation. e. Find a point on the graph that illustrates an inefficient use of resources. Explain why there is inefficiency, referring to specific quantities of corn and wheat in your explanation. f. Suppose the society moves from (efficiently) producing only wheat to producing both wheat and 40 units of corn. What is the opportunity cost of producing these first 40 units of corn? g. Suppose the society moves from (efficiently) producing 40 units of corn to producing 80 units of corn. What is the opportunity cost of producing these last 40 units of corn? h. Comparing your answer to part (g) to your answer in part (f), what point about the use of resources for different kinds of production is illustrated? i. Would producing at point D be the best choice for this society? Explain your answer. 2-11

23 Exercise on the Production Possibility Frontier: Corn and Wheat Answer Sheet a. 80 units of corn b. 60 units of corn c. Yes, point A is efficient. All points that lie on the PPF represent efficient production. d. Point B is unattainable. Point B represents production of 15 units of wheat and 80 units of corn. But if the society produces 15 units of wheat they only actually have enough resources left to produce, at the most, 60 units of corn. (Alternatively, if it produces 80 units of corn, it can produce zero units of wheat.) e. Point E illustrates inefficiency. At point E only 15 units of wheat and 10 units of corn are produced, when more of each output for example, 20 units of wheat and 40 units of corn at point D are possible. f. The opportunity cost of the first 40 units of corn is only five units of wheat. (Point F to point D) g. The opportunity cost of the last 40 units of corn is 20 units of wheat. (Point D to Point A) h. The first units of corn use the resources best suited for corn production, and least suited for wheat, and so are relatively cheap. As more corn is produced, it competes more for resources that could also be used for producing wheat, so the opportunity cost rises. i. Not necessarily. We cannot know which point is best for the society unless we know its needs and preferences for corn versus wheat. 2-12

24 Question on the PPF Use the picture below showing this year s production possibilities frontier for an imaginary country (producing guns and butter) to answer the three questions that follow it. A. Use an A to label one possible point on the graph that represents complete (full) use of resources and productive (technical) efficiency. B. Use a B to label one possible point on the graph that represent a case where resources (factors of production) are under-used or are used incorrectly in production. C. Show what happens when labor productivity rises during the next decade. Use an arrow marked with a C to indicate this change (either a movement along the curve or a shift of it). 2-13

25 Short Answer Question on the PPF Answer this question with a graph and a few sentences of explanation, in the space below. Suppose a society can use its resources to produce either an extensive system of private transportation (involving cars and superhighways) or an extensive system of public transportation (relying on trains and subways). Draw a carefully labeled Production Possibilities Frontier (PPF) that illustrates this case, and write a brief paragraph discussing: (1) how the graph illustrates trade-offs (2) how attainable and unattainable combinations can be illustrated in the graph (3) how an inefficient use of resources can be illustrated in the graph 2-14

26 Question on the PPF Answer Notes A. Any point on the frontier. B. Any point inside the frontier. C. The curve shifts outward, away from the origin. Short Answer Question on the PPF-- Answer Notes Quantity of Public Transportation B D C A PPF Quantity of Private Transportation This graph presents a production possibilities frontier for public transportation and private transportation. The frontier defines the necessary tradeoff between the two goods more of one can only be obtained by giving up some of the other. All points within and along the PPF are attainable, including points A, B, and D. All points beyond the PPF are currently unattainable, such as point C. We are efficiently allocating resources when we are operating along a PPF (such as points A and B) because no resources are idle. Point D represents a point in which society is operating inefficiently, because some resources are being wasted. 2-15

27 Ideas for Exercises 1. For the exercises, one could add a web research assignment, on the guns vs. butter topic. Have the students go to the national priorities website ( under Federal Budget 101, and then Charts), and find out how much the U.S. federal government spends on military vs. social spending. They see how much the share of military spending has changed over time, and also how U.S. military spending compares with other countries. 2. For an in-class activity, one can have the students get in to groups of 4, and ask them, if they were on the Council of Economic Advisors to the President, and had to give advice on how to spend $1,000 billion in discretionary spending, what would they advise? How much for guns and how much for butter? Then draw a PPF on the whiteboard, with guns vs. butter as the two axes, and have each group plot their point (their chosen allocation). 2-15

28 Chapter 3 WHAT ECONOMIES DO Macroeconomics in Context (Goodwin, et al.), 2 nd Edition Note to the Instructor Most textbooks say little or nothing about ecological sustainability, and cover distributional issues in a chapter that comes late in the book. This chapter puts these important topics up front where they belong. Objectives After reading and reviewing this chapter, the student should be able to: 1. Define the four essential economic activities. 2. Define the five types of capital. 3. Explain the difference between stocks and flows. 4. Discuss the limitations of substitutability with respect to natural capital. 5. Understand the importance of maintaining capital stocks. 6. Describe the difference between exchange and transfer. 7. Define the difference between wealth and income. 8. Describe the distribution of income and wealth in the United States. 9. Describe how inequality is measured. 10. Describe the three spheres of economic activity. Key Terms resource maintenance capital stock natural capital manufactured capital human capital social capital financial capital investment production inputs outputs waste products distribution exchange transfer in-kind transfers 3-1 consumption saving stock flow stock-flow diagram depreciation gross investment net investment renewable resource nonrenewable resource substitutability sustainable socioeconomic system restorative socioeconomic system labor income capital income dependency needs

29 social insurance programs means-tested programs proportional income tax regressive income tax progressive income tax Lorenz curve Gini ratio capital gain core sphere public purpose sphere regulation business sphere informal sphere Notes on Discussion Questions 1.1 Almost any activity involves the use of multiple types of capital. Take the example of getting together with friends and listening to CDs while popping popcorn in the microwave. Natural capital is required in the form of the popcorn as well as the natural materials required to produce the CDs, microwave, etc. Manufactured capital is being used such as the microwave, CDs, and popcorn packaging. Human capital is evident in the knowledge needed to play CDs, work the microwave, and appreciate the music. Friendship is a form of social capital but social capital is also part of the detailed process that leads to the production and distribution of goods such as CDs and popcorn. 1.2 a. Production. b. Has aspects of both (1) production of human capital and (2) resource maintenance in the form of investment in human capital c. Production in the form of producing manufactured capital; resource maintenance in increasing the stock of manufactured capital. d. Distribution in the form of a transfer payment. e. Production of a service. 2.1 Income is a flow variable. Thus, a person who earns a lot of money has a large flow of economic resources. Wealth, including houses and investments, is a stock variable. The definition of a rich person likely considers both flows and stocks. Realize that a stock of economic resources, such as investments, can also be used to provide a flow of income. For example, an investment of $100,000 earning 6% annually could be used to provide an indefinite income flow of $6,000 per year. As a high income could be lost when a job is lost, a significant stock of economic resources is likely to be a more stable source of riches. 2.2 Substitutes for the use of fossil fuels to power vehicles currently exist, including fuel cells, electricity, and even solar energy. However, all these technologies are more expensive and less convenient than gasoline. As fossil fuels are a nonrenewable resource, the conversion to alternative power sources for vehicles is inevitable. How long this takes will depend on when alternatives become cost competitive with gas. Technological advances will likely lower the cost of using alternate power sources over time. If the supply of gasoline becomes constrained by physical or political 3-2

30 factors, rising gas prices could hasten the switch to alternate power sources. Another factor that could motivate a quicker transition would be if the external costs of gasoline use were internalized through a carbon tax. While substitutes for some functions of the ozone layer could be envisioned, a complete substitute appears impossible. Humans could respond to a thinning of the ozone layer by using stronger sunblock and staying indoors most of the time. However, the ozone layer provides important protection for nearly all life on earth. Without some type of artificial global UV (ultraviolet ray) shield (not feasible with existing technology), there is no substitute for the ozone layer. 3.1 For traditional college-age students, transfers from parents and others should be seen as playing a large part in obtaining the necessities of life. Public schools and other transfer programs (welfare, scholarships) may have also been significant in their lives. They may recognize some non-market exchange within their families, and some market exchange from part-time or summer jobs, but should see that they have largely been recipients of transfers. They may expect this to change as they more thoroughly enter the labor force. For older students, of course, the picture may be quite different. Someone approaching retirement age may see a large role for exchange in the past, and transfers (in the form of Social Security) coming up. 3.2 Students who live off-campus should be able to discuss rents in the area. If there are students with children, they can discuss how much it costs to raise a child (which may surprise the younger students!). Make sure they consider other costs such as vehicles, insurance, health care, etc. It might be interesting to ask each student to write down their own guess and see how much the responses vary. How do they think these numbers compare with what they expect to earn when they graduate? You might ask students to guess the median household income in their area. Actual data can be found in the County and City Data Book, available online at the U.S. Census Bureau. 4.1 One could obviously write an extensive report on the advantages and disadvantages of different educational approaches. Education within the core sphere can provide highly personalized training. Special needs can be met and students can also advance more quickly than students constrained by the education system. There is also more room for creativity and response to special situations. Potential disadvantages of core-sphere education include educators that may not be adequately trained and reduced social interactions among students. Education through the public purpose sphere can provide a standardized system that mandates specific results. The public purpose sphere also provides students with more socialization although some of it may be a negative influence. For-profit firms may be ideally suited to respond to specific market demands, such as supplemental career training or preparation for placement tests. However, for-profit educational firms may not provide well-rounded training and may subject students to advertisements. 4.2 Again, answers to this question will vary significantly by student. Dinner at Gina s could have been provided by the core sphere if Gina is a personal friend or the 3-3

31 business sphere if Gina s is a restaurant. A student could receive housing from the business sphere (an apartment), the public purpose sphere (a dorm), or the core sphere (their parent s home). Students might notice that some items are provided by more than one sphere. For example, snacks at a campus sporting event might be jointly provided by the business and public purpose spheres. A gift a friend purchased at a store is provided by both the business and core spheres. Answers to Review Questions 1. The four essential economic activities are resource maintenance, production, distribution, and consumption. 2. The five types of capital that contribute to productivity are natural capital (physical assets provided by nature), manufactured capital (physical assets that are generated by applying human productive activities to natural capital), human capital (individual people s capacity for labor, particularly the knowledge and skills each can personally bring to his or her work), social capital (the stock of trust, mutual understanding, shared values, and socially held knowledge that facilitates the social coordination of economic activity), and financial capital (funds of purchasing power available to facilitate economic activity). 3. In common usage, sometimes people take capital to mean only financial capital, as in references to capital markets, undercapitalized businesses, and venture capital. Economists take a broader view of capital. 4. Economists use the term investment for actions taken to increase the quantity or quality of a resource now, in order to make benefits possible in the future 5. Production is the conversion of resources into usable products, which may be either goods or services. 6. Distribution can take place through either exchange (the trading of one thing for another) or through transfer (payments given with nothing expected in return). 7. Consumption is the final use of a good or services to satisfy current wants. This can be contrasted with saving, which is refraining from consumption today in order to gain benefits in the future. 8. A stock is measured at a particular point in time while a flow is measured over some period of time. For example the stock of water in a lake at a point in time might be 50,000 cubic meters but the flow of water through the same lake might be 2,000 cubic meters per day. 9. Gross investment includes all flows into a capital stock over a period of time. Net investment, on the other hand, adjusts this measure for the fact that some portion of the capital stock also depreciates over the same period. 10. A renewable resource regenerates itself through biological or other short-term processes, which may be helped out by human activity. A nonrenewable resource is available in a fixed supply, although new discoveries can increase the stock that is known to be available. 11. A sustainable socioeconomic system creates a flow of whatever is needed by using its renewable capital stocks without depleting them. Although a portion of some (especially nonrenewable) capital stocks may be used up in the process of production, 3-4

32 the overall quality and quantity of the resource base are preserved. Sustaining a system involves preventing erosion while restoring a system is about addressing deterioration. 12. The two major forms of income received in exchange are labor income and capital income. 13. The main reason for transfer programs is to meet dependency needs. 14. Mean-tested programs are intended to help people who simply have insufficient resources. Social insurance programs are designed to help people if certain specific events occur. 15. A progressive income tax system taxes higher income households more heavily, in percentage terms, than lower income households. A proportional income tax applies the same percentage tax rate to all income levels. A regressive income tax applies a higher tax rate to poorer households. 16. In 2003 in the United States the poorest fifth of households received 3.4% of income, the second fifth received 8.7%, the middle fifth received 14.8%, the fourth fifth received 23.4%, and the top fifth received 49.8%. 17. A Lorenz curve is a line used to portray an income distribution, drawn on a graph with percentiles of households on the horizontal axis and the cumulative percentage of income on the vertical axis. 18. The Gini ratio is a measure of inequality defined as the ratio of the area between the Lorenz curve and the diagonal to the total area under the diagonal line. Higher values of a Gini ratio represent greater inequality. 19. Income inequality has increased in recent decades. Some of the proposed reasons include demographic changes such as the aging of the population and increases in single parenthood, increases in international trade that have eliminated middleincome jobs, improvements technology such as computers and biotechnology that have benefited workers with specific skills, and the declining power of unions and government policies that have been less supportive of unions. 20. Wealth is less equally distributed that income because most people own relatively little wealth and those who do own substantial physical and financial wealth are generally able to put much of it into assets that increase in value over time and/or yield flows of capital income, which can in turn be invested in the acquisition of still more assets. 21. The three spheres of economic activity are the core, business, and public purpose spheres. 22. The core sphere includes households and small-scale community organizations that organize production, distribution, consumption, and resource maintenance primarily without monetary exchanges. In the core sphere, production tends to be rewarded directly with the output rather than with money. The core sphere also responds to immediately perceived needs rather than the ability to pay. 23. The public purpose sphere, which includes government, NGOs, and international institutions, exists for the purpose of the public good at some level. Organizations in the public purpose sphere tend to be formally structured and primarily obtain their money through monetary contributions rather than direct payment for goods or services. The public purpose sphere often provides public goods, which are not exchanged in markets. 3-5

33 Cumulative percent of income 24. The business sphere is made up of firms and proprietors that produce goods and services for profitable sale. While the primary goal of businesses is to make profits, firms may still have other goals such as community service or environmental protection. Businesses are formally structured and commonly involve the complex interaction of many actors. The drive for profits encourage firms to behave efficiently, respond to market influences, and innovate to remain competitive. Answers to Exercises 1. a. stock, natural capital b. flow, increase manufactured capital (may decrease natural capital) c. flow, increase financial capital d. stock, social capital e. stock, financial capital f. stock, manufactured capital g. flow, increase social capital h. flow, increase human capital 2. a. Exchange (between De Beers and wholesaler) b. Transfer (when viewed as a transfer from nature to De Beers) c. Exchange (you pay interest in exchange for the loan from the credit card company) d. Transfer (from bank to fair) 3. a. The Lorenz curve would be: Cumulative percent of households 49 b. The distribution of income in Thailand is very similar to the income distribution for the U.S. Note the similarity between the table in the question and Table 9.6. So, we would expect the Gini ratios to be quite similar for the U.S. and Thailand. In fact, the Gini coefficient for Thailand based on these data is 0.44, compared to 0.46 for the U.S. 3-6

