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Review Quiz Answers-Chapter 4 1. Define GDP and distinguish between a final good and an intermediate good. Provide examples. GDP is the market value of all the final goods and services produced within a country in a given time period. A final good or service is an item that is sold to the final user, that is, the final consumer, government, a firm making investment, or a foreign entity. An intermediate good or service is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service. For instance, bread sold to a consumer is a final good, but wheat sold to a baker to make the bread is an intermediate good. Distinguishing between final goods and services and intermediate goods and services is important because only final goods and services are directly included in GDP; intermediate goods must be excluded to avoid double counting them. For example, counting the wheat that went into the bread as well as the bread would double count the wheat—once as wheat and once as part of the bread. 2. Why does GDP equal aggregate income and also equal aggregate expenditure? GDP equals aggregate income because one way to value production is by the cost of the factors of production employed. GDP equals aggregate expenditure because another way to value production is by the price that buyers pay for it in the market. 3. What is the distinction between gross and net? ―Gross‖ means before subtracting depreciation or capital consumption. ―Net‖ means after subtracting depreciation or capital consumption. The terms apply to investment, business profit, and aggregate production. 1. What is the expenditure approach to measuring GDP? The expenditure approach measures GDP by focusing on aggregate expenditures. Data are collected on the different components of aggregate expenditure and then summed. Specifically, the Bureau of Economic Analysis collects data on consumption expenditure, C, investment, I, government expenditure on goods and services, G, and net exports, X-M. These expenditures are valued at the prices paid for the goods and services, called the market price. GDP is then calculated as C + I + G + X-M 2. What is the income approach to measuring GDP? The income approach measures GDP by focusing on aggregate income. This approach sums all the incomes paid to households by firms for the factors of production they hire. The National Income and Product Accounts divide income into five categories: compensation of employees; net interest; rental income; corporate profits; and proprietors’ income. Adding these income components does not quite equal GDP, because it values the output at factor cost rather than the market price and omits depreciation. So, further adjustments must be made to calculate GDP: Indirect taxes and depreciation must be added and subsidies subtracted. 3. What adjustments must be made to total income to make it equal GDP? Total income is net domestic product at factor cost. To convert it to gross domestic product at market prices, we must add the depreciation of capital and add indirect taxes minus subsidies. 4. What is the distinction between nominal GDP and real GDP? Nominal GDP is the value of final goods and services produced in a given year valued at the prices of that year. Real GDP is the value of final goods and services produced in a given year when valued at the prices of a reference base year. By comparing the value of production in the two years at the same prices, we reveal the change in production.

5. How is real GDP calculated? The traditional method of calculating real GDP is to value each year’s GDP at the constant prices of a fixed base year. 1. Distinguish between real GDP and potential GDP and describe how each grows over time. Real GDP is the value of final goods and services produced in a given year when valued at the prices of a reference base year. Potential GDP is the amount of real GDP that would be produced when all the economy’s labor, capital, land, and entrepreneurial ability are fully employed. So real GDP is the actual amount produced with the actual level of employment of the nation’s factors of production while potential GDP is the amount that would be produced if there were full employment of all factors of production. 2. How does the growth rate of real GDP contribute to an improved standard of living? A benefit of long-term economic growth is the increased consumption of goods and services that is made possible. Growth of real GDP also allows more resources to be devoted to areas such as health care, research, and environmental protection. 3. What is a business cycle and what are its phases and turning points? The business cycle is a periodic but irregular up-and-down movement of total production and other measures of economic activity. A business cycle has two phases: recession and expansion. The turning points are the peak and the trough. A business cycle runs from a trough to an expansion to a peak to a recession to a trough and then back to an expansion. 4. What is PPP and how does it help us to make valid international comparisons of real GDP? PPP is purchasing power parity. To make the most valid international comparisons of real GDP, we need to value each nation’s production using purchasing power parity prices rather than by using exchange rates and the prices within each country because relative prices within different countries can vary widely. As a result, if the real GDP of each country is valued using the same PPP prices then the comparison of real GDP among the countries is more accurate. 5. Explain why real GDP might be an unreliable indicator of the standard of living. Real GDP is sometimes used to measure the standard of living but real GDP can be misleading for several reasons. Real GDP does not include household production, productive activities done in and around the house by the homeowner. Because these tasks often are an important component of people’s work, this omission creates a major measurement problem. Real GDP omits the underground economy, economic activity that is legal but unreported or that is illegal. In many countries the underground economy is an important part of economic activity, and its omission creates a serious measurement problem. Real GDP does not include a measurement of people’s health and life expectancy, both factors that obviously affect economic well being. The value of leisure time is not included in real GDP. People value their leisure hours, and an increase in people’s leisure that enhances people’s economic welfare can lower the nation’s real GDP and lower the nation’s well-being. Environmental damage is excluded from real GDP. So an economy wherein real GDP grows but at the expense of its environment, as was the case with Eastern European countries under communism, falsely appears to offer greater economic welfare than a similar economy that grows slightly more slowly but at less environmental cost. Real GDP does not indicate the extent of political freedom and social justice enjoyed by a nation’s citizens.

