ANSWERS TO END-OF-CHAPTER PROBLEMS CHAPTER 1 Quick Check Loa Te, b. Tne. ©. False, d. Falseunceriain, ‘The rate of growth was higher during the decade beginning the previous wo decades, bu its probably unrealistic 10 expect productivity to continue to grow ‘at such a fast pace. 6. False. There are problems with the staisties, bu hs £, False, ‘The European “unemployment miracle” refers tothe relatively low Buropean ‘unemployment rate in the 1960 and the eurly 1970s, e consen sis is that growth in China has been ge True, he True, 2. a, More flexible labor market institutions may lead to lower unemployment, but there are questions shout how precisely to. resinicture these insitutions. The United Kingdom has restructured its labor market institutions to resemble more closely U.S. institutions and now has @ lower unemployment rate than before the restructuring. On the other hand, Denmark and the Netherlands have relatively low unemployment rates whi ing relatively generous social insurance programs for workers. In addition, some economists argue that right monetary policy has the high unemployment rates in Europe. at least something to do with b. Although the Euro will remove obstacles o free rade between European countries, each country ‘will be forced to give up its own monetary policy. Dig Deeper 3. 4. The Chinese govemment has encouraged foreign firms to produce in China Since foreign fiems are typically more productive than Chinese firms, the presence of foreign Firms has lead to an inerease in Chinese productivity. The Chinese government has also encouraged joint ventures Ibesween foreign and Chinese firms. These joint ventures allow Chinese firms to lear from more productive foreign firms, 'b. The recent inerease in US. productivity growth has been a result ofthe development and widespread use of information technologies The United States is a technological leader. Much of U.S. productivity growih is related to the development of new technologies. China is involved in technological cach-up. Much of Chinese productivity growth is related to adopting existing technologies developed abroad. 1s not clear to what extent China provides 1 model for other developing countries. High investment seems a good strategy for countries with Title capital, and encouraging foreign fms to produce (and participate in joint ventures) at home seems a good strategy for countries trying5 to improve productivity. On the other hand, the degree to which China’s centralized political control has been important in managing the pace of the transition and in protecting property rights of foreign firms remains open to question, 8. 10 years: (1.018)"1.195 or 19.5 % higher 20 years: 42.9% higher 50 years: 144% higher b. 1 years: 31.8 % higher 20 years: 50 years: 297.8% higher ‘e.Take output per worker asa measure of the standard of living 10 years: 1.195/1.318-1,103, so the standard of living would be 10.3% higher; 20 years: 21.6% higher S50 years: 63% higher 4. No. Labor productivity growth fluctuates a lot from year to year. The last ew years may represent good luck. It is too soon to tell whether there has been a change in the wend observed since 1970, a 13.2(1.034)~2.8(1.088) > Unf 13.2/2.8)/n1.O88/1.034)] 1303 yes This answer can be confirmed with a spreadsheet, for students unfamiliar with the use of logarithms b. No. Atcurrent growth rstes, Chinese output will exceed U.S. output within 31 years, but Chinese ‘output per person (the Chinese standard of living) will stil be less than U.S. output per person, Explore Further 6 we. As of February 2008, there had been 5 recessions (according to the traditional definition) since 1960. Seasonally-adjusted annual pereentage growth rates of GDP (in chained 2000 dollars) are given below. 19694 “19 losis 49 197051 “07 19821 “64 197433 38 199034 30 lore “16 [ork 20 19751 47 1980.2 18 19803 07 With respect to the note on 2001, the growth rates for 2001 are given below. 2001:1 0.5% 2001:2 1.2%2001-3 18% Doors 16% ah, 2 1969-7007 1s? BL 19909109 06 ‘The unemployment rate inereased by LS pereentage points between January 2001 and January 2002, CHAPTER 2 Quick Check Loa Tae. b. True Uncertain. Real GDP increased by a facior of 25; nominal GDP increased by a factor of 1. Real GDP per person inereased by a factor of 4, ec Fake. a Tae, e. False. The level ofthe CPI means nothing. The rate of change ofthe CPI is one measure ofinflation, £ Uncertain. Which index is better depends on what we are tying to measure— inflation faced by consumers or by the economy asa whole False. The underground economy is lange, but by far the majority of the measured ‘unemployed in Spain are not employed in the underground economy: 2. a, Nochange. This transaction isa purchase of intermediate goods. b. +8100: personal consumption expenditures +8200 million: gross private domestic fixed investment 4 +8200 milion: net exports ©. No change, The jet was already counted when it was producal, ie, presumably when Delia (or some other airline) bought it new as an investment, 3. Thevalue of Final goods “$1,000,000, the value ofthe silver necklaces b. Ist Stage: $300,000. 2nd Stage: $1,000,00-S300,000-$700,000, ‘GDP. $300,000+5700,000~$1,000,000. ©. Wages: 200,000 + $250,000-5450,000. Prolit:($300,000-S200,000)+($ 1,000,000-S250,000-300,000) =$ 100,000+8450,000-8550,000, GDP. $450,000+S551,000-$1,000.000. Aa. 2006 GDP: 10(S2,000}+-4(S1,000)+ 1000(51)-$25,000 2007 GDP: 12(83,000)+6(8500}+1000(S1)=S40,000 ‘Nominal GDP has increased by 60%Dig Deeper 1 2006 real (2006) GDP: $25,000 2007 real (2006) GDP: 12(52,000)+6(S ,000)-1000(S1)-S31,000 Real (2006) GDP has increased by 24%. 2000 real (2007) GDP. 10(S3,000)+-4(S500)*1,000($1)~5.33,000, 2007 real (2007) GDP: $40,000. Real (2007) GDP has inereased by 21.2%. The amwers messure real GDP growth in different units. Neidher answer is incorrect, just as measurement in inches is not more or less correct than measurement in 2006 base year: Deflatox(2006)~1; Deflator(2007)-S40,000/$31,000=1.29 Tiflation29% 2007 hase year: Defator(2006)-S25,000'$33,000-0.76; Deflater(2007)-1 Inflation=(-0.76)0.76~.32: Analogous to 4d 2006 real GDP ~ L01S2,500) + 448750) + 1OHASL) ~ $29,000 2007 real GDI ~ 12(52,500) + ($750) * 1000181) ~ $35,500 (35.500-29,000)29,000~ 224 Deflaor in 2006-825, 090'829,000~ 86 Delaiorin 2007-S40,000/835.S001.13 Inflation ~ (1.13 -86).86~ 31 ~ 31%. ‘Yes, see appendix for further die wsion ‘The quality ofa routine checkup improves overtime. Checkupsnow may inchnde EKGs, for example. Medical services are parculrly affected by this problem since there are continual improvements in medical cchnology TMhe new method represents 10% quality inerease, Uhere is 5% true price inercuse, "The other 10% represents a quality increase. The quaiy-adjustat prize of chockups using the mew method is only $% higher than eisekups using the old metho ‘You nead to know the relative value of pregnancy checkups with and without wlira- sounds in the year the new method is introduced. Still, since everyone chooses the new method, we ean say that the quality-adjusted price of checkups has risen by less than 15%, Some of the observed 15% inerease represents an inerease in quality8a Measured GDP increases by $10+512-$22. (Strietly, this involves mixing the final goods and income approaches to GDP. Assume here that the S12 per hour of work {reates a final good worth S12.) b. No. The true value of your decision to work should he less than $22. If you choose to work, the economy produces the value of your Work plus takeout meal, If you choose ot to work, presumably the economy produces a home-cooked meal. The extra output arising from your choice to work is the value of your work plus any difference in value between takeout and home-cooked meals. In fuel, however, the value of home-cooked. meals isnot counted in GDP. (Of couse, there are other details. For example, the value lf groceries used to praduce home-cooked meals would be counted in GDP. Putting such details aside, however, the basi point is clear ) Explore Further 9. a. Quarters 2000:HT, 2001-1, and 200 -1IT had negative growth, b. The unemployment rate increased after 2000, peaked in 2003, and then began to full. The participation rate fll steadily over the period from 67.1% in 2000 to 66% in 2004, Presumably, workers unable to find jobs became discouraged and left the labor force ©. Employment growth slowed after 2000, Employment actually fell in 2001, The cemploymentto-population mitio fell hetween 2000 and 2004, 6. Teseveral years after the recession forthe labor market to recover. ‘CHAPTER 3 Quick Check Loa Tre. b, False, Government spending excluding transfers was 19% of GDP. False. The propensity to consme must be Tessthan one for our model to make so a F e bY }-7=1000-100-900, € 1600.6(800)-700, 3. a, Equilibrium ouput is 1000, Total demaand=C+G-700150+150-1000, Total demand ‘equals production. We used this equilibrium condition to solve for output.Dig Deo| 4 6 ‘Ouxput falls by (40 times the multiplier) = 40/(1-.6)-100._ So, equilibrium eurpat is now 90, Tata demand=C+F+G=160440,6(800)+150110-900, Again, wal demand equals production Private saving-¥-C-7900-160-0,6(800)-100-160, Public saving ~7-G--10. National saving (or in short, saving) equals private pas publie saving, oF 150. National saving equals investment. This statement is