34 4. a. 10 b. 8 c. 12, d. 14 e. 7 f. 11 g. 2 h. 5 i. 4 j. 3 k. 1 l. 13 m. 6 n Progressive the percentage rises with income. Income Taxable Income Tax Tax as % of Income 10,000 7,000 1, % 50,000 47,000 9, % 100,000 97,000 19, % 6. For example, in the 2007/2008 Human Development Report (online at in the tables for Human Development Indicators (at Table 15 contains information such as: If your students are using this source, you may want to guide them towards the right table; tell them that it calls the Gini ratio, multiplied by 100, the Gini Index ; and warn them that they will not be able to get information for all the income quintiles. On the basis of the above, for example, they might write that In Guinea, the poorest income quintile receives 2.9% of total income, and the richest receives 46.1%. With a Gini ratio of.386, its income distribution is more equal than that of Rwanda, whose Gini ratio is.468. In Rwanda, only 2.1% of total income goes to the bottom quintile, and more than half of total income 53.0%--goes to the top quintile. 3-7

35 In World Development Indicators Online (if your library subscribes), students can interactively choose countries and variables, and get a table such as the following (for Argentina): 2004 GINI index 51 Income share held by fourth 20% 21 Income share held by highest 20% 55 Income share held by lowest 20% 3 Income share held by second 20% 8 Income share held by third 20% 13 If your students are using this source, you may want you may want to guide them towards the right variable names; tell them that it calls the Gini ratio, multiplied by 100, the Gini Index ; and warn them that they may have to search over several years to find the most recent figures. They will be able to get information for all the income quintiles. 3-8

36 Web Resources For data on the distribution of capital income, see the report by the Institute on Taxation and Economic policy available at For information on the distribution of household income over time, see the Census Bureau historical tables (e.g. Extensions 1. Graph of the top marginal individual income tax rates, The text simply states that In the United States the federal income tax is a progressive tax, although the rates paid by the highest earners have dropped over time. This graphically illustrates that drop. (1 page) 3-9

37 The Top Marginal Individual Income Tax Rates, 1913 to 2007 Note: The marginal tax rate is the percentage of the last dollar of income that goes to taxes. Data Source: accessed 7/16/2008. Based on Eugene Steuerle, The Urban Institute; Joseph Pechman, Federal Tax Policy; Joint Committee on Taxation, Summary of Conference Agreement on the Jobs and Growth Tax Relief Reconciliation Act of 2003, JCX-54-03, May 22, 2003; IRS Revised Tax Rate Schedules 3-10

38 Chapter 4 SUPPLY AND DEMAND Macroeconomics in Context (Goodwin, et al.), 2 nd Edition Note to the Instructor This chapter presents traditional supply-and-demand curve analysis, including discussions of the slopes of the curves, factors that shift the curves, equilibrium and market adjustment, and a simple discussion of elasticities. The contextual approach, however, leads to some subtle shifts in presentation. First, the model is explicitly presented as a thought experiment as a humanly-created analytical tool that may help us gain insight--rather than as a set of laws about the way the world works. Second, the discussion in the last section of the paper leads students to think about cases in which supply and demand analysis may and may not be useful in explaining macroeconomic phenomena. Objectives After reading and reviewing this chapter, the student should be able to: 1. Describe the concept of the supply curve. 2. Explain the difference between change in quantity supplied and change in supply. 3. Describe the concept of the demand curve. 4. Explain the difference between change in quantity demanded and change in demand. 5. Explain the difference between a substitute good and a complementary good. 6. Demonstrate an understanding of surplus, shortage, and equilibrium situations using the supply and demand graphical model. 7. Demonstrate an understanding of the difference between movement along a curve versus a shift in a curve using supply and demand analysis. 8. Describe the concept of price elasticity. 9. Describe the concept of a speculative bubble. Key Terms perfectly competitive market self-correcting market supply curve change in quantity supplied change in supply demand curve change in quantity demanded change in demand substitute good complementary good surplus equilibrium 4-1 market-clearing equilibrium shortage theory of market adjustment market disequilibrium price elasticity price elasticity of demand price elasticity of supply quantity adjustments menu costs speculation speculative bubble

39 Notes on Discussion Questions 1.1 Most students will probably have had some experience with ebay. With most ebay auctions, each bidder will state his or her maximum willingness to pay for an item. However, the high bid listed during an ongoing auction is only high enough to beat the second-highest bid. Thus the person with a listed high bid may actually be willing to pay much more than the listed bid. Only when someone places a new bid higher than the previous person s maximum willingness to pay does that new bidder then become the high bidder. You could ask students if they have any strategies or advice for bidding on ebay. With many ebay auctions, people wait until the last few minutes before bidding, and then frantically bid in small increments to try to win the auction. You might ask students if this seems like a smart strategy. The danger is that people might bid merely to win the item rather than think about what it is really worth to them. In some cases people end up buying an item on ebay for more than they could buy it from a local store probably a good illustration of compulsive buying! 1.2 In most cases students will have bought goods and services from a business at a stated price. Such markets do not involve a double auction but most likely it was a spot market the student immediately took possession of the good or received the service. Note that there may be some delay in actually receiving a good in a spot market. For example, it may take several days to receive something ordered off the Internet. Buying something off of ebay is an example of a double auction because sellers can state the minimum price they are willing to sell for and buyers must place bids. Most markets are not perfectly competitive it might be easier to think of markets that are highly competitive. For example, gasoline is a product that very similar across different stations, although there may not be many sellers of gasoline in your area. 2.1 You can use this question to encourage students to think more about supply curve issues. At a simplistic level, students may respond that sellers are willing to supply more as the price of something rises. But why is this so? If students are familiar with the concept of increasing marginal costs, they may respond that suppliers will only offer more for sale as long as it covers their increasing marginal costs. New suppliers may also enter a market as prices rise, suppliers that previously believed prices were not high enough to justify entry into the market. You could ask students to think of situations where suppliers might not, or could not, increase the amount they have for sale despite rising prices. 2.2 A change in the quantity supplied is represented by movement along a supply curve as a response to a price change. A change in supply is represented by the shift of a supply curve in response to something other than price. a. A rise in the going price of lawn mowing services would result from movement along the supply curve an increase in the quantity supplied. b. More people offering to mow lawns means that more will be supplied at a given price an increase in supply. 4-2

40 c. A rise in the price of gasoline will cause those supplying lawn mowing services to raise their prices for any given quantity of lawn mowing. This results in a decrease in the supply of lawn mowing services provided. 3.1 Demand curves normally slope downward because, as the price for a particular good or service increases, people will tend to want to purchase less of it. As price increases, people have an incentive to reduce the quantity of the good or service they purchase or seek other goods and services instead. Thus, demand curves both at the individual and market level normally slope downward. 3.2 A change in quantity demanded is represented by movement along a demand curve in response to a price change. A change in demand is represented by a shift in a demand curve in response to something other than price. a.a new office park means that more lawn mowing services will be demanded at a given price an increase in demand. b. Homeowners have more time (but less money) and therefore will likely reduce (and in some cases eliminate) requests for lawn mowing services a decrease in demand. c. A rise in the going price for lawn mowing services would reflect a movement along a demand curve a decrease in the quantity demanded. d. Greater preference for a natural yard means that at a given price, fewer lawn mowing services would be demanded a decrease in demand. 4.1 a) A rise in basketball players incomes will likely increase the demand for highquality basketballs. The demand curve will shift, causing both price and quantity to increase: 4-3

41 b) An increase in the wages paid to workers who make the balls will increase production costs and causes a decrease in supply. The supply curve will shift, causing price to increase and quantity to decrease: c) A decrease in the price of basketball hoops and other gear is a decrease in the price of complementary goods. This will cause an increase in the demand for basketballs. The demand curve will shift, causing price and quantity to both increase. 4-4

42 d) If the nation becomes obsessed with soccer, this will decrease the demand for basketballs. The demand curve will shift, causing both price and quantity to decline. 4.2 This question is designed to review the definitions of surplus and shortage, while leading into the discussion of rationing in the section that follows. When students cannot get into a class they want to take, this illustrates a shortage (the quantity of class sections demanded exceeds the quantity supplied at the going price ). In most educational institutions, however, classes are allocated administratively, not by markets. Students pay a flat fee per semester or per credit-hour, no matter whether the class they want is very popular or very unpopular. If there is a cap on enrollment in a class, either the administration has to scurry to find instructors and rooms for new sections, or some students (either unlucky or with little seniority) will have to wait and take the course another time. Using a market mechanism would mean letting students buy their way into a desired class by offer to pay a higher fee, while the higher fees collected would (presumably) allow the educational institution to offer the additional sections. For students very frustrated by being shut out, this may seem to be an appealing idea--the shortage could be eliminated! In addition, one could argue that the administration would have an economic incentive to give students just what they demand, and might expand popular courses (and cancel unpopular ones) more quickly than they do with an administrative system. On the other hand, such a change means that the rationing mechanism becomes ability-to-pay: a poor student may never be able to get a class he or she needs to graduate. The administration may also face constraints that are not reflected in the idea of an upward-sloping supply curve, such as the impossibility, at least in the short run, of replicating an exceptional instructor. The faculty and administration may also believe that educational goals should not be driven entirely by consumer (student) preferences. 5.1 Gasoline is probably the good most students will think of as changing price rapidly. Prices can of course vary day-to-day in response to world events. On the other hand, restaurant prices change infrequently because of menu costs, as discussed in the text. Students may mention that the price of some goods fluctuate depending on whether it is on sale. Does this necessarily represent a change in market conditions for that particular good? A temporary sale may be a 4-5

43 gimmick to entice shoppers into a store, rather than a response to changes in the market for that good, although sometimes a sale may be an attempt to clear out a slow-selling product which would be a result of market conditions. 5.2 The subprime-mortgage overvaluation and subsequent meltdown was in the news as this textbook was written. Stock markets and other financial markets (particularly foreign exchange), and real estate markets, are likely candidates for future speculative binges. Notes on Review Questions 1. The type of market featured in Classical analysis is perfectly competitive, a spot market, and a double-auction market. 2. A supply curve is a curve indicating the quantity that sellers are willing to supply at various prices (see Figure 4.1). 3. The difference between a decrease in quantity supplied and a decrease in supply is illustrated in the graphs below. 4. The factors discussed in the text that might cause a supply curve to shift include a change in the number of suppliers, a change in technology, a change in the known supply of a resource such as oil, and a change in natural conditions such as the harvest of a particular crop. Note that other non-price determinants of supply not discussed in the text include the prices of inputs, expectations of future prices, and changes in the prices of related goods and services. 5. A demand curve is a curve indicating the quantity that buyers are ready to purchase, at various prices (see Figure 4.4). 4-6

44 6. The difference between a decrease in quantity demanded and a decrease in demand is illustrated in the graphs below. 7. The factors discussed in the text that might cause a demand curve to shift include a change in population, changes in incomes, a change in the prices or availability of substitute or complementary goods, and weather. Note that other non-price determinants of demand not discussed in the text include changes in expectations of future prices and changes in tastes and preferences. 8. Two goods are substitutes if they can be used in place of one another. An increase in the price of a substitute will cause more people to demand the other good an increase in demand (the demand curve shifts to the right). 9. Two goods are complements if they tend to be used together. An increase in the price of a complementary good will tend to reduce the demand for a good (the demand curve shifts to the left). 10. A graph illustrating surplus, shortage, and equilibrium is given below. 4-7

45 11. An increase in supply results in a decrease in the equilibrium price and an increase in the equilibrium quantity, as illustrated in Figure 4.8. A decrease in supply results in an increase in the equilibrium price and a decrease in the equilibrium quantity, as illustrated in the graph below. 12. An increase in demand will increase both the equilibrium price and quantity, as illustrate in Figure 4.9. A decrease in demand will decrease both the equilibrium price and quantity, as illustrated in the graph below. 13. The price elasticity of demand measures the responsiveness of the quantity demanded to changes in a good s price. The price elasticity of supply measures the responsiveness of the quantity supplied to changes in a good s price. 14. Prices may often adjust slowly because a chain of markets is involved. As a result the most likely first response to a surplus situation is that manufacturers will cut production rather than reducing their price. Also, the presence of high menu costs would motivate sellers to adjust quantity rather than price. 15. Wild price swings can be problematic because people who made speculative purchases can lose significant amounts of money. Also, wild price swings can have macroeconomic implications, even precipitating a recession. 4-8

46 Answers to Exercises 1. a, b: c: The equilibrium price is 15 cents/kwh and the equilibrium quantity is 5 (million) kwh. See point E on the graph. d. At P= 17, quantity supplied = 9, quantity demanded = 3. Quantity supplied is greater than quantity demanded. There is a surplus. e. Quantity supplied is less than quantity demanded. Shortage. f. If the price is below equilibrium, shortages (and hence blackouts) would be more likely to occur. 2. a: 4-9

47 b. Quantity supplied would exceed quantity demanded, creating a surplus. (See the distance between point A and point E 1.) c. The new equilibrium price is 14 cents/kwh and the new equilibrium quantity is 3 (million) kwh. See E 2 on graph. d.yes, the curve shift is change in demand. Yes, there is a change in quantity demanded as well, relative to the initial situation: because the price does not stay at 15 cents/kwh, but drops to 13 cents/kwh, there is also movement down along the new demand curve (shown on the graph above as from point A to point E 2 ). (Note: this last part of this question is more subtle and difficult than the first part.) e. No, there is no change in supply (since the supply curve does not shift). Yes, there is a decrease in the quantity supplied, as the price drops from 15 cents to 14 cents. 3. a. D shifts out. P rises. Q rises. Consumers tastes for bananas has increased. Price S P 2 P 1 D 2 D 1 Q 1 Q 2 Quantity b. S shifts out. P falls. Q rises. Technological improvement has allowed shoes to be produced more cheaply. Price S 1 S 2 P 1 P 2 D Q 1 Q 2 Quantity 4-10

