Unit III Answers to Extra Practice Questions

CHAPTER 9
1. Define the consumption and saving schedules.

The consumption schedule shows the relationship between the consumption

and disposable income. Graphically this relationship is illustrated with
consumption measured on the vertical axis and disposable income measured
on the horizontal axis. If the two were equal, the relationship would follow a
straight line along the 45-degree line. However, historical data suggest that it is
a direct relationship, and that households spend a larger proportion of a small
income than of a large disposable income. In other words, consumption falls as
a proportion of income as disposable income increases.

Since saving is the difference between disposable income and consumption

spending, the saving schedule also shows a direct relationship between saving
and disposable income. Graphically, it is depicted with saving on the vertical
axis and disposable income measured on the horizontal axis. At very low
income levels, dissaving is believed to occur and saving increases proportionally
as income rises. [text: E pp. 152-153; MA pp. 152-153]

2. Explain how consumption and saving are related to disposable income in the
aggregate expenditures model.

Consumption and saving are directly related to disposable income in the

aggregate expenditures model. Consumption is positively related to disposable
income, but is a proportionally greater part of low income than of high income.
In fact, at very low income levels it is probable that consumption exceeds
income.

Since saving is income not spent, it is also directly related to income and will be
an increasing proportion of income as income rises. At very low levels of
income when consumption exceeds income, saving will be negative or
dissaving occurs. [text: E pp. 152-153; MA pp. 152-153]
3. Complete the following table assuming that (a) MPS = 1/5, (b) there is no
government and all saving is personal saving.

Level of output

and income Consumption Saving

$250 $260 $___

275 ____ ___

300 ____ ___

325 ____ ___

350 ____ ___

375 ____ ___

400 ____ ___

Level of output

and income Consumption Saving

$250 $260 $–10

275 280 –5

300 300 0

325 320 5

350 340 10

375 360 15

400 380 20

[text: E pp. 152-156; MA pp. 152-156]

4. Complete the following table assuming that (a) MPS = 1/3, (b) there is no
government and all saving is personal saving.

Level of output

and income Consumption Saving

$100 $120 $___

130 ____ ___

160 ____ ___

190 ____ ___

220 ____ ___

250 ____ ___

Level of output

and income Consumption Saving

$100 $120 $–20

130 140 –10

160 160 0

190 180 10

220 200 20

250 220 30

[text: E pp. 152-156; MA pp. 152-156]

5. Differentiate between the average propensity to consume and the marginal

propensity to consume.
 The average propensity to consume is defined as the relationship between the
amount consumed relative to the level of income; it is (consumption) /
(income). The marginal propensity to consume is a measure relating the
change in consumption resulting from a change in income to that change in
income; it is (change in consumption) / (change in income). [text: E pp. 154-
157; MA pp. 154-157]

6. What are the marginal propensity to consume (MPC) and marginal propensity
to save (MPS)? How are the two concepts related? How are the two concepts
related to the consumption and saving functions?

The marginal propensity to consume is the ratio of a change in consumption to

the change in income which caused that change in consumption. The
marginal propensity to save is the ratio of the change in saving to the change in
income which caused that change in saving. The sum of the MPC and MPS for
any change in disposable income must always equal 1 because any fraction of
a change in income which is not consumed is saved. The MPC is the numerical
value of the slope of the consumption schedule and the MPS is the numerical
value of the slope of the saving schedule. [text: E pp. 156-157; MA pp. 156-157]

7. Suppose a family’s annual disposable income is $8,000 of which it saves $2,000.

(a) What is their APC?

(b) If income rises to $10,000 and they plan to save $2,800, what are MPS and
MPC?

(c) Did the family’s APC rise or fall with their increase in income?

(a) APC = .75.

(b) MPS = .4; MPC = .6.

(c) APC fell to .72. [text: E pp. 153-157; MA pp. 153-157]

8. Complete the accompanying table.

Level of output

and income

(GDP = DI) Consumption Saving APC APS MPC MPS

$480 $___ $–8 ____ ____ ___ ___

520 ___ 0 ____ ____ ___ ___

560 ___ 8 ____ ____ ___ ___

600 ___ 16 ____ ____ ___ ___

640 ___ 24 ____ ____ ___ ___

680 ___ 32 ____ ____ ___ ___

720 ___ 40 ____ ____ ___ ___

760 ___ 48 ____ ____ ___ ___

800 ___ 56 ____ ____ ___ ___

(a) Using the below graphs, show the consumption and saving schedules
graphically.

(b) Locate the break-even level of income. How is it possible for households
to dissave at very low income levels?

(c) If the proportion of total income consumed decreases and the proportion
saved increases as income rises, explain both verbally and graphically how the
MPC and MPS can be constant at various levels of income.

Level of output

and income

(GDP = DI) Consumption Saving APC APS MPC MPS

$480 $488 $–8 1.02 –0.2 0.8 0.2

 520 520 0 1.00 0.0 0.8 0.2

560 552 8 0.99 0.1 0.8 0.2

600 584 16 0.99 0.3 0.8 0.2

640 616 24 0.96 0.4 0.8 0.2

680 648 32 0.95 0.5 0.8 0.2

720 680 40 0.94 0.6 0.8 0.2

760 712 48 0.94 0.6 0.8 0.2

800 744 56 0.93 0.7 0.8 0.2

(a) See graphs below.

(b) The break-even level of income is 520 where saving equals zero.
Households dissave by borrowing or by dipping into accumulated savings. [text:
E pp. 153-155; MA pp. 153-155]

(c) The MPC and MPS represent the slopes of the consumption and savings
schedules respectively. The fact that MPC and MPS are constant means that
the schedules will be straight-line graphs. However, the slope can be constant
and still not be a constant proportion of income as represented on the
 horizontal axis. In fact, the only time the MPC and the APC would be the same
would be along lines emanating from the origin.

[text: E pp. 154-155; MA pp. 154-155]

9. Complete the accompanying table.

Level of output

and income

(GDP = DI) Consumption Saving APC APS MPC MPS

$100 $___ $–5 ____ ____ ___ ___

125 ___ 0 ____ ____ ___ ___

150 ___ 5 ____ ____ ___ ___

175 ___ 10 ____ ____ ___ ___

200 ___ 15 ____ ____ ___ ___

225 ___ 20 ____ ____ ___ ___

250 ___ 25 ____ ____ ___ ___

275 ___ 30 ____ ____ ___ ___

300 ___ 35 ____ ____ ___ ___

(a) What is the break-even level of income? How is it possible for households
to dissave at very low income levels?

(b) If the proportion of total income consumed decreases and the proportion
saved increases as income rises, explain how the MPC and MPS can be
constant at various levels of income.

Level of output

and income
 (GDP = DI) Consumption Saving APC APS MPC MPS

$100 $105 $–5 1.05 –.05 0.8 0.2

125 125 0 1.00 .00 0.8 0.2

150 145 5 0.97 .03 0.8 0.2

175 165 10 0.94 .06 0.8 0.2

200 185 15 0.925 .075 0.8 0.2

225 205 20 0.91 .09 0.8 0.2

250 225 25 0.90 .10 0.8 0.2

275 245 30 0.89 .11 0.8 0.2

300 265 35 0.88 .12 0.8 0.2

(a) The break-even level of income is 125 where saving equals zero.
Households dissave by borrowing or by dipping into accumulated savings. [text:
E pp. 152-155; MA: pp. 153-155]

(b) The MPC and MPS represent the slopes of the consumption and savings
schedules, respectively. The fact that MPC and MPS are constant means that
the schedules will be straight-line graphs. However, the slope can be constant
and still not be a constant proportion of income as represented on the
horizontal axis. In fact, the only time the MPC and the APC would be the same
would be along the 45-degree line where the slope is equal to 1 and the ratio of
spending to income is equal to 1 at all levels.

[text: E pp. 153-155; MA pp. 153-155]

10. List five factors that could shift the consumption schedule.

Shifts in the consumption schedule could be caused by any of the nonincome

determinants of consumption and saving. This includes changes in any of the
following: wealth, expectations, real interest rates, household debt, and
taxation. [text: E pp. 156-157; MA pp. 156-157]

11. What is the effect of increase in wealth on the consumption and saving schedules?
 When wealth increases, it shifts the consumption schedule upward as people consume more at each level
of disposable income. There is an opposite effect on saving. The saving schedule shifts downward at
each level of disposable income because people save less. [text: E pp. 156-157; MA pp. 156-157]

New 12. (Consider This) What is a reverse wealth effect? Why did it not have much of an effect on the U.S.
economy during the stock market bubble in the 2000–2002 period?

A reverse wealth effect occurs when there is a significant drop in consumer wealth that will shift the
consumption schedule downward. Even though there was a significant loss of consumer wealth in the
U.S. stock market decline of 2000–2002, there was little or no reverse wealth effect—consumption
spending stayed relatively stable. The reason for this outcome was that there were offsetting factors that
keep consumption spending high even as the stock of wealth declined. Consumer spending was little
affected by the decline in the stock of wealth. These offsetting factors included the flow of income, which
remained high, tax cuts that boosted consumer spending, and lower interest rates. [text: E p. 159; MA p.
159]

13. Other things being constant, what will be the effect of each of the following on
disposable income (or GDP)?

(a) An increase in the amount of liquid assets consumers are holding

(b) A sharp rise in stock prices

(c) A rapid upsurge in the rate of technological advance

(d) A sharp increase in the real interest rate

(a) This should increase disposable income because an increase in consumer

wealth would lead to an increase in consumer spending which would shift the
consumption schedule upward to a higher equilibrium output level.

(b) The probable effect of a sharp rise in stock prices would be to increase
shareholder purchases as a result of a rise in wealth, thus shifting the
consumption schedule upward and increasing the equilibrium level of GDP. It
also could encourage business investment with funds gained by issuing new
shares of stock at the now higher prices. This would also tend to increase GDP.

(c) This should increase GDP because of the impact on new investment
spending and possible increased consumer purchases of goods having the new
technology. The consumption schedule will shift upward and real quantity will
rise.
 (d) A sharp increase in the real interest rate would limit consumer durables
purchases and also limit investment spending. Both of these events would
cause a downward shift in the consumption schedule causing a decrease in
GDP. One could even argue that higher real interest rates raise production
costs and shift the aggregate supply curve leftward as well, further leading to
the GDP decline. [text: E pp. 156-158; MA pp. 156-158]

14. Explain the difference between a movement along the consumption schedule
and a shift in the consumption schedule.

A movement from one point to another on the consumption schedule is a change in the amount consumed.
It is caused solely by a change in disposable income. By contrast, a shift in the consumption schedule is
the result of a change in one of the nonincome determinates of consumption such as a change in wealth,
expectations, taxation, or household debt. If a household decided to consume more at each level of
disposable income, the consumption schedule will shift upward. [text: E pp. 157-158; MA pp. 157-158]

15. Use the graphs below to answer the following questions:

(a) What types of schedules do graphs A and B represent?

(b) If in graph A line A2 shifts to A3 because households consume more and

this change is not due to changing taxes, then in graph B, what would happen
to line B2?

(c) If in graph B, line B2 shifts to B1 because households save less, then in graph
A, what will happen to line A2?

(d) In graph A, what has caused the movement from point A to point B on
line A2?

(e) If there is a lump-sum tax increase causing line A2 to shift to A1, then in
 graph B, what will happen to B2?

(a) Graph A represents the consumption schedule and B represents the

saving schedule.

(b) If consumption rises at each level of income, then saving must decline at
each level so B2 will shift down.

(c) The situation is the reverse of part (b). Line A2 would rise if B2 falls.
Consumption rises when saving falls.

(d) Since it is a movement along the curve rather than a shift in the curve, the
level of disposable income must have increased.

(e) A tax increase will lower both consumption and saving schedules
because disposable income has been reduced at each level of output. [text: E
pp. 157-158; MA pp. 157-158]

16. Describe the relationship shown by the investment demand curve.

The investment demand curve relates investment to the real rate of interest and
the expected rate of return. Graphically the interest rate and expected rate of
return are measured on the vertical axis and the amount of investment is
measured on the horizontal axis. The investment demand curve has a negative
slope reflecting the inverse relationship between the interest rate (the price of
investing) and the aggregate quantity of investment goods demanded. [text: E
pp. 159-161; MA pp. 159-161]

17. Use the following data to answer the questions.

Cumulative amount

Expected rate of investment

of return (billions)
 11% $55

10 75

8 90

5 105

3 150

1 190

(a) Explain why this table is essentially an investment demand schedule.

(b) If the interest rate was 8%, how much investment would be undertaken?

(c) Why is there an inverse relationship between the rate of interest and the
amount of investment?

(a) The investment demand schedule gives the amount of investment that
would be undertaken at various rates of interest. The rate of interest that an
investor would be willing to pay for any amount of investment will not exceed its
expected rate of net profit. Therefore, the expected rate of profit determines
the interest rate (or price) that investors would be willing to pay for various
amounts of investment and this is the definition of an investment demand
schedule.

(b) $90 billion

(c) The inverse relationship stems from the equality of the expected rate of
profit with the interest rate at each level of investment as explained in part (a).
There are fewer types of investment that yield a large expected net profit and
more and more investments that will yield a lower rate of return. Therefore, at
high rates of interest there is a smaller amount of investment that will be
undertaken because fewer investments yield an expected return high enough
to cover the high interest rate. As the rate declines, more and more investments
will yield enough return to cover the lower rates of interest.

[text: E pp. 159-161; MA pp. 159-161]

18. What is the investment-demand curve?

 The investment-demand curve shows the relationship between the real interest
rate and the level of investment spending. The relationship is an inverse one—
the lower the interest rate, the greater the investment spending—which means
that the investment-demand curve is downsloping. This curve can also be
shifted by five factors that can change the expected rate of return on
investment. [text: E pp. 159-161; MA pp. 159-161]

19. List five events that could cause a shift in the investment demand curve.

Five events would result from changes in the determinants of investment

demand. For example, changes in the price, cost of operation, or
maintenance of particular investment goods could cause the curve to shift;
changes in business taxes favoring or penalizing investment could cause it to
shift; a technological change favoring new investment could cause a shift;
changes in the stock of capital goods on hand will cause the existing demand
curve to shift; and changing expectations about future profits from investment
would have an effect. [text: E pp. 161-162; MA pp. 161-162]

20. State four factors that explain why investment spending tends to be unstable.

Investment spending is based to a large extent on expectations about future

profitability and this can vary significantly from period to period. Technological
changes affect investment spending and these changes are not predictable in
their timing. Investment goods tend to be long lasting and “lumpy” in nature;
that is, once a capital good is purchased it lasts a long time and the
expenditure will not be repeated on a frequent, regular basis. Furthermore, this
type of expenditure is usually large, so any changes tend to be substantial on a
firm-by-firm basis. Expectations and profits are both highly variable. Actual
profits may not meet expectations and this can affect expectations in the
future. Expectations are also based on many different external factors. [text: E
pp. 162-164; MA pp. 162-164]
21. Compare the determinants of consumption with investment. Most economists
regard investment as being less stable than consumption. Looking at the
determinants of each factor, support this contention.

The nonincome determinants of the consumption schedule are consumer

wealth, expectations, real interest rates, household debt, and taxation. The
determinants of investment are price of investment goods and their
maintenance and operating costs, business taxes, technological change, stock
of capital goods on hand, and expectations. Comparing the two lists there are
some similarities. For example, both include expectations, related price levels,
and relevant taxes. However, the technological change and the stock of
capital goods on hand have no analogy in the consumption determinants.

These latter two determinants of investment support the contention of

economists that the investment schedule is more unstable than the
consumption schedule. Technological change is difficult to predict and
certainly its impact would vary depending on the extent of the change. The
stock of capital goods on hand is a result of previous investment and because
of the nature of most capital goods, they can be made to last for a long period
of time. Once new capital spending occurs, it is “lumpy” in the sense that it will
not be repeated gradually, but only again when the particular capital good
wears out or becomes obsolete. Only the durable goods component of
consumption is similar, but most of consumer spending is of the more immediate
type such as nondurable goods and services which are primarily related to
income and would not vary greatly from period to period for most consumers.

