Chapter 8 Homework Due Tuesday, March 15, 2011 Please answer on a separate sheet of paper

1. Why is economic growth important? Why could the difference between a 2.5 percent and a 3.0 percent annual growth make a great difference over several decades? conomic growth means higher standard of living! provided the population does not grow even faster. "nd if it does! then economic growth is even more important to maintain the current standard of living. conomic growth allows the lessening of pverty even without an outright redistribution of wealth. #f population is growing 2.5 percent a year $ and it is in some of the poorest nations% then a 2.5 percent growth rate of real &'( means no change in living standards. " 3.0 percent growth rate means a gradual rise in living standards. )or a wealth nation! such as the *nited +tates! with a &'( in the neighborhood of ,10 trillion! the 0.5 percentage point difference between 2.5 and 3.0 percent amounts to ,50 billion a year! or more than ,150 per person per year. 2. +uppose an economy-s real &'( is ,30!000 in year 1 and ,31!000 in year 2. What is the growth rate of its real &'(? "ssume that the population was 100 in year 1 and 102 in year 2? What is the growth rate of &'( per capita? &rowth rate of real &'( . / percent 0. ,31!200 % ,30!0001 ,300002. &'( per capita in year 1 . ,300 0,30!00011002. &'( per capita in year 2 . ,305. 33 0.,31!20012002. &rowth rate of &'( per capita is 1.45 percent . 0,305.33%,30013002 3. What are the four phases of the business cycle? 6ow long do business cycles last? 6ow do seasonal variations and long%term trends complicate measurement of the business cycle? Why does the business cycle affect output and employment in capital goods and consumer durable goods industries more severely than in industries producing nondurables? 7he four phases of typical business cycle! starting at the bottom! are trough! e8pansion! peak and contraction. 7he length of a cycle varies rome about 2 to 3 years to as long as 15 years. 7here is a pre%9hristmas spurt in production and sales and a :anuary slackening. 7his ormal seasonal variation does ot signal boom or recession. )rom decade to decade! the long%term trend of the *+ economy has been upward. " per of no &'( growth thus does not mean all is normal! but that the economy is operation below its trend growth of output.

;ecause capital goods and durable goods last! purchases can be postponed. 7his may happen when a recession is forecast. 9apital and durable goods industries therefore suffer large output declines during recessions. #n contrast! consumers cannot long postpone he buying of nondurables such as food< therefore recession only slightly reduce non%durable output. "lso! capital and durable goods e8penditures tend to be =lumpy.> *sually! a large e8penditure is needed to purchase them! and this shrinks to ?ero after purchase is made. /. What factors make it difficult to determine the unemployment rate? Why is it difficult to distinguish between frictional! structural and cyclical unemployment? Why is unemployment an economic problem? What are the conse@uences of a negative &'( gap? What are the noneconomic effects of unemployment? Aeasuring the unemployment rate means first determining who is eligible and available to work. 7he total *+ population is divided into three groups. Bne group is made up of people under 15 years of age and people who are institutionali?ed. 7he second group! labeled =not in the labor force> are adults who are potential workers but for some reason% age! school or homemakers are not seeking work. 7he third group is the labor force! those who are employed and those who are unemployed but not actively seeking work. #t is not easy to distinguish between these three types and since the unavoidable minimum of frictional and structural unemployment is itself changing! it is difficult to determine the full%employment unemployment rate. )or e8ample! a person who @uits a Cob in search of a better one would normally be considered frictionally unemployed. ;ut suppose the former Cob then disappears completely because the firm is in a declining industry and can no longer make money. Bur still Cobless worker could now me considered structurally unemployed. "nd then suppose the economy slips into a sever recession so that out worker cannot find any Cob and has become cyclically unemployed. 7he unavoidable 5. *se the following data to calculate a2 the si?e of the labor force and b2 the official unemployment rateD total population! 500< population under 15 years of age or institutionali?ed! 120< not in labor force! 150< unemployed! 23< part%time workers looking for full%time Cobs! 10. 7he labor force . 230 0.500 $ 0120E15022< official unemployment rate . 10F 0.2312302G10022 5. +ince the *+ has an unemployment compensation program! which provides income for those out of work! why should we worry about unemployment? 7he unemployment compensation program merely gives the unemployed enough funds for basic needs. )urthermore! many of the unemployed do not @ualify for unemployment benefits. 7he programs apply only to those workers who were covered by the insurance! and this may be as few as one%third of those without Cobs. Aost of the unemployed get no sense of self%worth or accomplishment out of drawing this compensation. Aoreover! from economic point of view! unemployment is a waste of resources< when the