48 c. (Same graph as (b)). S shifts out. P (the wage) falls. Q rises. The number of producers has increased. d. (Same graph as (a)). D shifts out. P rises. Q rises. Consumers higher incomes allow more purschases of expensive goods. e. (Same as graph for (a)). D shifts out. P rises. Q rises. California grapes and Chilean grapes are substitute goods, from a consumer s point of view. So if the price of one rises, the demand for the other will rise. (Note that the conditions under which grapes are supplied from California is not affected, so the supply curve in THIS market does not shift.) f. D shifts back. P falls. Q falls. Salsa lessons and a place to dance are complementary goods from a consumer s point of view. If salsa dancing becomes more expensive, then people will want fewer lessons. g. (Same graph as (a)). D shifts out. P rises. Q rises. Consumers may rush to stock up on bottled water before the price goes up. Notes for discussion: Of course, if there is a rush to buy, the price will go up. So the rumor may be self-fulfilling even it there was no truth to it, originally. (One might also think about what producers might do. If they have the warehouse space to store stocks of water, they might also hoard cut back on what they supply to the market in order to benefit from the higher future price. This would drive the price still higher.) h. S shifts out AND D shifts out. The effect on P is ambiguous. Q rises a lot. The number of producers has increased AND the tastes of the buyers have changed. Both forces lead to an increase in quantity (that is, employment), but they have conflicting effects on price (the wage). Price S 1 S 2 or D 2 D 1 Q 1 Q 2 Quantity 4-11

49 4. The student s original supply curve and his willingness to sell three books at a price of $30 per book is shown in the graph below: a) If the student is offered $70 per book instead of $30, this would imply movement along the supply curve. Moving along the supply curve, the student would now sell seven books: b) If course material is available on the Internet for free, the student would be forced to lower his prices, shifting the supply curve downward: 4-12

50 c) If the bookstore raises their prices, the student would be able to raise his prices as well, shifting his supply curve upward: 5. a. False. A fall in the price of a good is shown by a movement along a supply curve. b. True. c. True. d. False. a large effect or is very inelastic. 6. a. Demand increases, price and quantity rise. More people want engagement rings around this holiday. 4-13

51 b. Supply falls, price rises, and quantity falls. Rings become more expensive to supply. c. Supply rises, price falls, and quantity rises. Rings become cheaper to supply. d. Demand falls, price falls, and quantity falls. Buyers consider cubic zirconium to be a substitute for a real diamond. 4-14

52 e. Demand rises, price rises, and quantity rises. The increase in wealth causes people to demand more diamonds (which are clearly a normal good). 7. a-5, b-9, c-10, d-3, e-7, f-8, g-1, h-4, i-2, j Situation (a) would reduce the supply of wheat which would lead to a price increase. So (a) is not a potential explanation. Situation (b), assuming rice and wheat are substitutes, would increase the demand for wheat. As this would lead to a price increase (b) is also not a potential explanation. Assuming some tobacco farmers started growing wheat, situation (c) would increase the supply of wheat. As shown in the graph below this would increase the price of wheat, so it is a potential explanation. Finally, in situation (d) the news would result in a decrease in the demand for wheat. As illustrated in the graph below, this is also a potential explanation for the fall in the price of wheat. 4-15

53 9. A handy source for stock quotes is Yahoo! Finance at For example, at the time of this writing, the Yahoo! Finance web page featured a Market Movers section. Included in this section was WB or Wachovia Corporation, a financial institution. Clicking on this ticker symbol and then on 5 yr (for a five year chart) showed a general run up in the stock price through early 2007 followed by a (sub- prime mortgage-related) sharp drop in the stock price from over $50 to just over $20 from late 2007 to early By default, the long-term graphs are presented in logarithmic scale, though an option is presented for expression in linear terms. You may want to explain to your class how logarithmic scales show equal percentage changes as equal vertical distances. 4-16

54 Chapter 5 MACROECONOMIC MEASUREMENT: THE CURRENT APPROACH Macroeconomics in Context (Goodwin, et al.), 2 nd Edition Note to the Instructor This chapter presents a fairly standard introduction to national income accounting, but with a contextual flavor. It emphasizes that the accounts have been created for specific purposes. It notes how the production and investment undertaken in the household and institutions and government sectors have historically been deemphasized in national accounting, and how these have been completely ignored in common abstract representations of the macroeconomy. If you haven t taught Macro for some years, some of the material in this chapter, such as the recent adoption of chained estimates in the National Income and Product Accounts, may be new to you. The 2003 comprehensive revisions also changed many NIPA definitions. For example, owner-occupied housing and the rental value of fixed assets owned by nonprofit institutions serving households are now considered production of the households and institutions sector. Formerly, these were considered business production. See Web Resources (below) for more information. Objectives After reading and reviewing this chapter, the student should be able to: 1. Understand when the U.S. system of national accounts was developed, in the context of the pressing problems of that time. 2. Identify the four sectoral classifications of the U.S. national accounts, and what is included in each sector. 3. Identify what capital stocks are included in the U.S. national accounts. 4. Define the Gross Domestic Product, and identify what is included and excluded in its measurement. 5. Understand and apply the three approaches to measuring GDP. 6. Calculate GDP growth rates, nominal GDP, and real GDP. 7. Identify commonly used price indices, and construct a constant-weight price index. 8. Identify the saving identity in a closed economy, and in an open economy; define the Net Domestic Product (NDP); and define Net Saving. 9. Understand the simplifying assumptions made by the traditional macroeconomic model, and identify the model s basic identity (taken from the spending approach). 10. (Appendix) Understand the value and limitations of the chained dollar method in measuring real GDP. 5-1

55 Key Terms National Income and Product Accounts (NIPA) Bureau of Economic Analysis (BEA) national accounting conventions fixed assets inventories consumer durable goods depreciation gross domestic product (GDP) final good intermediate good value-added imputation identity (accounting identity) closed economy open economy Net exports national income (NI) nominal GDP real GDP base year index number consumer price index (CPI) rule of 72 net national product (NNP) From Appendix: quantity index Fisher quantity index chain-type quantity index Notes on Discussion Questions 1.1 a. A city-government-owned golf course that charges fees would be classified as business sector. b. a nonprofit hospital would be classified as households and institutions sector. c. a U.S.-owned movie company based in Japan would be classified as foreign sector. d. a nonprofit trade association would be classified as business sector. 1.2 Spending on education is considered a consumption expenditure in the NIPA. It should be considered an investment in human capital, but is not since human capital is not recognized as a form of capital in the NIPA. Buying a share in a company is financial investment it transfers ownership rights to the company, but does not in itself create new productive capacity. Economists generally use the term investment to refer to investment in productive capacity. The BEA further limits this to only investments in equipment, software, and structures. So buying a share is not investment in BEA terms. 3.1 Students should be able to explain how, in a very simple closed economy, the process of production should generate flows of income equivalent in value to the value of the products, and when the production is sold it should generate flows of spending equivalent in value to the value of the products. Some production goes to replace worn out capital, so depreciation is part of GDP but not part of NI. Some domestic incomes are earned from foreign production, so these are part of NI but not part of GDP. Some domestic production results in foreign incomes, so this is part of GDP but not NI. 5-2

56 3.2 The definition clearly takes shortcuts. Owner-occupied housing services and much government and nonprofit production are not sold in markets. Their market value is imputed, not actual. Household production using unpaid labor is ignored. 4.1 Making student explain to each other the difference between nominal and real, and why the distinction is important, can help nail down the key points of this section. Otherwise, too often students may tend to lose the forest (the distinction between actual production growth vs. illusory growth) for the trees (formulas and calculations)! If we want to get a measure of production that does not reflect price changes, we have to somehow standardize prices and just look at quantity changes. 4.2 If we want to get a measure of price changes that does not reflect changes in people s purchasing patterns, we have to somehow standardize the market basket (quantities) and just look at price changes. In the case of calculating real GDP in constant dollars, the prices from one year are multiplied by the quantities in various other years. Calculation of the CPI reverses this using the quantities from one year to weight the prices in various other years. 5.1 Atlantis must have high savings, as indicated by the identity Saving = Investment + Net Exports. Olympus must be borrowing, as indicated by the identity Saving = Investment Net Foreign Borrowing. 5.2 When government debt is held by foreigners (that is, overseas parties have bought government bonds), this adds to Net Foreign Borrowing for the nation as a whole. This can potentially put the country in hock the funds raised from future taxpayers to pay interest and principle will need to flow to parties outside the country, decreasing prosperity inside the country. By contrast, internally held debt may have redistributive consequences within a nation in the future but it does not require a net outflow of funds to pay it down and therefore does not necessarily reduce future prosperity within the country. Answers to Review Questions 1. National accounting in the U.S. was started in order to track national production during the Great Depression. 2. The Bureau of Economic Analysis compiles the NIPA. 3. The four sectors are: (1) households and institutions, including families and unrelated individuals living together, and nonprofit institutions serving households. (2) business, including for-profit businesses, business-serving nonprofit organizations, and government enterprises. (3) government, including all federal, state, and local entities (except enterprises ) and (4) foreign, including all entities located outside the borders of the U.S. 4. The BEA largely tracks manufactured capital. (One exception is computer software). 5. Net investment is gross investment less depreciation. 6. (1) final goods and services means that GDP counts only the value of goods that are 5-3

57 ready for use. (2) newly produced means that production in earlier years is not counted. (3) in a country means that for production to be counted in GDP it must take place within the nation s borders. (4) total value means the actual or imputed dollar market value 7. The three approaches to GDP measurement are the product, spending, and income approaches. 8. In a very simple economy, everything produced would be bought, and everyone participating in production would receive compensation. So production, spending, and income would be equal in value. 9. The value-added approach calculates, for each industry that participates in the production of a good, the value that it added to the final price. The sum of the value-added figures should then equal the final price. 10. When a market value does not exist, imputations are used. These may be based on the value of related products or on the value of inputs. 11. The components of GDP according to the product approach are business production, household and institutions production, and government production. 12. The components of GDP according to the spending approach are household and institutions spending (or personal consumption), business spending (or private investment), government spending (or government consumption and government investment), and net foreign sector spending (or net exports). 13. In order to move from national income to GDP, you need to subtract off net income payments from the foreign sector and add in depreciation. 14. The constant dollar method measures GDP in any year using one set of prices those in a base year. The idea is to measure real GDP by taking out the variation in nominal GDP that is purely due to price changes. 15. When using the constant dollar method, you can get different numbers for GDP growth depending on which year is chosen as base. This method also suffers from other inaccuracies and biases. The chained dollar measure doesn t have the same problems, but it is more complex to compute. 16. A constant weight price index measures changes in prices by using for comparison a constant market basket or set of weights that stays constant from year to year. 17. No. There are several types of price indices, including the CPI, the producer price index, import and export price indices, and the implicit price deflator (or GDP deflator). 18. Saving = Investment + Net exports. This means, for example, that if net exports are positive, we are essentially lending our extra savings to foreigners so they can buy our goods. 19. A country that imports more than it exports can borrow from abroad. Answers to Exercises 1. At the time of the original design of the accounts, agriculture was a much larger part of the economy than it is today, and finance was much smaller. (For example, the agricultural sector was estimated to produce about 9% of GDP in 1949, but less than 1% in 2002 calculations based on NIPA Table 1.7.)The accounts continue to reflect someof the original categories set up. 5-4

58 2. a. business b. state and local c. nonprofit institutions d. not counted in any category (unpaid) e. not counted in any category (not domestic ) 3. a. national income b. net income payments from the rest of the world, this is foreign production but domestic income c. depreciation d. not counted in any category (note that it reflects both foreign production and foreign income, so it is counted in neither GDP nor NI) e. net income payments from the rest of the world (negatively) it is domestic production but foreign income 4. a. durable goods. b. exports c. fixed investment (added) and imports (subtracted) d. national defense e. change in private inventories f. not counted in any category (not newly produced ) g. services h. not counted in any category (since unpaid) 5. a. 100 b. 500 c. 48 d. 20 e

59 Note: These answers correspond to using the tables as follows (where numbers in bold are the numbers solved for): Product Approach: Households and institutions production 150 Private households 100 Nonprofit institutions 50 Business production 500 Government production 200 Total: Gross domestic product 850 Spending Approach: Household and institutions spending (personal consumption expenditures) 650 Business spending (gross private domestic investment) 50 Fixed investment 48 Change in private inventories 2 Net foreign sector spending (net exports of goods and services) 100 Exports 225 Less: Imports 125 Government spending (government consumption expenditures and gross investment) 50 Federal 20 State and local 30 Total: Gross domestic product 850 Income Approach: National income 795 Less: Net income payments from the rest of the world 5 Depreciation (consumption of fixed capital) 60 Statistical discrepancy 0 Total: Gross domestic product a. Year 1: $800. Year 2: $1000. b. 25%. c. Year 1: $800. Year 2: $880. d. 10%. (See spreadsheet table below) 5-6

60 Year 1 Price, Year 1 Quantity, Year 1 Value (at Year 1 Prices) = price times quantity Pillows $ $250 Rugs $ $550 $800 = nominal GDP in Year 1 Year 2 Price, Year 2 Quantity, Year 2 Value (at Year 2 Prices) = price times quantity Pillows $ $280 Rugs $ $720 $1,000 = nominal GDP in Year 2 growth rate of nominal GDP from Year 1 to Year 2 = Calculation of Constant Dollar Real GDP and Real GDP Growth Rates Using Year 1 prices GDP in Year 1 using Year 1 prices = $800 GDP in Year 2 using Year 1 prices: Price, Year 1 Quantity, Year 2 Value (at Year 1 Prices) = price times quantity pillows $ $ rugs $ $ $ growth rate of real GDP from Year 1 to Year 2 = a b % (See spreadsheet table below) Calculation of Constant Weight Price Index for Year 2 Sum of Year 1 Prices Weighted by Year 1 Quantities$800 Sum of Year 2 Prices Weighted by Year 1 Quantities Price, Year 2 Quantity, Year 1 weighted sum of prices=price times quantity pillows $ $ rugs $ $ $ Price index =

61 8. a-7, b-3, c-10, d-12, e-5, f-1, g-11, h-4, i-8, j-6, k-9, l a. only manufactured capital no natural, human, or social capital (not even computer software). b. household, business, and government only no nonprofit institutions.c. only the business sector produces and invests not households or governments 10. At the time of this writing, the GDP news releases and statistics from the NIPA are easily found on the BEA website. The questions asked can easily be answered by clicking on links to Current-dollar and real GDP and Percent change from preceding period Excel tables. For example, at the time of this writing, the most recent period for which figures have been reported is the 1 st quarter of 2008 ( 2008q1 ). At this time, nominal GDP (expressed in annual terms) in was $14,195.6 billion and real GDP was $11,701.9 billion. Real GDP grew in the 1 st quarter of 2008 at a 0.9% (seasonally adjusted) annual rate (while nominal GDP grew by 3.5%). Real GDP is expressed in chained 2000 dollars. This exercise gets students into the actual data though they may need help thinking through what the table labels mean, and how it is that a quarterly figure can be expressed in annual terms. 11. You may want to change the instruction given for this question to Use the seasonally unadjusted number or Note whether your statistics are before or after seasonal adjustment because of ways the reporting has changed since this question was written. At the time of this writing, links to the Consumer Price Index are prominently displayed on the BLS website, but the presentation can be confusing. The webpage Table 2. Consumer Price Index for All Urban Consumers (CPI-U): Seasonally adjusted U. S. City Average, by expenditure category and commodity and service group found under Economic News Releases says that in April 2008 the seasonally adjusted index for all items stood at The Consumer Price Index Summary html file contains, in Table A, the information that this is a 0.2% increase over March 2008, but only presents the 12-month change in unadjusted terms. The unadjusted index rose by 4.2% from April 2007 to April An enterprising student could calculate the change for the seasonally adjusted number by searching for historical data, but this may be more than you want them to do. 12. The chained estimate was $245, while the constant dollar estimate was $250. But the latter is consistent with a 25% growth rate over the previous year, which is high. Simply changing the base year (to Year 2) lowers the growth figure estimated using the constant dollar method to 20%. Estimated growth using the chained method was in the middle22.5%--so it makes sense that the estimated dollar value of GDP would also be less than $