The basic determinant of consumption is the level of income, but nonincome

factors include wealth, expectations, real interest rates, household debt, and
taxation. Aside from a drastic change in government tax or transfer policies,
the consumption schedule is quite stable. That is, changes in disposable
income are accompanied by predictable changes in consumption spending.
Furthermore the other factors are quite diverse and tend to be self-canceling
across the population.

The two basic factors determining the level of investment spending are the
expected rate of return and the real interest rate. Since the former is based on
 expectations and the latter based to a large extent on monetary policy, there is
potential for wide variation. Add to this the fact that investment goods are
usually quite durable, and new investment can be postponed depending on
expectations, or once it is made there will be a period of time before the new
capital goods will need to be replaced. Also the fact that innovations occur
irregularly leads to the inability to plan for gradual investment in innovative
technology. Finally, actual current profits are often not as expected, so
businesses can be expected to shift their investment plans from year to year.
[text: E pp. 156-164; MA pp. 156-164]

New22. Whenever there is change in spending real GDP will change by a multiple of the
initial change in spending. Explain this multiplier effect.

The economy is characterized by repetitive, continuous flows of expenditures

and income through which dollars spent by one group are received as income
by another group. Any change in spending will cause a chain reaction where a
group whose income changes because of the spending change will in turn
have a new level of spending which reflects their new level of income. When
their spending increases or decreases, another group will find its income
affected. Their spending will change by a fraction of that amount and so on.
The end result of the initial change in spending will be several rounds of changes
in income and spending so that the final impact on the economy’s GDP is a
multiple of the original change in spending. [text: E pp. 164-165; MA pp. 164-
165]

New23. Define the multiplier. How is it related to real GDP and the initial change in
spending? How can the multiplier have a negative effect?

The multiplier is simply the ratio of the change in real GDP to the initial change in
spending. Multiplying the initial change in spending by the multiplier gives you
the amount of change in real GDP. The multiplier effect can work in a positive
or a negative direction. An initial increase in spending will result in a larger
increase in real GDP, and an initial decrease in spending will result in a larger
decrease in real GDP. [text: E p. 164; MA p. 164]

New 24. What are two key facts that serve as the rationale for the multiplier effect?

First, the economy has continuous flows of expenditures and income in which income received by one
person comes from money spent by another person who in turn receives income from the spending of
 another person, and so forth. Second, any change in income will cause both consumption and saving to
vary in the same direction as the initial change in income, and by a fraction of that change. The fraction of
the change in income that is spent is called the marginal propensity to consume (MPC). The fraction of
the change in income that is saved is called the marginal propensity to save (MPS). The significance of
the multiplier is that a small change in investment plans or consumption-saving plans can trigger a much
larger change in the equilibrium level of GDP. [text: E pp. 164-165; MA pp. 164-165]

New25. Explain the economic impact of an increase in the multiplier.

The multiplier magnifies the fluctuations in economic activity initiated by

changes in investment spending, net exports, government spending, or
consumption spending. The larger the multiplier the greater will be the impact
of any changes in spending on real GDP. [text: E pp. 164-166; MA pp. 164-166]

New26. What is the relationship between the multiplier and the marginal propensities?

The multiplier is directly related to the marginal propensities. By definition, the

multiplier is related to the marginal propensity to save because it equals 1/MPS.
Thus, the multiplier and the MPS are inversely related. The multiplier is also
related to the marginal propensity to consume because it also equals 1/ (1–
MPC). [text: E p. 166; MA p. 166]

New 27. Describe the relationship between the size of the MPC and the multiplier. How does it compare to the
relationship between the size of the MPS and the multiplier?

The size of the MPC and the multiplier are directly related. The size of the MPS and the multiplier are
inversely related. In equation form, the multiplier = 1 / MPS, or the multiplier = 1/ (1–MPC). [text: E p.
166; MA p. 166]

New 28. Calculate the multiplier when the MPC is .5, .75, .90. What is the relationship between MPC and the
multiplier?

When MPC = .5, the multiplier is 2. When MPC = .75, the multiplier is 4. When MPC = .90, the
multiplier is 10. The relationship between MPC and the multiplier is direct. As the MPC increases, so
does the multiplier [multiplier = 1/ MPC]. [text: E p. 166; MA p. 166]

New 29. Calculate the multiplier when the MPS is .5, .25, .10. What is the relationship between MPS and the
multiplier?

When MPS = .5, the multiplier is 2. When MPS = .25, the multiplier is 4. When MPS = .10, the
multiplier is 10. The relationship between MPS and the multiplier is inverse. As the MPS decreases, so
the multiplier increases [multiplier = 1/ (1-MPS)]. [text: E p. 166; MA p. 166]
New30. How large is the actual multiplier?

The basic multiplier (1/MPS) in the text reflects only the leakage of income into
saving. There can also be other leakages of income from taxes or imports. It is
better to think of the denominator for the multiplier in more general terms as
“the fraction of the change in income which leaks or is diverted from the
income stream.” When all these leakages—saving, taxes, and import
spending—are added to the denominator of the multiplier, they reduce the size
of the multiplier effect. [text: E pp. 166-167; MA pp. 166-167]

New 31. (Last Word) Describe the events “Squaring the Economic Circle” and explain how they illustrate the
multiplier.

Humorist Art Buchwald illustrates the multiplier with this funny essay that shows how the effect of one
economic event on one party has an effect on a second party. These effects on the second party, in turn,
have an effect on a third party, and so forth, creating a ripple throughout the economy. These related and
multiple effects serve to illustrate the multiplier.

Hofberger, a Chevy salesman in Tomcat, VA, called up Littleton of Littleton Menswear & Haberdashery,
and told him that a new Nova had been set aside for Littleton and his wife. Littleton said he was sorry, but
he couldn’t buy a car because he and Mrs. Littleton were getting a divorce. Soon afterward, Bedcheck the
painter called Hofberger to ask when to begin painting the Hofbergers’ home. Hofberger said he couldn’t,
because Littleton was getting a divorce, not buying a new car, and, therefore, Hofberger could not afford
to paint his house. When Bedcheck went home that evening, he told his wife to return their new television
set to Gladstone’s TV store. When she returned it the next day, Gladstone immediately called his travel
agent and canceled his trip. He said he couldn’t go because Bedcheck returned the TV set because
Hofberger didn’t sell a car to Littleton because Littletons are divorcing. Sandstorm, the travel agent, tore
up Gladstone’s plane tickets, and immediately called his banker, Gripsholm, to tell him that he couldn’t
pay back his loan that month. When Rudemaker came to the bank to borrow money for a new kitchen for
his restaurant, the banker told him that he had no money to lend because Sandstorm had not repaid his
loan yet. Rudemaker called his contractor, Eagleton, who had to lay off eight men. General Motors
announced it would give a rebate on its new models. Hofberger called Littleton to tell him that he could
probably afford a car even with the divorce. Littleton said that he and his wife had made up and were not
divorcing. His business, however, was so lousy that he couldn’t afford a car now. His regular customers,
Bedcheck, Gladstone, Sandstorm, Gripsholm, Rudemaker, and Eagleton had not been in for over a month.
[text: E p. 167; MA p. 167]

CHAPTER 10
New 1. What are the simplifications used in this chapter?

The chapter first assumes that there is a “closed” private economy with no international trade. The chapter
then turns to an economy with international trade, or an “open” private economy. Finally, government is
included in the final sections of the chapter. When government is included, then the economy will be a
mixed economy with both public and private sectors and also an open economy. [text: E p. 172; MA p.
172]
New 2. What is the difference between the investment-demand curve and the
investment schedule for the economy?

The investment-demand curve shows the relationship between the real interest
rate and the level of investment spending. The relationship is an inverse one—
the lower the interest rate, the greater the investment spending—which means
that the investment-demand curve is downsloping. This curve can also be
shifted by five factors that can change the expected rate of return on
investment.

The investment decisions of individual firms can be aggregated to construct an

investment schedule. It shows the amount business firms collectively intend to
invest at each possible level of GDP. A simplifying assumption is also made that
investment is independent of GDP, so the investment schedule is graphed as a
horizontal line across the possible levels of real GDP. [text: E pp. 172-173; MA pp.
172-173]

New 3. Define the equilibrium level of output.

The equilibrium level of output is the level of output whose production will
create total income and spending which is just sufficient to purchase that
output. [text: E pp. 173-174; MA pp. 172-173]

New 4. Whenever there is change in spending, there will be a change in real GDP.
Explain why this is so.

A shift in the investment schedule and/or the consumption schedule indicates

that aggregate expenditures have changed. Therefore, the new aggregate
expenditures level will not be equal to the original level of aggregate output.
Real GDP must expand or contract until aggregate expenditures and
aggregate output are once again equal at a new equilibrium. [text: Figure 10.2
E pp. 173-176; MA pp. 173-176]
New 5. Explain the difference between an equilibrium level of GDP and a level of GDP
which is in disequilibrium.

If GDP is not in equilibrium, then aggregate expenditures will exceed real GDP or
vice versa. If aggregate expenditures exceed real GDP, then businesses will find
their inventories reduced below the planned level of inventories. Businesses will
therefore expand production to replenish inventories and the economy will not
be in equilibrium until the level of planned inventories is met.

On the other hand, if real GDP exceeds aggregate expenditures, then business
inventories will be above the level planned. In order to bring inventories down
to their planned level, production and output will be reduced until the real GDP
is equal to planned aggregate expenditures. [text: E pp. 174-175; MA pp. 174-
175]

New 6. In a graph relating private spending (C + Ig ) to real gross domestic product

(GDP), what does the 45-degree line represent?

The 45-degree line traces out the points where the economy is in equilibrium.
That is, it shows where real GDP is equal to private spending. [text: E pp. 175-
176; MA pp. 175-176]

New 7. Use the graph below to explain the determination of equilibrium GDP by the
aggregate expenditures-domestic output approach. At equilibrium C + Ig =
Real GDP ($550 + $50 = $600). Why does the intersection of the aggregate

expenditures schedule and the 45-degree line determine the equilibrium GDP?
 Equilibrium occurs where C + Ig = GDP. There is a direct relationship between
aggregate expenditures and the level of GDP, but they are equal only where
the AE schedule intersects the 45-degree line which shows equality of
expenditures and GDP. Where aggregate expenditures exceed GDP, the AE
line is above the 45-degree line and output will continue to expand. If
aggregate expenditures fall below GDP as would occur at levels above 600,
then GDP will contract until the expenditures-output equality is restored.

The 45-degree line in the aggregate expenditures model represents all of the
points where aggregate expenditures are equal to real GDP; all of the possible
equilibrium levels. [text: E pp. 175-176; MA pp. 175-176]

New 8. Explain why saving equals planned investment at equilibrium GDP.

It is based on the fact that saving is income not consumed. Saving therefore
represents a “leakage” or diversion of potential spending from the income-
expenditures stream. Consumption falls short of total output by the amount of
saving. However, investment spending can be viewed as an “injection” into this
income-expenditures stream. If planned investment is equal to the amount of
saving at a particular level of GDP, then leakages equal injections and GDP will
be in equilibrium. [text: E pp. 176-177; MA pp. 176-177]

New 9. What differentiates the planned equilibrium level of investment from

disequilibrium levels of investment? Explain.

Planned investment differs from unplanned investment by the changes in

inventories. If inventories exceed the planned level, then producers will want to
reduce output. If inventories are less than the planned level, then producers will
want to expand output. Only when inventories are at the planned level will
there be an equilibrium level of GDP. [text: E pp. 176-177; MA pp. 176-177]

New10. Explain the difference between planned and actual investment in the
economy. Why is the distinction important?
 Actual investment consists of both planned investment and changes in
inventories. Unplanned changes in inventories act as a balancing item which
equates the actual amounts saved and invested in any period. At above
equilibrium levels of GDP, saving is greater than planned investment, and there
will be an unplanned increase in inventories. At below equilibrium levels of GDP,
planned investment is greater than saving, and there will be an unplanned
decrease in inventories. Equilibrium is achieved when planned investment
equals saving, and there are no unplanned changes in inventories. [text: E pp.
176-177; MA pp. 176-177]

New11. What is the relationship between actual investment, planned investment, and
saving in an economy? What conditions among these concepts produce
equilibrium?

Actual investment consists of both planned and unplanned changes in

inventories. It equals saving by definition. Unplanned changes in inventories,
however, are the item that helps equate actual investment with saving. Thus,
planned investment and saving will only be equal when there are no
unplanned changes in inventories. Equilibrium occurs in the economy only
when planned investment equals saving. [text: E pp. 176-177; MA pp. 176-177]

12. What is the effect of net exports, either positive or negative, on equilibrium GDP?

Positive net exports increase aggregate expenditures beyond what they would be in a closed economy and
thus have an expansionary effect. The multiplier effect also is at work. Positive net exports will lead to a
positive change that is greater than the amount of the initial change. Negative net exports decrease
aggregate expenditures beyond what they would be in a closed economy and thus have a contractionary
effect. The multiplier effect also is at work here. Negative net exports lead to a negative change in
equilibrium GDP that is greater than the initial change. [text: E pp. 179-180; MA pp. 179-180]

13. Explain why exports are added to, and imports are subtracted from, aggregate
expenditures in moving from a closed to an open economy.

Exports must be added to aggregate expenditures because they represent

sales of current output which would not have been counted elsewhere in
summing up total expenditures. Imports must be subtracted from aggregate
expenditures because they would be included in any summing of expenditures
on final goods and services, but they do not represent goods or services
produced here. Thus, to have an accurate estimate of domestic production,
 their value must be subtracted from the total expenditures. [text: E pp. 179-180;
MA pp. 179-180]

14. Evaluate the statement that “for an open economy the equilibrium GDP always
corresponds with an equality of exports and imports.”

This statement would be true only by coincidence, if ever. Equilibrium GDP (in
the absence of government) exists when aggregate demand equals
aggregate supply (GDP). Aggregate private demand consists of three
components: C, Ig, and net exports. There is no reason why net exports must
equal zero. The only requirement is that the sum of the three components, C, Ig,
and (X – M ) sum to the same value as aggregate supply. At that point GDP will
be in equilibrium. C or Ig or X or M or any or all of these can adjust in a situation
where disequilibrium exists, but equilibrium doesn’t necessitate net exports of
zero. [text: E pp. 179-180; MA pp. 179-180]

15. When international trade is considered, explain how net exports could be either
positive or negative additions to aggregate demand. In which case would the
impact of net exports be expansionary? Explain.

When exports exceed imports, net exports are a positive addition to aggregate
expenditures. When imports exceed exports, net exports are a negative
addition to aggregate expenditures because more money is being spent on
products from other countries than foreigners are spending on products made
in the United States. Rather than adding to aggregate expenditures this latter
situation is a leakage from total expenditures. In the case where net exports are
positive and growing, their impact would be expansionary. [text: E pp. 179-180;
MA pp. 186-188]

16. How does the fact that imports vary directly with GDP affect the stability of the
domestic economy?

Actually this fact should help stabilize the domestic economy. During
inflationary periods of rapid growth, rising imports should dampen that growth in
domestic aggregate demand. During recessionary periods, the decline in
 imports should help to offset falling domestic demand as net exports should rise.
In other words, a smaller M makes the (X – M ) balance grow. [text: E pp. 179-
180; MA pp. 179-180]

17. The data in the first two columns below are for a closed economy. Use this
table to answer the following questions.

Real GDP Aggregate Net Aggregate

= DI expenditures Exports Imports exports expenditures

(billions) (billions) (billions) (billions) (billions) (billions)

$100 $120 $10 $15 $___ $___

125 140 10 15 ___ ___

150 160 10 15 ___ ___

175 180 10 15 ___ ___

200 200 10 15 ___ ___

225 220 10 15 ___ ___

250 240 10 15 ___ ___

275 260 10 15 ___ ___

(a) What is the equilibrium GDP for the closed economy?

