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 Chapter 1  

1. What is the difference between recession and depression in an economy? Provide an example of depression from the real  world that has hit the global economy.   

2. Refer to the following graph and identify the years for which Country A and Country B experienced recession.  

3.  Why do we call macroeconomics an imperfect science? Explain.     

Are the terms “market clearing” and “equilibrium” one and the same? Explain. 

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Chapter 1 57. What is the difference between recession and depression in an economy? Provide an example of depression from the real world that has hit the global economy. Use the following to answer question 58: Answer: When there is a mild fall in the gross domestic product (GDP) of an economy over a period of time it leads to recession in the economy. If the intensity of the fall in GDP is severe over a period of time, then it turns into a depression. Recession is cyclic in nature; that is, it repeats itself over a period of time in an economy. A famous example of depression is that of the Great Depression of the 1930s that occurred in the United States and affected the global economy. Even the financial crisis of 2008-2009 in the United States was very much reminiscent of the Great Depression. 58. Refer to the following graph and identify the years for which Country A and Country B experienced recession. Country A experienced its recession during 2003 and its early recovery during 2004. Country B experienced its first recession during 2002 and its early recovery in 2003. Country B experienced a second recession in 2007. 59. Why do we call macroeconomics an imperfect science? Explain. The study of macroeconomics depends mainly upon the historical data on different economies. Macroeconomists analyze these data to explain changes occurring in different economic parameters (income, prices, unemployment, etc.) and formulate policies. Additionally, macroeconomic studies cannot be conducted in controlled experiments, as in biology or chemistry, for example. In this way, macroeconomists are similar to weather forecasters. 60. Are the terms “market clearing” and “equilibrium” one and the same? Explain. Yes, both terms represent the same notion: the balance between supply and demand. It is the balancing point at which everything that is produced gets sold and fulfills the entire demand. Thus, if all other things remain constant, then there is no tendency to change the quantity supplied and demanded at this point. 61. Do you agree with the statement, “macroeconomics rests on the foundation of microeconomics”? Explain. Macroeconomics involves studying the aggregate of economic variables related to individual decision making parameters, which are microeconomic (think of individuals' expenses, investments, etc.). That is to say, the total expenditure in an economy is the aggregate (sum) of all the expenditures done by all consumers in that economy, or the total investment done in an economy is the aggregate (sum) of all individual investments done by firms in that economy. This reflects that macroeconomic study rests on the foundation of microeconomics. 62. Give two examples of macroeconomic variables and microeconomic variables. The income of your father is a microeconomic variable, while the gross domestic product (GDP) of your country is a macroeconomic variable. The money your father saves in the bank is a microeconomic variable, while the total money in all banks and post offices of your country is a macroeconomic variable. . 64. What is the difference between sticky prices and flexible prices? Explain. With flexible prices, instantaneous adjustment in changes between demand and supply brings market forces into equilibrium. In contrast, sticky prices delay the adjustment process due to their adherence to predetermined levels (though such delays are released over the long-run). 65. What is an exogenous variable? Illustrate with graphs the effect of a change in the exogenous variable on a demand and supply relationship. Mark the x-axis and y-axis clearly. An exogenous variable is the variable which an economic model assumes to be given. For example, in the supply and demand models below the income of consumers (Graph 1) and the cost of materials (Graph 2) are assumed to be given. Now if there is an change in the income of consumers, this effects the market. In Graph 1 (below), increase in income shifts the demand curve upward from D1 to D2,with increased quantity from Q1 to Q2, and also increases the prices from P1 to P2. In Graph 2 (below), the exogenous variable is the cost of materials. A rise in the cost of materials decreases the supply from S1 to S2. Quantity falls from Q1 to Q2 and prices rise from P1 to P2. Chapter 2 116. Assume two countries have the same nominal GDP (measured in the same currency using the same accounting rules). Explain at least three reasons why you cannot assume that citizens in each country enjoy approximately the same level of economic wellbeing. Answer :Some possible, but not all, explanations include: a. different price levels in the two countries would result in different amounts of real GDP, i.e., different quantities of goods and services available in each country; b. different-sized populations could result in different quantities of goods and services available per person in each country; c. different levels of nonmarket production in the two countries would alter the quantity of goods and services available in each country; d. different amounts of leisure time available (not captured in nominal GDP figures) would cause economic well-being to differ in the two countries; e. different distributions of income in the two countries could alter the quantity of goods and services available to the typical citizen in each country; f. different quantities of both positive and negative externalities associated with producing GDP, such as pollution and congestion, which are not measured in GDP, would cause the different levels of economic well-being between the two countries. 117. Economic statistics are not perfect. Explain at least one way in which each of the following statistics as currently calculated in the United States fails to completely or accurately measure the corresponding economic concept (in parentheses): a. real GDP per person (economic well-being); b. CPI (cost of living); c. unemployment rate (involuntary unemployment). Answer: a. The official measure of GDP does not include measurements of leisure time available, nonmarket production, production in the underground economy, the distribution of income, or production externalities (e.g., pollution). b. The CPI does not allow substitution away from products with rising prices and has difficulty distinguishing between price changes and quality changes in products included in the index. c. The official unemployment rate does not take into account discouraged workers, parttime workers who desire full-time employment, and workers employed in jobs not matching their skill level, such as taxi drivers with PhDs in physics. 118. There are a number of statistics computed to measure the price level, such as the GDP deflator and the CPI. The choice of which of these measures to use depends in many cases on the specific question in which you are interested. For each of the following situations, state whether the CPI or GDP deflator is a more appropriate measure to use and explain why the statistic is preferred. a. You are interested in looking at the impact of higher prices of imported oil in the overall cost of living. b. The government is interested in whether increases in defense spending are affecting the price level. c. An economic consulting firm is investigating the impact on the aggregate price level of more computers and electronic technology used in production. Answer: a. The CPI is the more appropriate statistic, because the price of imports is not included in the GDP deflator. b. The GDP deflator is the more appropriate statistic, because the CPI does not include the prices of goods and services purchased by the government sector. c. The GDP deflator is more appropriate, because the CPI does not include prices of goods and services purchased by businesses or the government sector. 