mathematically equivalent to the equilibrim ‘condition, total demand equals production. In ether words, there isan alternative (and equivalent) equilibrium condition: sational saving equals investment. Vineveasesby V(l-e) Ydecreases by ey (1-1) The answers difer because spemling affects demand directly, but taxes affect demand indirectly trough consumption, and the propensity to consume is less than one. The change in Y equals 1/(-e))-e/(I-e,)-1. Balanced bulget changes in Gand Tare not macroeconomically nete “The propensity wo consume has no effect because the balanced budget ax increase aborts the mulipier process. Y and T both inerease by one unit, so disposable income, and hence consumption, do not change Yeestes¥st +O implies Y[M Leste tlereteHO] The mubiplieU(I-c;tex4) measures the narginal effect of sn increase in the interest rate on investment. Note that the slope of the LM curve becomes larger ss money demand becomes move sensitive i income (Le as dy increases) andl becomes smaller as money cemand becomes more sensitive to the interest rate (Le. a8 ds increase). The JS curve shifis lef Output and the interes rate fall, ‘The effeet om investment ambiguous because the output and interest rate effects work in opposite directions: the fallin output tends reduce investment, but the fall in the interest rate tends 10 From the answer to 2c), P=[Li(1-e-byt bd eocaT ryt (bsld2X MPG, From the LM relation, Vdd) UP) To obtain the equilibrium interest rate, substitute for equilibrium from past (b). Feb ¥-bimbeabebubd PALA. AMUP) To cbiain equilibsium investment, substitute for equilibrium ¥ from pat (b). From part (b), holding M/P constant, equilibrium ¥ decreases by [1/(I-cy-h+bd/d)] when G deereases by one uit, From part (i), hokling MP constant / decreases by6 (be badd.) (I -crrby Badd) when G decreas tunit, investment will merease when fy. The price level changes in the medium run in response to either a demand or a supply shock. affects ihe interest rate inthe medium run and therefore affects, {1S shifts right, and LM shifts up. AD shifts right, and AS shifts up. Y returns to its unchanged natural level. The interest rate and the price level increase, ‘SR: short run IFS: wage-setting curve MR mediumsan PS: price-setting curve ws Ps AS ADSM Sk [up mo up moo change change _change MR mmo up asSR change frther change change fiher rs sts ts Dig Deeper jy i or 5p MR | falls tises rises fiether further further Money is neutral nthe sense thatthe nominal money supply has no effect on output or the interest ratein the medium run, Output returns to its natural level. ‘The interest rate is determined by the position oF the JS curve and the natural level of ouput, Despite the neutrality of money in the medium run, an increase in the money supply will inerease ‘output and reduce the interest mite in the short ran. Therefore, expansionary monetary ppoliey ean he used to speed up the cconomy’s return to the natural level of ouput when ‘output is low. Inthe medium rum, fiscal poliey affects the intrest rate and investment, so iseal policy is not considered neutral the natural level of output ‘SR: shoet run Is iM AD as. SR [lef down left no MR [sume down same down ‘Confis SF009 Ranier gat Ine: Pushing as Prece Haly P Tails ‘falls ‘alls ack io falls falls criginal Y, further further c 1 Private $ ‘alls ‘biguous ambiguous ack io Tises(above rises (above original original original level level) level) ‘The short-run change in investment is ambiguous, because the interest rate falls, which tends to increase investment, but output also falls, which tends to reduce investment. In the medium run, investment must rise (as compared to its short-run and original levels), because the interest rate falls bur ouput recurs 10 its original vel Since the budget deffeit does not ehange in this problem, the change in private saving ‘equals the change in investment. It is possible that private saving will fll im the short ‘un, but private saving must rise (above its short-run and original levels) in the medium ‘Open answer Firms may be so pessimistic about sales that they do not want to borrow at any interest rate The 1S curve is vertical the imteres ate doesnot affect equilibrium output ‘The LM curve is maected The AD curve is venical the price level does not affet equilibrium ouput The increase in = reduces the natural level of output and shifts the AS curve up. Since the AD curve is vertical, equilibrium output does not change, but the price level increases. Note that output s sbove its natural level. Since }°¥,, P=’. Therefore, P* rises and the4S curve shifis up. In fact, the 4S curve shifis up forever, and the price level increases forever. Output does not change: it remains above its natural level forever.7a The LA has. fat segment at 0 and then slopes up b. The 1S slopes down as before. There is no fat segment at /-0. Arguably, the 5 curve is undefined for nominal interest rates below zero. ©. ASP falls, MP rises, and the nominal interest rate falls. Eventually, when P falls far enough, the nominal interest reaches zero, The AD curve slopes down unl P reaches the level consistent with i-0. For levels of P below this threshold, the AD curve is vertical 4. There is no effect on output in the short run or the medium run. Singe the money’ stock does not affect the interest rate, it doesnot affect outa 8. a, The AD eurve shifsleflinthe shertrun. Output and the price evel fallin the shox mun, In the medium run, the expected price level falls, and AS shifts right, returning the ecomomy to the original natural level of output, but ata lower price level b. The unemployment rate rises inthe short un, but eturs to its original level (dhe natural rate, which is unchanged) inthe medium run © Tho Fed should increase the money supply, whieh shifts the AD curverright. monetary expansion of the proper size exactly offkels the effect of the decline in business teanidence on the AD wurve. The net effect is that the AD eurve does nat move in the short run o medium run, and neither does the 4S curve. 4. Under the policy option in part (€), output and the prive level are higher inthe short run In the medium run, output isthe same in parts (a) and (e), but the price level is higher in| pat (©). e. The unemployment rate i lower in the short mun in part (e). In the medium rm, the ‘unemployment rate isthe same in paris (b) and (c). 9a, ‘The AS curve shifts up in the short run and shifis up further in dhe medium run, ‘Output falls inthe short run and falls Further inthe mediuin sun, The price level rises in the short un and rises further in the medium run, b. The unemployment rate rises in the short run and rises further in the medium run, © The Fed could increase the money supply in the short run and shill the AD curve to the right. The AS curve would shift up over time, 4. Output and the price level are higher in the short namin part (c). Output is the stme inthe ‘medium run in parts (a) and (c), but the price level is higher in parte) e ‘The unemployment rat inthe short munis lower in past (e), but the sme in dhe medio, sun in parts (a) and (e). 10. The Fats job isnot so easy. It has to distinguish changes im the actual rate of unemployment from ‘changes in the natural rae of unemployment. ‘The Fed can use monetsry policy to keep the ‘unemployment rate near the natura rate, hut it eamnot affect the natural rate,‘The unemployment rate rises in the short run andLrises further inthe medium run. The ‘eal wage falls immediately to its new medium-run level The unemployment rate falls in the short run but retums to the original natural rate inthe ‘medium run, The real wage is unaffected. However, after ws ineome {In our model, the real wage depends only upon the markup. A fallin the markup jnereases the real wage, Poliey measures that improve product market competition for ‘example, more vigorous anti-trust en reement—could increase the real wage. “The fallin income taxes tended to inerease the afler-tax eal wage. The increase in ei prices tended to reduce the after-tax real wage. Intuitively, the immediate effect of anvil Drive increase isto reduce the real wage by increasing gas prices. Thus, the inerease in tas prices tends to absorb the extra allertax income provided by the tax cut Explore Further b @ PHP RW Po PLP YP Pn ‘The AS curve slopes up in ¥- IPP then I(r, ‘An increase in x implies that F must fall maintain the equality. Falls when w vises. So, an increase in the relative price of energy resources leads to an increase in the natural rate of unemployment ‘The AS curve shifts up in the short run and shifts up fther in the medium rum. The unemployment rate and the price [evel rise inthe short run and rise further in the medium ‘run. Outpt falls in the short nan and falls fart inthe medliam ra, An increase inthe relative price of enemy resommees eauses the 4S curve to shift up in the short run. If P* remains constant the 4S curve will not shift further after the initial, shor- run shift, In order for P* to remain constant, wage sels must be expecting the Fed to teduce the money supply, thereby shifing the 4D curve left. This monetary policy moves ouiput to its new, Lower natural level right away, and maintains the original price level, so there will be no price adjust ‘equilibrium. nt inthe transition to the new medium 19SKTV 1969I1V 52.9% 1969IV—19791V 38. 