(b) Including the international trade figures for exports and imports, calculate
net exports and determine the equilibrium GDP for an open economy.

(c) What will happen to equilibrium GDP if exports were $5 billion larger at
each level of GDP?

(d) What will happen to equilibrium GDP if exports remained at $10 billion, but
imports dropped to $5 billion?

(e) What is the size of the multiplier in this economy?

 Real GDP Aggregate Net Aggregate

= DI expenditures Exports Imports exports expenditures

(billions) (billions) (billions) (billions) (billions) (billions)

$100 $120 $10 $15 $–5 $115

125 140 10 15 –5 135

150 160 10 15 –5 155

175 180 10 15 –5 175

200 200 10 15 –5 195

225 220 10 15 –5 215

250 240 10 15 –5 235

275 260 10 15 –5 255

(a) For a closed economy, equilibrium GDP = $200 billion.

(b) For an open economy, equilibrium GDP = $175 billion.

(c) Equilibrium GDP would return to $200 billion.

(d) Equilibrium GDP would rise to $225 billion.

(e) When aggregate expenditures change by 5, equilibrium GDP changes by

25 so the multiplier must be 5. [text: E pp. 179-180; MA pp. 179-180]

18. The data in the first two columns below are for a closed economy. Use this
table to answer the following questions.

Real GDP Aggregate Net Aggregate

= DI expenditures Exports Imports exports expenditures

(billions) (billions) (billions) (billions) (billions) (billions)

$ 80 $100 $15 $5 $___ $___

 120 130 15 5 ___ ___

160 160 15 5 ___ ___

200 190 15 5 ___ ___

240 220 15 5 ___ ___

280 250 15 5 ___ ___

320 280 15 5 ___ ___

360 310 15 5 ___ ___

(a) What is the equilibrium GDP for the closed economy?

(b) Including the international trade figures for exports and imports, calculate
net exports and determine the equilibrium GDP for an open economy.

(c) What will happen to equilibrium GDP if exports were $10 billion larger at
each level of GDP?

(d) What will happen to equilibrium GDP if exports remained at $15 billion, but
imports rose to $15 billion?

(e) What is the size of the multiplier in this economy?

Real GDP Aggregate Net Aggregate

= DI expenditures Exports Imports exports expenditures

(billions) (billions) (billions) (billions) (billions) (billions)

$ 80 $100 $15 $5 $10 $110

120 130 15 5 10 140

160 160 15 5 10 170

200 190 15 5 10 200

240 220 15 5 10 230

280 250 15 5 10 260

320 280 15 5 10 290

 360 310 15 5 10 320

(a) For a closed economy, equilibrium GDP = $160 billion.

(b) For an open economy, equilibrium GDP = $200 billion.

(c) Equilibrium GDP would rise to $240 billion.

(d) Equilibrium GDP would fall to $160 billion.

(e) When aggregate expenditures change by 10, equilibrium GDP changes

by 40 so the multiplier must be 8. [text: E pp. 179-180; MA pp. 179-180]

19. Explain the relationship between net exports and the following factors:
prosperity abroad, tariffs on American exports abroad, depreciation of the
American dollar on foreign exchange markets.

Prosperity abroad improves net exports because it means foreigners will buy
more U.S. exports.

Tariffs on American exports abroad will initially decrease net exports as it makes
American products more expensive to foreigners. (If the U.S. later retaliates with
tariffs of its own, the effect is less certain.)

Depreciation of the American dollar should lead to improved net exports as

foreigners will find the purchasing power of their money rising relative to goods
priced in American dollars. Conversely, Americans will find foreign goods more
expensive in terms of the dollars they need to exchange for foreign currency to
buy foreign goods, so exports rise and imports fall. [text: E p. 181; MA p. 181]

20. Describe the probable impact of an increase in government spending assuming

no change in taxes or private spending and less than full-employment output.
 Assuming no change in taxes or private spending, the probable effect of an
increase in government spending will be expansionary. Furthermore, the
government spending increase will be multiplied in terms of its impact on
equilibrium GDP. The simple multiplier in this case should equal the reciprocal of
the marginal propensity to save. [text: E p. 182; MA p. 182]

21. Identify the relationship between GDP, taxes, and disposable income.

Disposable income consists partly of income earned by resources used in

producing the GDP minus the total taxes levied on productive incomes at the
various production stages. Depreciation allowances and corporate retained
earnings are also deducted from GDP and transfer payments are added to
arrive at the figure for disposable income. [text: E pp. 182-185; MA pp. 182-185]

22. “If taxes and government spending are increased by the same amount, there
will still be a positive effect on equilibrium GDP.” Explain.

The initial impact of government spending is to increase aggregate demand

directly by the amount of the increase in spending. Beyond that, spending is
increased in successive rounds of increased incomes that result by a fraction
equal to the marginal propensity to consume. This MPC-induced spending
which results from the increased government purchases will be exactly offset by
the tax increase whose initial impact is to reduce disposable income rather than
aggregate demand directly. Thus, government spending has an initial direct
effect equal to the amount of the increase in G which will not be offset. [text: E
pp. 182-185; MA pp. 182-185]

23. Compare and contrast the recessionary gap and the inflationary gap.

A recessionary gap is the amount by which aggregate expenditures fall short of

the noninflationary full-employment level of GDP. Real GDP will be below full-
employment real GDP by a multiple amount of the recessionary gap. An
inflationary gap, on the other hand, is the amount by which aggregate
expenditures exceeds the noninflationary full-employment level of GDP. This
 gap will cause demand-pull inflation as nominal GDP rises to meet the higher
level of aggregate expenditures, but real GDP is already at its full-employment
level. [text: E pp. 185-187; MA pp. 185-187]

24. If there is a recessionary gap of $100 billion and the MPC is 0.80, by how much
must taxes be reduced to eliminate the recessionary gap?

If the MPC is 0.80, then the MPS is 0.20 and the multiplier is equal to 5. Thus to
reduce a gap of $100 billion, taxes must be reduced by $25 billion, which is
equivalent to saying that disposable income rises by $25 billion. An increase in
income of $25 billion will cause an initial change in spending of $20 billion (or 0.8
× $25) and this multiplied by 5 will result in an increase in GDP of $100 billion
which is the amount of the recessionary gap. [text: E pp. 185-187; MA pp. 185-
187]

25. Assume the level of investment is $8 billion and independent of the level of total
output. Complete the following table and determine the equilibrium level of
output and income which the private sector of this closed economy would
provide:

Possible employment Real GDP = DI Consumption Saving

levels (millions) (billions) (billions) (billions)

80 $120 $122 $___

90 130 130 ___

100 140 138 ___

110 150 146 ___

120 160 154 ___

130 170 162 ___

140 180 170 ___

150 190 178 ___

 160 200 186 ___

(a) If this economy has a labor force of 140 million, will there be a
recessionary or inflationary gap? Explain the consequences of this gap.

(b) If the labor force is 110 million, will there be an inflationary or recessionary
gap? Explain the consequences of this gap.

(c) What are the sizes of the MPC, MPS, and multiplier in this economy?

(d) Using the multiplier concept, give the increase in equilibrium GDP that
would occur if the level of investment increased from $8 billion to $10 billion.

Possible employment Real GDP = DI Consumption Saving

levels (millions) (billions) (billions) (billions)

80 $120 $122 $−2

90 130 130 0

100 140 138 2

110 150 146 4

120 160 154 6

130 170 162 8

140 180 170 10

150 190 178 12

160 200 186 14

(a) At the 140-million employment level, aggregate expenditures will be $178

billion and output will be $180 billion. Therefore, there exists a recessionary gap
of $2 billion. Producers plan output to match anticipated aggregate
expenditures. If expenditures fall below this level of $180 billion, then producer
inventories will be greater than planned and they will reduce output until the
actual inventories equal planned inventories for that level of output.
 (b) At the 110-million employment level, aggregate expenditures will be $154
billion and output will be $150 billion. An inflationary gap exists because
aggregate expenditures exceeds full-employment output and producers will
attempt to expand output thinking full employment has not been reached.
Expansion takes place because the level of planned output was set to match
anticipated spending. Since aggregate spending exceeded this level of $150
billion, producer inventories will be lower than planned and they will increase
output to replenish these inventories.

(c) Consumption changes by $8 billion for every $10 billion change in DI.
Therefore, the MPC is 8/10 or 0.8. MPS = 0.2. Multiplier will be 1/.2 = 5.

(d) If investment spending rises by $2 billion, then equilibrium GDP should rise
by 5 x $2 billion or $10 billion. [text: E pp. 185-187; MA pp. 185-187]

26. Assume the level of investment is $8 billion and independent of the level of total
output. Complete the following table and determine the equilibrium level of
output and income which the private sector of this closed economy would
provide:

Possible employment Real GDP = DI Consumption Saving

levels (millions) (billions) (billions) (billions)

50 $ 80 $ 83 $___

60 90 90 ___

70 100 97 ___

80 110 104 ___

90 120 111 ___

100 130 118 ___

110 140 125 ___

120 150 132 ___

130 160 139 ___

(a) If this economy has a labor force of 110 million, will there be a
recessionary or inflationary gap? Explain the consequences of this gap.
(b) If the labor force is 80 million, will there be an inflationary or recessionary
gap? Explain the consequences of this gap.

(c) What are the sizes of the MPC, MPS, and multiplier in this economy?

(d) Using the multiplier concept, give the increase in equilibrium GDP that
would occur if the level of investment increased from $8 billion to $10 billion.

Possible employment Real GDP = DI Consumption Saving

levels (millions) (billions) (billions) (billions)

50 $ 80 $ 83 $−3

60 90 90 0

70 100 97 3

80 110 104 6

90 120 111 9

100 130 118 12

110 140 125 15

120 150 132 18

130 160 139 21

(a) At the 110-million employment level, aggregate expenditures will be $132

billion and full-employment output will be $140 billion. Therefore, there exists a
recessionary gap of $7 billion. Producers plan output to match anticipated
aggregate expenditures. If expenditures fall below this level of $140 billion, then
producer inventories will be greater than planned and they will reduce output
until the actual inventories equal planned inventories for that level of output.

(b) At the 80-million employment level, aggregate expenditures will be $112

billion and full-employment output will be $110 billion. An inflationary gap exists
because aggregate expenditures exceeds full-employment output and
producers will attempt to expand output thinking full employment has not been
reached. Expansion takes place because the level of planned output was set
to match anticipated spending. Since aggregate spending exceeded this level
of $110 billion, producer inventories will be lower than planned and they will
increase output to replenish these inventories.

(c) Consumption changes by $7 billion for every $10 billion change in DI.
Therefore, the MPC is 7/10 or 0.7. MPS = 0.3, multiplier will be 1/.3 = 3 1/3.

(d) If investment spending rises by $2 billion, then equilibrium GDP should rise
by 3 1/3 x $2 billion or $6 2/3 billion. [text: E pp. 185-187; MA pp. 185-187]
27. Refer to the following table to answer the questions.

(1) (2) (3)

Possible levels Real domestic Aggregate Expenditures,
of employment, output, (Ca + Ig + Xn + G)
millions billions billions
45 $250 $260
50 275 280
55 300 300
60 325 320
65 350 340

(a) If full employment in this economy is 65 million, will there be an inflationary or recessionary gap?
What will be the consequence of this gap? By how much would aggregate expenditures in column 3 have
to change at each level of GDP to eliminate the inflationary or recessionary gap? Explain.
(b) Will there be an inflationary or recessionary gap if the full-employment level of output is $250 billion?
Explain the consequences. By how much would aggregate expenditures in column 3 have to change at
each level of GDP to eliminate the inflationary or recessionary gap? Explain.
(c) Assuming that investment, net exports, and government expenditures do not change with changes in
real GDP, what are the sizes of the MPC, the MPS, and the multiplier?

(a) A recessionary gap. Equilibrium GDP is $300 billion, while full employment GDP is $350 billion.
Employment will be 10 million less than at full employment. Aggregate expenditures would have to
increase by $10 billion (= $350 billion – $340 billion) at each level of GDP to eliminate the recessionary
gap.
(b) An inflationary gap. Aggregate expenditures will be excessive, causing demand-pull inflation.
Aggregate expenditures would have to fall by $10 billion (= $260 billion – $250 billion) at each level of
GDP to eliminate the inflationary gap.
(c) MPC = .8 (= $20 billion/$25 billion); MPS = .2 (= 1 –.8); multiplier = 5 (= 1/.2).
[text: E pp. 185-187; MA pp. 185-187]

28. Use the table below to answer the following questions:

Real GDP C

$500 $495

510 504

520 513

530 522

540 531

550 540

560 549
 (a) What is the size of the multiplier in this economy?

(b) If taxes were zero, government purchases were $5, investment is $3, and
net exports are zero, what is the equilibrium GDP?

(c) If taxes are $10, government purchases are $10, investment is $6, and net
exports are zero, what is the equilibrium GDP?

(d) Assume investment is $50, taxes are $50, and net exports and government
purchases are each zero. The full-employment level of GDP is $545. How much
of a reduction in taxes is needed to eliminate the recessionary gap?

(e) Assume that investment, net exports, and taxes are zero. Government
purchases are $30 and the full-employment GDP without inflation is $530. By
how much must government spending be reduced to eliminate the inflationary
gap?

(a) To find the MPC compare the change in C with the change in GDP to get
9/10 or 0.9; this means the MPS is 0.1 and the multiplier will be 1/.1 or 10.

(b) Find the point where aggregate expenditures equals GDP. Aggregate
expenditures will include C plus investment and government purchases which
together equal $8. Adding $8 to C at every level gives an equilibrium GDP of
$530 (= 522 + 8).

(c) If taxes are $10, GDP is reduced by $10 at every level to result in
disposable income. Since the MPC is 0.9, we can calculate C at every level by
reducing each level of C by $9 (.9 x $10). This will result in aggregate
expenditures of $520 (504 + 10 + 6) and an equilibrium GDP of $520.

(d) If taxes are $50 and the MPC is 0.9, C will be reduced at every level by
$45. Currently, the equilibrium GDP will be $500 (495 – 45 + 50 = AE). To increase
it by $45 will require an increase in consumer spending of $45. To achieve an
increase in consumer spending of $45 requires an increase in disposable income
of $50. Therefore, taxes must be reduced from $50 to zero.

(e) In this case the equilibrium nominal GDP will be $560. To reduce it to $530,
aggregate expenditures must be reduced by $30, hence government
purchases must be reduced by $30. [text: E pp. 174-187; MA pp. 174-187]

29. Use the table below to answer the following questions:

 Real GDP C

$300 $290

310 298

320 306

330 314

340 322

350 330

360 338

(a) What is the size of the multiplier in this economy?

(b) If taxes were zero, government purchases were $10, investment $6, and
net exports are zero, what is the equilibrium GDP?

(c) If taxes are $5, government purchases are $10, investment is $6, and net
exports are zero, what is the equilibrium GDP?

(d) Assume investment is $50, taxes are $50, net exports and government
purchases are each zero. The full-employment level of GDP is $340. How much
of a reduction in taxes is needed to eliminate the recessionary gap?

(e) Assume that investment, net exports, and taxes are zero. Government
purchases are $30 and the full-employment GDP without inflation is $330. By
how much must government spending be reduced to eliminate the inflationary
gap?

(a) To find the MPC compare the change in C with the change in GDP to get
8/10 or 0.8; this means the MPS is 0.2 and the multiplier will be 1/.2 or 5.

(b) Find the point where aggregate expenditures equals GDP. Aggregate
expenditures will include C plus investment and government purchases which
together equal $16. Adding $16 to C at every level gives an equilibrium GDP of
330 (= 314 + 16).

(c) If taxes are $5, GDP is reduced by $5 at every level to result in disposable
income. Since the MPC is 0.8, we can calculate C at every level by reducing
 each level of C by $4 (.8 x $5). This will result in aggregate expenditures of $310
(294 + 10 + 6) and an equilibrium GDP of $310.