119. One senator criticizes the government for making an inadequate effort to stimulate the economy based on data from the BLS establishment survey that shows the number of jobs in the economy has fallen. Another senator counters that the number of employed workers in the economy has increased over the same period, based on the BLS household survey. Explain how both senators can be correct. Answer: If the number of self-employed workers and workers employed in new start-up firms (who are included in the household survey, but not in the establishment survey) has increased more rapidly than the decline in payroll jobs counted in the establishment survey, then the number of employed workers as measured in the household survey could increase while the number of payroll jobs decreases. 120. There are a number of measures of aggregate economic activity, such as GDP, GNP, national income, personal income, and disposable personal income. Each of these measures can be a good indicator depending on the issue under consideration. For each of the following issues, give your reasons for selecting one of the measures just mentioned as the best indicator to use in studying the issue: a. the proportion of income households save; b. the relative share of earnings going to labor versus capital; c. the total output of final goods and services. Answer: a. Disposable personal income provides a measure of the income households have to use for either consumption or saving after they pay taxes. b. National income provides a measure of the income going to the factors of production. c. GDP is the most complete measure of the value of newly produced goods and services in the economy. In contrast, personal income includes transfer payments, which do not represent newly produced goods and services. 121. Real GDP per capita is an imperfect measure of economic well-being because it does not value home production or production in the underground economy, among other factors. Give at least two examples that show why the omission of these types of items will make a difference in evaluating economic well-being. One example should explain how the omissions distort comparisons of economic well-being across countries and the other example should explain how the omission distorts comparisons of economic wellbeing in the same country over time. Answer Answers will vary, but one example could show that measured GDP in one country could be much lower than in another country, but the amount of home production in the first country could be very large. In this case, measured real GDP indicates a much larger difference in economic well-being than actually exists between the countries. The other example could explain how changes in the amount of home production in a country over time make it difficult to compare economic well-being over time. For example, if most people grew their own food initially and then over time moved to commercial agriculture, the increase in real GDP per person would overstate the increase in the amount of goods and services available in the country, since the food grown at home was not counted in real GDP in the early period. 122. Based on the data in the table below, explain what happened to output and prices in the economy between 2009 and 2010. 2009 2010 Nominal GDP ($ billions) $14,700 $15,200 Real GDP ($ billions 2000 chain weighted) $12,100 $11,900 Answer: Real GDP decreased, indicating that the production of final goods and services was lower in 2010 than in 2009. Nominal GDP increased, which indicates that prices, on average, were higher in 2010 than in 2009, given that real GDP decreased. 123. Explain why the value of GDP in 2012 would or would not change as a result of each transaction described below: a. In 2012, the Smith family purchases a new house that was built in 2012. b. In 2012, the Jones family purchases a house that was built in 2001. c. In 2012, a construction company purchases windows to put in the Smith family home that was built in 2012. d. In 2012, Mr. Jones paints all of the rooms of the Jones family house purchased in 2009, using paint and supplies purchased in 2012. e. In 2012, Mr. Smith uses an online brokerage service to purchases shares of stock in a construction company. Answer a. GDP in 2012 increases by the purchase price of the house, which is a newly produced good. b. GDP in 2012 does not change because the house is NOT a newly produced good, since it was built in 2001. Transactions involving used goods are not included in GDP. c. GDP in 2012 does not change directly because the windows are intermediate goods, not final goods. The value of intermediate goods is not included in GDP to avoid double counting. The value of the windows is implicitly included in the price of the house. d. GDP in 2012 would change by the purchase price of the paint and supplies, but not by the implicit value of the painting services provided by Mr. Jones because home production is not included in GDP. e. GDP in 2012 would increase by the charge for using the online brokerage service but not by the amount of stock purchase because financial transactions do not represent the production of final goods and services and are not included in GDP. 124. Explain which expenditure category of GDP changes and the direction of the change that results for each transaction described. a. A domestic business purchases a domestically produced computer to use in a business office. b. A domestic business produces a computer that is sold to a foreign company. c. The federal government purchases a domestically produced computer to use in a courthouse. d. A domestic household purchases a domestically produced computer to use in a home. e. A domestic household purchases a computer produced in a foreign country to use in a home. Answer a. b. c. d. e. Investment spending increases by the price of the computer. Exports (and net exports) increase by the price of the computer. Government spending increases by the price of the computer. Consumption spending increases by the price of the computer. Consumption spending increases by the price of the computer, but imports also increase by the price of the computer, so that net exports decrease by the price of the computer, and there will be no net change in GDP. 125. Into which of the three categories—employed, unemployed, out of the labor force— would an interviewer for the Current Population Survey place each of the following people? Explain. a. Jennifer Temple is working as a second-grade schoolteacher. b. Frank Peabody is attending college full-time to earn a degree in elementary education. c. Martin Hampton is working as a high school social science teacher but is at home sick with the flu. d. Kyle Brown does not currently have a job. He wants to be an elementary-school teacher. He has the appropriate degree. He has not looked for a position in the last month because he doesn't believe schools are currently hiring. e. Brenda Dewey does not currently have a job. She has sent her resume to several school districts in the past week in hope of finding a teaching position. Answer a. employed. She is working as a full-time employee. b. out of the labor force. Full-time students are not counted in the labor force. c. employed. He is out sick but still an employee of the school. d. out of the labor force. Discouraged workers are not counted in the labor force. e. unemployed. She is actively looking for a job. 126. Assume an economy in which the value of the GDP deflator is 2 and the current inflation rate is 4 percent. Calculate the real and nominal interest rates. Answer Start with the following equations for the known values: (a) GDP Deflator = Nominal interest rate / Real interest rate and (b) Nominal interest = Real interest + inflation By solving the above equations we get the following: (c) Real interest =Inflation / (GDP Deflator – 1) Plugging in the given values of inflation and GDP deflator, we find that: Real interest rate = 4 percent and Nominal interest rate = 8 percent. 