unemployed go back to work! nothing is forgone e8cept undesired leisure. )inally! unemployment could be inflationary and costly to ta8payersD 7he unemployed are producing nothing% their supply is ?ero% but the compensation helps keep demand high in the economy high. H. "ssume that in a particular year the natural rate of unemployment is 5 percent and the actual rate of unemployment is 4 percent. *se Bkun-s law to determine the si?e of the &'( gap in percentage%point terms. #f nominal &'( is ,500 billion in that year! how much output is being forgone because of cyclical unemployment? &'( gap . 3 percent I.04%52J G 2< forgone output estimated at ,/0 billion 0.3F of ,500 billion2. 3. 8plain how an increase in your nominal income and a decrease in your real income might occur simultaneously. Who loses from inflation? Who loses from unemployment? #f you had to choose between a2 full employment with a 5 percent annual rate of inflations or b2 price stability with an 3 percent unemployment! which would you choose? Why?

#f a person-s nominal income increases by 10 percent while the cost of living increase by 15 percent! then her real income decrease from 100 to45.55 0.11011.152. "lternatively e8pressed! her real income has decreased by /.35 percent 0.100%45.552. &enerally! whenever the cost of living increases faster than my nominal income! real income decrases. 7he losers from inflation are those on incomes fi8ed in nominal terms ot! at least! those with incomes that do not increase as fast as the rate of inflation. 9reditors and savers also lose. #n the worst recession since the &reat 'epression 01431%32! those who lost the most from unemployment were! in descending order! "frica%"mericans 0who almost suffer the most in good times2! the teenagers! and blue%collar workers generally. #n addition to the specific groups who lose the most! the economy as a whole loses in terms of the living standards of its members because of the lost production. 7he choice between and and b illustrates why economist are unpopular. Bption a spreads the pain by not having a small percentage of the population bear the burden of employment. 7here is the risk! however! that inflationary e8pectations will give rise to creeping inflation and ultimately hyperinflation< or that the central bank will raise interest rates to reduce inflation! stalling economic growth. #f one chooses b the central bank will no cause to raise interest rates and cut off the economic e8pansion needed to get unemployment down from the unforgivable 3 percent. 6owever! the weakness in spending resulting from an 3F unemployment rate might push the economy into deflation! which would ultimately e8acerbate the weak economic conditions.

4. What is the 9onsumer (rice #nde8 09(#2 and how is it determined each month? 6ow does the ;ureau of Kabor +tatistics calculate the rate of inflation from one year to the ne8t? What effect does inflation have on the purchasing power of a dollar? 6ow does deflation differ from inflation? 7he 9(# is constructed from a =market basket> sampling of goods that consumers typically purchase. (rices for goods in the market basket are collected each month! weighed by the importance of the good in the basket 0cars are more e8pensive than bread! but we buy a lot more bread2! and averaged to form the price level. 7o calculate the rate of inflation for year 5! the ;K+ subtracts the 9(# of yea / from the 9(# of year 5! and then divides by the 9(# of year / 0percentage change in the price level2 #nflation reduces the purchasing power of the dollar. )acing higher prices with a given number of dollar means that each dollar buys less than it did before. 7he rate of inflation in the 9(# appro8imates the difference between the nominal and real interest rates. " nominal interest rate of 10F with a 5F inflation rate will mean that real interest rates are appro8imately /F 'eflation means that the prices that the price level is falling! whereas with inflation overall prices are rising. 'eflation is undesirable because the falling prices mean that incomes are also falling! which reduces spending! output! employment! and! in turn! the price level 0downward spiral2. #nflation in modest amounts 0L3F2 is tolerable! although there is not universal agreement on this point. 10. #f the price inde8 was 110 last year and is 121 this year! what is this year-s rate of inflation? What is the =rule of H0>? 6ow long would it take for the price level to double if inflations persisted at a2 2! b2 5 and c2 10 percent per year? 7his year-s rate of inflations is 10F or I0121%11021100J G 100 'ivide H0 by the annual percentage rate of increase of any variable 0for instance! the rate of inflation or population growth2 will give the appro8imate number of years for doubling of the variable. a. 35 years< b. 1/ years! c. H years 11. 'istinguish between demand%pull inflation and cost%push inflation. Which of these two types is most likely to be associated with a negative &'( gap? Which with a positive &'( gap! in which actual &'( e8ceeds potential &'(? 'emand%pull inflation occurs when prices rise because of an increase in aggregate spending not fully matched by an increase in aggregate output. #t is sometimes e8pressed