(d) If taxes are $50 and the MPC is 0.8, C will be reduced at every level by
$40. Currently the equilibrium GDP will be $300 (290 – 40 + 50 = AE). To increase
it by $40 will require an increase in consumer spending of $40. To achieve an
increase in consumer spending of $40 requires an increase in disposable income
of $50. Therefore, taxes must be reduced from $50 to zero.

(e) In this case the equilibrium nominal GDP will be $360. To reduce it to $330,
aggregate expenditures must be reduced by $30, hence government
purchases must be reduced by $30. [text: E pp. 174-187; MA pp. 174-187]

30. Discuss an historical application of a recessionary gap and an historical

application of an inflationary gap in the United States.

The recession of 2001 is an example of a recessionary gap. Throughout the mid-

to late 19990s there was strong economic growth in the economy. This growth
ended with the bursting of the stock market bubble in 2000, an increase in the
number of new Internet firms that went bankrupt, and with increasing levels of
household debt. In March 2001 the economy moved into recession. The
unemployment rate rose. Aggregate expenditures were insufficient to achieve
full-employment GDP.

The U.S. inflation of the late 1980s is an example of an inflationary gap.

Aggregate spending was greater than the full-employment output. The price
level rose from 1.9 percent in 1986 to 4.8 percent in 1989. The recession of 1990
and 1991 help close the inflationary gap. [text: E pp. 186-187; MA pp. 186-187]

31. What are four shortcomings of the aggregate expenditures model?

First, although the model can account for demand-pull inflation, it does not
indicate how much the price level will rise when aggregate expenditures are
greater than the productive capacity of the economy. Second, the aggregate
expenditure model does not explain why demand-pull inflation can occur
before the economy reaches its full-employment level of output. Third, the
 aggregate expenditures model does not explain why the economy can
expand beyond its full-employment level of output. Fourth, the aggregate
expenditures model does not account for cost-push inflation. [text: E pp. 187-
188; MA pp. 187-188]

32. (Advanced analysis) Suppose that the linear equation for consumption in a
hypothetical economy is C = 50 + 0.9 Y. Also suppose that income (Y ) is $400.
Determine the following: (a) MPC; (b) MPS; (c) level of consumption; (d) APC;
(e) APS.

MPC = 0.9; MPS = 0.1; At Y = 400, C = $410; At Y = $400, APC = 410/400 = 1.025;
and APS = (–.025). [text: E pp. 177-178; MA pp. 177-178]

33. (Advanced analysis) Assume the following output-income and saving data for
the private sector of the economy.

Real GDP (Y) Consumption (C)

$240 $244

260 260

280 276

300 292

320 308

340 324

360 340

380 356

400 372

(a) Describe the consumption schedule in equation form.

 (b) Assuming net investment is $5 billion and independent of the level of GDP,
what will be the equilibrium level of GDP?

(c) Assuming net investment of $15 billion and independent of the level of
GDP, what will be the equilibrium level of GDP?

(d) Using your answers to (a) and (b), find the size of the multiplier.

(e) Check your answer using the MPC embodied in these data.

(a) C = 60 + 0.8Y

(b) Equilibrium GDP = $325 (where S = I )

(c) When I = $15, GDP rises to $375 because that is where S = I.

(d) When I rose by $10, GDP rose by $50. Therefore, M = 50/10 = 5.

(e) The MPC would be 0.8 or 4/5 because C changes by 20 when GDP
changes by 25. Therefore MPC = 20/25 or 0.8 and the MPS = 0.2 which makes
the multiplier 1/.2 or 5, the same result found in part (d). [text: E pp. 173-178; MA
pp. 173-178]

34. (Advanced analysis) Assume the consumption schedule for the economy is
such that C = 50 + 0.8Y. Assume further that investment and net exports are
autonomous or independent of the level of income and gross investment is 40
and net exports equal –10. Recall that in equilibrium, Y = C + Ig + Xn.

(a) Calculate the equilibrium level of income for this economy.

(b) What will happen to equilibrium Y if gross investment falls to 20? What
does this tell us about the size of the multiplier?

(a) Equilibrium GDP is 400 = (50 = 0.8Y) + 40 + (–10)

(b) If gross investment falls by 20, GDP will fall by 100 because the multiplier is
1/.2 or 5 and 5 x 20 = 100 decline. The new equilibrium would be 300. [text: E
pp. 179-180; MA pp. 179-180]
35. (Advanced analysis) Assume that without any taxes the consumption schedule
for an economy is as shown in the table:

GDP (billions) Consumption (billions)

$ 200 $ 240

400 400

600 560

800 720

1,000 880

1,200 1,040

1,400 1,200

(a) Graph the consumption schedule and note the size of the MPC and
multiplier using the below graph.

(b) Assume a lump-sum regressive tax of $10 billion is imposed at all levels of
GDP. Calculate the tax rate at each level of GDP and graph the resulting
consumption schedule. Compare the MPC and the multiplier with the pretax
consumption schedule. MPC and the multiplier are unchanged.

(c) Explain why a proportional or progressive tax system would contribute to

greater economic stability as compared with the regressive lump-sum tax.
Demonstrate graphically using a 10% proportional tax.

(a) The size of the MPC = 160/200 = 0.80. See graph below.

(b) The tax rate will be regressive: At $400, 2.5%; at $600, 1.67%; at $800, 1.25%;
at $1000, 1%; at $1200, 0.835%; at $1400, 0.71%.
 (c) A proportional or progressive tax system would not take such a big bite
out of low incomes as a regressive tax system does, and as incomes rose it
would take out more proportionately than a regressive, lump-sum tax does.
Thus, proportional or progressive taxes leave more disposable income for

spending during low-income periods and would reduce disposable income and
spending during expansionary phases. See graph below. [text: E pp. 182-185;
MA pp. 182-185]

New36. (Last Word) Explain Say’s law.

Say’s law, attributed to the 19th-century French economist, is that “supply

creates its own demand.” Essentially, this theory states that people engage in
production in order to be able to buy or demand other things. Whatever one
earns from production, one expects to spend on goods and services of
equivalent value. Thus, supply (production) has created its own demand. [text:
E p. 177; MA p. 177]

New37. (Last Word) “If production results in income and income is the source of
spending, it would seem that the production of a full-employment economy
would automatically guarantee enough spending to sustain itself. How, then,
can unemployment occur?” Explain.

The statement is a restatement of Say’s law. The fallacy in this statement is that
not all income has to be spent during the production period. Just because it is
a source of spending does not mean it will all be spent. Some may be saved
 and although some of this saving might be channeled back into spending
through investment in capital goods, this investment may not occur during the
same time period if investors do not expect to make an economic return on
their investment. [text: E p. 177; MA p. 177]

New38. (Last Word) What two events undermined the theory that supply creates its own
demand?

First, the Great Depression of the 1930s resulted in a sharp decline in production
and high rates of unemployment over a ten-year period. This event was
inconsistent with the classical theory that suggests that unemployment is only
temporary. Second, John Maynard Keynes developed an aggregate
expenditures theory that countered Say’s law and explained why
unemployment and underspending can occur in an economy. Keynes’
modern employment theory suggests that the macroeconomy was inherently
unstable and subject to fluctuations in output and employment because of the
downward inflexibility of wages and prices and lack of synchronization between
investment and saving decisions. [text: E p. 177; MA p. 177]
New39. (Last Word) Contrast the classical and Keynesian views of unemployment.

The classical view theorizes that unemployment will not persist because prices
and wages are flexible. If a temporary surplus occurs in one sector of the
economy, prices of that sector’s goods will fall until the quantity demanded is
brought into equilibrium with the quantity supplied again. If necessary, wages in
that sector will also fluctuate in response to the change in demand, falling when
demand is down and rising when demand increases.

The Keynesian view, on the other hand, believes that full employment is by no
means a consistent result of the market system. Cyclical unemployment is likely
to persist without intervention from the government to raise aggregate
expenditures. This view counteracts the classical view by stating that wages
and prices are not flexible in a downward direction. Also, saving and
investment plans can be at odds and can result in fluctuations in total output,
total income, employment, and the price level. [text: E p. 177; MA p. 177]

CHAPTER 11
1. Why is there a need for an aggregate demand and aggregate supply model of the economy? Why can’t the
supply and demand model for a single product explain developments in the economy?

The basic reason for an aggregate model is that there are thousands of individual products in an economy.
Single product supply and demand model does not explain: (1) why prices in general rise or fall; (2) what
determines the level of aggregate output; and (3) what determines changes in the level of aggregate output.
The aggregate model is needed to explain these changes. It simplifies the analysis of prices by combining
the prices of all individual goods and services into one aggregate price level. It simplifies the analysis of
quantities by combining the equilibrium quantities of all individual goods and services into a singe entity
called the real domestic output. [text: E pp. 193-206; MA pp. 193-206]

2. What is the aggregate demand curve? What is the characteristic its slope?

The aggregate demand curve shows the relationship between the price level
and real domestic output (real GDP). It shows the amounts of real output that
domestic consumers, businesses, government, and foreign buyers collectively
desire to purchase at each price level. As the price level increases, the amount
of real domestic output purchased will decrease, so the aggregate demand
curve is downsloping. [text: E pp. 193-195; MA pp. 193-195]
3. What is the difference in the explanation of the shape of the aggregate demand curve and a single product
demand curve? After all, both demand curves show an inverse relationship between price and quantity.

The aggregate demand curve shows an inverse relationship between the price level (the general level of all
prices) and real domestic output (the equilibrium quantity of all products). The explanation of this inverse
relationship is based on the real-balances effect, the interest-rate effect, and the foreign-purchases effect.
In this case, as the price level rises, the quantity of real domestic output decreases.

The supply and demand model for a particular product shows an inverse relationship between the price of
that product and the quantity of that product. The explanation for the inverse relationship between price
and quantity in the demand for a single product is based on the substitution and income effects. The
substitution effect is not applicable to the aggregate case because there is no substitute for all products in
the economy. Also, the income effect is not applicable to the aggregate case because income now varies
with aggregate output. [text: E pp. 193-195; MA pp. 193-195]

4. Explain the three reasons given for the downward slope of the aggregate
demand curve.

The three reasons given are the real-balances effect, the interest-rate effect,
and the foreign purchases effect.

The real-balances effect refers to the idea that a higher price level will reduce
the purchasing power of the population’s accumulated financial assets.
Because of the decline in value of such assets, people will feel poorer and will
reduce their spending. Conversely, as the price level falls the opposite will
occur.

The interest-rate effect assumes that as the price level rises so will interest rates,
and rising interest rates will reduce certain kinds of spending such as
consumption spending on durable goods and investment spending.

The foreign purchases effect assumes that if the price level rises in the U.S.
relative to that in foreign countries, Americans will increase spending on imports
at the expense of domestically produced goods and services, and foreigners
will reduce purchases of U.S. goods. In other words, net exports decline. [text: E
pp. 193-195; MA pp. 193-195]
5. The determinants of aggregate demand “determine” the location of the
aggregate demand curve. Explain three of the four basic determinants of
aggregate demand.

The four basic determinants of aggregate demand are found in Figure 11.2 in
the text. They are a change in consumer spending, a change in investment
spending, a change in government spending, and a change in net export
spending. Explanations for each follow.

A change in consumer spending could occur as a result of an increase or

decrease in consumer wealth resulting from factors such as increased stock
values. It could also be caused by a change in consumer expectations about
the future, a change in the level of household indebtedness, or a change in
personal taxes.

Changes in investment spending may occur as a result of changes in the

interest rate (not related to changes in the price level), changes in profit
expectations having to do with predictions about future returns on possible
projects, changes in business taxes, technological improvements which induce
more capital investment, and the degree of existing excess capacity.

Government spending might change for any of a number of reasons, including

a change in priorities resulting from a change in elected officials.

Net export spending can change for two nonprice-level-related reasons such as
rising or falling national incomes in other countries and exchange rate changes
unrelated to domestic price levels. [text: E pp. 195-197; MA pp. 195-197]

6. Identify the ways in which each of the following determinants would have to
change if each was causing a decrease in aggregate demand: consumer
wealth, consumer expectations, business taxes, national income in countries
abroad, exchange rates.
 To decrease aggregate demand, consumer wealth would have to fall. For
example, a decline in real estate values or a stock market decline would cause
a decrease in consumer wealth. If consumers expected prices to fall in the
future, or a recession which creates insecurity about jobs, they might cut back
on spending now. If business taxes were raised, or some present tax breaks
eliminated or reduced, this could reduce business investment spending which,
in turn, reduces aggregate demand. When national income abroad is falling,
U.S. exports will decline, which reduces the net export spending component of
aggregate demand. A dollar appreciation will cause a decline in net exports
as U.S. exports become more expensive to foreigners and foreign imports
become less expensive to holders of American dollars. [text: E pp. 195-197; MA
pp. 195-197]

New 7. Define aggregate supply. Describe the characteristics of the aggregate supply
curve from long-run and short-run perspectives.

The aggregate supply is a curve that shows the total quantity of goods and
services that will be produced (supplied) at different price levels. In the long
run, the aggregate supply curve is vertical at the full-employment level of
output for the economy because the rise in wages and other inputs will match
changes in the price level. In the short run, the aggregate supply curve is
upsloping because nominal wages and input prices adjust only slowly to
changes in the price level. With this curve, an increase in the price level
increases real output and a decrease in the price level reduces real output.
[text: E pp. 197-198; MA pp. 197-198]

8. Explain the three major factors that can cause a shift in aggregate supply. That
is, explain the three major determinants of supply.

The determinants of supply include changes in input prices, productivity, and

the legal-institutional environment. Included as factors behind changes in input
prices are availability of domestic resources, prices of imported resources
(particularly energy resources), and changes in market power of resource
suppliers. Included as factors related to the legal-institutional environment are
business taxes and subsidies and government regulation. [text: E pp. 199-201;
MA pp. 199-201]
 9. Describe the change in aggregate supply that should result from each of the
following changes in determinants. Assume that nothing else is changing
besides the identified change. (Use “Decrease” or “Increase.”) (a) A rise in the
average price of inputs; (b) An increase in worker productivity; (c) Government
antipollution regulations become stricter; (d) A new subsidy program is enacted
for new business investment in productive equipment; (e) Energy prices decline.

(a) Decrease; (b) Increase; (c) Decrease (unless the increase in antipollution
device production outweighs the decline in production caused by the
increased cost of the regulations); (d) Increase; (e) Increase [text: E pp. 199-
201; MA pp. 199-201]

10. Prepare a list of events that would shift the aggregate supply curve leftward.

Students should list examples that fit the determinants indicated in Figure 11.5.
Some possibilities are a rise in the prices of domestic resources, an increase in
wages beyond any rise in productivity, an increase in the prices of imported
resources, declining rate of productivity without corresponding wage
concessions, rising business taxes, reduction in research and development
efforts, and more government regulation which adds to production costs. [text:
E pp. 199-201; MA pp. 199-201]

11. Prepare a list of government tax or spending policy options that would tend to
shift the aggregate supply curve rightward.

Tax cuts or rebates in any area which would improve productivity. For example,
tax credits for investment in new capital goods or buildings, tax credits for
education and training.

Tax breaks for various types of natural resource exploration and development
especially for resources important in energy and construction industries.
 Reducing or eliminating tariffs on imported resources.

Tax penalties for companies which grant inflationary wage increases. [text: E
pp. 199-201; MA pp. 199-201]

12. What determines the equilibrium price level and the level of real domestic
output in the aggregate demand-aggregate supply model?

The interaction of aggregate supply and aggregate demand will determine the
equilibrium. The price and quantity levels where aggregate demand and
aggregate supply are equal will be the equilibrium levels of price and quantity.
In a graphical illustration such as Figure 11.7, it is where the two curves intersect.
[text: E pp. 201-203; MA pp. 201-203]

13. Suppose that a hypothetical economy has the following relationship between its real domestic output and
the input quantities necessary for producing that level of output.

Input quantity Real domestic output

400 800

300 600

100 200

(a) What is the level of productivity in this economy?