127. Sam wants a loan from Dean. While discussing the interest, Dean told Sam that he will give him two options. Which one should Sam choose and why? The options are: a. Sam will pay the nominal interest of 8 percent per annum. b. Sam will pay real interest of 4 percent per annum. Answer Remember that Nominal interest = Real interest + inflation. The answer actually depends upon the inflation rate. If the inflation rate is less than 4 percent, Sam should choose option (b). If the inflation rate is more than 4 percent, then option (a) is a more favorable choice for Sam. If inflation is 4 percent, Sam can go with either of the options as they will yield the same result. 128. “GDP deflator is a better price level indicator than CPI.” Give reasons both supporting and opposing the statement. Answer The advantage of using a GDP deflator is that it is calculated using all goods and services produced, including those bought only by firms and the government as well as consumers, and allows a changing basket of goods. This allows it to take consumers' ability to substitute less expensive goods for more expensive ones into account. The CPI is calculated using a fixed basket of goods bought only by consumers and does not take substitutions into account, so it tends to overstate the cost of living for consumers. However, the GDP deflator does not include imported goods, which do impact the CPI. It also doesn't count for any changes in consumer welfare that may result from substituting goods, and tends to understate the cost of living for consumers. 129. City A has a total population of 10 million, of which 70 percent are adults. Assume that 20 percent of the adult population is not looking for a job and 60 percent of the remaining adult population is employed. Compute: a. Labor-force participation rate b. Unemployment Rate Answer Adult Population = (10)(70))/100 = 7 million. Labor force = (7,000,000)(100-20))/100 = 5,600,000 Labor-force participation rate = (5,600,000)(100))/7,000,000 = 80 percent Unemployed population = ((100-60)(5,600,000))/100 = 2,240,000 Unemployment rate = ((2,240,000)(100))/5,600,000 = 40 percent 130. Is real GDP a better measure of economic well being of a country than nominal GDP? Give an explanation for your answer. Answer: Yes. Nominal GDP is the current price multiplied by the quantity of all the goods and services produced in a country. Real GDP actually measures the total output, i.e. the quantity, not the price. A growth in nominal GDP can be due to increase in quantity or price or both. Real GDP keeps price constant using a base year, so it provides a clearer picture of economic well being. 131. In 2015, John buys a factory built in 2009 and constructs a new storage house within the premises. The transaction of buying the factory is not counted in the GDP, but the construction of the storage house in the same factory is counted in GDP. Why? Answer: The factory was built in the year 2009, so it was already counted in that year’s GDP. The storage house was a new addition in the year 2015, so only it will be considered in the current year’s GDP, and not the whole factory. 132. “GDP as a measurement unit of economic well-being has a flaw which is removed by imputations.” Explain with an example. Answer: Homeowners basically provide themselves with housing services, but because those services are not being sold in the market place, they can't be counted in GDP (unlike rental property, where the rent paid by tenants is income to the landlord, and therefore shows up in GDP). To remove this accounting error in the GDP, such values are added as imputed value. 133. “I like eating mangoes daily, but when their price rises, I switch to mango juice.” Does this statement support the fact that CPI overstates inflation? (Assume mango is included in the goods basket used to calculate the CPI, but the mango juice is not included.) Answer: While calculating CPI, a fixed basket of goods and services is used. But as the statement shows, it is quite possible that when prices rise, people may switch to substitutes which are not accounted for in CPI. This non-adjusting attribute of CPI overstates inflation. 134. Cass was paid $500 in social security from the government. Though it was expenditure made by the government, it is not included in the G component of GDP. Explain why. Answer: Even though the government paid Cass, it did not receive any good or service from Cass in return. This is a transfer payment (a reallocation of existing income). That is why this payment will not be included in the G component of GDP. 135. Bob bought $5000 worth of Adobe Systems stock. This transaction was brokered by John, who received $50 for his help. I think the $5000 should be included in GDP, and the $50 should not be included in GDP. State whether I am right or wrong with an explanation for your answer. Answer: You are wrong. The buying of shares does not contribute anything new to the economy: it is just transferring partial ownership from Adobe to Bob, so it will not be included in GDP. Help provided by John was actually a service, which add to the total output of the economy, and so $50 will be added to the GDP. Chapter 5 104. A classical economist wears a T-shirt printed with the slogan “Fast Money Raises My Interest!” Use the quantity theory of money and the Fisher equation to explain the slogan. ANSWER: According to the quantity theory, if velocity and real output are constant, then increases in the rate of money growth increase the rate of inflation. Fast money increases inflation. Based on the Fisher equation, the nominal interest rate equals the real interest rate plus the rate of inflation. If the real interest rate is constant, the higher inflation (from the faster money growth rate) raises the nominal interest rate. 105. In classical macroeconomic theory, the concept of monetary neutrality means that changes in the money supply do not influence real variables. Explain why changes in money growth affect the nominal interest rate, but not the real interest rate. ANSWER: According to the Fisher equation, the nominal interest rate equals the real interest rate plus the expected rate of inflation. The expected rate of inflation depends on the rate of money growth, so the nominal interest rate depends on the rate of money growth. According to classical macroeconomic theory, the real interest rate adjusts to bring the level of saving and investment (both real variables) into equilibrium without reference to the rate of money growth. 106. Econoland finances government expenditures with an inflation tax. a. Explain who pays the tax and how it is paid. b. What are costs of the tax, assuming the tax rate is expected? ANSWER: a. Holders of money pay the inflation tax, since the purchasing power of their money holdings declines as a result of inflation generated when the government prints more money. b. The inflation tax rate is the rate of inflation. If the inflation (tax) rate is expected, then the costs of expected inflation include shoeleather costs, menu costs, the costs of relative price variability, tax distortions, and the inconvenience of making inflation corrections. 