62 Web Resources The Bureau of Economic Analysis has many documents available on its website. Some that we found to be especially helpful in writing this chapter include (along with their url s at the time of this writing): A Guide to the NIPA s in National Income and Product Accounts of the United States, , BEA, 2001, pp. M1-M25. Updated Summary NIPA Methodologies, Survey of Current Business, October 2002, BEA s Chain Indexes, Time Series, and Measures of Long-Term Economic Growth, by J. Steven Landefeld and Robert P. Parker, Survey of Current Business May 1997, pp Preview of the 2003 Comprehensive Revision of the National Income and Product Accounts: Changes in Definitions and Classifications, by Brent R. Moulton and Eugene P. Seskin, Survey of Current Business June 2003, pp Preview of the 2003 Comprehensive Revision of the National Income and Product Accounts: New and Redesigned Tables, by Nicole Mayerhouser, Shelly Smith and David Sullivan, Survey of Current Business August 2003, pp

63 Chapter 6 MACROECONOMIC MEASUREMENT: ENVIRONMENTAL AND SOCIAL DIMENSIONS Macroeconomics in Context (Goodwin, et al.), 2 nd Edition Note to the Instructor This chapter gives a more thorough introduction to social and environmental accounting and alternative measures of economic performance than can be found in any other introductory economics textbook. As an alternative to the usual economic "circular flow" diagram that ignores the resource base of production, this chapter introduces an image of economic activity as embedded in social and physical contexts, and relates this approach to issues of macroeconomic concern. Objectives After reading and reviewing this chapter, the student should be able to: 1. Explain why GDP should not be confused with national welfare. 2. Identify the dimensions of well-being as described by the Sarkozy Commission. 3. Explain trends in social well-being data across countries and across time. 4. Understand why GDP does not measure well-being, and describe two examples of alternative measures of economic well-being. 5. Explain and Critique the historical exclusion of household production from the national accounts. 6. Understand the methods used to measure household production and impute a monetary value to it. 7. Identify and provide examples of the three economic functions of the environment. 8. Identify how, conceptually, the depreciation of natural capital can be included in measures of production and saving. 9. Understand the issues involved in assigning monetary values to environmental asset stocks, depreciation, and service flows. Key Terms satellite accounts subjective well-being defensive expenditures Genuine Progress Indicator (GPI) Better Life Index (BLI) Human Development Index (HDI) replacement cost method opportunity cost method environmentally adjusted net domestic product (eandp) damage cost approach maintenance cost approach 6-1

64 Notes on Discussion Questions 1.1 Particularly in relation to nonrenewable resources, throughput is not justifiable as a measure of sustainable well-being. Higher GDP just means running through irreplaceable resources at a faster pace. 1.2 Some ways in which economists have tried to answer this question will be reviewed in this chapter, but the point of this question is to get students brainstorming a bit. Stocks of natural capital might be measured in terms of estimated oil in the ground, the size of the hole in the ozone layer, etc. Social capital may seem harder to measure. Social surveys that look at the level of confidence people express in their leaders, concerns they express towards people around them, trust in business associates, happiness with their families and communities, etc., are sometimes helpful. In the book that touched off much of the social capital debate (Bowling Alone, New York: Touchstone, 2000), Robert Putnam used indicators including memberships in bowling leagues as one measure of social cohesiveness. For technology as a form of social capital, some researchers have used crude measures such as the number of patents granted. For human capital, you might think of measures of health (e.g., work days lost to illness, indicators of mental illness) and education (e.g. years of schooling, quality indicators for early care and education). (The World Bank in 1996 changed its measure of genuine saving, discussed a little later in this chapter, to also include education expenditures, considering them to be saving in the form of human capital. See Monitoring Environmental Progress: A Report on Work in Progress, John C. O Connor et al, the World Bank, 1995 and 1996 editions.) 3.1 Students who are slow to engage with the material could be encouraged to think broadly on this. Perhaps to some students spiritual life is very important, or others are fascinated by advances in technology. How could these be put into an indicator? Students who are already thinking broadly may be better narrowed down a bit, perhaps by thinking about what the basics are that people really need to live a meaningful life maybe economic planners worldwide should focus on food production and clean water sources, for example. 3.2 At the least, this question could be used to review the types of measures covered in this chapter: Expanded measures of production =satellite accounts for environment and household production; measures of production adjusted for well-being =GPI; wellbeing itself =HDI. Of course, students may argue for multiple indicators as well. 3.3 Satellite accounts, The Key National Indicators System, and Subjective Well- Being data are three examples of efforts to supplement GDP. Time Use Surveys (combined with the replacement cost or the opportunity cost method of valuing household time) and environmentally-adjusted net domestic product (EDP) are two examples of efforts to adjust GDP. The Genuine Progress Indicator, the Better Life Index, and the Human Development Index are three examples efforts to replace GDP altogether. 6-2

65 4.1 This discussion question provides an opportunity for a classroom conversation about how much our society values (or doesn t value) unpaid household production. It might be helpful to explore the example from the chapter about policy bias under the current system (e.g., Social Security stipends) and challenge students to think about the fairness of this approach. The question also raises the issue of the informal sector and provides an opportunity to raise awareness about the importance of this sector in developing countries. 4.2 Examples could include cooking, cleaning, driving, laundry, etc. Students may have an idea of the cost of a market alternative (e.g., restaurant meal cooked by a short-order cook, wash-and-fold service) from which a replacement cost estimate could be derived. You might point out that child care work is one of the lowest paid occupations in the United States one can make more as a parking lot attendant (watching cars) than as a person responsible for the health, safety, and development of young children. How does this affect calculations of replacement cost? Is there a bias involved? You might note that a lawyer who reduces his or her hours at a law firm to take care of an infant is unlikely to agree that his or her time with the child is worth only the minimum wage. Students could estimate opportunity costs based on their own time at a paid job, or on what they might earn at such a job if they had one. (Presumably they value their time spent in education at least at this rate, following opportunity cost logic.) You might note that, by the opportunity cost approach, the value of a part-time lawyer s time spent in child care is estimated to be much higher than the value of child care time provided by a part-time food service worker, though both may be equally attentive to their child. Manufactured capital involved could include stoves, vacuum cleaners, cars, washing machines, etc. 5.1 A damage cost approach would look at the value of lost corn production. You would need to know the quantity of lost corn yield, and the price of corn. A replacement cost approach would look at ways of avoiding soil salinization. Perhaps there is an alternative irrigation technology that does not lead to salinization, or a process of desalinization that can be applied. You would need to know about the effectiveness of these technologies and the costs of implementing them. 5.2 Considering how often GDP numbers are quoted, and how closely policy-makers watch them, people who want some number have a point. An environmental cost that is not evaluated in dollars may, in policy, be treated as if it has a cost of $0.00. However, as the reading points out, creating dollar-valued figures for environmental accounts would require making many controversial assumptions and adopting many, perhaps arbitrary, conventions. Market values would have to be imputed for things (like species) that have never been and will never be traded in markets. Human life and suffering would have to be assigned a dollar price tag. Many people find these valuations ethically problematic--while we have a deep moral sense that these things are valuable, valuing them in dollars can seem to be overly commercial and reductionistic. Other concerns are more practical than philosophical. The future value of assets would have to be forecast, even though the future is very uncertain. A decision would have to be made between using a damage cost or a maintenance cost approach to evaluating environmental services. Going beyond what is in the reading, you might point out two additional issues. First, some attempts at money accounting for natural resources have 6-3

66 come up with the contradictory conclusion that the value of a resource rises as its quantity becomes depleted! This can happen when the price per unit of the resource rises very quickly, in response to the increasing scarcity. Second, if one puts together an aggregate number for, say, genuine saving, then one seems to be implicitly saying that a country could substitute one kind of saving for another. That is, a country could, say, invest in more machinery to make up for making more species become extinct. People who believe strongly in the precautionary principle (that one should err on the side of caution when dealing with complex ecological systems) sometimes oppose dollar-valued environmental accounting for this reason, preferring more detailed physical accounts that may help highlight the most pressing particular ecosystem problems. 6.1 This question challenges the students to carefully review the various alternatives presented in section 3 of the chapter and to reflect in some detail how effectively each alternative addresses the critiques of GDP offered in section 2.2. As the text emphasizes, there is no one best approach to addressing the limitations of GDP. Consequently students should not find this to be a quick or easy question to answer. 6.2 This question could be used to frame an in-class exercise to be conducted after prior out-of-class preparation. Initially students are placed in small groups and each group is assigned a country (individual assignments could be selected with an eye to different issues from the critique list.) Groups would each be instructed to research in advance how the various critiques of GDP presented in the chapter specifically affect their assigned country and to then collectively decide how the various alternative measures from section 3 of the chapter would impact their assigned country with respect to public policy initiatives. Following this out-of-class preparation the individual small groups could present their findings to the class. It might be helpful if the instructor modeled this process with an initial case study prior to the out-ofclass work by the small groups. Answers to Review Questions 1. The two major contexts for economic activity are social and environmental (students can refer back to chapter three to reinforce this in even greater detail.) 2. Satellite accounts are additional or parallel accounting systems that measure social and environmental factors and are intended to supplement standard accounts. 3. Subjective well-being (SBW) is a measurement of welfare. The measure is constructed using survey data based on self-perceived satisfaction. 4. The scientific research suggests that SWB data are positively correlated with higher levels of GDP per capita but with diminishing returns (refer back to Figure 6.1 in the chapter.) More specifically, as GDP per capita increases at the high end of the scale gains to SWB tend to approach zero. 6-4

67 5. Average levels of SWB have historically improved as a nation has developed economically and real GDP per capita has grown. The chapter notes that average SWB rose in 45 of 52 countries studied with the greatest gains occurring in low-income countries. 6. Some of the main critiques of GDP as a measure of well-being include: the exclusion of household production, not accounting for volunteer work, neglecting the value of leisure time, the loss of human and social capital formation, ignoring impacts on the natural world, the positive treatment of defensive expenditures, the positive treatment of unhealthy products, ignoring the role of financial debt in consumption levels, and neglecting increases in inequality. Clearly GDP is NOT a reasonable measure of overall well-being. 7. The Genuine Progress Indicator is a measure of human well-being expressed in monetary terms. It excludes most government expenditures, and treats investment differently. Starting with Personal Consumption Expenditures from the national accounts, it adjusts for changes in income inequality, adds in additional benefits including the value of household and volunteer work, and then subtracts measures of bads such as the cost of crime, lost leisure time, and environmental damages. 8. Over the last several decades (since 1978) GDP per capita growth in the United States has NOT corresponded to growth in the Genuine Progress Indicator for the U.S. Over the last 35 years per capita GPI has essentially remained unchanged in the United States. 9. The Better Life Index is produced by the Organization for Economic Cooperation and Development (OECD) and considers eleven different dimensions of well-being. 10. The Human Development Index is generated by the United Nations Development Programme and includes three dimensions of well-being: life expectancy at birth, years of formal education, and real per capita GDP. 11. Some examples of household production include time spent cooking, time spent cleaning, time spent on yard work, and time spent caring for children or elderly family members. 12. The replacement cost method is the wage it would take to get someone else to do the work. The opportunity cost method values the time according to what the worker could have earned in a paid job. 13. The three functions through which the natural environment interacts with the human economy are resource functions (such as providing mineral ores), environmental service functions (providing habitat), and sink functions (absorbing waste). 14. Environmentally adjusted net domestic product (EDP) is constructed by subtracting depreciation of manufactured capital and natural capital from Gross Domestic Product. 6-5

68 15. Estimating environmental impact in monetary terms is very difficult. One potential problem is the difficulty of accurately estimating the future value of natural assets. Changes in technology, changes in demand, changes in government policy, and changes in known reserves can each complicate this estimation process. An additional potential problem comes from placing a monetary value on natural capital that does not have an apparent market value (e.g., diversity of amphibian species). A third potential problem comes from the often invisible nature of the role that natural capital plays in providing important services to the human community. 16. The damage cost approach to estimating the value of environmental services assigns monetary value equal to the damage done when the service is withdrawn. 17. The maintenance cost approach to estimating the value of environmental services assigns monetary value equal to what it would cost to maintain the same standard of services using an alternative method. Answers to Exercises 1. Some products reduce well-being, tobacco being a specific additional example. Some outputs reflect defensive expenditures. Increased buying of sump pumps to counteract flooding would be an additional example. Measures of output do not account for the loss of leisure. Standard measures of output do not count education or community building activities as investments; time spent in these activities are seen as time not spent on productive activities. Some methods of production reduce well-being. Measures of output alone do not reflect the distribution of incomes. Students may think of more examples, as well as more entire categories. 2. a. Purchasing bottled water would increase GDP. b. Drinking from a water fountain would NOT increase GDP. c. Paying a lawn care company for landscaping services would increase GDP. d. Bartering landscaping services for plumbing work would NOT increase GDP. e. Employing people to plant trees would increase GDP. f. Providing volunteers to plant trees would NOT increase GDP. Note: in several of these examples exactly the same service was provided but sometimes it increased GDP and sometimes it did not. 3. a. Bad things subtracted from Personal Consumption Expenditures in the GPI: social costs such as the cost of crime and environmental costs include carbon dioxide emissions damage. Adjustments for income inequality and net foreign borrowing also reduce the GPI. b. Defensive expenditures: all government spending except for services of highways and streets, are not included. Differences in accounting methods: (business) investment, consumer durables. 4. This exercise gives students an opportunity to explore OECD well-being dimensions (including: housing, income, jobs, community, education, environment, civic engagement, health, life satisfaction, safety, and work-life balance) in some detail. After spending some time on the OECD Better Life Index website students should be 6-6