Review Quiz Answers-Chapter 5 1. Why do we need methods of allocating scarce resources? Because resources are scare, it is not possible to fulfill everyone’s wants. As a result, some method of deciding which wants will be fulfilled and which will not—that is, some method of allocating resources—must be utilized. 2. Describe the alternative methods of allocating scarce resources. Resources can be allocated using: • Market price: People who are willing and able to pay the price get the resource. • Command: Someone in command decides who gets the resource. • Majority rule: The majority vote decides how resources are allocated. • Contest: Winners receive the resource. • First-come, first-served: People first in line get the resource. • Lottery: Randomly selected winners receive the resource. • Personal characteristics: People with the ―right‖ characteristics get the resource. • Force: The stronger person or group gets the resource. 3. Provide an example of each allocation method that illustrates when it works well. Below are examples of when each allocation scheme works well: • Market price: Generally works well in competitive markets and for most goods and services. An example is the allocation of cat food. • Command: Generally works well in organizations where lines of authority are clear and it is easy to monitor subordinates. An example is in a fast food restaurant when the supervisor tells a worker to clean the tables. • Majority rule: Generally works well when large numbers of people are affected by the allocation. An example is an election in which people vote whether or not to support a tax to build more parks. • Contest: Generally works well when the efforts of the participates are hard to monitor. An example is the contest run by Pfizer in which three top managers competed to see who would be appointed CEO. • First-come, first-served: Generally works well when a resource can be used by only one user at a time. An example is a line at a movie ticket booth. • Lottery: Generally works well when there is no way to easily distinguish which user of a resource would use it most effectively. An example is the lottery used to allocate cell phone frequencies. • Personal characteristics: Generally works well when resource use is tied between different people. An example is the decision whom to marry. • Force: Generally works well when used to uphold the rule of law. An example is the state imprisoning thieves. 4. Provide an example of each allocation method that illustrates when it works badly. Below are examples of when each allocation scheme would work poorly: • Market price: Deciding court cases on the basis of who will pay the most for the decision. • Command: Running an economy. • Majority rule: Deciding how many acres of wheat to plant. • Contest: Allocating food in a winner-take-all contest.