1OT91V — 1989:1V 1989.1 1999.1 1999V — 200731 ‘The 70s, 80s, and 90s look remarkably similar. The 60s had by far the highest growth.‘Clearly, the first decade of the 21" century will have the lowest growth, ‘Note, although the problem did not ask forthe growth rates of GDP per person, the ranking of the decades would be similar. The growth rates of GDP per person are given below: 19501 344% 1969:1V 24.0% 1979:1V 23.0% 1989:1V 21.8% 199921 17%. CHAPTER 8 Quick Check 1a Taw, bo False ce False Taw, False, True, No. In the 1970s, we experienced igh inflation and high unemployment. The expectitionsaugmented Phillips curve is a relationship between inflation and memployment conditional on the natural rate and inflation expectations. Given inflation ‘expectations, when the natural rate of un nployment increases (i.c., when there is an increase in = or w), there is also an increase in both the aetual unemployment rate and the inflation rate. In addition, increases in inflation expectations imply higher inflation for any level of unemployment. In the 1970s, both the natural rate and expected inflation increased, so both unemployment and inflation were relatively high, "Note that increases in inflation expectations also tend to inerease the unemployment rite in the short run from the supply side—think of un increase in the expected price level, given last period's prive, in the AD-AS framework. However, increases in inflation expectations may tend to increase short nun output from ihe demand side, because of the real interest rate effec, The real interest rate i introduced in Chapter 14 No. The expectations-augmented Phillips curve implies that maintaining a rate of unemployment below the natural rate requires not merely high inflation but increasing inflation. This is because inflation expectations continue to adjust o actu inflation. ue 0.1/2=5% x01. (0.03) ~ 4% every year beginn sa with year > Oand x-4% forever. Inflation expectations will be farever wrong. This is unlikely,a8 ight increase because inflation expectations adapt to persistently positive inflation. ‘The increase in @ has no effect on wy. (0.03)=4%64 For 5.278% (tS) Inflation increases hy four percentage points every Inflasion expectations will again he forever wrong. Thisis unlikely 4 8A higher eost of produetion meuns a higher marian of the price level over wages. In the the markup reflects all nonwage components of the price of a Be (0.084042 The natural ate of unemployment inereases from 5" 40%. fo 6% a8 W increases from 20% to Dig Deeper Sa meOL 2605 Bio y= May 08)~ ys +P i= Deg mp AM R= OE Rm bm OSx+OSR, 20-08) OG a= Ay Au 05) =A; w= 8965 ea Ms a= LOM 4. As indexation inereases, inflation becomes more semsiive tothe difference between the unemployment me and the natural rate 6a Yes The average rate of unemployment was Tower in the 1990s, Indeed, even though the unemployment rate ws at a historical low, inflaton rose very bite b. The natural rate of unemployment probably decreased. To Ge Ts 0%; DBM ‘As wages hacome more flexible, more ofthe effeet of supply shocks (changes in jt and is transmitted to chinges in’ wages and less to changes in th natural rate of unemployment Bas uns OP Hr Inan environment with more wage flexibility (higher q), the natural rate of | unemployment rises less response to an increase in the price of el Explore Further 5. aed. As oF 2006, the equation tha seems to fit well ism, — m7 4.4% 0.731, which implies 3 natural rate of approximately 6%, 9. The relationships imply lower natural rate in the mere recent periCHAPTER 9 Quick Check 1, a, False, The unemployment meres when ouput grouth is ess than the normal rae and ‘ses when output growth is greater than the normal rate. bo Tue, © Tre 4. Fake. The Phillips curve relstes the change in inflation o the diference between the unemployment rite and the natural rate, Okun’s law relates the change in. the unemployment rate to the difference between output growih and the normal rate. The aggregate demand relation equates inflation to eal money growth, It is rue that the ‘aggregate demand relation implies that inflation equals adjusted money growth, which is the difference between money growth and output, but this is only a relation between inflation and ouput growth condidonal on money growth, False. Tn the medium nin, inflaton equals adjusted money growth, which isthe difference between nominal money growth and output growth. £ Tne. Uncertain. Inprincipl, she statement is true, but nominal sigidiies may make even filly credible policy costly ho Tre i True 2 a ‘The unemployment rate will inerease by 1% per year when 2°0.5%, Absent output growth, productivity growth tems to increase the unemployment rate, since fewer ‘workers are required to produce a given quantity of goods. Absent output growth, labor force growth also tends to increase the unemployment rate, since more workers are ‘the growth sate exceeds the sum of productivity growth and labor force growth b. For the unemployment rate decrease by 0.5% per year forthe next four years, output snus! grow at 4.28% per year foreach of the next four years © Okun’s law is likely to bevome aa Bk uns Assume she economy as en athe natural rt of anemplyment fr two yeas (hie yur and last year). Then, g,~ 396; 2.7 2.) © a tt im & 3% oH 1% 12: 1 oh m% 4, See text for full answer. Gradislism raduces the need far lenge policy swings, with effects that are difficult wo predict, but immediate reduction may be more exedible and encounge rapid, favorable changes in inflaion expectis credible staggering of wage decisions suggests that a gradual dsinMation—as long a isthe option consistent wth no change inthe unemployment rae bth lower ster wer is not clear, Based in Ball's evidence fast disinflation probably restlis in etato, depending on the features liste in part (©), © Relevant features include the degree of indoxation, the natireof the wage-seting proces, and the inital rate of ilation. Sa. Iallation wil stan increasing b. should et unemployment increase to isn, igher, Dig Deeper 6 siece rat be UN% ae 1% 2 BMG Hea BG Hea 1% a= 10 years; sacrifice rat (10 point years of excess unemployment) 10 percentage point reduction in inflaton )~1 A RS zm 59M RaW Mesm 24MG Mum LIM Less than 5 years ae required sacrifice ration 5412-1. 3-047 ‘The sacrifice ratio is lower because people are somewhat forward-looking and ‘incorporate the target inflation rate into their expectations, ce. The central bank can let the unemployment rate return to the natural rate bezinning at ime £1. The ex post sacrifice ratio from this scenario ~ (1 point year of excess ‘unemploymen:)(10 point reduction of ination) = 0.1 £ Take measures to enhance credibility. fu 05) = 0A(.on-03) aan, wet, b. Assuming go 13%, m= 10%, 10 5%, and beginning in year f, g-=3%, the economy evolves as follows, TIM 7.9%, wl: 3% 91% HE 0.7% 8.8% E32 75% be a1, 5.9%, 6S 3.5% 44% GE 21% 3.6% eT 0.5% 34% PR 0.8% 3%915% 43% 10: 1.6% 4% Inflation does not decline smoothly. In the early years, the large unemployment rates (elative to the natural rate) reduce inflation to negative values. In this example, money growth equals the normal growth rate of output, so negative inflation drives real money growth (and hence output growth) ahove the nermal output growth rate, and unemployment falls. Eventually, when unemployment falls below the natal rate inflation begins 10 ineresse again. These eyeles continue, with decreasing amplitude, —u°$% and a-0% in the medium run, Explore Further Ra Yes b. —Theunemployment rate ineseased from 5.7% in January 2002 to 6.3% in June 2008. €. Although growth was positive, it well below the normal rate of 3% for most of the pesiod. ‘Therefore, growth was too low to prevent the unemployment rate from rising, Employment fel. eo Ye. art according io non-sessonally adjusted data, the level of unemployment fell in ths of 2001. although it rose over the entite year. Nevertheless, in several ‘months in which the level of unemployment rose (e.g, July), the level of employment also rose, which is the point of the problem. b. The levels of employment and unemployment can both rise if the participation rate CHAPTER 10 Quick Check La Tae bh True. Fale 4 Fake. © Tae. bo Babe. a Tne. The table should read as follows.The table should read as follows. a. US. consumption per person ~ S1(1000) + $22.000)-$5000 b. Mexican consumption per person=5(400) pesos + 2(2000) pesos ~ 6000 pesos From the US. pointof view, the exchange rate (E10 pesos’. Mesican consumption per person in dollars ~ 6000 pesos’E=$600 4. Mexican consumption per person (SPPP)=$1(400}+82(200)-$800 Exchange rate method: 600/500 =0.12 PPP method: 800/5000-0.16 a 63 b-Ydoubles.ce Ye. FINK ce KINS4 implies ¥IN=2. K/N=8 implies ¥IN=2.83. Output less than doubles. £ No. No. Inpart(), we are essentially looking at what happens to output when we inorease capital only, not capital and labor in equal proportion. ‘There are decreasing returns 10 capital bho Ye. Dig Deeper 4a ANY~.S(AKIK) ‘growth rate of output ~ 1/2 growth rae of eaptal bh doperyear © KiVinereases. 