69 better equipped to have a classroom conversation about well-being across multiple dimensions. 5. Detailed data to answer this question can be found in the 2013 Human Development Report in the Statistical Annex beginning on page 139 of the report. The report is available at 6. In current GDP: the cost of the machine and flour are personal consumption expenditures. The machine would be a consumer durable, while the flour would be a nondurable good. The time spent would not be counted anywhere. In an expanded account: the machine would be household investment, and the flour would be an intermediate good. Your time shopping and your time cooking and supervising the children would be productive household services, valued either at replacement or opportunity cost. 7. This exercise provides an opportunity for students to become more familiar with wage data from the Bureau of Labor Statistics website. Following completion of this exercise, students should be well-equipped to discuss the replacement cost method for valuing household production. 8. a. sink b. resource c. sink d. resource (enters human production as it is harvested) e. environmental service f. environmental service 9. a. Natural capital depreciation should be subtracted in calculating eandp and genuine saving. b. The reduction in environmental production could be estimated two ways. The damage cost approach would calculate this as the value of lost fish and tourist spending, and damage to wildlife. The maintenance cost approach would calculate this as the cost of preventing or containing the spill e.g. thicker hulls on oil tankers or spill-cleanup efforts. 10. a. Natural capital depreciation should be subtracted in calculating eandp and genuine saving b. The release of CO 2 probably has both current and long-term impact. The long term impact can be seen as a degradation of the environmental sink function, and counted like a depreciated asset. The current impact can be seen as a loss of climate stabilization for the year, resulting in lost crops or flooding. According to the damage cost approach, this might be calculated as the value of lost crops and flood damage. According to the maintenance cost approach, this might be calculated as the cost of stabilizing the climate by, say, preventing greenhouse gas emissions with new combustion technology. c. This is the loss of an environmental service. By the damage cost, a value might be calculated by surveying how much people value the lost scenery and reduced activity. (You might go beyond the reading to explain the use of contingent valuation surveys to try to estimate people s willingness to pay for a non-marketed good.) By the maintenance cost approach, the value of this loss might be calculated as the cost of pollution control devices to prevent the smog. 6-7

70 11. a-6; b-10; c-7; d-5; e-1; f-2; g-3; h-9; i-11; j-4; k-8. Web Resources For more information on the Sarkozy Commission, see Interactive components of the Better Life Index can be found at the OECD website: The Human Development Report 2013 provides detailed information on the HDI: Scorecard ( provides detailed information on environmental pollution on both a national and on a local scale. For the status of the Kyoto Protocol, The definition of eandp can be found at Integrated Environmental and Economics Accounting 2003, pp , For more on accounting for household production, see Household Accounting: Experience in Concepts and Compilation. Information on the American Time Use Survey (and links to surveys in other countries) can be found at For more on the GPI, see Extensions 1. A Time Use Survey exercise, suggested by a user of this textbook. Note that most actual time use surveys, people are asked to keep more detailed records over a shorter period of time, for the sake of increased accuracy. Many also ask respondents to include both primary and secondary activities if two activities are done simultaneously, so that, for example, cooking a meal (primary) while watching TV (leisure) can both be recorded. Some surveys, including the American Time Use Survey, also ask questions about whether one has responsibility for care of a child during any hours, to get information on child care work that might otherwise go unreported, due to the simultaneous presence of other activities. 6-8

71 Time Use Survey Over the next week, fill out the following time use survey, tracking the hours per day you spend on the following activities. Track your time over one week, and then calculate a daily average. E.g., if you volunteer at a community center twice a week for 2 hours each week, then the total hours per week would be 4 hours. The daily average would be 4/7 = 0.57 hours (i.e minutes per day). Activity S M T W Th F S Total hours per week Personal care Total hours per day (your daily average) Eating and drinking Household Housework Food prep. and cleanup Lawn and garden care Household management Purchasing goods and services Caring for and helping people Working and workrelated activities Educational activities Organizational, civic, and religious activities Leisure and sports Other activities Total Are you a male or female? 6-9

72 Chapter 7 THE STRUCTURE OF THE UNITED STATES ECONOMY Macroeconomics in Context (Goodwin, et al.), 2 nd edition Note to the Instructor Most introductory macroeconomics textbooks do not include a chapter presenting an overview of the United States economy. We include a chapter such as this for several reasons. First, it makes the text more real world to students. Second, it provides basic economic literacy that we believe is sorely lacking among most economics students. Finally, it presents the context to illustrate several economic debates, such as the loss of manufacturing jobs and the rising costs of health care. Instructors could also use this chapter as a basis for introducing other current issues of interest to them. Objectives After reading and reviewing this chapter, the student should be able to: 1. Explain what is meant by the primary, secondary, and tertiary sectors of an economy. 2. Describe the relative magnitude of these sectors in the United States, and how this has changed over time. 3. Describe some major characteristics of agriculture, energy, and other primary sector industries in the United States. 4. Describe some major characteristics of construction, textile manufacturing, and automobile manufacturing industries in the United States. 5. Discuss various explanations given for the decline in manufacturing employment in the United States. 6. Describe some major characteristics of service industries in the United States, especially health care, education, financial and insurance, and retail services. Key Terms output sectors primary sector secondary sector tertiary sector manufacturing productivity financial institution financial assets financialization 7-1

73 Notes on Discussion Questions 1.1 Students will probably have no problem thinking of lots of businesses that would be classified into the tertiary sector, such as restaurants, supermarkets, and their college. In the secondary sector, students may think of their utility company, a local construction business, or a factory. Depending on their location, students may have little interaction with the primary sector. Examples may include a local farmers market, a timber company, or a mine. They will probably realize that nearly all their purchases occur in the tertiary sector. 1.2 This question is designed to get students to think about how their lives interact with the three sectors. An exploration of the changes that they anticipate in the future could provoke an interesting classroom discussion. 2.1 Students may not have thought much about the complex chain that brings food (and other products) to them. Most likely they have recently eaten food from other countries, which is typically transported by boat. Domestically produced food would be transported by rail or truck. Even for domestic food, the U.S. Department of Agriculture estimates a weighted average source distance (WASD) of over 1,500 miles. You might extend the discussion into issues of equity. For example, ask students if they drink coffee and if they know anything about fair trade coffee. They could also discuss the environmental impacts of food production - perhaps some vegetarians in the class would be glad to know that meat production is responsible for a disproportional share of the negative environmental impacts of food production. The students may come to realize that there are ethical implications to their purchases of food. 2.2 A discussion of U.S. dependence on fossil fuels could be lively! Some students may have ideas about controversial topics such as Alaskan or offshore drilling, some may want to discuss fracking, and others may be interested in talking about so-called new domestic sources like oil shale. In the end, it s worth reminding them that fossil fuels are, by definition, nonrenewable resources and therefore it s only a matter of time before renewable alternatives need to be integrated into our energy infrastructure. 3.1 This question helps to illustrate that housing sales are determined by more than just prices. In fact a variety of factors including rising unemployment, banking problems, tighter credit markets, and the bursting of an asset bubble all played roles in shifting the demand for housing to the left. This shift would explain the combination of lower prices and declining sales. 3.2 The prediction that the age of the automobile is drawing to a close seems premature. One could make a reasonable argument using the concept of path dependence that the fascination we seem to have had with automobiles in the United States is not likely to go away quickly or painlessly. If automobile use were to drop in half over a fifteen year period there would likely be some painful economic adjustment. This might be a good place to introduce the concept of 7-2

74 structural unemployment (examined in detail in the next chapter.) 4.1 This could be a very controversial topic, and possibly one that is in the news at the time. Some students might suggest that the public provision of health care avoids the need to make profits thus offering a cost savings. But on the other hand we would expect that competition should drive down prices. Administrative costs are partly responsible for the high health care costs in the U.S. without a central bureaucracy there is duplication and inefficiency. You may bring in some articles on the politics of health care and ask students to discuss the merits of different proposals. In particular, you may wish to have the students compare/contrast Obamacare with the Massachusetts state plan implemented during the Romney administration. Comparisons of Obamacare with the systems in other industrialized countries might also be useful. 4.2 This question could be used to clarify a potential topic of confusion. While students will probably make the majority of their expenditures in the tertiary sector, they aren t necessarily purchasing services. For example, purchasing a textbook from the college bookstore is a tertiary sector transaction, but it is not a purchase of a service. Answers to Review Questions 1. The primary sector is the sector of the economy that involves the harvesting and extraction of natural resources and simple processing of these raw materials into products which are generally sold to manufacturers as inputs. The secondary sector is the sector of the economy that involves converting the outputs of the primary sector into products suitable for use or consumption. It includes manufacturing, construction, and utilities. The tertiary sector is the sector of the economy that involves the provision of services rather than of tangible goods. 2. Considering the total (private and public) economy, about 2% of economic production occurs in the primary sector, 19% in the secondary sector, and 64% in the tertiary sector. In recent decades, the share attributed to the tertiary sector has been increasing while the share associated with the other sectors has been holding steady or declining. 3. Technological optimists tend to place tremendous faith in markets and the innovative potential of technology. From this perspective, human ingenuity and the effective functioning of market mechanisms will direct us to alternatives with minimal disruptions as various resource constraints become problematic. For an interesting exercise, have students read and discuss writings by Julian Simon on the topic of infinite resources. 4. Potential future natural resource constraints can be explored in terms of nonrenewable resources (e.g., fossil fuels, minerals), renewable resources (e.g., fresh water, collapsed fisheries, deforestation), or in terms of the capacity of the planet to accommodate waste products (e.g., greenhouse gases). 5. Agriculture has changed in several ways over the last century. The percentage of 7-3

75 people working in agriculture has declined significantly (currently less than 1% of the U.S. workforce is directly employed in agriculture. Productivity gains have come about from increased mechanization and use of chemicals. The total number of farms has declined while the average farm since has increased. Currently, about 19 cents of every dollar spent on food goes to farmers. 6. No, the primary sector still provides the raw materials for the production of goods. The tertiary sector is often directly dependent on the primary sector, such as a supermarket or restaurant needing food. A significant share of the jobs in the U.S. could be traced back to the primary sector. For example, workers in a furniture factory could trace their jobs back to the forest products they use to make furniture. 7. The largest source of energy in the U.S. is petroleum, followed by coal. The largest use is industrial, followed by transportation. 8. Housing starts is highly dependent upon macroeconomic conditions. During a recession, the number of housing starts tends to decline, then rise during a recovery. Thus housing starts generally follow the cyclical nature of business cycles in general. 9. The American textiles industry has seen a dramatic decline losing 65% of its jobs since the 1970s. With imports of textiles from such countries as China expected to continue to increase, the future for the American textiles industry is not positive. Meanwhile, overall employment in the automobile industry has remained relatively stable. While the number of people employed by Americanowned auto manufacturers has declined, this has been offset by an increase in employment in factories owned by foreign auto manufacturers. 10. There is some truth to this idea because American demands for consumer goods are being increasingly met by imports. However, it isn t accurate to say that American manufacturing jobs are simply being shifted overseas. Manufacturing jobs in nearly all countries are also declining as a result of productivity gains from increased mechanization. 11. Not all service sector jobs are low paying, just consider such jobs as doctors and lawyers. However, service jobs do pay less on average than jobs in manufacturing. 12. Financialization refers to a process where the financial sector of the economy is increasingly able to generate and circulate profits that are not closely related to the real economy. Both asset prices and debt levels throughout the economy suggest that financialization is an increasingly important reality the United States in recent decades. 13. The United States spends more per capita on health care than any other nation. But public funding of health care is lower in the U.S. than in any other industrial country because the U.S. does not have publicly-funded universal coverage. According to several measures of health outcomes, such as average lifespan and infant mortality, the U.S. tends to rank lower than average. Still, health care for those having sufficient insurance coverage or the ability to pay for quality health care, receive some of the best care in the world. 14. Retail services are becoming increasing concentrated in a small number of very large firms, such as Wal-Mart. Thus retailing is becoming more oligopolistic. 7-4

76 Answers to Exercises 1. a. 3 b. 7 c. 2 d. 5 e. 8 f. 1 g. 6 h Students should be able to locate plenty of articles quoting politicians claiming to be able to halt the flow of jobs overseas. 3. Currently, going to and clicking on Interactive Tables: GDP by Industry gets one to interactive tables including Value Added by Industry as a Percentage of Gross Domestic Product. 4. a. 6 Note that this table gives values for the specific industries listed in Table 8.1 (e.g., mining, utilities ). Students will have to do some addition to aggregate the figures up to the primary/secondary/tertiary level. b. 3 c. 7 d. 2 e. 4 f. 5 g. 8 h

77 Chapter 8 EMPLOYMENT AND UNEMPLOYMENT Macroeconomics in Context (Goodwin, et al.), 2 nd Edition Note to the Instructor This chapter discusses standard macro labor topics such the definition of the unemployment rate, the different types of unemployment, and theories of the causes of unemployment. Unlike more Classically-oriented textbooks, however, more attention is paid to labor market institutions and aggregate demand issues. A final section discusses economic mobility and wage inequality. Objectives After reading and reviewing this chapter, the student should be able to: 1. Explain how employment and unemployment are officially measured. 2. Explain why some analysts prefer measures of labor force utilization that differ from the official unemployment rate. 3. Understand economists notions of frictional, structural, and cyclical unemployment. 4. Describe the classical theory of unemployment. 5. Describe theories of labor market imperfections. 6. Describe a variety of factors that influence labor productivity. 7. Describe the role that natural resources play in the determination of wages. 8. Explain how economic mobility in the U.S. has evolved over time and why it matters. Key Terms Bureau of Labor Statistics (BLS) employed person employed person unemployed person labor force not in the labor force unemployment rate marginally attached workers discouraged workers underemployment labor force participation rate frictional unemployment structural unemployment 8-1 cyclical unemployment recession sticky wage theories efficiency wage theory aggregate demand labor productivity wage-productivity gap technological unemployment skill-biased technical change economic mobility

78 Notes on Specific Topics (by Section Number) 1.1 and 1.2 Measuring Employment and Unemployment The household survey is the Current Population Survey (CPS) and the establishment survey is the Current Employment Survey (CES). More information can be found at While the textbook concentrates on the household survey, the BLS also estimates and publishes employment figures generated from the establishment survey. Instead of talking to individuals, in this survey businesses and branches of government are asked to report the number of employees on their payroll. The numbers from the establishment survey and household survey do not, however, exactly agree. This discrepancy can be a good entrée into talking about data issues, if you would like to focus on that in your class. Which is the better survey? On the one hand, there are some recognizable flaws in the sample used by the establishment survey. If a person holds two jobs, he or she may be counted twice in that survey, while if a person is self-employed or works on a farm, he or she is not counted at all. In a growing economy, the establishment survey will tend to overestimate the increase in jobs if large, established businesses are growing faster than the rest of the economy, and underestimate it if job growth is coming about largely from the creation of brand-new businesses or self-employment. These are the reasons some people give for preferring the household survey numbers. On the other hand, while the household survey may ask superior questions, it asks them of far fewer people. Data from the household survey represents only about 70,000 jobs (held by members of 60,000 households), while the establishment survey represents an average of 40 million jobs. The establishment survey is also checked every year for its consistency with official tax records, while the household survey is not. As a result, estimates based on the household survey tend to show more month-tomonth movement, some of which may reflect purely statistical issues rather than actual changes in economy. These are also legitimate concerns, and lead many economists and government agencies to believe that the figures coming from the household survey are less reliable than those from the establishment survey. 3.2 Imperfect Labor Markets Even the insider-outsider and efficiency wage theories are not, in fact, as consistent with the pure supply-and-demand model as they are sometimes represented to be. Superficially, the fact that both theories result in a higher-than-market-clearing wage would seem to imply that they, like minimum wage theory, could be portrayed by Figure 7.4. Recall, however, that the Classical model assumes that buyers and sellers are dealing in some completely standardized units of a good or service (see Chapter 4). In terms of Figure 7.4, however, both of these theories imply that the quality of labor services is higher at the elevated wage (W*) than it is at the marketclearing wage (W E ). In insider/outsider theory this is because the insiders refuse to cooperate with new employees. In efficiency wage theory, this is because people employed at the higher wage work harder and stay longer. But if the quality of work changes as we move along the curves, we have violated the assumption that all units 8-2