• First-come, first-served: Admitting students to college based on who applied first. • Lottery: Assigning grades based on random chance. • Personal characteristics: Renting only to married couples. • Force: Stealing by threat of physical harm. 1. How do we measure the value or marginal benefit of a good or service? The value, or marginal benefit, of a good or service is measured by the maximum amount that consumers are willing to pay for one more unit of a good or service. 2. What is consumer surplus? How is it measured? Consumer surplus is the value or marginal benefit of a good minus the price paid, summed over the quantity of the good purchased. The price per unit of a good is assumed to be equal for all units of the good purchased. The quantity purchased is determined by equating the marginal benefit to the price paid. This means that the consumer surplus can be measured as the area under the demand curve and above the price paid, summed over the entire quantity purchased. 1. What is the relationship between the marginal cost, minimum supply-price, and supply? The minimum supply-price of producing one more unit of a good or service is its marginal cost, and the marginal cost is the minimum price that producers must receive to induce them to offer one more unit of a good or service for sale. 2. What is producer surplus? How is it measured? Producer surplus is the price received for each unit of a good minus the cost of producing it, summed over all units produced. The price per unit of a good is assumed to be the same for all units of the good sold. The quantity purchased is that quantity where the marginal cost is equal to the price received. This means that the producer surplus can be measured as the area under the price and above the supply curve, summed over the entire quantity sold. Do competitive markets use resources efficiently? Explain why or why not. In the absence of the obstacles mentioned earlier in the chapter, competitive markets use society’s resources efficiently. For resources to be used efficiently they must be allocated to produce the quantity of a good or service where the marginal cost of the last unit produced in the market is equal to the marginal benefit. This condition will be met in a competitive market because equilibrium quantity occurs where the demand curve (which equals the marginal social benefit curve) intersects the supply curve (which equals the marginal social cost curve). 2. What is deadweight loss and under what conditions does it occur? The deadweight loss is the is the decrease in total surplus that results from an inefficient level of production. This is the decrease in consumer surplus plus the decrease in producer surplus that occurs when the market either overproduces or underproduces relative to the efficient quantity.. 3. What are the obstacles to achieving an efficient allocation of resources in the market economy? Markets with price or quantity regulations, taxes or subsidies, externalities, public goods or common resources, monopoly power, or high transactions costs will not produce the efficient quantity of a good or service. In each of these situations, the market prices charged or quantities produced and sold will not result in the efficient allocation of resources. Efficiency requires that the marginal social benefit of the

last unit produced be equal to the marginal social cost. The equilibrium at the intersection of the demand and supply curves in the competitive market creates this result. When the market price or quantity is pulled away from the market equilibrium, the marginal social benefit of the last unit produced does not equal its marginal social cost.

1. What are the two big approaches to thinking about fairness? The two big approaches to thinking about fairness are: • ―It’s not fair if the result isn’t fair,‖ or utilitarianism. • ―It’s not fair if the rules aren’t fair,‖ or equality of opportunity. 2. What is the utilitarian idea of fairness and what is wrong with it? The utilitarian idea of fairness implies that equality of incomes is necessary for the allocation of resources to be ―fair.‖ There should be income transfers from the rich to the poor until equality is achieved, because the marginal benefit of the last dollar of income is the same for everybody. There are two problem with utilitarianism: • It ignores the cost of implementing the income transfers, which will decrease the total goods and services that the finite resources of society can produce. The size of the economic pie will be smaller. • It assumes that the existence of decreasing marginal benefits allows us to make inter-personal comparisons about value gained and lost at different levels of consumption of a good or service. While one can compare the marginal benefits from consuming different levels of a good or service for an individual, this is not the same as comparing the marginal benefits from consuming different levels of a good or service across individuals. 3. Explain the big tradeoff. What idea of fairness has been developed to deal with it? The big tradeoff is the tradeoff between equality and efficiency. Redistributing incomes changes the incentives facing producers and consumers. Taxing income decreases producer surplus and taxing purchases decreases consumer surplus. Producers produce less and consumers consume less, and total economic activity declines, such that the size of the economic pie decreases. The big tradeoff has led to the idea that the fairest distribution is that which makes the poorest person as well off as possible. 4. What is the idea of fairness based on fair rules? The fair rules idea of fairness is that of providing equality of opportunity is necessary for the allocation of resources to be ―fair.‖ This is the economic application of the symmetry principle, that people in similar situations be treated similarly. Equality of opportunity can be achieved if two rules are obeyed: • The government must enforce laws that establish and protect rights to private property that are held by individuals in society, and • Private property may be transferred from one person to another only by voluntary exchange and without fraudulent representation.