4. No. Since capital is growing faster than output, the saving rate will have to inerease to ‘maintain the same pace. Eventually, the requiral saving will exceed output. Capital ‘must grow faster than output because there are decreasing returns to capital in the production funetion 5, Eventhough the United States was making the most important technical advances, the ther ‘countries were growing faster beeause they were importing technologies previously developed in the United States. In other words, they were reducing their technological gap with the United States. Explore Further 5. The figures on GDP per person are chained ($2000) PPP nusnbers. 8. Version 62 of the Penn World Table through 2008 yields the following average growth us, Tapan b. Had the United States and Japan maintained the growth rates they achieved over the period 1951 to 1973, Japanese real output per person would have surpassed US. output per person hy 2003. Instead, in 2003 US, real output per person ($34,878) was substantially higher than Japanese rea urpat per person ($24,037), 7. ‘The figures on GDP per person are chained ($2000) PPP nunbers 8, There was substantial convergence for the Frunce, Rela, snd Tely through 1991 Since then, the standard of living of these countries relative to the US. standard of Fiving, tas fallen somewhat,b. Argentina, Chad, Madagisear, and Venez In fact they have grown steadily poorer relative 10 the Us wave not converged to the United States, cd States. The figures on GDP per person ae clstined ($2000) PPP numbers. a. LO Richest Countries in 1970 Qatar $65, 763 Kuwait seis 530.749, 321.492 suit s17321 Bahamas Si6ai1 Luxembours $16,806 Denmark S16 584 Sweden $15,785 b. LO Richest Countries i 2003 Luxembourg $49,262 Qatar $36,187 Bermuda 835.738 United Arab Frsirates $35,658 United States SB4875 Norway ssolr Macao 330420 Switzerland $28,792 Ireland $28,248 Denmark, $27,870, Luxembourg 2.93 United States 201 Denmark 1.69 Bermuda 1.66 Sweden 1.66 Switzerland 136 Bahamas 1.09 Brimei oss Qatar ost Kuwait 040. ‘The dataset includes 152 countries with observations for both 1970 and 2003,biggest proportional increase in standard of living: China 9.94 smallest proportional increase in standard of living: Liberia 0.17 faction with negative growth: 18/152-18%, CHAPTER 11 Quick Check 1a True, ifsaving includes public and private saving, b. False. © Thue. In the model without depreciation, there is no steady state. A constant saving rate prodluces a positive but declining rate of growth. In the infinitestime limit, the growth rate equals zero. Output per worker rises forever without bound In the mvlel with depreciation, if the economy begins with a level of capital per worker below the steady- state level, a constant saving rate also produces a positive but declining rate of growth, ‘with a limit of zero._ In this ease, however, output per worker approaches a fixed number, fined hy the steady-state condition of the Solow mexlel. Note that depreciation iso needed to define a steady state ifthe model includes labor force growih or technological progress. 4. Uneertain, See the discussion of the golden-rule saving rate Uncertain/False. It is likely the U.S. rate is below the golden rule rate and that transforming Social Security to a pay-as-you-go system would ultimately increase the USS. saving rate. These premises imply that such @ transformation would increase U.S. consumption in the future, but not necessarily in the present. Indeed, if the only effect of Such a transformation is to increase the saving rate, we know that consumption per worker will fall in the short run Moreover. moving to a pay-as-you-go system requires transition costs. If these costs are borrowed, then the reduction in public saving will offfet the increase in private saving during the transition, IPthese costs are not borrowed. then transitional generations must suffer either a reduetion in promised henefis or an increase in taxes to finance their own retirement (a leat to some degree) in addition to the retirement of a previous generation. Thus, whether the US. “should” move toa pay= asyour-go system depenis on the likely resolution of tntergeneratanal distributional issues and your view about the equity of such a resolution. f—Uneertain. The U.S. capital stock i below the golden rue, but that does not nsoessarily imply tht there should be ax breaks for saving. Even if the tax breaks were effective in stimulating saving, the inerease in future eonsumption would come atthe eost of eutent consumption. False. Even if you accept the premise (that educational investment inereases output, as ‘would be implied by the Mankiw, Romer, Wel papen), it does not necessarily follow that ‘countries should increase educational saving. sin ftureinerases in ouput will come at the expense of current consumplion. Of couse, there are other arguments for subsidizing education, particularly for low-income houscholds Disogwe. An ineroase in the saving rate does not aflet growth in the long run, but does increase growth in the short run, In addition, an inezease inthe saving rate leads to an inerease in the long run level of output per worker. Finally, since the evidence suggests tha the U.S. saving rate is below the goldenrule mate, an increase in the saving rate would increase steady-state ‘consumption per workerAssume tat ihe economy begins in steady sic. One decade afer an nerwase in the saving ra, the growth rate of output per worker will be higher than it was in ils initial steady state. Five ‘decades alter an increase i the saving rate, the growth rate of output per worker will be close 4 its value inthe initial steady state (this value is zero in the absence of technological progress) The level of ouput per worker will be higher, however, than it asin the sia steady stato Dig Deeper 4 This would ikely lead to higher saving rate, so ouput per worker and output per person will he higher in the long mun 1b. Treatan increas in female participation as a one-time increase in employed labor. In this case, an increase in female participation would have no effect on the level of output per worker, but would lead toa higher level of eusput per person, since a greater action of the population is employed. A transformation to fly fimded systom leads to an inerease inthe savingrate. Ignoring any short-run transition costs in dhe long run an inerease in Uhe saving rate leads toa higher level of ‘ouiput per worker, but has no effect on the growil rate of output per worker, a KIN (IBV FINSEB) b CN(LS)FINNS(9 (48) ee. YNinereases with s. CiNincreases until sO, dhen decreases. a Yes Ye. ce Yes YIN= (KIM © Imsteady state, S/N ~ KIN, which, given the production function in part (a), KIN-(818) YIN (iB)! g YN=2 ho yIN=2 a. Substituting from problem 7 parte) implies K/NA1 b, Substituting from problem 7 part (2), YNS1 c.-KIN-D.35; YIN-O.7L a Aa w © 100 1.00 090 097 2 080 0.93 ea 07 ox)KIN= (0.15/.075) YN) KIN=(020075F 7.11 YNS(TA2.67 Capital per worker and output per worker increase. Explore Further 1D. a. For 2006, the national saving rte was approximately 14.1%. Instead state, KIN = (0,141,075) ~3.86, and Y/N-G.25)?-1.89, b. For 2006, the budget deficit including the of budget items) was 1.9% of GDP. Eliminating the deficit increases the national saving rate 1 16% (14.1% + L9%@). Asa ‘osu in steady stata, KIN ~ (0,16.07S)—488, and VINELS8)" 2.13. Stoady-site ‘output per worker inereases by 12.7%, CHAPTER 12 Quick Check Low Tne, be True ©. False. Inswady state, there is ne growth of ouput per effective worker ‘True. False, The seadly-state rate of growth of output per eflective worker is zero. A higher saving rate leads to higher steady-state level of capital per eflective worker, but has no effect om the steady-state rate of growth of output per effective worker. Tne. False Fake Uncesain, Even pessimists about technological progress typically argue thatthe rate of progress will dectine, not that it will be zero. Strictly, however, the truth of this statement is uncertain, because we eannot predict the future Most technological progress seems to come from R&D activities, Soe discussion on fertility and appropsiability in Chapter 12.2 This proposal would probably lead to lower growth in poorer countries, but higher _srowth in rich countries. This proposal would lead to an increase in R&D spending. [fertility didnot fall, there ‘would he an inerease in the ites of technological progress and outpt gmt Presumably. tis propost! would lead to a (small) decrease in dhe Festility of applied rescarch and therefore toa (small) decrease in growth This propesal would reduce in the approprsbility of drug research. Presumably, there ‘would be a reduction in the development of new drugs, a reduction in the rate of teclinological progress and a reduction inthe growth rate.