107. If the demand for money depends positively on real income and depends inversely on the nominal interest rate, what will happen to the price level today, if the central bank announces (and people believe) that it will decrease the money growth rate in the future, but it does not change the money supply today? ANSWER: People will expect lower inflation in the future. The nominal interest rate will fall. Money demand will increase. Since the central bank does not immediately decrease the money supply, prices must fall to keep the newly increased money demand equal to the constant money supply. Thus, current prices fall as a result of expected future decreases in money growth rates. 108. Although “inflation is always and everywhere a monetary phenomenon,” explain why: a. the start of a hyperinflation is typically related to the fiscal policy situation, and b. the end of a hyperinflation is usually related to changes in fiscal policy. ANSWER: a. Hyperinflations frequently begin when governments require additional revenue from seigniorage because tax revenue and/or government borrowing is insufficient to cover government spending. The additional seigniorage is obtained by printing money, which leads to hyperinflation. b. Hyperinflations usually end when fiscal policy changes, including tax increases and government spending cuts, are made to eliminate the need for seigniorage and stops the excessive increase in money. 109. Consider two countries, Hitech and Lotech. In Hitech new arrangements for making payments, such as credit cards and ATMs, have been enthusiastically adopted by the population, thereby reducing the proportion of income that is held as real money balances. Over this period no such changes occurred in Lotech. If the rate of money growth and the growth rate of real GDP were the same in Hitech and Lotech over this period, then how would the rate of inflation differ between the two countries? Carefully explain your answer. ANSWER: The rate of inflation would be higher in Hitech. According to the quantity theory, if the rates of money growth and real GDP growth rates are the same, differences in rates of inflation are related to differences in velocity. An increase in velocity leads to a higher rate of inflation, holding other factors constant. In Hitech the reduction in the proportion of income held as real balances (smaller k) is the equivalent of an increase in velocity and, consequently, a higher rate of inflation in Hitech than in Lotech. 110. Interest rates played a part in the 1984 U.S. presidential debates. Some politicians claimed that interest rates rose over the 1981–1983 period, while others claimed rates fell. Below is a table showing interest rates and annual inflation rates from 1981 to 1983. Interest Rate Annual Year (annual %) Inflation Rate 1981 14.03% 10.3% 1982 10.69% 6.2% 1983 8.63% 3.2% Reconcile these conflicting claims. ANSWER: Using the Fisher effect, the nominal interest rate fell from 14 percent to 8.6 percent over the period, but the ex post real interest rate rose from 3.73 percent to 5.43 percent. 111. The costs of expected inflation cause productive resources of an economy to be directed away from their efficient allocation. Explain how each of the following costs of expected inflation distort the allocation of productive resources: a. shoeleather costs b. menu costs c. the inconvenience of a changing price level ANSWER: a. Resources are used to go to the bank and in other activities to reduce cash holding, rather than in producing goods and services. b. Resources are used to update prices on menus, in catalogs, and on other price lists, rather than in producing goods and service. c. Resources are used to specify and compare the value of dollars at different t 112. The quantity equation of money can be re-written as the quantity theory of money when we assume velocity of money (V) to be constant. Assume there are three possible developments: a. There is a rise in the number of shopping malls. b. There is a rise in the number of banks operating. c. There is a rise in the number of ATMs. Which of the above can alter the money velocity, and how? ANSWER: A rise in ATMs can lead to people reducing their average money holding and thereby reducing k of the money demand function. As V=1/k, this can alter velocity V. 113. Assume a simple economy where only burgers are traded. In a year, 100 burgers are traded at the rate of $5 per burger. Assume two scenarios: a. The economy has $100 in the form of 20 pieces of $5 bills. b. The economy has $100 in the form of 100 pieces of $1 bills. Calculate the velocity of money for both situations. ANSWER Velocity of money does not depend on the currency denominations. It is a measure for each unit of money and not the unit of the currency. In this example, the velocity of money V = (PT) / M = (5(100)) / 100 = 5 in both cases. 114. For a country A, the GDP growth rate is 8 percent and inflation is 4 percent. If the velocity of money remains constant, what is the change in real money balances? ANSWER: Percent change in M + percent change in V = percent Change in P + percent change in Y . Here, percent change in V=0. Percent change in M - percent change in P = percent change in Y. Given that the GDP growth rate is 8 percent, the change in real money balances is 8 percent as well. 115. You are presented with the following equation: (1 + r )= (1 + i )/(1 +π). Expand the expression to solve for i. What assumption is required for this expression to be equal to the Fischer equation? ANSWER: On expansion, the equation reads i = r + π +r π. If both r and π are substantially lowered, their product is much lower, such that i= r + π is a good enough approximation 116. If one were to own government bonds or other forms of financial assets, they would earn a real interest rate. Yet, the opportunity cost of holding money is equal to the nominal interest rate. Explain why and how. ANSWER: Holding financial assets would give us returns r. The money we hold earns (– πr) as it loses value due to inflation. The sum total opportunity cost is r – (– πr) = r + πr = i, the nominal interest rate, as per the Fisher equation. 117. The money demand function can be written as L (i, Y). Given the Fisher equation, this means that the money demand function of the population already takes into account inflation (i = r + π). Why do you think people have a problem with inflation? ANSWER: There is a difference between expected inflation and actual inflation rate. In the money demand function, i = r + E π, E π is the expected inflation rate. The real problem is when actual inflation rates do not match expected inflation rates. Thus, variable inflation is the main concern rather than inflation per se. 118. Suppose a government has a tax revenue shortfall. Will hyperinflation inevitably follow unless the government cuts in its fiscal expenditures? ANSWER: No. A government has the option of borrowing money just like any other economic entity. It is only when a government is deemed as a poor borrower and lenders refuse to lend to it that the government is forced to print money to cover its expenses, which might trigger hyperinflation. 119. During inflation, does a rise in shoe leather cost signify change in velocity of money? ANSWER: No. V = Y / (M/P). Only when Y and V are fixed does an increase in M lead to a subsequent rise in P to balance the equation. Conversely, any rise in P is compensated by an equivalent rise in M such that the velocity of money does not actually change. 