(b) What is the unit cost of production if the price of each input is $2.00?

(c) If the input price decreases from $2 to $1.50, what is the new per unit cost
of production? In what direction would the aggregate supply curve move?
What effect would this shift have on the price level and the level of real
domestic output if the economy is initially operating in the intermediate range?

(d) Suppose that instead of the input price decreasing, the productivity had
increased by 25%. What will be the new unit cost of production? In what
direction would the aggregate supply curve move? What effect would this shift
have on the equilibrium price and output level if the economy?
 (a) The level of productivity is 2 output units per input unit.

(b) Since productivity is 2 units of output per input unit, the cost of production
per unit is 2 units/$2 or $1 per unit of output. (Total input cost/output) = PUPC.
[($2 x 400)/800] = $1.

(c) The unit cost will decline from $1/unit to $.75/unit. The aggregate supply
curve has moved rightward and the level of prices has declined while the level
of real domestic output has increased.

(d) If productivity rose by 25%, then there would be 1.25 units produced per
$1 of input costs. The unit cost of production would be $.80/unit. The
aggregate supply curve would move in the same direction with similar effects to
(c) above. However, the cost reduction is not quite as great so the real GDP
would not rise as much as (c) nor would the price level decline by as much as
(c). [text: E pp. 200-201, 205-206; MA pp. 200-201, 205-206]

14. Suppose the aggregate demand and supply schedules for a hypothetical
economy are as shown below:

Amount of real

Amount of real domestic Price level domestic output

output demanded, billions (price index) supplied, billions

$ 200 300 $800

400 250 800

600 200 600

800 150 400

1,000 100 200

(a) Use these sets of data to graph the aggregate demand and supply
curves on the below graph.
(b) What will be the equilibrium price and output level in this hypothetical
economy? Is it also the full-employment level of output? Explain.

(c) Why won’t the 150 index be the equilibrium price level? Why won’t the
250 index be the equilibrium price level?

(d) Suppose demand increases by $400 billion at each price level. What will
be the new equilibrium price and output levels?

(e) What factors might cause a change in aggregate demand?

(a) See graph below.

(b) The equilibrium GDP is $600 billion and price level 200. There is not enough
information given to determine whether or not this is the full-employment level
of output.

(c) At 150, the aggregate demand would exceed aggregate supply and
prices would be bid up. At price level 250, aggregate supply would exceed
aggregate demand and the resulting surpluses would cause prices to be bid
downward toward the equilibrium level of 200.

(d) The new equilibrium price and output level will be 250 and $800 billion
respectively on the schedule shown.

(e) Look at Figure 11.2, Determinants of Aggregate Demand, to help with this
answer. An increase in consumer wealth, expected future inflation, decline in
household indebtedness, or decreased personal taxes could increase the
consumer spending component of aggregate demand. Investment spending
might increase as a result of lower interest rates, expectations of improved
profits in the future, decline in business taxes, new and improved technology, or
 decline in excess capacity. Government spending might increase for a variety
of reasons. Net export spending could increase as a result of improved
economic conditions abroad or a depreciation in the American dollar. [text: E
pp. 201-204; MA pp. 201-204]

15. Suppose the aggregate demand and supply schedules for a hypothetical
economy are as shown below:

Amount of real

Amount of real domestic Price level domestic output

output demanded, billions (price index) supplied, billions

$ 60 350 $240

120 300 240

180 250 180

240 200 120

300 150 60

(a) What will be the equilibrium price and output level in this hypothetical
economy? Is it also the full-employment level of output? Explain.

(b) Why won’t the 200 index be the equilibrium price level? Why won’t the
300 index be the equilibrium price level?

(c) Suppose demand increases by $120 billion at each price level. What will
be the new equilibrium price and output levels?

(d) List five factors that might cause a change in aggregate demand.

(a) The equilibrium GDP is $180 billion and price level 250. There is not enough
information given to determine whether or not this is the full-employment level
of output, but there is no reason why it should be one way or the other.
 (b) At 200, the aggregate demand would exceed aggregate supply and
prices would be bid up. At price level 300, aggregate supply would exceed
aggregate demand and the resulting surpluses would cause prices to be bid
downward toward the equilibrium level of 250.

(c) The new equilibrium price and output level will be 300 and $240 billion
respectively on the schedule shown.

(d) Look at Figure 11.3, Determinants of Aggregate Demand, to help with this
answer. (1) An increase in consumer wealth, (2) expected future inflation, (3)
decline in household indebtedness, or (4) decreased personal taxes could
increase the consumer spending component of aggregate demand, (5)
investment spending might increase as a result of lower interest rates, (6)
expectations of improved profits in the future, (7) decline in business taxes, (8)
new and improved technology, or (9) decline in excess capacity. Government
spending might increase for a variety of reasons. (10) Net export spending
could increase as a result of improved economic conditions abroad or from a
depreciation in the American dollar.

[text: E pp. 201-204; MA pp. 201-204]

16. Describe each of the following outcomes in terms of shifts in aggregate

demand or aggregate supply curves.

(a) A recession deepens while the rate of inflation increases

(b) The price level rises sharply while real output and employment increase

(c) The price level falls, but the unemployment rate rises

(d) Real output rises, unemployment rate falls, and the price level rises

(a) The aggregate supply curve has shifted to the left causing the price level
to rise and output and employment levels to fall.

(b) The aggregate demand curve has shifted to the right.

(c) The aggregate demand curve has shifted leftward.

(d) The aggregate demand curve has shifted rightward. [text: E pp. 203-206;
MA pp. 203-206]
17. What is the effect of the multiplier when aggregate demand increases and there is a large increase in the
price level? What happens when there only is a small increase in the price level?

The multiplier effect is weakened with price level changes. In the vertical range of aggregate supply, an
increase in aggregate demand only produces in increase in the price level but no increase in real output. In
the intermediate range, the increase in aggregate demand raises the price level and real output, but real
output does not increase by as much as it would have if there had been no price level increase (as would
be the case in the horizontal range). The conclusion is that the more the price level increases, the less
effect any increase in aggregate demand will have in increasing real GDP. [text: E p. 203; MA p. 203]
18. In the table below are aggregate demand and supply schedules.

Real domestic output

Price level Demanded Supplied

(1) (2) (3) (4)

250 1,400 1,900 2,000

225 1,500 2,000 2,000

200 1,600 2,100 1,900

175 1,700 2,200 1,700

150 1,800 2,300 1,400

125 1,900 2,400 1,000

100 2,000 2,500 500

(a) On the graph below, plot the aggregate demand curve shown in
columns (1) and (2) in the above table, and label this curve AD1.

(b) On the graph below, plot the aggregate supply curve shown in columns
(1) and (4) in the above table; and label this curve AS.

(c) What is the level of equilibrium real domestic output and price level?

(d) Now assume that aggregate demand changes. Use columns (1) and (3)
to plot the new aggregate demand curve; and label this curve AD2.

(e) What is the new level of equilibrium real domestic output and price level?

(a) See below graph.

(b) See below graph.

(c) 1,700; 175

(d) See below graph.

 (e) 2,000; 225 [text: E pp. 201-203; MA pp. 201-203]

New19. Use this aggregate demand–aggregate supply schedule for a hypothetical

economy to answer the following questions.

Real domestic Real domestic

output demanded output supplied

(in billions) Price level (in billions)

$3000 350 $9000

$4000 300 $8000

$5000 250 $7000

$6000 200 $6000

$7000 150 $5000

$8000 100 $4000

(a) What will be the equilibrium price level and quantity of real domestic output?
(b) If the quantity of real domestic output demanded increased by $2000 at each price level, what will be
the new equilibrium price level and quantity of real domestic output?
(c) Using the original data from the table, if the quantity of real domestic output demanded increased by
$5000 and the quantity of real domestic output supplied increased by $1000 at each price level, what
would the new equilibrium price level and quantity of real domestic output be?

(a) 200 and $6000

 (b) 250 and $7000
(c) 300 and $9000
[text: E pp. 201-206; MA pp. 201-206]

20. What are five reasons for the downward price-level inflexibility, especially as it
pertains to wages and prices?

First, wage contracts will fix wages for the length of the contract period, so it is
difficult to cut wages until the contract is renegotiated. Also, wages and
salaries of nonunion workers are typically adjusted just once a year. Second,
some businesses may pay efficiency wages that are designed to get the
maximum work effort out of employees. Cutting such wages may cause morale
problems and reduce productivity, so businesses are hesitant to make these
cuts. Third, the minimum wage sets a legal minimum that employers must pay
for low-skilled workers. Fourth, there are menu costs of changing prices.
Repricing or reprinting prices can be costly and be disruptive to customers.
Businesses are reluctant to make such changes. Fifth, there is the fear of a price
war. If one business starts cutting prices then other businesses can follow suit to
maintain market share. Businesses may decide to maintain prices rather than
risk starting a price war. [text: E pp. 203-205; MA pp. 203-205]

21. Is the downward price inflexibility applicable to today’s economy? Why or why
not?

Some economists give many reasons for the downward price-level inflexibility in
the economy. They note that the price level has not declined since one year in
the 1950s despite the fact that there have been many recessions since then.
Also, there are a number of reasons for price-level inflexibility that include long-
term wage contracts, the payment of efficiency wages, a minimum wage, the
menu cost of making price changes, and fear of price wars.

Other economists argue that downward price inflexibility is not applicable to

today’s economy because union power has diminished over the years and the
1981–1982 recession showed that wages could be cut in major industries. Also,
foreign competition reduces monopoly power in certain industries and keeps
firms from resisting price cuts. The past forces that caused price-level inflexibility
 have declined according to these economists. [text: E pp. 203-205; MA pp. 203-
205]

New22. (Consider This) What is the ratchet effect? How does it apply to price level
changes in the economy as aggregate demand changes?

A ratchet effect allows movement in one direction but not movement back.
Some economists argue that when aggregate demand increases, there will be
an increase in the price level, but when aggregate demand decreases, there is
downward price inflexibility that prevents the price level from falling. They note
that the price level has not declined since one year in the 1950s despite the fact
that there have been many recessions since then. So a higher price level
remains even when aggregate demand falls. [text: E p. 205; MA p. 205]

23. Explain “cost-push” inflation using aggregate demand-aggregate supply

analysis.

“Cost-push” inflation using the AD-AS analysis could be explained by a leftward

shift in the aggregate supply curve. If aggregate supply decreases in this
manner, it will intersect the aggregate demand curve at a lower real GDP and
a higher price level since the aggregate demand curve is downward sloping.
This view suggests that prices might rise even if aggregate demand has not
increased. The more traditional view has been that inflation is caused by
increases in aggregate demand at or near the full-employment level of GDP.
[text: E pp. 205-206; MA pp. 205-206]

24. Some economists argue that it is easier to resolve demand-pull inflation than it is
cost-push inflation. Use the aggregate demand and aggregate supply model
to explain this assertion.

By shifting aggregate demand leftward when the equilibrium occurs in the

intermediate or classical range, the inflation rate should fall. This assumes that
the price-level increase was due to demand factors only. It is possible to
decrease aggregate demand by using tax policies which decrease consumer
 or business spending, or by using monetary policies which tighten the availability
of credit for spending.

However, the factors which cause leftward shifts in the aggregate supply
schedule (see Figure 11.5) are not as easy for government policy to control.
Government cannot quickly change worker demands for higher wages; it
cannot quickly increase productivity which would also bring down production
costs; it cannot control the price of imported resources. These three factors
have contributed much to cost-push inflation in the past, and help to illustrate
the difficulty in controlling cost-push inflation. [text: E pp. 203-205; MA pp. 203-
205]

25. Suppose an economic advisor to the President recommended a personal

income tax increase. Indicate the expected effects on aggregate demand
and on aggregate supply.

The advisor would recommend this in hopes of dampening consumer demand

and lessening demand-pull inflation. This should happen as consumers find
themselves with less disposable income. However, at the same time there may
be some less desirable effects on aggregate supply. For example, workers
might demand higher wages to compensate for the higher taxes. Higher taxes
may cause lessened work incentives which could cause a decline in
productivity and, therefore, a rise in production costs. In other words, while
raising personal taxes seems to be a correct policy for dampening demand and
demand-pull inflation, it may have an offsetting effect on supply which could
cause cost-push inflation. [text: E p. 203; MA p. 203]

26. Use an aggregate demand-aggregate supply analysis to explain the impact of

the public’s expectations of severe inflation on real domestic output and the
price level.

The answer depends partly on where the economy is at the beginning of this
change. Assuming that inflation was already a problem, then increased
expectations would cause the demand curve to shift further rightward, adding
to the demand-pull type of inflation.
 The effect on aggregate supply would also be to worsen inflation from the cost-
push perspective. People would want higher wages and salaries now to
compensate them for the expected inflation of the future. Unless productivity
rose at the same rate, these demands for higher incomes would push up labor
costs of production which would shift the supply curve to the left. As this
happens the new equilibrium would be not only at a higher level of inflation, but
also at a lower level of employment. In other words, this leftward shift could
offset any possible increase caused by the rightward shift in aggregate
demand. The only certainty is that expectations of severe inflation add to the
probability of severe inflation because of the behavior of consumers and wage
earners. [text: E pp. 203-205; MA pp. 203-205]

27. (Last Word) Why was unemployment in Europe so high in recent years?

There are two basic perspectives on the reasons for high European unemployment rates. First, there are
high natural rates of unemployment that is due to frictional and structural unemployment. This results
from government policies and union contracts that increase the costs of hiring and reduce the cost of being
unemployed. Among the policies that affect these high costs are high minimum wages, generous welfare
benefits for the unemployed, restrictions against firings that discourage firms from employing workers,
long periods for paid vacation and holidays, high worker absenteeism that reduces productivity, and the
high costs of paying for fringe benefits that discourages hiring. Second, there is deficient aggregate
demand. European governments worried too much about inflation and have not enacted monetary or
fiscal policies that expand the economy. If such policies had been enacted, aggregate demand would
expand and unemployment rates would fall, without the threat of inflation because there is excess capacity
in the economy. [text: E p. 207; MA p. 207]
C. Appendix Questions

28. How can the aggregate demand curve be derived from the aggregate
expenditures model?

29. Explain the relationship between the aggregate expenditures model in graph
(A) below and the aggregate demand-aggregate supply model in graph (B)

Graph Graph

below. In other words, explain how points 1, 2, and 3 are related to points 1', 2',
and 3'.

30. How does the aggregate expenditures analysis differ from the aggregate
demand-aggregate supply analysis?

31. Why does aggregate demand shift outward by a greater amount than the
initial change in spending?
32. Explain the relationship between the aggregate expenditures model in graph
(A) below and the aggregate demand-aggregate supply model in graph (B)

below where aggregate demand is shifting while the price level remains
constant.

(A) (B)
D. Answers to Appendix Questions

28. How can the aggregate demand curve be derived from the aggregate
expenditures model?

The aggregate demand curve is derived from the intersections of the

aggregate-expenditures curves and the 45-degree curve. As the price level
falls, the aggregate expenditures curve shifts upward and the equilibrium real
GDP increases, but as the price level rises, the aggregate expenditures curve
shifts downward and the equilibrium real GDP decreases. The inverse
relationship between the price level and equilibrium real GDP is the aggregate
demand curve.

Note that for the aggregate-expenditure model that a decrease in the price
level: (1) increases the value of wealth; thus increasing the consumption
schedule. A decrease in the price level decreases the interest rate, thus
increasing the investment schedule. A decrease in the price level decreases
imports and increases exports, thus increasing net exports expenditures. Thus a
decrease in the price level will increase aggregate expenditures (and real
domestic output) because of these changes in wealth, interest rates, and net
exports. These three effects are also the ones that define the inverse
relationship between the price level and real domestic output in the aggregate
demand curve. [text: E pp. 211-212; MA pp. 211-212]

29. Explain the relationship between the aggregate expenditures model in graph
(A) below and the aggregate demand-aggregate supply model in graph (B)

Graph Graph
 below. In other words, explain how points 1, 2, and 3 are related to points 1', 2',
and 3'.