‘Tho economic leaders ypically achieve twehnolagieal progress by generating new ideas ‘through research and development b. Developing countsies can import technology from the ecanomie leaders by copying this technology or by receiving a transfer of technology as a result of jit ventures with firms headquartered in the economic leaders. Even in the absence of technology transfer, foreign direct investment ean increase technological progress in the host country by substituting more productive foreign production techniques for less efficient domestic Poor patent protection may’ faciltawe 2 more rapid adoption of new technologies in developing countries. ‘The costs of such a policy are relatively small, since developing ‘countries generate relatively few new technologies. Dig Deeper 4 2 The growth rate of cutput per worker falls inthe shortrun and continues to fall over time. In the long run, the growth rate approaches a new steady state with a permanently lower (hut sill postive) growth rate. Output per worker continues to rise over time, just at slower rate, b. A permanent reduetion inthe saving rate has no affect on the steady-state growth rate of | ‘output per worker The gnoth rate of eutpist per worker falls (hut remains positive) in the short rum bur inthe long run it approaches its original steady-state rate. b. A permanent reduction in the saving rate has no affeet on the steady-state growth rate of ‘ouput per worker. The growth rate of output per worker Alls (fut remains positive) in the short run but in the long run it approaches its original steady-state rate. 2. Nominal Gop ‘Year 1: 10(160)+10(200)-3000Year 2: 12(100)+12(230)-3960 ‘Year 2 Real GDP (Year 1 Prices)=10(100)~10(230)=3300 growth cate of real GDP-3300/3000— 1 ~ 10% ‘Year 1 = 3000/100-30; Year 2 = 3300/110=30 Labor productivity growth is zero, ‘Year 2 Real GDP (Year | Prices} 10(1.00}+13(230)-3990 ‘output growth™3990/3000— 1 ~ 33%. ‘Year |=1; Year 2-3960/3990-0.992 inflation=0.9921 — 1 =-0.8% Real GDP)warker36.3 in year 2. Labor productivity growth is 36.330-21% h.—Thhis statements true, sssurning there is progress in the banking services sector i RIAN) = (siBrgetgyr—1 YAN (KAN) =1 gna 0 ging ve geste bi, RIAN) = (s(Begetey 0.64 YUAN (KAN) “08, Brie gis BBM vi gm getgr 10% [An increase in the ‘oF technological progress reduces the steady-state levels of capital and output per effective worker, but increases the rate oF growth of output per warker, KAN) ~ (o(B ire 0.64 fi YAN (Kian 08,‘An increase in the rate of technological progress reduees the steady-state levels of capital and output per effective worker, but increases the rate of growth of output per worker. KAN) ~ (s/(8+g-R0) P= 0.64 YAN)" (KANY “8 gouy= 0 Bon= Be $% En kg 10% (RIAN) = IS) (YAN)) = (A'S); Byrn) ~ 05 By 4%%5 By ~ 10% People are better off in case a. Given any set of initial values, the level of technology is the same in cases (a) and (¢), but the level of capital per effective worker is higher at every point in time in case (a). Thus, since Y/N=ATAN)-A(KICAND) AUK ‘ouiput per worker is always higher in ease (a). Probably affects 4. Think of climate Alfacts H and possibly 4, iP beter education improves the Ferily ofresearch, Alfects 4. Strong proteetion tends wp encourage more RAED but also to limit diffusion of| technology May affeet 4 through diffusion. May affect K, Hy and 4. Lower tay rates increase the afterax return on investment, and ‘thus tend to lead to more accumulation of K’and [Vand to more R&D spending If we interpret Kas private capital, han infrastructure affects 4 (eg. beller transportation networks may make the economy more productive by reducing congestion tte). Assuming no technological progress, a reduction in. population growth implies an cadly-sate level of output per worker. A redaction in population growth leads to an increase in capital per worker If there is technological progress thee is no steady-state level of output per worker. In this ease, however. a redaction in population growth implies that output per worker will increase at every point in ime, for any gives path of technology. See the answer to problem 6),Explore Further 8a, Thequamtty g/g. is the growth nate of ouput per worker. The quantity ge isthe growth rate oF capital per worker. bo gen ay Me) 2es e ane us, 18% France 3.2% Japan 42% UK 24% CHAPTER 13 Quick Check Ta False, Productivity growth is unrelated o the natural rate of unemployment. Ifthe Unemployment rate is constant, employment grows al same rate as Une labor Force. b. Fake. © Te a Tre. Tne £ Te zB False. 2 a LM yal) b 1-(1/(10,08) = 4.89%, © No Since wages adjust to expected productivity, an inerease in productivity eventually leaas to equiproportional inereases inthe real wage implied by wage setting and the real wage implied by price setting, at the original natural rate of unemployment. Thus, ‘equilibrium can be maintained without any change inthe natural rate of unemployment, 3. Aminerease in labor productivity has no effect on the natural rate of unemployment, because the ‘wage ultimately rises to capture the added productivity. The increase in the wage also implies that an increase in labor productivity has no permanent effect on inflation. From the price setting equation, P>(Mu)IFIA. If the wage (1) inereases by the same proportion as productivity (4), the price level will not change. 4. a, Reduce the gap if this leads ton inevease in the relative supply of high skill workers. b. Reduce the gap, since it leads o a decrease in the relative supply of low-skill workers. 4 Reduce the gap, iit leads to an increwe in the rektive supply oFhigh-skill workers. Tnerease the gap, if it leads U.S. firms hire low-skill workers in Central America, since this reduces the relative demand for U.S. low=skill workers.Dig Deeper 5 a WIP=F(L-NIL, An improv ‘Technological change has led 10 a reduction in agricultural employment, but evidently has had no effect om the natural race of unemployment a Pe PCW AKVAL) ‘Thenew variablesare technology variables, 4 andl 4%. Am inerease in A has 10 effets, i, Fors given level of ¥, an inerease in 4 reduces Yt, which implies a reduetion in Nand in increase in u. The merase in w tends to reduce Wand therefore to roluce P. This is the elfect that teids to increase the actual rate of ‘unemployment in the short run. li, othe extent that 4” lags behind 4, 4/4 falls. In effect, workers do not receive Fan increase in wages as warranted by the inerease in productivity, This is the effect that tends to reduce the actwal and natural rates of ‘unemployment fora time. ‘The effects in (i) and (i) both shift the 4S curve down, so output increases in the short ‘un, The effect on short-run unemployment depends on the relative strength of the efleets in (@) and (i. AS shifts down, Given 4/471, only effect (i) is relevant In this ease, effects (i) and (i) ffom part (a) are relevant. Compare 10 part (b) the AS carve shifts down further: b. Labor supply stopes up. As Nimereases, 1 falls for given Z, so HP increases, WIP-MPLI(I*p) Labor demand slopes down. As N inereases, the MPL falls, 0 17P falls nest in technology ineveases the MPL, so the labor demand curve shills| right, The real wage increases when technology improves. a, Thereal wage of high- 100001 + gy +r ++ 10001 + gh IL r+! = [00001 =r HL (Leg tr tay gh er xy += 10000 x2) $50,000; $20,000 $10,000; $7692.31 $16,666.67; SUT.a ‘The stock price inewases when the risk premiur a fallin the real interest rate. Explore Further 8. ‘The Fed ean reduce the growth rate of money. ‘The nominal interest rate inereases inthe shogt run, but falls in dhe medium run. 1b. Inflation was highest im early 1980. The [2-month inflation rate peaked at 14.6% in ‘March and April of 1980, 4. Appositive spread means dhat expected future interest rates are higher dhan current interest rates. A declining spread means thatthe expected increase in future short-term interest rates is falling. The one-year T-ill rite increased from 7.28% to 12.6% between Fanary 1978 and January 1980, but the spread declined from 0.9 percentage points to 1.46 petcentage points over the same period. Financial market parteipunts were not expecting shom-ceem interest rates to continue to inereise, Indeed, by the end of the 1970s, Uk negative spread indicates that short-lerm interest rates were expected to decline im the future There spreal declined by almost one percentage point in October 1979. The decline is consistent with expectations of lower inflation inthe future. £ The one-year interest rate fl During the rate cut in the recession, spreads went up, as shos-tem rates declined, However, long-term rates did not increase, which suggests that inflation expectations did not inerease, Instead, the increase in spreads is consistent with the expeciation that the anti-inflationsry policy would continue with high short-term interest rate after the recession. This is inleed what happened 9. Answers will vay 10, Answers will vary CHAPTER 16 Quick Check Loa False, b. Fake. ce False. a False, ec False f The. Te 2 75/1 1.051 1.085)$40,000-394,575 b. s194.s75Dig Deeper 5 4 ‘The consimer works for three mare years andl will be retired for seven years, so there are 10 more years of consumption, So, since the real interest rate is zero, the consumer can ‘consume one-tenth of her total wealth, or 19,487.50, this y ‘Consumption could increase by S2,000 armually Bionefits imply extra annual consumption of 0.6(1.052)-40,000(7/10)-$ 18,522, ‘The EPDV of purchasing the machine is TT(8)~ S18,000/(r0.08) Buy. EPDV-S138,462>100,000 Broak-even. EPDVS100,000 Do not buy. EPDV-S78,261<$100,000 $44,000(1-0.4)86-540,000(1-0.4)38-838 400 $544,000(1-0.3)36-S40,000(1-0.3)38-$44:800 EPDY of future Iabor income ~ $30, ConsummptionS10 inal three periods, youth: -S; mide age: 15; old age: -10 Total saving ~a(-5+15-10)-0 0- Sn 10n= Sn youth: 5 middle age: 12.5; old age: 12.5 The eonsumer cannot borrow against future income when young. 