120. If there are no unexpected changes in money supply in an economy, can there still be unexpected inflation in the economy? ANSWER: Yes. If there are shocks in the real economy affecting the factors of production and production function such that total output Y is affected (say, falls), for a given money supply M and fixed velocity of money V, P will rise leading to unexpected inflation levels. 121. Under high historical inflation rates, can non-indexation of contracts be non-damaging for either party? ANSWER: Yes. The real damage in a case of non-indexed contracts is high variable inflation. Thus, even if expected inflation is high, as long as there is no high variable inflation, non-indexed contracts may be party neutral. Chapter 3 155. In an economy with flexible prices, competitive factor markets and fixed supplies of the factors of production, graphically illustrate the impact of a change in immigration policy in a country that permits a huge influx of foreign workers into the labor market, ceteris paribus. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curve's shift; and v. the terminal equilibrium values. Explain in words how the equilibrium values of labor, the real wage, saving, investment, and the real interest rate change. 155 The supply of labor force increases, which forces the real wage lower and increases the quantity of labor employed, since there is no unemployment in this model. Output (Y) increases as labor increases, national saving (Y – C – G) increases, which makes the equilibrium rate of interest fall to bring national saving and investment into equilibrium. 156. In an economy with flexible prices, competitive factor markets, and fixed supplies of the factors of production, graphically illustrate the impact of an advance in technology that greatly improves the productivity of capital, ceteris paribus. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the terminal equilibrium values. Explain in words how the equilibrium values change. 156. The demand for capital increases, which increases the real rental price of capital, but the quantity of capital employed is unchanged at the level of the fixed supply. 157. In an economy with flexible prices, competitive factor markets, and fixed supplies of the factors of production, graphically illustrate the impact of a deadly virus that kills a large part of the labor force, but leaves the other factors of production untouched, ceteris paribus. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the terminal equilibrium values. Explain in words how the equilibrium values change. 157. The supply of labor decreases, which increases the real wage. All of the reduced labor force is employed. 162. a. Suppose a government moves to reduce a budget deficit. Using the long-run model of the economy developed in Chapter 3, graphically illustrate the impact of reducing a government's budget deficit by reducing government purchases. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction curves shift; and v. the terminal equilibrium values. b. State in words what happens to: i. the real interest rate; ii. national saving; iii. investment; iv. consumption; and v. output. 162. a. b. i. real interest rate decreases ii. national saving increases iii. investment increases iv. consumption is unchanged v. output is unchanged, fixed because it is determined by the factors of production 163. a. Suppose a government moves to reduce a budget deficit. Using the long-run model of the economy developed in Chapter 3, graphically illustrate the impact of reducing a government's budget deficit by increasing (lump-sum) taxes on household income. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction curves shift; and v. the terminal equilibrium values. b. State in words what happens to: i. the real interest rate; ii. national saving; iii. investment; iv. consumption; and v. output. 163. a. b. i. real interest rate decreases ii. national saving increases iii. investment increases iv. consumption decreases v. output is unchanged, fixed because it is determined by the factors of production 164. a. Suppose a government education program succeeds in getting households to save more (you may interpret this as a downward shift in the consumption function). Using the long-run model of the economy developed in Chapter 3, graphically illustrate the impact of the higher saving rate by households. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction curves shift; and v. the terminal equilibrium values. b. State in words what happens to: i. the real interest rate; ii. national saving; iii. investment; iv. consumption; and v. output. 164. a. b. i. real interest rate decreases ii. national saving increases iii. investment increases iv. consumption decreases v. output is unchanged, fixed because it is determined by the factors of production 165. a. Suppose there is a technological breakthrough that increases the productivity of all capital and, consequently, increases the demand for investment. Using the long-run model of the economy developed in Chapter 3, graphically illustrate the impact of the increased investment demand. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction curves shift; and v. the terminal equilibrium values. b. State in words what happens to: i. the real interest rate; ii. national saving; iii. investment; iv. consumption; and v. output. 165. a. b. i. real interest rate increases ii. national saving is unchanged iii. amount of investment is unchanged iv. consumption is unchanged v. output is unchanged, fixed because it is determined by the factors of production 166. a. Suppose a government decides to reduce spending and (lump-sum) income taxes by the same amount. Using the long-run model of the economy developed in Chapter 3, graphically illustrate the impact of the equal reductions in spending and taxes. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction curves shift; and v. the terminal equilibrium values. b. State in words what happens to: i. the real interest rate; ii. national saving; iii. investment; iv. consumption; and v. output. 166. a. b. i. real interest rate decreases ii. national saving increases iii. investment increases iv. consumption increases v. output is unchanged, fixed because it is determined by the factors of production 167. Consider two competitive economies that have the same quantities of labor (L = 400) and capital (K = 400), and the same technology (A = 100). The economies of the countries are described by the following Cobb–Douglas production functions: North Economy: Y = A L.3K.7 South Economy: Y = A L.7K.3 a. Which economy has the larger total production? Explain. b. In which economy is the marginal product of labor larger? Explain. c. In which economy is the real wage larger? Explain. d. In which economy is labor's share of income larger? Explain. 167. a. Output is the same in both economies, given the symmetry of the parameters of the productions function and the equal quantities of labor and capital. b. The MPL is larger in the South Economy. The MPL depends on the value of (1 – ) and the average productivity of labor (Y/L). Since the average productivity of labor is the same in both countries, differences in the MPL depend on the value of (1 – ), which is larger in South Economy (.7) than in North Economy (.3). c. Since factors are paid according to the values of their marginal products, the real wage is larger in South Economy, because the MPL is larger in South Economy than in North Economy (from part b). d. Labor's share of income equals (1 – ), which is larger in South Economy (.7) than in North Economy (.3). 