Review Quiz Answers- Chapter 6 1. What is economic growth and how do we calculate its rate? Page-135 Economic growth is the sustained expansion of production possibilities. It is measured by the increase in real GDP over a given time period. The economic growth rate is the annual percentage change in real GDP. To calculate this growth rate, we use the formula: Real GDP growth rate = [(Real GDP current year- Real GDP last year)/real GDP last year] X 100. For example, if real GDP in the current year is $11 trillion and if real GDP in the previous year was $10 trillion, and then the economic growth rate is 10 percent. 2. What is the relationship between the growth rate of real GDP and the growth rate of real GDP per person? The growth rate of real GDP tells how rapidly the total economy is expanding while the growth rate of real GDP per person tells how the standard of living is changing. The growth rate of real GDP per person approximately equals the growth rate of real GDP minus the population growth rate. 3. Use the Rule of 70 to calculate the growth rate that leads to a doubling of real GDP per person in 20 years. The rule of 70 states that the number of years it takes for the level of any variable to double is approximately equal to 70 divided by the growth rate. If the level of real GDP doubles in 20 years, the rule of 70 gives 20 = 70/ (growth rate) so that the growth rate equals 70/20, which is 3.5 percent per year. 1. What has been the average growth rate of U.S. real GDP per person over the past 100 years? In which periods were growth the most rapid and in which periods was it the slowest? Page138 Over the past 100 years, U.S. real GDP per person grew at an average rate of 2 percent per year. Slow growth occurred during mid-1950s and 1973–1983. Very slow growth (negative growth!) also occurred during the Great Depression. Growth was rapid during the 1920s and 1960s. Growth was also (extremely!) rapid during World War II. 2. Describe the gaps between real GDP per person in the United States and other countries. For which countries is the gap narrowing? For which is it widening? And for is it remaining the same? Some rich countries are catching up with the United States, but the gaps between the United States and many poor countries are not closing. Amongst the rich countries, since 1960 Japan has closed the gap with the United States but the gaps between the United States and Canada, and the ―Europe Big 4‖ (France, Germany, Italy, and the United Kingdom) have tended to remain constant. Other Western European nations and the former Communist countries of Central Europe have fallen slightly farther behind the United States. The gap between the United States and most nations in Africa, and Central and South America has widened. But some nations in Asia— including Hong Kong, Singapore, Taiwan, Korea, Malaysia, Thailand, and China—have grown very rapidly. The gap between these nations and the United States has shrunk; indeed, Singapore has slightly surpassed the United States and Hong Kong has virtually tied the United States.

3. Compare the growth rates and levels of real GDP per person in Hong Kong, Korea, Singapore, Taiwan, China, and the United States. How far is China’s real GDP per person behind that of the other Asian economies? Since 1960, income per person in the nations of Hong Kong, Singapore, Taiwan, Korea, and China have grown very rapidly and are rapidly catching up to the United States. Income per person in Hong Kong is virtually the same as that in the United States and income per person in Singapore slightly exceeds that in the United States. Income in Taiwan and Korea also are relatively close and income in China is the lowest, though recently China has been growing the most rapidly. China’s level of income in 2008 is similar to that of Hong Kong in 1968. 1. What is the aggregate production function? Page -144 The aggregate production function is the relationship that tells us how real GDP changes as the quantity of labor changes when all other influences on production remain the same. An increase in the quantity of labor (and a corresponding decrease in leisure hours) brings a movement along the production function and an increase in real GDP. 2. What determines the demand for labor, the supply of labor, and labor market equilibrium? The demand for labor depends on the real wage rate. A fall in the real wage rate increases the quantity of labor demanded because of diminishing returns. The demand for labor also depends on productivity. If productivity increases, the demand for labor increases. The supply of labor also depends on the real wage rate. An increase in the real wage rate increases the quantity of labor supplied because more people enter the labor force and the hours supplied per person increases. The real wage adjusts so that the labor market is in equilibrium. If the real wage rate is above (below) its equilibrium, there is a surplus (shortage) of labor that then causes the real wage rate to fall (rise). For example, if the real wage rate is above the equilibrium level, there is a surplus of labor so the real wage rate falls until it reaches its equilibrium. The equilibrium quantity of employment is the full employment quantity of labor. 3. What determines potential GDP? Potential GDP is determined from the labor market equilibrium. Labor market equilibrium occurs when the quantity of labor demanded equals the quantity of labor supplied. When the labor market is in equilibrium, there is full employment. Potential GDP is the quantity of real GDP determined by the production function at the full-employment quantity of labor. 4. What are the two broad sources of potential GDP growth? The two broad sources of growth in potential GDP are growth of the supply of labor and growth of labor productivity. Growth of the supply of labor: The quantity of labor is the number of workers employed multiplied by average hours per worker. The quantity of labor changes as a result of changes in Average hours per worker, the employment-to-population ratio, and the working-age population. Average hours per worker have decreased as the workweek has become shorter, and the employment to- population ratio has increased as more women have entered the labor force. Growth in the supply of labor has