79 of the good or service are identical. The use of a simple market supply-and-demand graph is hence not really justified even for these two popular theories of unemployment. Once we let in any aspects of employee or employer power or motivation, we are already dealing with a more complicated world. Notes on Discussion Questions Schools do not seem to count as institutions, so most students will probably either classify themselves as employed (if they hold a full-time or part-time job) or not-inthe- labor-force. People who do unpaid family work, work in the military, or work in places like prison or sheltered workshops would be working but not classified as employed. It is not true that people not working are generally counted as unemployed unless they are actively seeking paid work and available, they are counted as not in the labor force The point of this question is to get students to try to join BLS definitions up with cases they know about, personally. Answers may vary Students should be encouraged to consider issues of labor force participation, hours (number and flexibility), benefits, unionization, and how people combine paid work with family care. Labor force experiences of students family members are likely to vary systematically by sex, race, class, immigration status and the like, as well as due to more idiosyncratic factors. Students may have real fears about whether they will be able to achieve the American Dream by doing better than their parents if their parents have achieved wealth or at least middle-class stability or how they will combine paid work and family. Students often welcome a chance to talk about their own aspirations and anxieties concerning their future work lives The point of this question is to encourage students to see personal experiences, of themselves or people they know, as part of larger trends. Encourage students to think about ways people now often work something other than 40 hours a week, Monday- Friday. Some students may have parents who work as highly-paid consultant, or who employ workers on schedules designed to fit business needs, and thus take a positive view. Others may have parents who patch together several parttime jobs (or do this themselves), or have seen employers frustrated with accommodating family leaves, and see flexibility as more negative. 2.1 This question may get more responses from older or commuting students who have some labor force experience of their own, than from younger, residential students. But many students should at least have experience looking for a summer job. Concerning what might make frictional unemployment last a longer or shorter period of time? you might get into a discussion about the technology of job search. For example, in many urban areas people now use websites like Craig s List to search for jobs. 2.2 Answers to this question will vary depending on where you teach and the state of the economy at the time. For a view of structural unemployment and its effects on a community, you might consider showing the film Roger & Me (1989). Or you might 8-3

80 assign students to do some research on this question for homework, and then discuss the results in class. 3.1 The Classical argument is clearly the most elegant, as it purports to explain the broadest possible range of phenomena using a simple model. But is the model too simple? Your students may disagree about which model seems to give the most realistic view of the world. Ask them to cite evidence to back up their opinions. 3.2 In a workplace where workers are more or less interchangeable greater flexibility would seem to impose minor, if any, costs on firms. Alternatively, workers with skills and/or knowledge that cannot be easily replaced are more likely to encounter obstacles to greater personal choice with regard to their working hours. Changes to the social safety net (e.g., erosion of Social Security benefits) and/or changes in health care costs both also have implications for this topic. Policies that improve the social safety net as well as policies that strengthen workplace rights would be priorities for promoting greater choice of working hours. Answers to Review Questions 1. Age 16 or over, non-institutionalized, non-military. 2. Last week, did you do any work for pay or profit? is the main question. People are also asked about work in a family business (or more than 15 hours) or if they were sick, on vacation, or on leave from a job. 3. Not employed, but actively searching for and available for work. 4. unemployment rate = number of unemployed / number in labor force Marginally attached workers want employment and have looked in the past twelve months but have not looked in the past four weeks. Discouraged workers want employment but have stopped looking for work. 6. Employment flexibility is about factoring varying needs such as family care, studying, or leisure pursuits from the perspective of workers. For employers employment flexibility is about having more power over worker hours and pay as well as greater power to terminate employees or to not offer benefits. 7. The labor force participation rate measures the percentage of potential workers either with a job or actively seeking a job. It can be calculated by dividing the labor force by the civilian noninstitutional population. In recent decades the labor force participation rate for men has declined slightly while the LFP rate for women has increase dramatically. 8. Maintaining high levels of aggregate demand are critical for maintaining high levels of employment in the Keynesian model. 9. Frictional: due to transitions between jobs. Structural: mismatch between available jobs and people s skills, experience, education and location. Cyclical: due to macroeconomic fluctuations. 10. Frictional: technologies for job matching, unemployment insurance. Structural: industrial policies, adjustment assistance, business policies of retraining. 11. When the unemployment rate goes up, we generally expect the average duration of 8-4

81 unemployment to rise as well. Figure 8.4 in the text supports this view. 12. Unemployment occurs when the wage is too high, so that there is a surplus in the labor market. 13. Regulations and safety net policies may also reduce employment. 14. Sticky wages are wages that stay high, instead of falling to bring the labor market back into equilibrium (in a Classical labor market). 15. Minimum wage. Long term contracts. Worker resistance. Insider-outsider dynamics. Efficiency wages. 16. Wages paid in excess of the minimum necessary, to improve employee productivity through better health, fewer quits, fear of being caught shirking, fear of unemployment. 17. Labor productivity and median wages in the U.S. both grew together for several decades following World War II. Beginning in about 1970 this pattern changed. Productivity growth in recent decades has not been matched by gains in the median wage. 18. Technology has the potential to boost productivity and therefore could be a factor that would boost earnings. The chapter also reminds readers that technology can be labor-saving and therefore have adverse effects on prevailing wage rates. 19. Skill-biased technical change suggests that workers who have the skills and knowledge to make the most of modern technologies will enjoy greater relative wage gains. 20. The text presents the case that when natural resources become more scarce economic theory predicts a greater demand for labor which should boost wages. The chapter also informs readers that the macroeconomics of resource scarcity and recent experience suggest that greater scarcity of these resources can have negative consequences and put downward pressure on wages. 21. Although the U.S. historically had a reputation as a land of opportunity, economic mobility in the United States is now lower than it is in other industrialized nations examined in figure 8.8. Answers to Exercises 1. a. 10 (= population under age 16 employed not in labor force = ) b. 200 (= employed + unemployed = ) c. 5.0% (= unemployed/labor force = 10/ ) d. 71.4% (= labor force/adult population 100= (200/(350 70)) 100) under age LF= 200 employed 190 unemp rate 5.0 not in the labor force 80 LFP overall 71.4 unemployed 10 population 350 adult pop

82 2. a. See first two columns of table: adult pop = 5 Luis employed pop = 6 Robin employed Sheila not LF LF= 2 Shawna not LF lfp= 40.0 Bob not LF(discouraged) unemp= 0 Ana not surveyed 3. a. b. 40.0% ( labor force/adult population 100= (2/5) 100) c. 0% (no one is unemployed) Wage $ 20 Labor Surplus (Unemployment) Supply $ 15 Demand Quantity of Labor (millions) b. Assumed to be a single, static market characterized by perfect competition, spot transactions, and institutions for double-auction bidding. 4. This could be a case of efficiency wages. The company may find that paying a higher wage provides it with more productive workers, who are less likely to quit or shirk, than if it just pays the minimum it has to. According to sticky wage theories, wages that are above the market clearing level can cause unemployment by creating a labor surplus situation. 5. a-14; b-12; c-11; d-10; e-9; f-8; g-6; h-1; i-4; j-5; k-2; l-7; m-13; n

83 6. Consult the BLS website. News Releases have their own section. For example, if one currently goes to the Economic News Releases tab and clicks on Employment Situation, one gets a document that begins: Transmission of material in this release is embargoed until USDL :30 a.m. (EDT) Tuesday, October 22, 2013 Technical information: Household data: (202) cpsinfo@bls.gov Establishment data: (202) cesinfo@bls.gov Media contact: (202) PressOffice@bls.gov THE EMPLOYMENT SITUATION SEPTEMBER 2013 Total nonfarm payroll employment rose by 148,000 in September, and the unemployment rate was little changed at 7.2 percent, the U.S. Bureau of Labor Statistics reported today. Employment increased in construction, wholesale trade, and transportation and warehousing. Web Resources See for current reports on employment and unemployment. See for details on labor force definition. See for info on job vacancies. For definitions of recessions, see For a review of the literature and controversy concerning the minimum wage, see 8-7

84 Chapter 9 AGGREGATE DEMAND AND ECONOMIC FLUCTUATIONS Macroeconomics in Context (Goodwin, et al.), 2 nd Edition Note to the Instructor This chapter introduces the analysis of business cycles, presents the Classical theory of savings-investment balance through the market for loanable funds, and develops Keynesian aggregate demand analysis in the form of the traditional "Keynesian Cross" diagram. Our treatment of these topics is fairly standard, although our "in context" approach gives more emphasis to the possibility of persistent unemployment than do many current textbooks. This approach is particularly timely given the labor market challenges that our economy faces for the foreseeable future. Objectives After reading and reviewing this chapter, the student should be able to: 1. Describe how unemployment and inflation are thought to normally behave over the business cycle. 2. Model consumption and investment, the components of aggregate demand in the simple model. 3. Describe the problem that leakages present for maintaining aggregate demand, and the classical and Keynesian approaches to leakages. 4. Understand how the equilibrium levels of income, consumption, investment, and savings are determined in the Keynesian model, as presented in equations and graphs. 5. Explain how, in the Keynesian model, the macroeconomy can equilibrate at a less- than-full-employment output level. 6. Describe the workings of the multiplier, in words and equations. Key Terms Okun s law full-employment output (Y*) aggregate demand (AD) behavioral equation marginal propensity to consume marginal propensity to save 9-1

85 Notes on Discussion Questions 1.1 Students will very likely all have first-hand experiences related to the Great Recession that began in The discussion could easily be organized around themes such as labor market experiences, financial market experiences, and/or contrasting the experiences of different generations. Students may vary in whether they know people who experienced the Great Depression in the U.S. or perhaps in other countries--and whether the people they know were among those hard-hit. This discussion question could also be turned into an assignment for them to talk to a relative or neighbor of the right age and report back to class. You might also share stories from experiences of people you know about, or ask students to reflect on literature or movies related to that period. 1.2 This will depend on when the book is being used. Media reports or the NBER business cycle page (see Web Resources, below) might be consulted for information. 2.1 The actors are households and firms. Households' consumption spending is part of aggregate demand for currently produced goods and services. The intended investment spending of firms also adds to aggregate demand. Households saving supplies funds to the Classical market for loanable funds, while firms demand (borrow) funds on that market. 2.2 The actors on the demand side of the Classical loanable funds market are business firms. When interest rates are low, firms will find borrowing to be cheap and will want to borrow more funds to finance investment projects. The actors on the supply side are households. Classical economists assume that when interest rates are high, people will want to save more (and consume less), thus making more funds available to borrowers. 3.1 This would depend on the student. Students of traditional college age are rarely big savers in fact, they are usually increasing their debt with student loans (and perhaps high spending!). Such students have an mpc=1, or even >1 if their increased income makes them borrow more because they now expect a higher future income stream as well. Their mps would be 0 or negative. Looking at consumption and savings over a longer range of the lifespan, however, students should be able to see that during their working years they may want to set their mpc<1 in order to save for a house, their kids' college, retirement, etc. (This textbook doesn't explicitly cover the life-cycle issues in consumption, but you might bring those in here, if discussion is lively.) 3.2 If spending is too low to support a full employment level of production and income, unintended inventories will build up. This will cause firms to cut back on production, until the point where the level of production matches the level of spending. As long as spending stays low, there is nothing inherent in the economy that will get the economy back to full employment, according to Keynesian theory. 4.1 Students may have varying viewpoints on this, but should be encouraged able to back up their arguments with reasons and examples. 9-2

86 4.2 Students may or may not be familiar with the argument that high consumption is good for the economy. A couple quotes from politicians shortly after September 11, 2001 might help get discussion going: "We need to respond quickly so people regain confidence and consider it their patriotic duty to go shopping, go to a restaurant, take a cruise, travel with their family Frankly, the terrorists win if Americans don t go back to normalcy."--florida Governor Jeb Bush (source: "Show your confidence...show you're not afraid. Go to restaurants. Go shopping."--new York Mayor Rudy Giuliani (source: The Keynesian model seems to confirm this view since low spending is seen as leading to recession. This question will be revisited in Chapter 12, so while you may want to allow students to reflect on what they have heard in terms of counterarguments here, you may want to hold off on a fuller discussion until you cover that chapter. Answers to Review Questions 1. During a recession, the unemployment rate typically rises. Output typically falls, inflation may ease off or fall. 2. Classical economists thought the economy would soon start to expand again, on its own. Keynes thought that policies were needed. 3. Households receive income, spend on consumption, and save. Firms spend on investment. 4. AD = C + II. Y = C + I. They differ because AD includes intended investment, while GDP includes actual investment. 5. S = I or AD = Y 6. Savings is the part of income that is not spent on consumption. It does not contribute directly to AD, meaning that AD could end up being below Y. 7. More saving means less spending, and if spending falls firms will cut back on production. Decreased production means less income flowing to households, which further depresses spending. 8. Households supply funds to the market, through saving. A higher interest rate makes them save more, so the supply curve slopes upward. Firms demand funds from the market, for investment. A higher interest rate discourages investment by making it more costly, so the demand curve slopes downward. 9. If saving does not equal investment, the interest rate in the market for loanable funds will adjust until equilibrium is restored. Thus the level of saving will always equal the level of investment. 10. Consumption depends on an autonomous component and on income, according to the equation: C = C + mpc Y. See Figure Wealth, consumer confidence, attitudes toward spending and saving, consumptionrelated government policies, and the distribution of income. 9-3