as =too much spending chasing too few goods. 9ost%push inflation describes prices rising because of increases in per unit costs of production. 9ost%push inflation is most likely to be associated with a negative &'( gap! as the rising production costs reduce spending and output. 'emand%pull inflation is more likely to occur with a positive &'( gap! because actual &'( will e8ceed its potential only when aggregate spending is strong and rising. "s the economy produces its potential! bottlenecks and more sever resource scarcity occur! driving up prices. 12. 8plain how =hyperinflation> might lead to a sever decline in total output. With inflation running into the double! triple! @uadruple or even greater number of digits per year! it makes little sense to save. 7he only sensible thing to do with money is to spend it before its value is cut in half within a month! a week or a day. 7his very fact of everyone trying to spend as fast as possible will speed the inflationary spiral and cause people to spend more and more time trying to figure out what good are most likely to go up fastest in price. Aore and more people will turn away from productive activity! because wages and salaries are ot keeping with inflation. #nstead they will spend their time speculating! transferring goods already in e8istence and produce nothing. ventually! money may become worthless. Mo one will work for money. ;arter and living by one-s wits become the only means of survivial. (roduction falls for this reason and also because investment in productive capital practically ceases. *nemployment soars. " massive depression is at hand. 13. valuate as accurately as you can how each of the following individuals would be affected by unanticipated inflation of 10 percent per year. a. b. c. d. e. " pensioned railroad worker " department%store clerk " unioni?ed automobile assembly%line worker " heavily indebted farmer " retired business e8ecutive whose current income comes entirely from interest on government bonds f. 7he owner of an independent small%town department store. a2 "ssuming the pensioned railway workers has no other income and that the pension is not inde8ed against inflation! the retired worker-s real income would decrease every year by appro8imately 10 percent of its former value. b2 "ssuming the clerk was unioni?ed and the contract had over a year to run! the clerk-s real income would decrease in the same manner as the pensioner. 6owever! the clerk could e8pect to recoup at least part of the loss at contract renewal time. #n the more likely event of the clerk not being unioni?ed! the clerk-s real income would decrease! possibly as much as the pensioned railroad worker. "lthough with prices increasing! the store hiring the clerk may be able to pay the

clerk better. c2 +ince the *"W worker is unioni?ed! the loss in the first year would be the same as in b! but it is likely% barring a deep recession% that the loss will be made up at contract renewal time plus the usual real increase that may or may not be related to increased productivity. #) the contract had a cost%of living allowance clause in it! the wage would automatically be raised at the end of the year to cover the loss in purchasing power. Me8t year-s wage would rise by 10 percent. d2 #f the inflation is also in the price the farmer gets fir his products! he could gain. ;ut more likely the price increase are mostly in what he buys! since farm machinery! fertili?er! etc. tend to be sold by less competitive sellers with more poer to raise their prices. 7he farmer faces lots of competition and has to rely on the market price to go up% the farmer has little control over prices on an individual basis. Aoreover! if interest rates on the farmer-s new debts have gone up with the process! the farmer could be even worse off. 7he other side of the coin is that if no new borrowing is necessary! the inflation will reduce the real burden of the farmer-s debt! because the purchasing power declines on the fi8ed payment he contracted to make before inflation. e2 7he retired e8ecutive is in the same boat as the pensioned railroad worker! e8cept that the e8ecutive-s income from the bonds or other interest bearing assets is probably greater than that od the worker from the pension. 7he increase in inflation has most probably been accompanied by rising interest rates! with a proportional drop in the price of bonds. 7herefore the retired e8ecutive would suffer a capital loss if he or she decided to cash in some of the bonds at this time and the fi8ed interest received on these e8isting bonds is worth less in terms of purchasing power. #n other words! the e8ecutive! although wealthier than the retired worker! may be affected Cust as much ore more from inflation. f2 "ssuming the storeowner-s prices and revenues have been keeping pace with inflation! his or her real income will not change unless the costs have risen more than the product prices.