Through the real-balances, interest-rate, and foreign purchases effects, the consumption, investment, and
net exports schedules and therefore the aggregate expenditures schedule will rise when the price level
declines and fall when the price level increases. If the aggregate expenditure schedule is at (C + Ig + Xn)2
when the price level is P2, we can combine that price level and the equilibrium output, GDP2, to determine
one point (2') on the aggregate demand curve. A lower price level such as P1 shifts aggregate
expenditures to (C + Ig + Xn)1, providing us with point 1' on the aggregate demand curve. Similarly, a
higher price level at P3 shifts aggregate expenditures down to (C + Ig + Xn)3 so P3 and GDP3 yield another
point on the aggregate demand curve at 3'. [text: E pp. 211-212; MA pp. 211-212]

30. How does the aggregate expenditures analysis differ from the aggregate
demand-aggregate supply analysis?

The aggregate expenditures analysis assumes a constant price level. Output measures are in terms of real
GDP and real income. The aggregate demand-aggregate supply model shows the relationship between
real GDP and the price level. The Keynesian model ignores price level effects of increased aggregate
expenditures. In contrast, the AD-AS model indicates that the price level will rise as aggregate demand
rises in the intermediate or vertical ranges of aggregate supply. [text: E pp. 211-212; MA pp. 211-212]

31. Why does aggregate demand shift outward by a greater amount than the
initial change in spending?

The basic reason is because of the multiplier. As shown by the aggregate

expenditures model, an initial increase in spending times the multiplier will be
the amount that aggregate expenditures shift upward. The size of this total
increase will also be the amount of the shift of the aggregate demand curve
outward. Thus, the shift of the aggregate demand curve will be equal to the
initial change in spending times the multiplier. [text: E p. 212; MA p. 212]

32. Explain the relationship between the aggregate expenditures model in graph
(A) below and the aggregate demand-aggregate supply model in graph (B)
below where aggregate demand is shifting while the price level remains
constant.
 (A) (B)

In (A) we assume that some determinant of consumption, investment, or net

exports other than the price level shifts the aggregate expenditures schedule
from (C + Ig + Xn)1 to (C + Ig + Xn)2, thereby increasing real domestic output from
GDP1 to GDP2. In (B) we find that the aggregate demand counterpart of this is
a rightward shift of the aggregate demand curve from AD1 to AD2 which is just
sufficient to show the same increase in real output as in the expenditures-output
model. [text: E p. 212; MA p. 212]

CHAPTER 16
1. What is the basic difference between the short run and long run as these terms
relate to macroeconomics? Why does this difference occur?

The short run is a period in which nominal wages (and other input prices) do not
fully adjust as the price level changes. The long-run is a period in which nominal
wages are fully responsive to changes in the price level. Nominal wages tend
to remain fixed in the short run as the price level increases because workers may
not be fully aware of how inflation has eroded real wages. Also many workers
are under fixed contracts for several year periods. As a consequence of these
factors, nominal wages do not change immediately with changes in the price
level. [text: E pp. 292-293; MA pp. 292-293]

2. Complete the table below.

 Price Index Nominal Wage Real Wage

Per hour

100 $10 $_____

97 10 _____

94 10 _____

91 10 _____

88 10 _____

85 10 _____

Price Index Nominal Wage Real Wage

Per hour

100 $10 $10.00

97 10 10.31

94 10 10.64

91 10 10.99

88 10 11.36

85 10 11.76

[text: E p. 293; MA p. 293]

3. Complete the table below.

Price Index Nominal Wage Real Wage

Per hour

100 $10 $_____

103 10 _____

106 10 _____

109 10 _____

112 10 _____

115 10 _____
 Price Index Nominal Wage Real Wage

Per hour

100 $10 $10.00

103 10 9.71

106 10 9.43

109 10 9.17

112 10 8.93

115 10 8.70

[text: E p. 293; MA p. 293]

4. Assume that one year the nominal wage for a worker is $12 per hour and there
is no inflation. The next year the nominal wage stays the same but the rate of
inflation is 10 percent. What is the new real wage after taking inflation into
account? What nominal wage would workers ask for to keep their real wage
equal to what it was the first year?

The first year the nominal wage and the real wage are the same: $12 per hour.
The second year the nominal wage is $12, but the real wage is now $10.91. (To
obtain this number you take the $12 nominal wage and divided it by 1.10, which
is the 10 percent inflation expressed as price index in hundredths.) To
compensate for inflation, workers would want the nominal wage of $12 to
increase by 10 percent, or rise to $13.20 [$12 + ($12 x 1.10) = $13.20]. This
increase in the nominal wage to $13.20 would make the new real wage
($13.20/1.10 = $12) equal to the original $12 real wage. [text: E p. 293; MA p.
293]

5. Assume that one year the nominal wage for a worker is $15 per hour and there
is no inflation. The next year the nominal wage stays the same but the rate of
inflation is 8 percent. What is the new real wage after taking inflation into
 account? What nominal wage would workers ask for to keep their real wage
equal to what it was the first year?

The first year the nominal wage and the real wage are the same: $15 per hour.
The second year the nominal wage is still $15, but the real wage is now $13.76.
(To obtain this number you take the $15 nominal wage and divided it by 1.08,
which is the 8 percent inflation expressed as price index in hundredths). To
compensate for inflation, workers would want the nominal wage of $15 to
increase by 8 percent, or rise to $16.20 [$15 + ($15 x 1.08) = $16.20]. This nominal
wage of $16.20 would make the new real wage ($16.20/1.08 = $15) equal to the
original $15 real wage. [text: E p. 293; MA p. 293]

6. Describe the characteristics of the short-run aggregate supply curve. Explain

what happens to: (1) nominal wages; (2) real wages; (3) employment; (4)
output; (5) revenues; and, (6) profits as the price level increases from the full-
employment level of output. Then explain what happens to these variables as
the price level decreases from the full-employment-level of output.

The short-run aggregate supply curve will be an upsloping curve with the price
level on the vertical axis and real domestic output on the horizontal axis. The
initial level of output will be the full-employment level of output.

As the price level increases from the full-employment level of output, revenues
to the firm increase because nominal wages are fixed, and the profits for firms
will rise. Firms will have an incentive to increase output and employment (hiring
temporary or part-time workers or paying for overtime), so real GDP will increase
and unemployment will fall below its natural rate.

As the price level decreases from the full-employment level of output, revenues
to the firm decrease and because nominal wages are fixed, the profits for firms
will decrease. Firms will have an incentive to decrease output and
employment, so real GDP will decrease and employment will fall below its
natural rate. [text: E pp. 293-294; MA pp. 293-294]
7. Suppose the potential level of real domestic output (Q) for a hypothetical
economy is $250 and the price level (P) initially is 100. Use the following short-run
aggregate supply schedules below to answer the questions.

AS (P = 100) AS (P = 110) AS (P = 90)

P Q P Q P Q

110 280 110 250 110 310

100 250 100 220 100 280

90 220 90 190 90 250

(a) What will be the short-run level of real GDP if the price level rises
unexpectedly from 100 to 110 because of an increase in aggregate demand?
Falls unexpectedly from 100 to 90 because of a decrease in aggregate
demand? Explain each situation.

(b) What will be the long-run level of real GDP when the price level rises from
100 to 110? Falls from 100 to 90? Explain each situation.

(c) Show the circumstances described in (a) and (b) on the graph below and
derive the long-run aggregate supply curve.

(a) In the short run, the table reports that real GDP will rise to 280 when the
price level rises from 100 to 110. If it were to fall unexpectedly, then the real
GDP would fall to 220 temporarily. (a) In other words, short-run changes are
only temporary responses to changes in aggregate demand.

(b) In the long run, the wages and resource prices adapt to the changes in
the price level so that business profits will return to their original level and the
motivation to expand or contract output will disappear. The long-run real GDP
will be 250 according to the figures listed in the above table.
 (c) See graphs below. [text: E, pp. 293-294; MA pp. 293-294]

8. Suppose the potential level of real domestic output (Q) for a hypothetical
economy is $160 and the price level (P) initially is 200. Use the following short-run
aggregate supply schedules to answer the questions.

AS (P = 200) AS (P = 210) AS (P = 190)

P Q P Q P Q

210 190 210 160 210 220

200 160 200 130 200 190

190 130 190 100 190 160

(a) What will be the short-run level of real GDP if the price level rises
unexpectedly from 200 to 210 because of an increase in aggregate demand?
Falls unexpectedly from 200 to 190 because of a decrease in aggregate
demand? Explain each situation.

(b) What will be the long-run level of real GDP when the price level rises from
200 to 210? Falls from 200 to 190? Explain each situation.

(a) In the short run, the table reports that real GDP will rise to 190 when the
price level rises from 200 to 210. If it were to fall unexpectedly, then the real
GDP would fall to 130 temporarily. (a) In other words, short-run changes are
only temporary responses to changes in aggregate demand.
 (b) In the long run, the wages and resource prices adapt to the changes in
the price level so that business profits will return to their original level and the
motivation to expand or contract output will disappear. The long-run real GDP
will be 160 according to the figures listed in the above table. [text: E, pp. 293-
294; MA pp. 293-294]

9. Describe the characteristics of the long-run aggregate supply curve. Explain

how changes in the price level affect the short-run aggregate supply curve and
the long-run aggregate supply curve.

The long-run aggregate supply curve will be vertical at the full-employment

level of output. Changes in the price level will not affect the full-employment
level of output in the long-run. Changes in the short-run aggregate supply
curve will define the long-run aggregate supply curve at the full-employment
level of output.

With the short-run aggregate supply curve, as the price level increases from the
full-employment level of output along the curve, revenues to the firm increase
because nominal wages are fixed, and the profits for firms will rise. Firms will
have an incentive to increase output and employment (hiring temporary or
part-time workers or paying for overtime), so real GDP will increase and
unemployment will fall below its natural rate. This situation is a short-run one
because nominal wages (and other input prices) will eventually increase and
shift the short-run aggregate supply curve to the left. The new equilibrium will
return to the full-employment level of output, but at a higher price level.

Conversely, as the price level decreases from the full-employment level of

output, revenues to the firm decrease and because nominal wages are fixed,
the profits for firms will decrease. Firms will have an incentive to decrease
output and employment, so real GDP will decrease and employment will fall
below its natural rate. This situation is a short-run one because nominal wages
(and other input prices) will eventually decrease and shift the short-run
aggregate supply curve to the right. The new equilibrium will return to the full-
employment level of output, but at a lower price level. [text: E pp. 293-294; MA
pp. 293-294]
10. What is the long-run equilibrium in the extended aggregate demand and
aggregate supply model?

The equilibrium GDP and price level occur at the intersection of the aggregate
demand curve, the long-run aggregate supply curve, and the short-run
aggregate supply curve. The output level will be at the full-employment level of
output. [text: E p. 294; MA p. 294]

11. Describe the process that occurs with demand-pull inflation in the extended
aggregate demand and aggregate supply model.

Assume that the economy is initially in equilibrium at the full-employment level of

real output. If the price level rises because of an increase in aggregate
demand, then this event will cause a movement along the short-run aggregate
supply curve. The revenues and profits of firms increase because nominal
wages and the prices of other resources are fixed. Employment and output will
increase beyond the full-employment level to a temporary equilibrium. In the
long-run, once workers and resource suppliers realize that the price level has
risen they will want higher prices for their resources. When these higher
payments are made, the short-run aggregate supply curve will shift to the left.
This change will eventually result in a new equilibrium at a higher price level with
real output and employment returning to its full-employment level. [text: E pp.
295; MA p. 295]

12. Describe cost-push inflation in the extended aggregate demand and

aggregate supply model. Explain the policy dilemma for government policy if
they take no action or use monetary and fiscal policy to counter the cost-push
inflation.

Assume that the economy is initially in equilibrium at the full-employment level of

real output. Also assume that there is a major increase in the price of a major
resource (e.g., oil) for the economy. In this case, the price level rises because of
a decrease in the short-run aggregate supply curve caused by this increase in
the price of a major resource. This cost-push event will cause a movement
 along the aggregate demand curve to a short-run equilibrium at a higher price
level, but lower level of output.

If the government takes no action to counter the inflation, then a recession will
occur that will lead to higher levels of unemployment. At some point, the price
of the major resource that caused the inflation will decline along with nominal
wages (because of the recession), so that the short-run aggregate supply curve
shifts back to its original position.

If the government tries to counter the cost-push inflation and recession by using
stimulative monetary and fiscal policies, it will shift the aggregate demand
curve to the right. The action will increase employment and real output to its
full-employment level, but the price level will now be even higher. The higher
price level is likely to kick off another round of demands to increase nominal
wages that will cause another leftward shift in the short-run aggregate supply
curve. Thus, an inflationary spiral can result from government actions to
increase aggregate demand to counter cost-push inflation. [text: E p. 296; MA
p. 296]

13. Differentiate between “demand-pull” and “cost-push” inflation in the basic

aggregate demand and aggregate supply model.

Demand-pull inflation occurs when an increase in aggregate demand pulls up

the price level. Graphically, the demand curve is shifting rightward in the
intermediate or classical range of the aggregate supply curve. Cost-push
inflation is a result of aggregate supply decreasing relative to aggregate
demand. Graphically, the aggregate supply curve would be shifting leftward,
intersecting the aggregate demand curve at a higher level of prices. [text: E
pp. 295-296; MA pp. 295-296]

14. Explain what happens in the extended aggregate demand and aggregate
supply model when there is a recession.
 With a recession, the aggregate demand curve will decrease or shift left. As the
price level decreases from the full-employment level of output, revenues to the
firm decrease, and because nominal wages are fixed, the profits for firms will
decrease. Firms will have an incentive to decrease output and employment (to
reduce labor cost), so real GDP will decrease and employment will fall below its
natural rate. This situation is a short-run one, however, because nominal wages
(and other input prices) will eventually decrease and shift the short-run
aggregate supply curve to the right. The new equilibrium will return to the full-
employment level of output but be at a lower price level. [text: E pp. 296-297;
MA pp. 296-297]

15. What are three significant generalizations supported by results from the
extended AD-AS model?

First, under normal circumstances, there is a short-run tradeoff between the rate
of inflation and the rate of unemployment. Second, aggregate supply shocks
can cause both higher rates of inflation and higher rates of unemployment.
Third, there is no significant tradeoff between inflation and unemployment over
longer periods of time. [text: E p. 297; MA p. 297]

16. What is the Phillips Curve? What concept does it illustrate?

The Phillips Curve shows the relationship between the unemployment rate and
the rate of inflation. The relationship is an inverse one, so there is a short-run
tradeoff between the unemployment rate and the rate of inflation. For
example, if the unemployment rate increases by 1% then the inflation rate might
decline by .5%. The concept was developed by A.W. Phillips in Great Britain
based on empirical observation of the relationship between unemployment
and inflation in that nation. Modern economists reject the idea of a stable,
predictable Phillips Curve, although many economists do agree that there is a
short-run tradeoff between unemployment and inflation. [text: E pp. 297-298;
MA pp. 297-298]

17. Explain the Phillips Curve concept and construct an example of the curve on
the below graph.
 The Phillips Curve concept shows a stable inverse relationship between the rate
of unemployment and the rate of inflation. It is based on the idea that as
aggregate demand increases in the horizontal range of the aggregate supply
curve, unemployment will decline as real GDP rises without an inflationary
effect. However, as aggregate demand continues to grow and the
unemployment rate approaches full-employment, the price level and real GDP

will increase. Finally, at the point of full capacity, only the price level will rise as
potential real GDP has been achieved. See graph below. [text: E pp. 297-298;
MA pp. 297-298]

18. If the Phillips Curve exists in reality, what dilemma does this create for fiscal and
monetary policies? Explain.

The dilemma is that an expansionary fiscal and monetary policy aimed at

reducing unemployment may cause inflation, and vice versa for policies aimed
at reducing inflation. If there truly is a tradeoff, then successful elimination of
unemployment cannot be accomplished without creation of inflation; likewise,
stable prices occur only in the presence of some unemployment. [text E pp.
297-299; MA pp. 297-299]

19. What is stagflation and what was one of its causes in the 1970s and early 1980s?

Stagflation is the presence of both inflation and unemployment over a period of

time such as occurred in the 1972–1974 and 1977–1980 periods. The major
cause appears to be a series of adverse aggregate supply shocks that shifted
the economy's short-run aggregate supply curve to the left. One of the major
shocks was the quadrupling of oil prices by the Organization of Petroleum
Exporting Countries (OPEC) that significantly increased energy prices. Other
shocks included severe agricultural shortfalls around the world, the depreciation
 of the dollar, wage and price increases after wage-price controls were
removed, and a decline in productivity. [text E pp. 299-300; MA pp. 299-300]

20. Assume the following information is relevant for an advanced economy over a
three-year period. Describe in detail the macroeconomic situation faced by
this society. Is cost-push inflation evident? What corrective policies would you
recommend and why?