87 Interest rate 12. Empirical and theoretical support for the idea that savings increases with increases in the interest rate is weak. 13. The optimism or pessimism ("animal spirits") of investors. 14. AD is determined by the levels of consumption and intended investment. See Figure No. They may experience unintended inventory build up or depletion. 16. See Figure Firms adjust production, in light of intended excess or depleted inventories. They stop adjusting when output just equals aggregate demand. 18. No. There can also be a persistent unemployment equilibrium. 19. The multiplier is equal to 1/(1-mpc) and describes the change in equilibrium income that results from such a change. An initial drop in AD is followed by a drop in income, which lowers consumption and leads to further drop in AD, through a series of ever- smaller cycles. Answers to Exercises 1. a. Households now save more, so the supply curve shifts to the right: Original Supply New Supply E 0 E 1 Demand for Loanable Funds Quantity of funds borrowed and lent b. Quantity of loanable funds rises c. interest rate falls d. quantity of investment rises 2. No, that is intended investment. Inventories are only "excessive" if they build up unintentionally. 3. a. They save $.25, and spend $.75. b and c d. Consumption rises by $75. mpc = ΔC /ΔY = 75/100 =.75. e. The intercept is 90 and slope is.75. The two lines cross at Y=C=360. Savings is the vertical distance between the consumption function and the 45-degree line. 9-4

88 Aggregate Demand and Output Income (Y) Autonomous Consumption.75 times col (1) C S a. The AD shifts up: AD 1 (higher C ) E 1 AD0 (lower C ) E 0 45 Income (Y) b. There is unexpected inventory depletion (or negative unintended investment). Firms will increase production. c. Production rises, income rises, and spending rises. 5. ("Paradox of Thrift") a. This is essentially the same graph as in Figure 9.14 of the text. The corresponding aggregate demand levels are 80, 320, 400, and 480. (See AD 0 in the completed graph below). b. Y = 400. S =

89 c. Income (Y) Consumption (C) Intended Investment (II) Aggregate Demand AD = C + II d. The initial equilibrium Y was 400, C at an income level of 400 now equals 320, and S = Y C. So saving would be equal to 80. Yes, this is 20 more than the original 60. e. The important parts of this graph to note are that the intercept of AD 0 is 80 and the corresponding equilibrium income is 400, while the intercept of AD 1 is 60 and the corresponding equilibrium income is 300. (Other values have been noted, to correspond to the chart above.) f. Y = 300, S = 60. Income is lower and saving is the same. g. People intend to save more, but end up saving exactly the same amount. In the Keynesian model, income rises or falls to keep saving and investment in line. Since investment hasn't changed, income has to adjust to get saving to stay at a. Income (Y) C II AD

90 b. Unintended inventory investment = Y AD, so at Y= 600 and AD = 575 this would be +25. Inventories would be excessive. c. No unintended inventory investment. d. 500 e. mult = 1/(1-mpc) = 1/(1-.75) = 1/.25 = 4. f. ΔY = multδ II = 4(25) = a. AD = ( C + II ) + mpc Y = Y b. Y = 1 1 mpc ( C + II ) = 10 (100) = 1000 c. mult=1/(1-.9) = 10. II = 10. So Y =mult II = (10)(10) = a. 7 b. 10 c. 9 d. 2 e. 8 f. 4 g. 1 h. 5 i. 6 j

91 Web Resources National Bureau of Economic Research business cycle page: Extensions 1. A graph showing the relative volatility of consumption and investment. While consumption spending is a larger share of GDP, the attention given to investment in business cycle analysis is due to its higher level of volatility. 9-8

92 The Volatility of Investment Spending Percent Change from Previous Period, Seasonally Adjusted at Annual Rates: Personal consumption expenditures Gross private domestic investment Data Source: BEA, Table Percent Change From Preceding Period in Real Gross Domestic Product, Downloaded on 7/17/

93 Chapter 10 FISCAL POLICY Macroeconomics in Context (Goodwin, et al.), 2 nd Edition Note to the Instructor This chapter balances formal analysis of fiscal policy with real-world data and examples. Analysis of fiscal policy impacts is presented in fairly simple terms, with an algebraic treatment of more complex multiplier effects in appendices. A simple analysis of excessdemand inflation is presented, but more sophisticated treatments of inflation are left to Chapters 12 and 13. While the basic analysis presented here follows the Keynesian model, the text also discusses classical or supply-side perspectives. (For more on supply-side policies, see also the policy discussion in section 4.1 of Chapter 8.) The section on budgets and deficits should give students an understanding of deficits, debt, and how these affect the economy. The difference between automatic stabilizers and discretionary policy is made clear, and recent fiscal policies are discussed (in the News in Context box) in terms of their economic impact and differing analytical perspectives on spending increases and tax cuts. By the end of this chapter, students should have a clear sense of the basics of macroeconomic analysis, with the exception of money and inflation, topics which are dealt with in the coming chapters. Objectives After reading and reviewing this chapter, the student should be able to: 1. Understand the impact of changes in government spending, taxes, and transfers on aggregate demand and output. 2. Carry out calculations using multipliers. 3. Describe the major types of government outlays, and major government revenue sources. 4. Distinguish between government deficits and government debt. 5. Describe the recent history of U.S. debt and deficits, and the controversies surrounding them. 6. Discuss the issue of lags in fiscal policy, and the relative advantages and disadvantages of automatic and discretionary policies. Key Terms fiscal policy government spending (G) transfer payments disposable income tax multiplier balanced budget multiplier 10-1 net taxes expansionary fiscal policy contractionary fiscal policy government outlays government bond off-budget expenditures

94 on-budget expenditures appropriation (of federal funds) deficit spending countercyclical policy procyclical policy automatic stabilizers cyclical deficit (surplus) discretionary fiscal policy time lags structural deficit (surplus) supply-side economics crowding out crowding in Notes on Discussion Questions 1.1 The answer will depend on when you are teaching your class. As this manual is being written, the most recent fiscal policy news pertains to the sixteen day government shutdown as some Congressional Republicans refused to fund the U.S. government for fiscal year 2014 unless they could undermine the recently enacted health care reforms (sometimes referred to as Obamacare ). Other recent fiscal policy developments would include the sequestration of 2013, a direct consequence of political battles over the future of tax cuts and entitlements. 1.2 Nobody likes a tax increase. But a tax increase might be wise if the budget is going deeply into deficit, or to pay for increased social spending that improves well-being, or increased military expenditures during a war. One important indicator of a possible need for higher taxes would be if inflation is getting worse, indicating that government spending and tax cuts may have gone too far in stimulating aggregate demand. Students might discuss the tension between the macroeconomic impacts of tax policy and the political implications of raising or cutting taxes. 2.1 This discussion question provides an opportunity to expose students to the political nature of the budget process. The political battles regularly waged across party lines are not new but the process has become increasingly dysfunctional in recent years. For a lively discussion it might be worth assigning student groups to investigate and report back on the budget battles between (1) the Democratic Congress of the early 1980s vs the Reagan Administration, (2) the Republican Congress of the mid 1990s vs the Clinton Administration, and (3) the Republican House vs the Obama Administration of recent years. The relative merits/hazards of budget deficits are a source of ongoing disagreement with the economics profession. An internet search of deficit hawks versus deficit doves versus deficit owls is likely to generate sufficient background material for a lively discussion about deficit spending. 2.2 This discussion question provides the opportunity to explore the contrasting visions of supply-side economics versus more demand-oriented approaches. It also offers an opening to consider the politics of fiscal policy: it is much easier for elected officials to cut taxes and increase spending than to do the opposite. 10-2

95 Answers to Review Questions 1. An increase in government spending shifts aggregate demand upwards by an amount equal to the original spending. It shifts economic equilibrium up (to the right on the graph) by an amount equal to the original government spending times the multiplier: ΔY = mult ΔG A reduction in government spending has the opposite effect, shifting economic equilibrium down (to the left on the graph) by the amount of the spending reduction times the multiplier. 2. A lump-increase in taxes shifts the aggregate demand schedule downwards by an amount equal to the change in taxes times the mpc. This amount is the change in consumption resulting from the reduction of disposable income due to the tax increase. It shifts economic equilibrium down (to the left on the graph) by the amount of reduction in consumption times the multiplier, or: Y = (mult) C = (mult) (mpc) T A decrease in taxes will have the opposite effect, shifting economic equilibrium up (to the right on the graph) by (mult) (mpc). The effect is smaller than the effect of an equivalent change in government spending, since part of the change in tax payments comes out of (or goes into) savings. 3. Expansionary: increase in government spending, tax cut, increase in transfer payments. Contractionary: reduction in government spending, tax increase, decrease in transfer payments. Specific examples could include changes in military spending, domestic spending, Social Security payments, personal or corporate taxes, etc. 4. The Federal budget surplus or deficit is defined as revenues minus outlays: Budget Surplus (+) or Deficit ( ) = T Government Outlays = T (G + TR) See Figure 10.4 for the historical pattern of the deficit. 5. An automatic stabilizer is a tax or spending institution that tends to increase government revenues or lower government spending during economic expansions, but lower revenues or raise government spending during economic recessions. Example include unemployment compensation, which rises during recessions, and personal income tax receipts, which rise during expansions. 6. Discretionary fiscal policy can help the economy recover from recessions or avoid inflation. But fine-tuning of the economy through fiscal policy is not usually possible, due to time-lags which can render policy counterproductive since its impact comes at the wrong time. Some economists question whether fiscal policy works at all, but most administrations have used some form of fiscal policy, either overt (such a promising and delivering tax cuts) or implicit (such as allowing government spending to increase over time). 10-3

96 7. Cyclical deficits are caused by economic conditions (the business cycle to be more precise) while structural deficits are the result of taxation and government spending policy decisions. One way to think about the contrast is that structural deficits can be attributed to our elected officials while cyclical deficits cannot. 8. The term crowding out refers to a reduction in the availability of private capital for private borrowing. If it occurs, crowding out is caused by government borrowing to finance deficits where the level of government borrowing is significant enough to reduce the pool of loanable funds and drive up interest rates for private borrowers. The term crowding in refers to the boost in business and consumer confidence in the macroeconomy that results from aggregate demand stimulus achieved through government spending. Crowding in has the beneficial effect of inducing more private investment and fostering job creation. Answers to Exercises 1. Government spending of 60 gives a new C + II + G line which intersects the 45º line at 700. This is the new equilibrium. This equilibrium is below full employment, but above the equilibrium of 400 without government spending. This is shown in the table and graph below. (1) Income (Y) (2) Consumption (C) (3) Intended Investment (I I ) (4) Original Aggregate Demand (AD = C + I I ) (5) Government Spending (G) (6) New Aggregate Demand (AD 1 = C + I I + G)

97 2. The government spending multiplier is 5, so the effect of a government spending level of 100 on the economy is 100 x 5 = 500. The tax multiplier is equal to (mult) (mpc) = (5)(0.8) = 4. Thus the effect of a tax level of 100 (assuming this is a lump-sum tax) is ( 4)(100) = 400. The combined effect is = 100. Thus the equilibrium output level would increase by 100. We can say that the balanced budget multiplier = 5 4 = 1. The impact of a balanced budget on economic equilibrium is positive, and exactly equal to the original change in government spending (and taxes). The two effects do not cancel out, since the government spending multiplier is more powerful. The reason for this is that government spending adds directly to aggregate demand, and also has induced consumption effects, while the effect of a tax increase is felt only through induced consumption effects. 3. This question would be clarified by noting that fixed investment and intended investment are the same only if we assume that intended inventory investment is zero. (In reality, the business sector may intend to build up or draw down inventories to some extent.) This question in some sense reviews the material covered in Chapter 5, but by this time the students should be becoming more familiar with the uses of the national accounts. The numerical answers for this question will, of course, depend on when you assign it. For more frequently updated data, you could send students to the Bureau of Economic Analysis ( GDP tables (currently, Table Gross Domestic Product ) instead of the Economic Report of the President. Below are answers for 2006, the last full year (that is, not quarterly) available in the Economic Report of the President at the time of this writing: From Table B-1: Gross Domestic Product for 2006: $13,195 billion Personal Consumption Expenditures: $9,225 billion Gross Private Domestic Investment: $2,209 billion Fixed Investment (= Intended Investment, under the assumption above): $2,163 billion Consumption as %GDP = 70% Fixed Investment as %GDP = 16% (Partial) Aggregate Demand C + II = $11,387 billion 10-5

98 4. (a) automatic stabilizer occurs with no change in government budget policy. (b) discretionary policy requires specific government budgetary action. (c) discretionary policy requires specific government budgetary action. (d) could be either automatic stabilizer (if payments increase simply because farm income declines) or discretionary policy (if government budget specifies increased farm support payments). (e) automatic stabilizer payments rise automatically as the number of unemployed grows. If government acts specifically to extend or increase unemployment payments, this would be discretionary policy. 5. a-7; b-3; c-1; d-5; e - 4 ; f-2; g - 6. Web Resources The Budget Explorer, a website designed for student use, is available at Economic Report of the President, 2013: President/2013 U.S. Office of Management and Budget Analytical Perspectives, Budget of the United States Government, Fiscal Year U.S. Bureau of Economic Analysis:

99 Chapter 11 MONEY, BANKING, AND FINANCE Macroeconomics in Context (Goodwin, et al.), 2 nd Edition Note to the Instructor The introduction of money and the treatment of the banking system in this chapter is quite standard. This chapter goes beyond the tradition treatment of these topics by providing a more detailed exploration of nonbanking financial institutions, and with a discussion of financialization and speculative bubbles. Objectives After reading and reviewing this chapter, the student should be able to: 1. Describe the consequences of inflation and deflation. 2. Describe the functions and types of money. 3. Describe the measures of the money supply and explain the liquidity continuum. 4. Explain the basic workings of private banks including the use of balance sheets. 5. Explain how banks create money. 6. Describe the categories and functions of nonbank financial institutions. 7. Explain the concept of financialization and provide examples. 8. Explain the concept of speculative bubble and illustrate it with concrete examples. Key Terms barter deflation liquidity commodity money intrinsic value fiat money exchange value M1 M2 financial intermediary Economic liability bank reserves fractional reserve system required reserves excess reserves portfolio investment leverage non-bank financial institution collective investment vehicle hedge fund pension fund insurance company securities broker mortgage broker 11-1