0 1250 12.520 0+0*1250= 1250 By allowing people w borrow to consume when young, financial hberalization mary lead to less overall accumulation of capital Expected valve of earns during midi: age is0.5(S40,000 1S 100,000)-370,000, EPDY of lifetime earnings ~ $20,000 + $70,000-$80,000, The consumption plan is $30,000 per year. The gonsumer will save -$10,000 (ie. the consumer will Borrow $10,000) in the First period of life In the worst ase, the EPDV of lifetime earings ~ $60,000, CConsuraption ~ $20,000 and saving-0 inthe First poriod of Hite Consurapton is lower than part (a), and saving is higher. Consumption in youth i $20,000: in middle age is $50,000; and in old age is $50,000. Consumption will not be constant over the consumer's lifetime,4. The uncerstiny leads w higher saving by consumers in the first period of Explore Further 8. ae, Between 1989 and 2006, consumption accounted for 66% of GDP on average snl Investment for about 13%, so consumption is about five times bigger than investment, Relative to average changes, movements in consumption and investment are of similar sagnitude, which implies investment is much more volatile than consumption. 9. Consumers may be more optimistic about the future (and spend more) when disposable income is higher, so consumer confidence might be positively related to disposable income. However, corsumer confidence should depend on expectations shout the future, rather than on curtent variables per se. Hence, there are reasons to think clanges in consumer confidence might not always track changes in disposable income b. There appears tobe positive relationship between the variables, but i is not tight, ‘e._Persomal disposable income inercased at an snnual rte of 11.5% in 2001 TF and at an ‘annual rate of 11.6% in 200234, Consumer confidence fell in 2001 -IL but rose in 20021 The events of September 11, a5 wel as the ongoing recession, probably played a role in the consumer confidence numbers for 200121 CHAPTER 17 Quick Check La Fae, b False ce Fake, 4 TrueiUncertain, Consumers can rely on forecasts by others, but somebody has todo it ec Fake, L Taw. g Fale, 2 a Higher real stock prices led 10 an inerase real wealth directly, which would tend 10 ferease consumption. Mereever, the ype about the New Economs, combined with \reasing stock prices, may have led to favorable expectations aout fumre labor income, which would also tendo inerease consumption, |. Subsequent declines in the stock: market decreased wealth and may have Ted consumers to revise (downward) expectations about future labor income, effects that would tend 19 reduce consumption, 3. The curve shits rig, b. The Zfcurve shifts ight,5 n the economy. ‘These effvers tend co reduce output (or the row ra The JScurve shifts to the lel 4, Rational expectations may be unrealistic, but it does set imply that every consumer has perFeet Knowledge of the econemy. I implies that consumers use the best available information ‘models, data, and technigues—to assess the future and make decisions. Moreover, consumers do ‘not have 1o work out the implications of economic models forthe future by themselves. They ean rely on the predictions of experts o television or in the newspapers. Essentially rational expectations rules out systematic mistakes on the part of consumers Thus, although rational ‘expectations may aot literally be tue, i seems a reasonable benchmark for policy analysis. The answers below ignore any effect on capital accumulation and output in the long rum, ‘Assume the tax cut poliey in the future is wemporary, so we need only worry ubout future short- run effects a. ‘The effect on current output is ambiguous. The tax eut in the fuure will lead w a boom. ‘Output and the real interest rate will increase. ‘The increase in expected future output tends to shift the S curve to the right; the inerease in the expected future real interest rate tends to shift the JS curve to the lefl. Finally, the fall in expected {ature taxes tend increase expecied future aflersax income (lor any given level of income). ‘This effect tends to shift the JS curve to the right b. This means that the Fed will inerease the interest rate in the future (shift the LM curve vo the left in the Future). ‘The expected interest rate will increase more, which tends to to. shift the /S curve to the lef but there is still the effect of lower expected taxes on current consumption. The effect today on output is still ambiguous, but more likely to be negative tan in part (a). c. Fuure output will be higher, the future interest rate will not imerease, and future taxes will be lower. The JS curve definitely shifts to the right in the current period, and eurrent ourput increases. Dig Deeper 6. th Scethe discussion in the tex. ‘There are three effects. First, an inomease in expected fiire taxes tends to reduce expected fiture after-tax income (for any given level of income), and therefore to reduce consumption. This effect tends to shift the IS curve to the lef. Second, the increase in future taxes (a deficit reduction program) tonds 10 reduce val interost rates in the future ‘The fll inthe expected future interest rate tonds to shift the JS curve to the right. Third the fallin future real interest rates leads to an increase in investment in dhe medium eun ouput inthe long run ‘The inerease in expected future output tends fo the right. The net effect on the IS eurve is ambiguous. Nove that has lump sum taxes. In taxes are not lump sum, the a inerease c. The gesture seemed to indicate that the Fed supported deficit reduction, and was willing to conduct expansionary monelary policy in the future to aft the direct negative effects ‘on output from spending cuts and tx increases. A belief that the Fed was willing to act in this way would tend to increase expected future output (relative to the ease where the Fed did nothing) and to reduce expected future interest rates. Both of these effects would tend to inerease output in the short-run,7. a, Future interest rates will wend to rise, Future ouput will tend to fall, Beth effects shift the 7S curve the left in the present. Current output and the current interest rate fall ‘The yield curve gets steeper on the day of the announcement, b No. © Compared to original expectations, the nominee is expected to follow a more expansionary monetary policy. The yield curve will get Matter on the day of the ‘announcement Explore Further 8. a, The interest rate will inerease in the short run, and increase even further in the medium ‘tun, The yield curve will get steeper. b. The spread increased over the period. ‘Scar Viel minus 3-Month Vield ‘August 2002, January 2003: ‘August 2003 Sanusry 2004 CHAPTER 18 Quick Check True. bd. Fale, ce. False, do False. ec. False, £ ‘The statement should read: “Given the definition of the exchange rate adopted in this chapter, if the dollar is the domestic currency and the euro the foreign currency, a nominal exchange rate of /./0 means that one dollar is worth 1.1 euros.” This statement is True. g False. Domestic Country Balance of Payments (S) Current Account Exports 25 Imports 100 ‘Trade Balance -75 (=25-100) nvestment [necme Received 0 Investment Income Paid 15 Net Investment Income Net Transfers Received (0-15) Current Account Balanee -L1S (75-15-25)Capital Account Increase in Foreign Hollings of Domestic Assets 80 (=65+15) Increase in Domestic Holdings of Foreign Assets -50 ‘Net Inerease in Foreign Holdings 130 (=80-(-50)) Statistical Diserepancy =15 (115-130) Foreign Country Balanee of Payments (S) 100 28 75 (100-25) Is Investment Income Paid 0 Net Investment Income 15,(-15-0) Net Transfers Received 23 Current Account Balance 115 (-75+15425) Capital Account Increase in Foreign Holdings of Domestic Assets -50 Increase in Domestic Holdings of Foreign Assets $0 (-65415) ‘Net Inerease in Foreign Holdings Statistical Diserepaney 3. a, —Thenominal return on the U.S. bond is 10,000(9615.38) I-%. ‘The nominal return on the German bond is 6%. b. Uncovered interest parity implies that the expected exchange rate is given by (1+ Y(1-+)-0.75(1.06)((1.04}-0.76 Euro’S. ©. Ifyou expect the dollar to depreciate, purchase the German bond, since it pays & higher inferest rate and you expect a capital gain on the currency 4. The dollar dopresiates by 4%, so the total return om the German band (in $) is % Investing in the US. bond would have produced a 4% return &Theumeovered interest party contition is about equality of expected returns, not equality of actual returns Dig Deeper 4.4 GDPig IS ineach economy. Consumers will spend 5 on each good. bh Bach country has a zero trade balance. Country Aexports elothes to Country B, Country B exports cats o Country C, and Country C exports computers to Country A. © Nocountry will havea zem» trade balance with any other country There is no reason to expect that the United States will have balanced trade with any particular county, even if the United States eliminates its overall trade defi Sa The relative price of domestic goods falls. Relative demand for domestic goods rises. The domestic unemployment rate falls inthe short runb. The price of fireign goods in terms of domestic curency is PE, A nominal Uepreciaiion (a fall in £) inereases the price of foreign goods in terms of domestic currency. Therefore, a nominal depreciation tends to increase the CPL c.Thereal wage fall. a sentially, nominal depreciation stimulates output by reducing the domestic real wage, \which leads to an increase ia domestic