Increase in Increase in Average

Price labor industrial Unemp. hourly

Year index productivity production rate wage

1 167 4% 4% 4.5% $6.00

2 174 3 2 5.2 6.50

3 181 2.5 1.5 5.8 7.10

This economy seems to be in a period of stagflation-inflation is rising at the same

time that unemployment is increasing. There appear to be two reasons for this:
labor productivity and industrial production growth are falling, and at the same
time the hourly wage rate is rising. This indicates an increase in unit labor costs
that must be covered by rising prices or firms will cut back still further on output
plans due to declining profits, which would be caused by the increase in labor
cost, and decline in production. Cost-push inflation is present. [text: E pp. 299-
300; MA pp. 299-300]

21. What contributed to stagflation's demise between 1982 and 1989? How did
these events affect aggregate supply and the Phillips Curve?

There was a deep recession from 1981 to 1982 that reduced the pressure for
workers to increase wages and for firms to increase prices. Increased foreign
competition also restrained domestic wage and price increases in the United
States. The U.S. economy also underwent deregulation in many basic industries
 that stimulated more competition and further restrained price and wage
increases. In addition, the monopoly and pricing power over oil by the OPEC
cartel was weakened, thus reducing energy prices for consumers and
businesses. These factors worked to reduce the per-unit cost of production and
shift the economy's short-run aggregate supply curve to the right and shift the
Phillips Curve back to the left. [text E p. 300; MA p. 300]

22. Compare and contrast the short-run Phillips Curve and the long-run Phillips
Curve.

In the short-run, an expansion of aggregate demand may temporarily increase

profits and therefore output and employment. Nominal wages, however, will
soon rise as workers demand that their nominal wages keep pace with inflation,
which reduces profits and negates the short-run stimulus to production and
employment. Consequently, in the long run there is no tradeoff between the
rates of inflation and the unemployment rate because the unemployment rate
tends back to its natural rate after resource markets adapt to changes in policy.
The long-run Phillips Curve is thus vertical with the unemployment rate equal to
the natural rate and constant at all levels of inflation. [text: E pp. 300-302; MA
pp. 300-302]

23. Answer the questions based on the following diagram.

(a) Assume the economy is initially at point B1 and there is an increase in

aggregate demand which results in a 4% increase in prices. Describe the short-
run and long-run outcomes that would result in this economy.
 (b) Assume the economy is initially at point B2, and there is an increase in
aggregate demand. What will happen in the economy? Explain, using the
graph.

(c) Based on this diagram, what would the prediction be for the natural (full-
employment) rate of unemployment?

(a) In the short run, the unemployment rate will fall to C1, or 5% from its original
level of 7% as firms increase prices, obtain more revenues, and thus can afford
to hire more workers at the fixed nominal wage. In the long run, as workers and
firms adapt to the higher price level, the unemployment rate will return to 7% as
indicated by point B2 at the annual rate of inflation.

(b) Essentially the same answer as in (a). In the short run, the unemployment
rate will fall to C2, or 5% from its original level of 7%. In the long run, as workers
and firms adapt to the new higher price level, the unemployment rate will return
to 7%, as indicated by point B3.

(c) According to the diagram 7% is the natural rate. [text: E pp. 301-302; MA
pp. 301-302]

24. Why is the difference between the actual and expected rates of inflation
important for explaining inflation?

When the actual rate of inflation is higher than the expected rate of inflation,
profits temporarily rise because prices that firms charge for their products are
rising faster than wage rates. (The nominal wage rates were based on a lower
expected rate of inflation than actually exists.) With more revenues, firms can
afford to employ more workers so the unemployment rate temporarily falls. In
the long run, firms and workers adjust their expectations to the new higher rate
of inflation. This means that there will be an increase in the nominal wages rate,
so the profits decrease. The firm cannot afford to hire as many workers so some
workers get laid off. The unemployment rate rises and returns to its natural rate.
[text: E pp. 301-302; MA pp. 301-302]

25. What is disinflation? Give examples of it.

 Disinflation is a reduction in the inflation rate from year to year. If the inflation
rate was 10 percent the first year, the rate might be only 8 percent the next
year, and 6 percent the year after. In each year, there is inflation in the
economy, but the rate of inflation is lower from one year to the next. [text: E p.
302; MA p. 302]

26. Why is the difference between the actual and expected rates of inflation
important for explaining disinflation?

When the actual rate of inflation is lower than the expected rate of inflation,
profits temporarily fall because the prices that firms charge for their products are
falling faster than wage rates. (The nominal wage rates were based on a higher
expected rate of inflation than actually exists.) With less revenue, firms cannot
afford to employ more workers so the unemployment rate temporarily rises. In
the long run, firms and workers adjust their expectations to the new lower rate of
inflation. This means that the increase in nominal wages falls and the profits of
firms rise. Firms can afford to hire more workers, so the unemployment rate falls
and returns to its natural rate. [text: E p. 302; MA p. 302]

27. Explain the basic arguments for supply-side economics.

The basic tenet of supply-side economics is that macroeconomic policies have

focused on aggregate demand while ignoring the impact of those policies on
aggregate supply. Supply-siders contend that changes in aggregate supply
are just as active a force in determining employment and price levels as are
changes in aggregate demand. In particular, they argue that high marginal
tax rates, public transfer programs, and overregulation have caused the
aggregate-supply curve to shift leftward while the aggregate-demand curve is
being shifted rightward. [text: E pp. 302-303; MA pp. 302-303]

New28. Contrast “supply-side” economics with “demand-side” fiscal policy.

“Supply-side” economics advocates the use of government tax or spending

policies to alter the supply schedule, that is, the production side of the
economy. Tax reductions may have an expansionary effect on aggregate
 supply as well as aggregate demand. Some economists argue that as taxes
are cut, savings and investment will increase. Also tax cuts could be aimed
specifically at encouraging business investment such as investment tax credits.
“Supply-side” economists also argue that tax increases can reduce tax
revenues rather than increasing them due to a leftward shift in the aggregate
supply curve which causes a decrease in domestic output. [text: E pp. 302-303;
MA pp. 302-303]

New29. (Consider This) How did Arthur Laffer use Robin Hood and Sherwood Forest to
explain the advantage of supply-side economics?

Laffer considered people passing through Sherwood Forest as taxpayers from

which Robin Hood collected taxes. The tax rate in this case was almost 100
percent because travelers had all their money confiscated when they passed
through the forest. The reaction to this situation would be to avoid the forest. In
this case, there would be less revenue for Robin Hood. Laffer suggested that
people, when confronted with high taxes, would change their behavior by
working less, saving less, retiring early, and doing other things to avoid taxes.
The tax collection policy would result in less revenue for government rather than
more. [text: E p. 304; MA p. 304]

30. What is the Laffer Curve? Explain the relationship that is shown in the curve.

The Laffer Curve indicates that the relationship between tax rates and tax
revenues is not a clear one. At the extreme, both a zero rate and 100% tax rate
will produce zero revenue. In between the two extremes there is an optimal tax
rate in terms of maximizing revenue. If tax rates are above the optimal level,
then tax revenues will rise as tax rates are cut. If tax rates are below the optimal
level then tax revenues will fall as tax rates are cut. Laffer argued that tax rates
were above the optimal level and that by lowering tax rates, the government
could increase tax revenue and increase economic output at the same time.
[text: E p. 303; MA p. 303]
31. Use the following diagram to answer the next three questions.

(a) What is this diagram called and what does it say about the relationship
between tax rates and tax revenues?

(b) If tax rates are at level c, should the government raise or lower tax rates to
increase revenues? Explain.

(c) What does tax level b represent? Could policy makers find the actual
rate that b represents? Discuss this point.

(a) This diagram is called the Laffer Curve, named after the economist who
first used the diagram to illustrate the hypothesized relationship between tax
rates and tax revenues shown. It illustrates that there is an optimal rate of taxes
in terms of maximizing tax revenues and that rates above or below that level will
cause revenue to decline. At the extreme, a zero rate and a 100% rate of tax
have the same zero revenue.

(b) If rates are at level c, the government could increase revenue by lowering
the tax rate to any rate between levels c and b. Tax revenues rise according to
the diagram as rates fall from c to b, but below level b, revenues fall again.

(c) Tax level b represents the maximum revenue-producing rate. It is difficult

for policy-makers to find this point because of the different types of taxes levied
and their differing impact on both supply and demand. If a cut in taxes can be
shown to increase revenue, then we know that the rate was above b. The
problem is that this is often not known until the tax cut is enacted and if policy
makers were wrong, the tax cut could end up reducing revenues. Then it is very
difficult to raise taxes again to bring revenues back to their former level. [text: E
p. 303; MA p. 303]
 32. Draw a Laffer Curve and explain the relationship it purports to portray. Why
might this curve be important for macroeconomic policy?

Draw a curve similar to Figure 16.10 from the text. The following curve suggests
that up to point b higher tax rates will result in larger tax revenues, but beyond
that any increase in rates will have adverse effects on incentives, result in tax
avoidance or tax evasion, and generally reduce overall tax revenues. The

curve is important for macroeconomic policy because it correctly suggests that

there is an upper limit to tax rates in terms of their potential to increase revenue.
Beyond the limit, higher rates will not raise revenues, but will lower them. Laffer
was suggesting that the government had already reached the limit and that by
lowering rates the government could increase revenue. That is the point of
debate. There is little evidence to suggest what the upper limit on tax rates
might be in terms of their revenue-raising potential. See graph below. [text: E p.
303; MA p. 303]

New33. What is supply-side economics? What is the rationale for it? Is it effective?

Some economists argue that a reduction in taxes will expand aggregate supply.
From this perspective, fiscal policy can be used to increase real GDP with little or
no rise in the price level, as would be the case if tax cuts expanded aggregate
demand.

There are three possible reasons for the supply-side effect of tax cuts. First, lower
taxes increase disposable income that may increase household saving. They
 may also stimulate businesses’ investments because they increase the after-tax
profitability of businesses. Second, lower taxes also give people more incentive
to work because they keep more of their income. Third, lower taxes will
encourage more risk-taking and entrepreneurship in society because the after-
tax reward has been increased.

Many economists are skeptical about the supply-side effect of tax cuts based
on the experience with them during the 1980s. The positive effects on incentives
to save, invest, or work may not be very large, and therefore the stimulus to the
supply-side may be minor. In other words, the demand-side effects of tax cuts
appear to be far greater, and more immediate than any of the supply-side
effects. [text: E pp. 302-305; MA pp. 302-305]

34. What are the major criticisms of the Laffer curve and supply-side economics?

First, a fundamental criticism relates to the question of economic incentives and

whether they are affected much by existing tax rate changes. The skeptics
contend that tax cuts have minimal effects on short-run incentives to work,
save, and invest. These tax cuts do not appear to increase productivity.
Second, most economists believe that the demand-side effects of tax-transfer
policies outweigh any offsetting supply-side effects. If the tax cuts increase
aggregate demand more than aggregate supply, inflation is likely to result.
Third, it is difficult to determine the optimal level of taxation. If the tax rate for
the economy is below the optimal tax rate, a tax cut can reduce tax revenues
rather than raise them. [text: E p. 304; MA p. 304]

35. (Last Word) Has the effect of oil prices increases on the economy been
diminished? Cite evidence to support the case for a diminished effect.

An increase in oil prices has been thought to contribute to stagflation. Oil prices
are a major input into the cost of producing many products. If this price
increases, then the AS curve would decrease, driving up the price level and
reducing real output.
 Several reasons are cited as to why the oil price increase in the late 1990s has
been less severe than would be expected. First, some firms that used oil-related
products for production may have thought that any oil price increases would
be temporary, and thus did not change their production plans or prices.
Second, and perhaps most important, other factors affecting aggregate supply
may have offset the negative effects of the oil price increase. One such factor
would be an increase in productivity due to investments in new technology.
Third, the nation is less sensitive to changes in oil prices than in past decades
because it uses less energy to produce GDP. The Federal Reserve has also
become more adept using monetary policy to respond to short-term changes in
energy prices so that they have less of an effect on the core inflation rate. [text:
E p. 305; MA p. 305]

CHAPTER 12
1. Give a brief definition of fiscal policy? What are its economic goals?

Fiscal policy is the use of the federal budget to achieve full employment, control
inflation, and stimulate economic growth. The changes to the federal budget
can be made through increases or decreases in government spending or
through increases or decreases in tax revenues. [text: E p. 214; MA p. 214].

2. What is the Council of Economic Advisers?

The Council of Economic Advisors is responsible for assisting and advising the
president on economic affairs. One of its principal responsibilities is to prepare
an annual report for the president that is submitted to Congress that describes
the state of the economy and recommends economic policies to achieve full
employment, control inflation, and encourage economic growth. [text: E pp.
214-215; MA pp. 214-215].

3. “The Employment Act of 1946 is no more than a vague and ill-defined

commitment by the Federal government to assist in the achievement of full
employment.” Do you agree? Explain.
 To agree with this statement does not diminish the importance of the
Employment Act of 1946. The Constitution has also been called vague and ill-
defined, but that does not diminish its importance. This act committed the
Federal government to following policies which would attempt to stabilize prices
and promote full employment and established the CEA and JEC to assist in this
task. While specific policies were not outlined, the intention of the act is clear it
is a responsibility of the Federal government to assist in this effort. That had not
been an explicit on-going policy before 1946. [text: E p. 214; MA p. 214]

4. Explain the effect of a discretionary cut in taxes of $40 billion on the economy
when the economy’s marginal propensity to consume is .75. By how much is
output likely to expand if the economy is operating in the horizontal range of its
aggregate supply curve and there are no complications to this fiscal policy?
How does this discretionary fiscal policy differ from a discretionary increase in
government spending of $40 billion?

If MPC is .75, the multiplier is 4. A tax cut of $40 billion will result in initial increase
in consumption of $30 billion (.75 × $40 billion). This initial increase in spending
will ultimately result in an increase in consumption spending of $120 billion
because of the multiplier process. In contrast, an initial increase in government
spending of $40 billion will ultimately increase consumer spending by $160 billion
(4 × $40) because none of the initial increase is siphoned off as savings as would
be the case with a $40 billion tax cut. [text: E pp. 215-216; MA pp. 215-216]

5. Explain the effect of a discretionary increase in government spending of $50

billion on the economy when the economy’s marginal propensity to consume is
.75. By how much is output likely to expand if the economy is operating in the
horizontal range of its aggregate supply curve and there are no complications
to this fiscal policy?

If MPC is .75, the multiplier is 4. An initial increase of $50 billion government

spending will result in a total increase in output of $200 billion. [text: E pp. 215-
216; MA pp. 215-216]
6. Explain the aspects of expansionary and contractionary fiscal policy. During
which phases of the business cycle would each be appropriate?

Expansionary fiscal policy refers to increases in government spending or

decreases in taxes or both, so that the net effect on aggregate demand is an
increase in net government spending. Contractionary fiscal policy is the
opposite: an increase in taxes or decrease in government spending or both, so
that the net effect on aggregate demand is a decrease in net government
spending.