100 Notes on Discussion Questions 1.1 This will depend on current conditions. The most recent data on inflation rates calculated in terms of the Consumer Price Index (the most frequently discussed numbers) are available at Students may answer from their knowledge of the news, or perhaps travel experiences or family ties to other countries. 1.2 The costs of unemployment were described in Chapter 8, and include financial and emotional hardship for the unemployed, uncertainty for those tenuously employed, and a loss of overall output to the economy. The costs of inflation include wiping out savings, harming people on fixed incomes, redistributing wealth from debtors to creditors, menu costs, and uncertainty. Students may discuss which they feel is worse, unemployment or inflation or at what rates inflation starts to become a serious problem. 2.1 People often think that a dollar bill is backed by gold or silver. This is incorrect, since it is "fiat" money, backed only by a declaration of the government and society's consent. 2.2 This will depend on the students' experience. On-line payments, for example, will be "money" if they come directly from checking accounts, but "credit" if they are charged to credit cards. 3.1 The key to this question is getting students to understand that money is not strictly a physical thing. A potential metaphor to introduce this idea is to ask students what would happen to their academic grades if you physically destroyed a copy of their transcript. In any case, because money does not require a physical existence to fulfill its various roles identified in the chapter, banks do indeed have the ability to expand the money supply without printing any new currency. 3.2 This question provides an opportunity to explore student understanding of fractional reserve banking. For a more detailed exploration of this topic, a concrete example of a bank run can be constructed using a hypothetical bank balance sheet. 4.1 This question revisits real vs nominal contrasts that students have been exposed to since chapter five. It provides an opportunity for students to update their understanding to incorporate new information about the role of finance in the macroeconomy. If the question is used as a basis for a classroom discussion then it also provides an entry point into the topic of financialization. 4.2 This question provides an opportunity to explore tradeoffs between regulatory constraint and free market competition. The discussion might begin in a way that encourages students to actively contribute by exploring extreme positions in this debate, but a deeper understanding of the tension between the extremes will almost certainly require providing historical context. This context could include the historic relationship between financial crises and real sector downturns (e.g., the Great Depression, the Great Recession) and might also include an exploration of institutional developments that have been designed to reduce financial fragility (e.g., deposit insurance, the Glass-Steagall Act). 11-2

101 Answers to Review Questions 1. First would be a stable, low-inflation economy. Second would be an economy suffering from very high inflation. Third would be an economy with financial crises and deflation. 2. Medium of exchange, store of value, unit of account. 3. (3 of the following 4) Commodity money. Coins made of precious metal. Silver certificates. Fiat money. 4. M1 = currency (in circulation), checkable deposits, and traveler's checks. M2= M1 + savings deposits, and other accounts such as small certificates of deposit and retail money market funds. 5. See Table The textbook identifies six useful properties for commodity money: it must be generally acceptable, standardized, durable, portable, scarce, and easily divisible. 7. Leveraging refers to the use of debt to pursue financial objectives. It can be very useful because high leverage has the potential for higher rates of return than might have been possible without borrowing. It is, however, also worth reminding students that high levels of leverage expose the borrower to a much greater risk if market and credit conditions drastically change. 8. Pooled funds collect investments from many different investors and combine them into a pool that can be invested at a lower cost. Mutual funds are an example of pooled funds and a hedge fund is another example. These financial inventions reduce administrative costs, typically offer a better return than a traditional savings account, and can be used to reduce risk through diversification (e.g., an index mutual fund) or can be used to embrace risk through speculation (a strategy often employed by hedge funds.) 9. A financial bubble describes an irrational increase in the price of a financial asset, generally fueled by speculative activity. If you are familiar with the concept of positive feedback from systems theory, this topic is a good place to introduce the concept. Section 4.3 in the text offers several concrete examples of financial bubbles, including the 1920s stock market bubble, the 1990s dot-com bubble, the recent housing bubble, and an assortment of international examples. 10. This question revisits the roles of money introduced early in the chapter. Any currency that economists view as money must, by definition, serve as a reasonable store of value. While almost any specific domestic currency is typically considered extremely liquid and therefore an effective medium of exchange, most foreign currencies fall further along the liquidity continuum and are therefore NOT an effective media of exchange. 11-3

102 Answers to Exercises 1. The inflation data of the most recent twenty years for Germany range from a low of 0.234% (2009) to a high of 4.476% (1993). The Japanese experience over the same interval includes twelve different years with deflation (the greatest deflation, 1.342%, occurred in 2009) and a peak inflation rate of 1.378% (!) in The U.S. inflation experience for this interval includes one year of deflation ( 0.320% in 2009) and a peak inflation rate of 3.815% (in 2008). 11-4

103 2. From late 2003 through 2013, the M1 definition of the money supply grew by 103.4% (from billion dollars to billion dollars). Over the past five years (late 2008 through 2013) the same time series grew by 65.7%. Over the ten-year interval ( ) the M2 definition of the money supply grew by 82.1% (from billion dollars to billion dollars). Over the five-year interval the same series grew by 33.8%. The FRED time series data suggest that M1 grew more dramatically than M2 (in percentage terms) and remind students that M2 is significantly larger in magnitude than M

104 3. a. Liability side b. Asset side c. Liability side d. Asset side e. Asset side 4. a. Required reserves = required reserve ratio * deposits Required reserves = 0.10 * $2,000,000 Required reserves = $200,000 b. Initial excess reserves = total reserves required reserves Initial excess reserves = $800,000 - $200,000 Initial excess reserves = $600,

105 Chapter 12 THE FEDERAL RESERVE AND MONETARY POLICY Macroeconomics in Context (Goodwin, et al.), 2 nd Edition Note to the Instructor The introduction of monetary policy in this chapter is quite standard, with the exception that the graphical exposition of monetary policy focuses on the market for federal funds. We chose this approach because it corresponds closely to the way your students will find Fed actions presented and discussed in the media. Objectives After reading and reviewing this chapter, the student should be able to: 1. Understand the basic workings of central banks. 2. Describe the tools the Federal Reserve can use to carry out monetary policy. 3. Understand how the Fed uses open market operations to influence the federal funds rate. 4. Explain how monetary policy is expected to affect investment and aggregate demand. 5. Explain the U.S. monetary policy experience of the period in the context of Federal Reserve priorities and monetary policy actions. 6. Become familiar with the notions of liquidity trap and credit rationing. 7. Understand the quantity equation, the quantity theory of money, and monetarism. 7. Describe possible sources of inflation. 8. Understand the controversy over rules versus activism in monetary policy. If the Appendix is included: 9. Understand the relation of bond prices to interest rates. 10. Describe the transactions demand model of money. 11. Understand the difference between real and nominal interest rates, and their impact on the economy. Key Terms open market operations quantitative easing (QE) liquidity trap credit rationing quantity equation velocity of money quantity theory of money monetary neutrality bond coupon amount face value bond price money supply rule monetarism monetizing the deficit 12-1

106 Appendix: bond yield to maturity real interest rate expected real interest rate Notes on Discussion Questions 1.1 The Federal Reserve is the central bank for the United States. It was created by the U.S. Congress in 1913 as a response to the Panic of Because the U.S. has a long tradition of mistrusting powerful banking interests (e.g., Andrew Jackson and the Bank Wars of the 1830s), the U.S. Congress deliberately created a decentralized system of twelve regional Federal Reserve Banks with regional headquarters in: Boston (Massachusetts), New York City (New York), Philadelphia (Pennsylvania), Cleveland (Ohio), Richmond (Virginia), Atlanta (Georgia), Chicago (Illinois), St. Louis (Missouri), Minneapolis (Minnesota), Kansas City (Missouri), Dallas (Texas), and San Francisco (California). The Federal Reserve System also includes a Board of Governors based in Washington D.C. 1.2 The Federal Reserve is neither a purely public nor a purely private institution. Federal Reserve district banks permit their member banks to vote for most of the regional boards of directors (this sounds like a private institution), but the Board of Governors consists exclusively of presidentially appointed and U.S. Senate confirmed governors (a government agency?) Nonetheless, the Federal Reserve largely enjoys relative autonomy and independence from political influence. The Fed (as it is also known) is responsible: for providing the nation s currency, for providing check clearing services, for regulating the private banking system, and for conducting monetary policy. 2.1 Banks issued their own currencies (see chapter 11). They did not have national agencies monitoring them for error and fraud. They had no place to turn to if they needed an emergency loan. They probably had to work out a way to clear their own checks, from bank to bank. Problems created included non-standard currencies, the possibility that a "bank run" would close a bank down, the likelihood of error and fraud, and other inefficiencies. There was also no centralized way to influence the money supply for policy purposes. 2.2 A Fed open market purchase of bonds increases bank reserves the Fed pays for the bonds by crediting the account that it holds of the banks that sell it the bonds. (Sometimes this is also expressed as writing a check on itself. ) With more reserves, banks make more loans, creating more deposits within the banking system. 3.1 Students may be familiar with interest rates on student loans, credit card debt, house mortgages, car loans, or other types of loans, as well as interest rates on deposits such as savings accounts. If interest rates are changing, sometimes there will be news stories about how banks are changing their various consumer rates in response to changes in the "prime," or they may offer loans in terms of, for example, prime + 2%. Since the prime rate follows the federal funds rate very closely, students may find that many rates 12-2

107 they deal with are affected by the Fed. On the other hand, some rates may show less responsiveness to Fed policy. Some student loans are guaranteed by the government at a fixed rate, which changes rarely. Some of the very high rates charged on credit cards, or to high-risk mortgage borrowers, don't change very much due to Fed actions because the cost of the funds to the company making the loan is only a small part of what it considers in setting its rates. 3.2 In the model, lower interest rates lead to higher investment and thus higher aggregate demand. But as the accelerator theory and the episode from show, shifts in firms' confidence about the future can be more important than interest rate changes in influencing their decisions. It may be that an interest rate decrease just keeps investment from falling as far as it might have otherwise. 4.1 Quantitative easing refers to the central bank (e.g., the Fed) practice of purchasing longterm bonds in an effort to reduce long-term interest rates. This unconventional practice is a relatively recent development in monetary policy and has emerged as a strategy to improve the effectiveness of traditional monetary policy stimulus and its focus on shortterm interest rates. As the financial crisis unfolded in 2008 it became clear that something beyond traditional monetary policy strategies was necessary and quantitative easing has been the Federal Reserve s answer. The longer term implications of this decision still remain to be seen. 4.2 The liquidity trap refers to a situation where interest rates have reached a point where the central bank has lost all ability to maneuver them any lower. As of late 2013 the federal funds rate has not exceeded 0.25% (one-quarter of one percent) since the end of This experience suggests the concept of the liquidity trap effectively describes the current macroeconomic climate. 5.1 The quantity equation is simply a relation among aggregate variables M, P, and Y, that defines V. The quantity theory further assumes that V is constant, so that the level of the money supply is directly and predictably related to the level of nominal GDP (=PY). 5.2 The answer to this will depend on recent economic conditions. The Bureau of Labor Statistics news releases on inflation in the Consumer Price Index ( give some insight into this question, by reporting on which parts of the index grew fastest. But more in depth economic analysis is usually required to sort out the underlying cause(s). 6.1 An argument in favor of following a rule is that, by doing the wrong thing or at the wrong time, activist Fed policy can make things worse. It could cool down an economy too soon or too late, or undertake expansionary policy that, due to lags, won't affect the economy until during the next boom. Arguments against using a rule are that velocity has often been very unstable, and that new shocks are hitting the economy all the time. If this is the case, then it is very hard to know what rule to set, and it is better for the Fed to maintain some flexibility in its responses to events. 6.2 Fiscal policy has a longer "inside lag." Monetary policy has a longer "outside lag. 12-3

108 Answers to Review Questions 1. See Table See Table See Table 12.3 and related discussion. 4. Changes in required reserves and changes in the discount rate. 5. The open market purchase increases bank reserves, which shifts out the supply of federal funds and lowers the equilibrium federal funds rate. 6. The interest rate represents the cost of borrowing (or the opportunity cost of using retained earnings) and therefore is inversely related to the level of intended investment. Confidence in future sales also affects investment. See Figures 12.4 and See Figure From 2001 to early 2004, the Fed drove the federal funds (and related) rates down, keeping residential investment high and perhaps preventing a further fall in fixed investment. From early 2004 into 2007, the Fed increased the federal funds rate in an attempt to keep the economy from overheating. Then in late 2007, after the collapse of the sub-prime mortgage market, The Fed drove the federal funds rate down again. Fed Chair Bernanke, recognizing that traditional monetary policy would be insufficient during the financial crisis, introduced quantitative easing in late Two additional rounds of quantitative easing were initiated by the Fed through late The quantity equation is depicted by M * V = P * Y. The quantity theory of money is M * V = P * Y where V is assumed to be constant. 10. Monetarism is a school of macroeconomic thought most associated with Milton Friedman. This perspective is very suspicious of activist policy and instead contends that the appropriate role for monetary policy is to have the money supply grow at a steady rate. 11. Under Classical assumptions, velocity (V) is constant and the economy is at or near the full employment level of output (so Y is also constant). Under these assumptions, increases in the money supply (M) must be absorbed by increases in the average price level (P). In Milton Friedman s famous words, Inflation is always and everywhere a monetary phenomenon. 12. There are a number of problems associated with using a monetary rule. Recent history has demonstrated that velocity is not always constant. A monetary rule is also problematic if output is below a level associated with full employment (another recent experience.) Finally, inflation may be caused by something other than money supply growth. 12-4

109 Answers to Exercises 1. Open market purchase. a) Change in the Fed Balance Sheet Assets Liabilities Government Bonds + $ 200,000 Bank reserves + $ 200,000 b) Change in QRSBank's Balance Sheet Assets Government Bonds $ 200,000 Reserves +$ 200,000 Liabilities c) QRS will be able to loan out $200,000: Next Change in the QRSBank's Balance Sheet Assets Loans +$ 200,000 Reserves $ 200,000 Liabilities d) Change in TUVBank's Balance Sheet Assets Liabilities Reserves +$ 200,000 Deposits +$ 200,000 (e) TUVBank has to keep 10% of the value of the new deposits ($20,000) as required reserves, but can lend up to $180,000 of new excess reserves. 2. Open market sale a) Change in the Fed Balance Sheet Assets Liabilities Government Bonds $15 million Bank reserves $15 million b) Change in HIJBank's Balance Sheet Assets Government Bonds Reserves + $15 million $15 million Liabilities 12-5

110 Aggregate Demand and Output Interest rate (r) Federal Funds Rate c) (All graphs are the reverse of those in the text) New Supply of Federal Funds r 1 E 1 Original Supply of Federal Funds r 0 E 0 Deman d for Federal Funds Quantity of Federal Funds Borrowed and Lent d) r 1 r 0 II II 1 II 0 Intended Investment (II) e) AD 0 (with old interest rate, r 0 ) E 0 AD 1 (with new, higher interest rate, r 1 ) E 1 45 Y 1 Y 0 Income f) Since consumption and saving both depend on the level of aggregate income, both are now lower. 12-6

111 Aggregate Demand and Output Federal Funds Rate 3. Fall in investor confidence. a) b) The Fed does an open market purchase: Original Supply of Federal Funds New Supply of Federal Funds r 0 E 0 r 1 E 1 Demand for Federal Funds c) No change in AD or Y: Quantity of Federal Funds Borrowed and Lent AD 0 (with original level of investor confidence and interest rate, r 0 ) E 1 = E 0 = AD 1 (with lower level of investor confidence and lower interest rate, r 1 ) 45 Y 1 = Y 0 Income 12-7