168. Assume that a competitive economy can be described by a constant returns to scale (Cobb–Douglas) production function and all factors of production are fully employed. Holding other factors constant, including the quantity of capital and technology, carefully explain how a one-time, 10-percent increase in the quantity of labor (perhaps the result of a special immigration policy) will change each of the following: a. the level of output produced; b. the real wage of labor; c. the real rental price of capital; d. labor's share of total income. 168. a. Output increases by less than 10 percent because of diminishing returns to labor. b. The real wage decreases because the average productivity of labor decreases (Y/L decreases, as Y increases less in proportion than the increase in L), so the MPL, which equals (1 – )Y/L, decreases. c. The real rental price of capital increases because the average productivity of capital increases (Y/K increases, as Y increases and K is constant), so the MPK, Y/K, increases. d. Labor's share of income is unchanged, since it depends only on the parameter (1 – ) from the production function, which does not change. 169. Assume that a competitive economy can be described by a constant returns to scale (Cobb–Douglas) production function and all factors of production are fully employed. Holding other factors constant, including the quantity of labor and technology, carefully explain how a one-time, 50-percent decrease in the quantity of capital (perhaps the result of war damage) will change each of the following: a. the level of output produced; b. the real wage of labor; c. the real rental price of capital; d. capital's share of total income. 169. a. Output decreases by less than 50 percent because of diminishing returns to capital. b. The real wage decreases because the average productivity of labor decreases (Y/L decreases, as Y decreases and L is constant), so the MPL, which equals (1 – )Y/L, decreases. c. The real rental price of capital increases because the average productivity of capital increases (Y/K increases, as Y decreases proportionally less than K decreases), so the MPK, Y/K increases. d. Capital's share of income is unchanged since it depends only on the parameter () from the production function, which does not change. 170. Consider a competitive economy in which factor prices adjust to keep the factors of production fully employed and the interest rate adjusts to keep the supply and demand for goods and services in equilibrium. The economy can be described by the following set of equations: L = L, K = K , G = G , T = T , Y = AK L(1 – ) Y=C+I+G C = C (Y – T) I = I(r) Suggest at least two policies that a government could use to increase the equilibrium quantity of investment in the economy, and carefully explain how these policies produce this result. 170. The government could cut spending (G), which would increase national saving (Y – C – G), lower the equilibrium interest rate, and produce an increase in the equilibrium quantity of investment. The government could increase taxes (T), which would increase national saving (Y – C – G) by reducing consumption, lower the equilibrium interest rates and produce an increase in the equilibrium quantity of investment. 171. Consider a competitive economy in which factor prices adjust to keep the factors of production fully employed, and the interest rate adjusts to keep the supply and demand for goods and services in equilibrium. The economy can be described by the following set of equations: L = L, K = K , G = G , T = T , Y = AKL(1 – ) Y=C+I+G C = C(Y – T) I = I(r) How does an increase in government spending, holding other factors constant, affect the level of: a. public saving? b. private saving? c. national saving? d. the equilibrium interest rate? e. the equilibrium quantity of investment? 171. a. Public saving equals T – G. An increase in government spending, G, reduces public saving. b. Private saving equals Y – T – C. An increase in government spending does not affect private saving. c. National saving equals Y – C – G. An increase in government spending reduces national saving by an amount equal to the increase in government spending. d. The equilibrium interest rate increases to bring desired investment into equilibrium with the reduced quantity of national saving. e. The equilibrium quantity of investment is reduced via the increase in the interest rate by an amount equal to the increase in government spending. 172. Price flexibility plays a key role in the classical model by ensuring that the markets reach equilibrium. a. Explain which price adjusts to bring equilibrium in the labor market. Describe how the price adjusts when demand exceeds supply in this market. b. Explain which price adjusts to bring equilibrium in the loanable funds market. Describe how the price adjusts when supply exceeds demand in this market. 172. a. The real wage adjusts to make labor demand equal to labor supply. If labor demand is greater than labor supply, the real wage rises, decreasing the quantity of labor demanded until the quantity demanded equals the fixed supply of labor. b. The real interest rate adjusts to make the supply of loanable funds equal to the demand for loanable funds. If the supply of loanable funds is greater than the demand for loanable funds the interest rate will decrease, increasing the desired quantity of investment spending, which is the demand for loanable funds, until the demand and supply are equal. 173. Consider a production function for an economy: Y = 20(L.5K.4N.1) where L is labor, K is capital, and N is land. In this economy the factors of production are in fixed supply with L = 100, K = 100, and N = 100. a. What is the level of output in this country? b. Does this production function exhibit constant returns to scale. Demonstrate by example. c. If the economy is competitive so that factors of production are paid the value of their marginal products, what is the share of total income will go to land? 173. a. 2,000 b. Yes, the production function exhibits constant returns to scale. Doubling each factor of production to 200 will double output to 4,000. c. 10 percent 176. The production of an economy is explained by a function: Y = 20 (L.5K.5) where L is labor and K is capital with L = 400 and K = 400. Does this economy support constant returns to scale? 176. When increase in percentage of output equals the increased percentage of all factors of production it is called constant returns to scale. Here output is 8000 units, so if we double the factors of production, i.e., L = 800 and K = 800, we see that the output becomes 16000 units, double of 8000 units supporting the constant returns to scale. 177. After studying the circular flow of dollars in the economy, explain with an example how saving done by households goes back into the circular flow. In reality, does all saving go back as an investment? 177. According to the circular flow of dollars diagram, households save their money in financial markets and then financial markets lend this money to markets of goods and service for investment. In reality, not all saving is done in the financial markets, some of the money is kept by people to themselves as cash, which does not get converted to investment. 178. Suppose people in an economy reduce their saving. What will be the effect on real interest rate and investment? 178. If households develop a tendency of saving less, there will be less money to lend, so the supply of loanable funds will be less. This will increase the real interest rates r, and due to the increase in r investors will find it more costly to take a loan, so investment will decrease. 180. What effect does advancement in technology have upon the equilibrium between real rental price and capital (assuming supply of capital is fixed)? 