Expansionary policy would most likely be used during a recession (or trough)
phase. A contractionary policy would most likely be employed near the peak
of the business cycle as the economy reaches full-employment GDP and the
potential for inflation accelerates. [text: E pp. 215-217; MA pp. 215-217]

7. Differentiate between discretionary fiscal policy and nondiscretionary or built-in

stabilization policy.

Discretionary fiscal policy is the deliberate manipulation of taxes and

government spending by the Congress to alter real domestic output and
employment, to control inflation, and to stimulate economic growth during a
particular period of time. Nondiscretionary fiscal policy, on the other hand, is
the change in government expenditures or taxes which occurs automatically as
a result of existing laws. In particular, personal income taxes have progressive
rates and will slow spending and inflation as GDP expands; when GDP declines,
taxes will decrease by a more than proportionate amount allowing incomes
and spending to decline at a slower rate than GDP. There are also many
transfer payment programs which become effective when incomes decline or
unemployment occurs to reduce the decline in disposable income. Conversely,
these programs automatically are reduced when the economy expands and
unemployment declines and spending increases. [text: E pp. 215, 219-220; MA
pp. 215, 219-220]

8. Describe two ways the Federal government can finance a deficit and explain
which would have the more expansionary effect.
 The government can borrow money from the private sector in which case it will
be competing with private business borrowers for funds. If planned investment
spending is “crowded out,” the impact of expansionary deficits will be offset by
the decline in investment spending.

The government can also finance a deficit by issuing new money which
essentially means that the Federal Reserve has financed the deficit. This type of
financing would be more expansionary than borrowing from the private sector.
[text: E pp. 217-218; MA pp. 217-218]

9. Describe two ways the Federal government could retire debt in the event of a
budget surplus and explain which would have the most contractionary impact.

The government could use a budget surplus to pay off existing debt which
would “recycle” funds back into the economy and potentially offset the decline
in government spending. Alternatively, the government could impound the
surplus funds, or allow them to stand idle, which means these funds are not
injected into the economy and would have a more contractionary effect than
the first alternative. [text: E p. 218; MA p. 218]

10. What is the anti-inflationary or contractionary effect of a budget surplus?

The anti-inflation effect of a budget surplus depends on what the government

does with the surplus. The budget surpluses may be used for debt reduction. In
this case, bonds are bought back by the government and money is pumped
back into the economy. Interest rate will tend to fall, and this may increase
consumer and investment spending, thus offsetting some of the contractionary
effect of the budget surplus. The government may also impound funds (not
spend them). This action will be more contractionary because it actually
removes spending from the economy that would have been spent otherwise.
[text: E p. 218; MA p. 218]
 11. Explain how a small budget surplus could actually be somewhat expansionary
rather than contractionary.

This could be the unlikely result of what the government decides to do with the
surplus. If it is used to retire existing debt, then the surplus is pumped right back
into the economy and with the multiplier effect this additional liquid wealth in
the hands of individuals could lead to an increase in aggregate demand and
GDP. [text: E p. 218; MA p. 218]

New12. Comment on the statement: “Increasing government spending is preferred to a

cut in taxes when the U.S. government seeks to fight a recession.”

The statement is a normative one. Either action, increased government

spending or taxation, can be use to fight a recession. The policy choice will
depend on the preferences of the individual. Those individuals who want to
fight a recession with an increase in government spending may want to
preserve the size of government in the economy and have specific government
programs they would like to see funded. Those individuals who prefer a tax cut
may want to reduce the size of government and give people more money and
the freedom to spend it as they chose. [text: E p. 218; MA p. 218]

13. Explain what is meant by a built-in stabilizer and give two examples.

Built-in stabilizers are changes in tax revenues or government spending which

occur automatically during different phases of the business cycle. For example,
the progressive income tax will dampen any expansion of aggregate demand
in the recovery peak phases; and will dampen any decline in income and
aggregate demand during a recession as taxes are automatically reduced by
a greater proportion than the decline in personal income. There are also
government spending programs which increase during recessionary periods
automatically as incomes decline or are lost. The so-called “safety net”
programs include unemployment compensation, welfare programs, and food
stamp spending. These spending programs are automatically reduced during a
recovery peak phase which would dampen aggregate demand and
inflationary pressures automatically. [text: E pp. 218-219; MA pp. 218-219]
14. “The more progressive a tax system, the greater is the economy’s built-in
stability.” Explain this statement for both recessionary and peak phases of the
business cycle.

A progressive tax would take a progressively greater proportion of rising incomes

during the peak phase of the business cycle which means it would dampen
spending increases and aggregate demand which, in turn, reduces inflationary
pressures. On the other hand, a progressive tax would take proportionately less
away from declining incomes during a recessionary phase allowing disposable
income to fall less rapidly than real GDP. Therefore, aggregate demand would
decline less rapidly than GDP and the magnitude of the spending decline that
might occur in the absence of the tax would be reduced. [text: E pp. 219-220;
MA pp. 219-220]

15. Explain how the below graph illustrates the built-in stability of a progressive tax

structure.

The graph illustrates how net taxes are negative as GDP declines which will add
to aggregate demand. When GDP expands, tax revenues increase which
dampens aggregate demand. [text: E pp. 219-220; MA pp. 219-220]

16. In Year 1, the full-employment budget showed a deficit of about $100 billion
and the actual budget showed a deficit of $150 billion one year. In Year 2, the
full employment budget showed a deficit of about $125 billion and the actual
budget showed a deficit of $150 billion. Based on these data, what can be
concluded about the direction of fiscal policy?
 Fiscal policy was expansionary because the full-employment budget deficit
increased from one year to the next. The actual deficit is composed of the full-
employment portion and the cyclical portion. The full-employment portion of
the actual budget deficit rose from $100 to $150 billion. The cyclical portion is
determined by taking the actual deficit and subtracting the cyclical portion
from it. The cyclical portion of the actual deficit fell from $50 billion to $25 billion.
The actual budget deficit did not change, but it does not provide a good
indication of the direction of fiscal policy. Only the full-employment budget tells
the direction of fiscal policy. [text: E pp. 220-221; MA pp. 220-221]

17. What is the difference between the actual deficit, the full-employment deficit,
and the cyclical deficit?

The actual budget deficit for any year consists of the full-employment and the
cyclical deficit. The full-employment deficit is the difference between
government expenditures and tax collections which would occur if there were
full employment output. The cyclical deficit is the portion of the actual deficit
that arises because the economy is in recession and is produced by this
downturn in the business cycle. During a recession, a cyclical deficit often
occurs because tax revenues fall as incomes fall and government expenditures
increase as more is spent for government transfer payments and other
programs. The cyclical deficit occurs because of the operation of these
automatic stabilizers. [text: E pp. 221-222; MA pp. 221-222]

18. What does the “full-employment budget” measure and of what significance is
this concept?

The full-employment budget refers to the budget deficit or surplus that would
result with existing tax and spending programs if the economy were operating
at full-employment. In other words, tax revenues and government spending are
estimated at the level that would result if full employment existed.

Some economists believe that the full-employment budgetary deficit or surplus

is what should determine the expansionary or contractionary nature of fiscal
 policy rather than the actual budgetary deficit or surplus. If the full-employment
budget is not in deficit, then expansionary fiscal policy is not being followed
according to this view even if the actual budget is in deficit. [text: E pp. 221-
222; MA pp. 221-222]

19. Complete the table below by stating whether the direction of discretionary
fiscal policy was contractionary (C), expansionary (E), or neither (N), given the
hypothetical budget data for an economy.

(1) (2) (3) (4)

Actual budget

deficit (–) or Full-employment budget Direction of

Year surplus (+) deficit (–) or surplus (+) fiscal policy

1 – 3.9% – 2.1%

2 – 4.5 – 2.6 E

3 – 4.7 – 3.0 E

4 – 3.9 – 2.6 C

5 – 2.9 – 2.0 C

6 – 2.2 – 1.9 C

[text: E pp. 221-222; MA pp. 221-222]

20. In what fundamental way do the spending-taxation decisions of government

differ from the consumption-saving plans of households? Why is this difference
significant?

The spending-taxation decisions of government are made in a political

environment in which the majority must be satisfied, or satisfied enough to
continue to vote for its elected representatives. Furthermore, since the
 government does not have a limited lifespan and always has the ability to tax,
deficit-spending and debt do not have the same significance to governments
that they do to individual households. Households face a much more uncertain
future with regard to their power to raise revenue (income) and therefore must
plan their spending and saving to coincide with their lifetime earnings
expectations.

The difference is significant because so many people try to draw an analogy

between government spending policies and household spending plans when it
is usually not appropriate to do so. [text: E pp. 223-224; MA pp. 223-224]

New21. Comment on the statement: “Discretionary fiscal policy offers an ideal

approach to dealing with the nation’s economic problems. It is without
problems, criticisms, or complications.”

Discretionary fiscal policy does offer government policymakers potential tools

(changing taxes or government spending) to use for stimulating the economy
during a recession or for contracting the economy during a period of high
inflation. Fiscal policy, however, is not without its problems, criticisms, or
complications. First, there are timing problems in getting it implemented at the
right time so it will be effective. Second, there are political problems in getting it
accepted because it takes time to get the actions passed through Congress
and signed by the President. Third, there are expectations problems because
policies may be reversed in the future. Fourth, the taxing and spending
decisions of the Federal government may be partially offset by the taxing and
spending decisions of state and local governments. Fifth, some economists are
concerned that expansionary fiscal policy that requires the Federal government
to borrow money will raise interest rates and crowd out investment spending,
thus reducing the expansionary effect of the fiscal policy. Sixth, there are
complications arising from the connection of the domestic economy to the
world economy. Aggregate demand shocks from abroad or a net export
effect may increase or decrease the effectiveness of a given fiscal policy. [text:
E pp. 223-225; MA pp. 223-225]

New22. Explain the six problems, criticisms, or complications that arise in the
implementation of fiscal policy.
First there is a timing problem. Three lags are identified under the “timing
problem” category. There is a lag in recognizing the phase of the business
cycle; there is an administrative lag in deciding which policies to follow; there is
an operational lag in terms of the impact of the policy once it is implemented.

Second, there are political considerations in the adoption of fiscal policy. There
is some evidence of a political business cycle where particular expansionary
policies are followed in election years whether or not economic conditions merit
them.

Third, there is an expectations complication. If businesses and households

expect that the fiscal policy will be reversed in the future, they may not change
their behavior in the way that would be expected if the fiscal policy was
permanent.

Fourth, the taxing and spending decisions of state and local governments may
counteract or reduce the effectiveness of fiscal policy decisions at the federal
level. The U.S. government may enact an expansionary fiscal policy by
increasing its budget deficit, but state and local governments often have to
balance a budget and economic conditions may force them to adopt a
contractionary policy that partially offset what the federal government is
seeking to achieve.

Fifth, there is concern about possible offsetting effects of government borrowing

crowding out private spending that would occur in the absence of the
government deficit; and an offsetting net export effect which partly
counteracts expansionary policy or contractionary policy.

Sixth, there are complications to domestic fiscal policy from the national
economy’s connection to the world economy. Economic shock from abroad
can have an effect on the nation’s imports and exports. The net export effect
can reduce the intended effects of fiscal policy. [text: E pp. 223-226; MA pp.
223-226]
New23. Explain the problems giving rise to this statement: “You would think the
government would want to do something to improve economic conditions
when the economy is in trouble, but the government is slow to act.”

Fiscal policy is subject to timing problems. There are three timing lags that limit
the speed with which fiscal policy can be enacted and effective. First, there is
a lag in recognizing the phase of the business cycle to determine when the
government might want to provide help. Second, there is an administrative lag
in decision-making that involves deciding which specific policies should be
adopted. Third, there is an operational lag because the adoption of policies
takes time to have an effect on output and employment. [text: E p. 223; MA p.
223]

New24. How do expectations about the future by households and businesses affect the
effectiveness of fiscal policy? Cite examples.

If households or businesses expect that the fiscal policy changes are only
temporary, they may not change their behavior in the expected way. For
example, if tax cuts are enacted to stimulate consumer spending, some
consumers may not change their spending habits if they think the tax change is
only temporary. In the future, they will have to pay more in taxes, so they might
increase their saving. Similarly, businesses may not invest in new plants and
equipment if they get a tax cut, if they expect taxes in the future to rise or the
fiscal policy to be ineffective. [text: E pp. 223-224; MA pp. 223-224]

25. “If economic forecasting was a more exact science, the business cycle could
be entirely corrected by fiscal measures.” Do you agree?

Exact forecasting, if possible, would still not solve all of the problems
encountered in trying to correct the business cycle. There is also the problem of
timing the enactment and application of fiscal policy, not to mention the
coordination of monetary policy and international economic policies, or
 reduced private spending (“crowding out”). [text: E pp. 223-225; MA pp. 223-
225]

26. Explain the crowding-out effect.

The crowding-out effect is the notion that government borrowing to finance a

deficit may crowd out or reduce private borrowing. To the extent that this
occurs, the expansionary impact of fiscal policy is reduced because increased
demand by the government is partially offset by reduced demand in private
investment. [text: E pp. 224-225; MA pp. 224-225]

27. Using the below graph, illustrate the possible impact of a crowding-out effect of
a fiscal policy by drawing in the relevant aggregate demand shifts. Label and

explain any shifts in the demand curve shown.

Expansionary fiscal policy increases demand from AD1 to AD2, but this crowds
out some private investment spending that offsets the increase to some extent
 causing AD2 to decrease to AD3. See graph below. [text: E pp. 224-225; MA pp.
224-225]

28. Explain how the net-export effect would reduce the effectiveness of fiscal
policy.

If an expansionary fiscal policy brings with it higher interest rates, this could
increase the demand for American dollars by foreign investors seeking to earn
the higher U.S. returns. This appreciation of the dollar makes U.S. goods and
services more expensive to foreigners and foreign imports less expensive to
Americans. The net export category of aggregate demand will be reduced
which would reduce the impact of expansionary fiscal policy. A contractionary
fiscal policy could have the opposite effect causing net exports to increase that
again reduces the desired effect of the contractionary fiscal policy. [text: E pp.
225-226; MA pp. 225-226]

New29. What fiscal policy is most likely to be invoked during a period of recession and
high unemployment? A period of rapid inflation? What political, investment,
and international problems might the U.S. Congress encounter in enacting these
policies and putting them into effect?

During recession and high unemployment, the government would most likely
initiate an expansionary fiscal policy. A contractionary fiscal policy would most
likely be called for during a period of rapid inflation, especially if it seems to be
demand-pull inflation.

Several problems are likely to arise in enacting either of these policies. Timing
lags in recognition, implementation, and impact are one concern. Another has
to do with political realities. A contractionary policy has many unpopular
aspects to it because it calls for raising taxes and for cutting government
spending. There are also unique problems associated with expansionary policy:
crowding out is one potential result that would reduce the expansionary effect
of the policy. In both cases, the net-export part of aggregate demand is likely
to move in a direction that would tend to offset the policy. [text: E pp. 223-226;
MA pp. 223-226]
30. (Last Word) What is the purpose of the Conference Board’s index of leading economic indicators?

The index of leading indicators is a monthly index of economic statistics that are used to forecast the
direction of real GDP. Changes in the index provide an indication of the future direction of the economy
and are useful to policy makers in developing responses to deteriorating conditions in the economy. The
rule of thumb is that three successive decreases or increases in the index indicate a change of direction in
the economy. [text: E p. 227; MA p. 227]

31. (Last Word) Why is the index of leading economic indicators a composite index of ten economic statistics
and not just one?

Each of the economic statistics used to prepare the index may increase or decrease in any month and thus
give false or contradictory signals about the direction of the economy. It is less likely that all these
economic indicators, taken together, will give as many false signals about the direction of the economy as
one indicator will. Thus the composite index is more reliable than any one indicator. The composite
index, however, is not infallible and can also give false indications about the direction of the economy
because of changes in the structure of the economy or developments that are not covered by the indicators
that make up the index. [text: E p. 227; MA p. 227]