employment. Explore Further 6. a. Considering the evidence through May 2008, the yen appreciatad fiom mid- 1985 to mid 1995, depreciated until rid-1998, appreciated through the end of 1999, depreciated through the end of 2001, appreciated through 2004, depreciated through mid-2007, and then began to appreciate. From s broader perspective, between the January 1979 and May 2008, the yen appreciated by 910%. The yen reached its strongest value against the dollar inmid-1995, b. Depreciation ofthe yen, The yen appreciated from the end of 2001 to the end of 2004, and again after mid-2007, ‘This did not help the Japanese recovery. a, The stm of world current aceount bakimees should be zem, In 2007, the sum was positive, which implies literally that the world as a whole wasborrowing. Obviously this cannot have been true, bn 2007, the United States was the world’s biggest borrower by fir. The rest of the advanced economies as a whole were lenders, although the Fura area as a borrower. The economies of the Midile East and developing economies in Asa were other large lenders: the economies of central and eastern Europe were large borrowers, In 2007, the saving of the advaneed economies other than the Untied States amounted 10 only 24% of US. borrowing So, the United States was bortowing heavily from all regions of the world. d. The projections in the April 2008 Work! Economic Outlook suggestal no qualitative change in the answers to parts (a) through (©). 8. a, World saving essentially equals world investment, as it must logically. b. Im 2007. US. saving was 13.6% of GDP, but U.S. investment was 18.8% of GDP. The United States financed the difference by borrowing from abroad. ‘The April 2008 World Economie Outlook projected a gap of similar magnitude For the next two yearsCHAPTER 19 Quick Check 1a Fake, 1b. False. An increase in the budget deficit will lead to an increase in the trade deficit, but ‘we can’t conclude that from the national income accounting identity. We have to use our model to make that prediction, ©. Fake. Te. ¢. False. Econometric evidence suggests that a real depreciation does not lead to an immediate improvement inthe trade balance. Typically, the trade balance improves six to twelve months after a real depreciation. only after six to twelve months between only _afler six to twelve months. £ Tne. Fake. 2. a There isa real appreciation over time, Over time, the trade balance worsens, b. The currency depreciates at the rate of -n*, 3. a. The share of Japanese spending on U.S. goods relative wo US. GDP is (0.06)(0.11)-0.7%. b._ US. GDP falls by 2(.05).007)-0.07% U.S. GDP fall by 2(.08)(0.11)=1.1%%, d.— This & an overstatement. ‘The numbers above indicated that even if U.S. exports fall by 5%, the effect is to reduce GDP growth by 1.1%. 4. Answers follow the model in the text Dig Deeper Sa The ZZand Nines shift up. Domestic output and domestic net exports inerease. b. Domestic investment will increase because output increases. Assuming taxes ure fixed, there is no elfect on the deficit, ©. NAESAT-G. Since the budget deficit is unchanged, and and NW inerease, § must Except for G and (for our purposes) T, the other vasiables in equation (19.5) are wdogenous. An exogenous shock such as an increase in foreign output can affect all of the endogenous variables simultaneously 6. a ‘There must be areal depreciation, b. YOCHAGHNN, LEN rises while ¥remains constant, CFG must fall. The goverment ccan reduce G or increase T, which will reduce C. 2 YCHI+G+N I Yoosre( ¥-Drdtd-Geo Ym Y[1Ml-cyadstm NegteyT hy GeyOutput increases by the multiplier, which equals (I-crdstm). ‘The condition 0< m< evtdiP Asa sult, P falls, the AS ceurve shifls down, and P falls. In the JS-LM diagram, the fall in P implies an increase MOP, so the LM curve shilis right. Expected inflation is likely to fall. The fallin expected inflation tends to increase the real strate and shif IS to the left. Ouspust moves further away from the natural level No. If the Fed does nvthing, the economy may notreturn w the msiwral level oPoutpus, if the effect ofthe fall in expected inflation is strong enough,bP falls and MIP rises, so the LM curve shifls right. The adjustment mechanism does not ‘work when the nominal does not change. leres rate equals zero. As the EM curve shifls right, output c. Monetary policy is ineffective, An inerease in M shifls the LM eurve to the right, which ddoes not lead oan increase in output when the nominal interest rate equals zero. Yes. An increase in G or a reduction in T would shift the ZS curve to the right. AS a result, output would inerease. © This is mot wise advice. Ifthe economy is in a liguiity teap, the central bank cannot restore output to its natural level, Dig Deeper 4. a, Short-term unemployment has a greater effect on wages. The long-term unemployed ‘may not be searching for employment and may not be very employable. ber L.05/1.05(1-0.51)1 cI B-0, 04, 0.8, the natural rate ~4.8%, 6.0%, 7.9%. Intuitively, if the weight an long- term unemployed were zero instead of 0.5, the wage-seiting and price-setting equations would determine the natural short-term rate of unemployment. The long-term unemployed would simply increase the aggregate unemployment rate. Thus, as the proportion of long-term unemployed increased, the natural rate of unemployment would increase. The same kind of reasoning applies here, but the effect is less strong because the weight on long-term unemployed in the wage-setting equation is not zero. In terms of the logic of the labor market, the long-term unemployed put less downward pressure on wages than the short-term unemployed. So, increasing the proportion of long-term unemployed tends to inerease the real wage. Effectively, this implies that the labor supply curve (the wage-setting equation) shifls up. If the labor demand curve were downward-sloping, employment would fll asthe real wage rose sinee workers would be less attractive to firms. In this problem, labor demand (the price-setting equation) is fat ata fixed real wage, which implies that all of the adjustment from an inerease in the proportion of long-ierm unemployment takes the form of less employment (and a higher {unemployment rate) and none of the adjustinent takes the form of a higher eal wae. Higher unemployment implies lower wages given expected prices. This implies bower prices given expected prices. Equivalently, it implies lower inflation given expected inflation, which here equals past inflation Beem als FH) Rion = alls —U) means = all = Blu The curve will shift to up, so that any unemployment rate is associated with a greater inerease in the inflation rate,More overall unemployment is needed to achieve the same decrease in inflation, The cost of disinflation increases, 8 Anincreae in the proportion of long-term unemployed tends o imply s larger inerease in inflation. In the Great Depression, peri the long-term unemployed did not exert much pressure on wages and prices, so deflation ended despite high unemployment Explore Further 6. Answers will vary depending upon when the question is answered CHAPTER 23 Quick Check a Tne, b Fabse & Fabse 4. FabeUncertain. Incomes policies may be part of a su some eases, but they don't seem in general to he a prerequisite fr stabilization © False £ Fae. 2. a If money growth = 25%, 50%, 75%, seigmorage-162.5, 325, 487.5 b. In the medium rm, if money growth ~ 25%, $0%, 75%, seignorage-162.5, 200, 112.5. ‘The fall in real money bakinees associated with higher ongoing inflation reduces the potential for seignorage, Part (a) did not allow for this effect. 3. a This policy would reduce the effect of inflation on real tax revenues. b. ‘This policy would reduce the effect of inflation on real tax reverts ©. This policy would dacranse the effect of inflation on real tax revenues, but wouk! ako have other effects. ‘The income tax can tax the rich at a higher rte than the poor, but the sales tax rate isthe same for rich and poor Dig Deeper 4. a. Theendto the erisis depends on shifting the composition of taxes away from the inflation tax und toward other taxes. Workers are already paying the inflation tax. b. ‘The central hank must make a credible commitment that it will no longer automatically ‘monetize the government debi. Although a curency board! would do this, itis a drastic and perhaps unnecessary step. ©. Price controls may help, but price controls without other policy changes only cause distortions and are a recipe for lailure. 4. A recession is mot needed, but it may happen Although nominal rigilities are less ‘important during hyperinflations—a fact that implies that the sacrifice ratio is small —the issue of credibility remains. Unless firms and workers believe in the stabilization program, a severe recession may be the result© The Statement has two companents: (i) there is an ongoing Fiscal deficit that the government is unable or unwilling to finance from nonmonetary sourees, and (ii) the central bank is willing to monetize the debt, The order in which these issues are resolved ultimately depends on the political realities. The fiscal authority could eliminate the deficits. ITit does not do so, the central bank could commit not to menetize government debt. However, this could drive the government into default on its bonds 5. seignorage=(Y/P\0.9-AMIM\ AMIN) Seignoruge is masimized when AM/MH4S%. Explore Further 6. Answers miy vary depending upon when the website isaccessed, but itis clear that Fall cil ‘Prices would tend to increase the budget deficit in Venezuala. This would create the possibilty ‘of a hyperinflatio for unable to finance itself and the central bank if the government is uni finances the deficit dhrough money creation. CHAPTER 24 Quick Check Loa Fake. b. True/Unoectan. c False, a False «Tne, £ Unveruiin. 