180. Provided that the supply of capital is fixed, advancement in technology will increase the demand for capital. But as the supply is fixed, the real rental price will increase. So the new equilibrium will be in same supply amount of capital with increased real rental price. 181. The government of an economy has increased its spending and taxes by the same amount. What is the effect on investment? 181. With increased taxes, people will have less money to consume and save, so there will be reduction in private saving. With increased government spending, public saving will also be reduced. Reduction in both private saving and public saving will lead to a reduction in national saving, and as national saving is equal to investment, this implies a decrease in investment. 182. What is the effect of an increase in interest rate on keeping government spending constant on consumption and investment? 182. With increase in interest rates, firms find taking loans for investments to be more costly, so they will decrease investments. And households start looking to saving as a better option than consuming, so consumption will decrease Chapter 4 101. Assume that the monetary base (B) is $100 billion, the reserve–deposit ratio (rr) is 0.1, and the currency–deposit ratio (cr) is 0.1. a. What is the money supply? b. If rr changes to 0.2, but cr is 0.1 and B is unchanged, what is the money supply? c. If rr is 0.1 and cr is 0.2, but B is unchanged, what is the money supply? 101. a. The money supply is $550 billion. b. The money supply is $366.67 billion. c. The money supply is $400 billion. 102. As the U.S. economy approached the millennium, January 1, 2000, many people cautiously began to hold larger than normal quantities of currency as protection against a possible disruption of banking services that could result from computer glitches. a. How did this greater preference for currency affect the money supply? b. How could the Federal Reserve offset such an increase in currency preferences? 102. a. The greater preference for currency increased the currency–deposit ratio, which reduced the money multiplier and reduced the money supply for a given monetary base. b. The Fed could engage in open-market purchases to increase the monetary base to offset the decline in the money multiplier. (Reducing the discount rate and reducing reserve requirements could theoretically achieve the same outcome but are not as practical). 103. The Federal Reserve's tools to control the money supply include: open-market operations, the discount rate, and interest payments on reserves. a. How should each instrument be changed if the Fed wishes to decrease the money supply? b. Will the change affect the monetary base and/or the money multiplier? 103. a. The Fed would conduct open-market sales, raise the discount rate, and raise interest paid on reserves. b. Open-market operations and discount rate changes affect the monetary base. Changing interest payments on reserves alters the money multiplier. 104. Some economists have advocated replacing government deposit insurance with 100percent- reserve banking. Under this plan, banks would hold all deposits as reserves. Deposit insurance would no longer be necessary, because banks would always have the reserves to meet customer withdrawals. a. What would happen to the money supply (defined as currency and bank deposits) in the transition from fractional-reserve to 100-percent-reserve, if this plan were implemented, holding other factors constant? b. What will be the value of the money multiplier? 104. a. In the process of moving from fractional-reserve to 100-percent-reserve banking, the money supply would have to contract if the monetary base remained unchanged. Deposits will have to contract to equal the quantity of reserves. b. The money multiplier equals 1= [(1 + cr)/(1 + cr)]. 105. Why does the Federal Reserve not have complete control over the size of the money supply? Give at least two reasons. 105. For a given monetary base, controlled by the Federal Reserve, the money supply also depends on: (1) the amount of currency the public chooses to hold relative to deposits, and (2) the amount of reserves that banks choose to hold relative to deposits. Therefore, actions of both the public and banks influence the size of the money supply in addition to the actions of the Fed. 106. Construct a bank balance sheet with the following items: reserves, deposits, loans, securities, capital, and debt. Choose values so that the reserve–deposit ratio is 10 percent and the leverage ratio is 10. Give an example of a change in asset values that would push bank capital to zero. What happens when bank capital is gone? 106. Many values are possible in the balance sheet, but (1) assets should equal liabilities and net worth, (2) items should be correctly categorized as assets or liabilities, (3) the ratio of reserves to deposits should be 10 percent, and (4) the ratio of assets to capital should be 10, as in the example below. If asset values fall by 10 percent of total assets (for example, if loans fall from 100,000 to 85,000 in the example below), then capital equals zero. When capital is exhausted, the bank will not have sufficient resources to pay off depositors or debt holders if there is a further decline in asset values. Bank Balance Sheet Assets Liabilities & Net Worth Reserves $ 10,000 Deposits $100,000 Loans 100,000 Debt 35,000 Securities 40,000 Capital 15,000 107. As the 2008–2009 financial crisis unfolded, one major U.S. bank had a leverage ratio of 54. In Canada regulators put a ceiling on bank leverage ratios of 20. Compare the change in asset values that would push the capital in the U.S. bank to zero with the change required to eliminate capital in a Canadian bank at the ceiling-leverage ratio. What is the implication of the differences in maximum leverage ratios for the stability of the banking system? 107. With a leverage ratio of 54, a 1.85 percent fall in asset values wipes out capital, while with a leverage ratio of 20, a 5 percent fall in asset values wipes out capital. The higher leverage ratio of the U.S. bank makes it much more susceptible to losing capital and being unable to pay off depositors. The higher leverage ratio puts the U.S. system at greater risk for bank runs, bank failures, and greater instability. 108. Economists occasionally speak of “helicopter money” as a short-hand approach to explaining increases in the money supply. Suppose the Chairman of the Federal Reserve flies over the country in a helicopter dropping 10,000,000 in newly printed $100 bills (a total of $1 billion). By how much will the money supply increase if, holding everything else constant: a. all of the new bills are held by the public? b. all of the new bills are deposited in banks that choose to hold 10 percent of their deposits as reserves (and no one in the economy holds any currency)? c. all of the new bills are deposited in banks that practice 100-percent-reserve banking? d. people in the economy hold half of their money as currency and half as deposits, while banks choose to hold 10 percent of their deposits as reserves? 108. a. $1 billion; b. $10 billion; c. $1 billion; d. $5.5 billion 109. A macroeconomist threatens to call the Secret Service to have Mr. Biggy Rich arrested for counterfeiting because Mr. Rich claims he “makes a lot of money.” a. Carefully explain why the macroeconomist is making this threat based on the macroeconomic definition of money. Be sure to explain the macroeconomic functions of money. b. Suggest an alternative phrase that Mr. Rich can use that will not result in a charge of counterfeiting. 109. a. Money consists of the assets used to make transactions. Money serves as a store of value, unit of account, and medium of exchange. In most fiat money economies, the government maintains a monopoly over the supply of money. If Mr. Rich is “making money,” i.e., increasing the supply of money, this is counterfeiting and is illegal. b. Mr. Rich could say he “earns a large income,” or “is very wealthy,” or “has a lot of money,” or “makes big profits.” 110. Explain at least three factors that will affect the quantity of reserves that a bank wishes to hold. 110. Banks' demand for reserves will be affected by: (1) legal reserve requirements, (2) the size and regularity of customer deposits and withdrawals, (3) the interest rate paid on reserves relative to alternative bank investments, and (4) the number of bank failures and level of uncertainty in the economy. 111. The development of fiat money is quite perplexing, as people began to value something that is intrinsically useless. Explain why fiat money came into use. 111. Fiat money fulfills all the three purposes of money better than other types of money. Fiat money provides a store of value, i.e. it can be stored to be used in future. It has a unit of account, e.g., dollar, euro, etc. And it is a widely accepted medium of exchange. 112. John withdraws $100 from his checking account and deposits it in his saving account. What will be the effect of this transaction on different measures of money, i.e. C, M1, and M2? 112. Checking accounts are included in M1 and M2, but not in C. Saving accounts are included only in M2. So this transaction will have no effect on C and M2, but M1 will be reduced by $100. 113. How do credit card transactions affect the measurement of money? 113. When a credit card is used, there is no actual payment made by the credit card holder at the moment, since this payment is deferred. So this transaction does not affect any measure of money. Only when a credit card payment is made to the bank is the transaction included in different measures of money. 114. The monetary base of Moneyland is $500 million. The current-deposit ratio (cr) is 0.2 and reserve-deposit ratio (rr) is 0.2. Calculate the money multiplier and money supply. 114. Money multiplier = (1 + cr) / (rr + cr) = 1.2/0.4 = 3 Money supply = money multiplier x monetary base Money supply = (3)(500) = $1500 million 115. How much effect do the purchase and sale of bonds through open-market operations have on the money supply? 115. When the Federal Reserve purchases bonds through open-market operations, it increases the monetary base and the money supply, while the selling of the bonds to the public decreases the monetary base and money supply. 116. “Some economists believe that the large decline in the money supply was the primary cause of the Great Depression of the 1930s.” Explain how this can be the case. 116. Banks defaulted on their deposits. This caused current-deposit ratios to fall, and hence there was a reduction in the money multiplier. So, despite the increase in the monetary base, the money supply was reduced further, making the depression worse. 117. Why can the Federal Reserve not control the money supply with complete accuracy? 117. The Federal Reserve cannot completely control the money supply because it has no control on how much money the public will hold as currency and not deposit in banks. Another reason is that it cannot control how much reserve banks will keep against the deposits they have. 118. What is the effect of the following on the money supply? a. Increase in currency-deposit ratio, keeping all other things constant b. Decrease in reserve-deposit ratio, keeping all other things constant 118. a. This will decrease the money multiplier and so the money supply will also decrease. b. This will increase the money multiplier and so the money supply will also increase. 119. The table below represents the balance sheet of a bank. What is the leverage ratio of the bank, and what does it mean? Assets Reserves Loans Securities Liabilities and Owners’ Equity 500 Deposits 1400 1000 Debt 400 500 Owners' equity 200 119. Leverage ratio = Total assets / capital (owner’s equity) = 2000/200 = 10 This means that for the contribution of every dollar by the bank owner, nine dollars are contributed through deposits and debts. 120. The Federal Reserve wants to increase the money supply by printing and distributing 1 million dollars worth of currency notes. What will be the actual increase in money supply if the public holds one fourth of the currency as cash, and deposits rest of the money in banks that hold 5 percent of their deposits as reserves? 120. Money multiplier = 1 / reserve-deposit ratio = 1/.05 = 20. As 0.25 million will be held by the public and 0.75 million will be deposited in the bank, the money deposited in banks will increase the money supply by ((.75)(20))($5 million). The net increase in money supply will be = .25 + 15 = $15.25 million.
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Chapter 1
57. Answer: Recession occurs due to a mild fall in the GDP on an economy. Over the period
that GDP experiences an intense fall, this results in a depression. Recession repeats itself
regularly adding to its cyclic nature. The Great Depression that happened to the U.S. in
1930 is a well-known example of a depression that affected the global economy. The
2008-2009 financial crisis was reminiscent compared to it.
58. Answer: A recession in country A was occurred in 2003 and had it earlier recovery in
2004. Country B had two recessions. The first started in 2002, and its early recovery was
2003 while the second was in 2007.
59. Answer: The historical records of diverse economies if essential for the study of
macroeconomics. The analysis of this data is done by macroeconomists in order to
explain changes in income, unemployment, product prices, etc. as well as formulate
policies. Macroeconomists are much like weather forecasters, and therefore the studies
they conduct cannot be done n controlled experiments like in chemistry or biology.
60. Yes, they both symbolize a similar notion which is a balance between demand and
supply. At this point, the balanced outcome implies that everything being produced
fulfills the demand as long as everything else remains constant.
61. Answer: Macroeconomics involves studying cumulative variables of the economy that
relate to the parameters of an individual’s decision making, which are microeconomic.
Therefore, the total individual investments from firms in an economy or the total
expenditure by all consumers in an economy amount to the total investments and
expenditure of that economy respectfully. This implies that microeconomics is the basis
of macroeconomics.
62. An example of a microeconomic variable is the income of your father while the county’s
macroeconomic variable is the gross domestic product. Your father’s savings in a bank is
a microeconomic variable while the total savings in all banks of a country is the
macroeconomic variable.
64. An equilibrium is brought by adjustments immediate changes and flexible prices between
the demand and supply. The correction is delayed by sticky prices because of their
adherence to scheduled levels.
65. The economic variable assumed to be given the exogenous variable. In the graphs below,
the consumers’ income in graph 1 and materials prices in graph 2 are considered to be
provided.
Changes in consumer income affect the market.
In graph 1, the demand curve is shifted upward by an increase in income, i.e., from D1 to
D2, a Q1 to Q2 for an increase in quantity as well as a P1 to P2 rise in prices.

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The cost of materials in graph 2 is the exogenous variable. The supply is reduced f...


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