1 may be wise for a government io commit not to negotiate with hostage lakers as a means to deter hijackings, even recognizing that after 2 hijacking has taken place. there is a strong incentive to negotiate. However. the phrase “under no vay some circumstances under which a government circumstances” is categorical. ‘There ‘might wish wo violate its commitment. This statement, of course, illustrates the difficulty ‘of precommitment. Can a government really commit not to negotiate, no matter what the citeumstances, even if these circumstanees may not have been imagined at the time the ‘commitment was made? Fab. 2a Tnflation will inerease in the fourth year b. The President shoul! aim for high unemployment early in the administration, to reduce nflation before the fourth year. . The policies are not likely to achieve the desired the increase in output desired in the four year. Since people are forward-looking, expected inflation fourth year will account for the intentions of policymakers. If inflation equals expected inflation, ‘unemployment equals the natural rate Answers will vary, but there is some discussion of this fsare in the text 4. New Zealand wants. eliminate fears chat she cenwal bank might uy w reduce mempleyment below the natural rte with expansionary monetary poliey and higher inflation. See Chapter 25 fora discussion of inflation targeting,VS(Ro + He) The unemployment rate will be less than the natural rate, laflation will be higher than expected. The unemployment raw will be greater dhan the natural rate. Inflation will be lower than expected. ‘The resuks it the evidence in Table 2 administration, and not just che first year. 1 if one looks at the first ewe years of each ‘The unemployment will equal the natural rate, because x x, and there will be high inflation, The payoff should be symmetrical, as written below, The table presented in the text eads to the same equilibrium, however. Welfare Cuts Yes No. Defense Yes (R=1, D=1) (Re2, D=3) (R=1,D=1) cout welfare, but 3 they do not. So their best response is to vote against welfare cuts, The Republicans will gel 2 in this ease Ifthe Republicans do not cut military spending, the Demoerats get 2 ifthey cut welfare, bbut Lif they do not. So their best response is not to eut welfare. ‘The Republicans wil get] Given the answers above, che Republicans will not cut military spending, and the Democrats will not cut welfare. The two parties are locked in a bad equilibrium. They could make a deal: both vote for cuts. [they do, they will botlibe better off. Explore Further 7. Answers will vary CHAPTER 25 Quick Check La Fake, b. False. ce Fake. Gd. Fake'Uncertain, Evidence suggess that people have money illusion, when would seem to imply that inflation would distort decision making. Pale True ‘The eapital gains tax isnot indexed to inflation, 2 Demand for A falls while demand for M2 is unchanged. People shifl funds from savings accounts to time deposits.dig 5 G Demand for M/ increases as people transfer finds from money market funds to checking accounts. Demand for M2 remains unchanged. There is a shift in the composition of MI (and consequently M2) as people hold more ccurrency and make fewer trips to the hank while holding smaller checking account balances ‘Tho demand for M2 inereases as the benefit of holding government securities falls 5A OAM, HL LO%MAPH 4 AMA 1-0.28)-0%-B6r fi. IAV(1-0.25)-10%6=10.5%4- 1% .5% ar the daducibility of nominal moryage interest payment, inflation is good for ‘homeowners in the United States. The unemployment rate will remain equal to the natural rate. kis unlikely that dhe central bank will be able t it its target every period. ‘There will be surprises, and there are lags and uncertainty in policymaking. (Changes in the natural cate will make it more difficult fr the Fed t hits its tanget_ Iti be harder to distinguish changes ithe actual rale of unemployimeat from changes i the ‘natural rate of unemployment, Deeper Diseussion question, b. ‘The JS curve slopes down, snd the M/P relation slopes up. €. Am increase in government spending shifls the JS curve right, so output and the real ierest rate rise. 4. "The MP relation shifts up. Outpt falls and the real interest rate increases 4, ‘The MP relation shifts up. Output falls and the real interest rate increases b. Since YY,” falls. Lnflation tends to returns to its target level ‘The AMP relation shifts down, Ourpat increases and the real interest rate falls 4 Since Y>¥,,3¢ rises. Inflation tends to move away from its target level. A value of @=1 ‘makes no sense as part of the poliey rule, because inflation would tend to move away fom is target Explore Further Answers will depend upon curent Fed policy 8 CHAPTER 26Quick Check Taw. False Uncertain, False False False False Interest payments are [0% of GDP, so the primary sueplus is 10%-4%~6%, Real interest payments are (10%-794)"100%-3% of GDP. So the inflation-adjusted Assume that last period unemployment was at the natural rate, so there has been a two percentage point inerease in the unemployment rate over the last period. By Okun's law ‘6vith a normal growth rate of 3%), output growth is lower hy two percentage points, So ‘output is roughly two percent lower than it would have been, Using the rule of thumb in the text, the surplus is lower by 0.5°2%-1%. So the cyelically-adlusted, inflation- adjusted surplus is 2% % ‘The debt to GDP The change in the debe to GDP ratio = B% 2%)" 100% - 3% ratio falls by 2% a year. In 10 years, the debt to GDP ratio will be 80%, 4. The new interest rate is 106 $4202)-20%, So assuring that expected depreciation ‘was previously zero, the domestie interest rate inereases from 109% to 207% b. The real imerest rite inereases from 3% to 132%, The high real interest rate is likely to decrease growth. c. The official deficit increases from 4% 10 14% of GDP. ‘The inflation-adjusted deficit increases from 3% (a surplus) to 7% (a deci). The change inthe dob ratio ~ (1 3%-{-294))*100°%-3% 2%. Tt goes up very quickly. €. Inthis example, the worries were sel falling Firs, even a temporary deficit leads to an increase in the national debt, and therefore to hi interest payments This, in Lum, implies continued deficits, higher taxes, or lower government spending in the fuure Second, the evidence does not support the Ricardian equivalenc proposition. Third, f Ricardian equivalence did hold, then government spending would ave the same effect on output regardless of whether it was financed by bonds (ic, with a deficit) taxes. ‘Thus, a deficit, per se, would not be needed to simulate output. Fourth, war-time economies are already low-unemployment economies. There is no need for further stimulation by using deficits rather than tax finance. The only correct past of the statement is the First sentence, A deficit can be preferable to higher taxes during a war, but not forthe reasons sated here,Dig Deeper 5. Discussion question, Also see the box on Savial Security in Chapter Il (p. 215). 6. If financial market participants discount future dividends at the rate of interest on government bonds, then this economy will exhibit Ricardian equivalence. I?there is risk-premium applied to stocks, then this economy will not exhibit Ricardian equivalence. To see why. lett be the dividend tax rate at time sand consider the pre-dividend stock price under fixed sequence of expected dividends. SQ, ~ SDUL- 2) + SD (1 -t-)L + id = [SD SD) iL +i). ]> [SD a+ SDE itv + in) + ‘The second term in brackets is the present discounted value of tax receipts for the government. To finance a given expendiure policy, the government must keep the PDV of tax receipts ant. ‘Thus, fora given sequence of expecied dividends, the timing of dividend taxes will not afiget the stock price, consumption or investment. As a result, this economy will exhibit Ricardian equivalence Note that, ex post, dividends will vary from their expectad values, so be adjusted in the future. ‘This new information could affect stock prices. In addition, note that the level of dividend taxes the PDV of tax receipts could affeet stock prives, If stocks are assessed a risk premium (@), however, so that they are discounted at rate i+ 0, then the timing of dividend taxes will matter, because the government budget constraint will incorporate a different discount rate than the stock market price. Asan example, suppose that forever but 0 is positive. In this case, the government can assess taxes at any time with no ‘consequence, but shifting taxes to the future will be favorable to holders of stocks. Since future dividends are uncertain, so are future tax payments they might not have to be made if dividends um out to be low. In this scenario, shifting taxes to the future would tend to increase the current stock price, and thus increase consumption and investment (if firms are liquidity constrained). So, Ricardian equivalence is violated.