come from growth in the working-age population. Population growth brings growth in the supply of labor. Growth of labor productivity: Labor productivity is the quantity of real GDP produced by an hour of labor. It is calculated by dividing real GDP by aggregate labor hours. When labor productivity grows, real GDP per person grows, bringing a rising standard of living and production possibilities expand. The quantity of real GDP that any given quantity of labor can produce increases. If labor is more productive, firms are willing to pay more for a given number of hours of labor so the demand for labor also increases. So an increase in labor productivity increases potential GDP for two reasons: Labor is more productive and more labor is employed. 5. What are the effects of an increase in the population on potential GDP, the quantity of labor, the real wage rate, and potential GDP per hour of labor?

An increase in the population increases the supply of labor. The supply of labor curve shifts rightward. There is now surplus of labor so the real wage rate falls and aggregate labor hours increase. The increase in aggregate labor hours brings an increase in potential GDP. But the population increase decreases potential GDP per hour of labor. Diminishing returns are the source of the decrease in potential GDP per hour of labor.

6. What are the effects of an increase in labor productivity on potential GDP, the quantity of labor, the real wage rate, and potential GDP per hour of labor?

The increase in labor productivity shifts the aggregate production function curve upward. It also increases the demand for labor, and the demand for labor curve shifts rightward. The increase in the demand for labor raises the real wage rate and increases employment. The increase in employment as well as the upward shift of the aggregate production function increase potential GDP. Real GDP per hour of labor increases.

1. What are the preconditions for and sources of labor productivity growth? Page- 146 The fundamental preconditions for labor productivity growth are: firms, markets, property rights, and money. These fundamental preconditions create an incentive system that can lead to labor

productivity growth. Once these preconditions are in place, the sources of labor productivity growth are physical capital growth, human capital growth, and advances in technology. All of these activities enable an economy to grow and they all increase labor productivity. They all also interact: human capital creates new technologies, which are then embodied in both new human capital and new physical capital. 1. What is the key idea of classical growth theory that leads to the dismal outcome? page- 151 Classical growth theory is a theory on economic growth that argues that economic growth will end because of an increasing population and limited resources. Classical Growth Theory economists believed that temporary increases in real GDP per person would cause a population explosion that would consequently decrease real GDP. Economists behind this theory developed an idea of a "subsistence level" to model the theory. In the classical growth theory, an increase in productivity increases the demand for labor. The real wage rate rises and GDP increases. The increase in the real wage rate means that people’s incomes rise, which then creates a population boom. The increase in population increases the supply of labor. Because of diminishing returns to labor, the increase in the supply of labor lowers the real wage rate. As long as the real wage rate remains above the subsistence level, population growth and hence growth in the labor supply continues. Eventually the real wage rate falls to equal the subsistence level, at which time the population stops growing. Total GDP is higher than before the increase in productivity, but GDP per person is the same as before and is at the subsistence level. The ―dismal outcome‖ in classical theory is the conclusion that in the long run real GDP per person equals the subsistence level. 2. What, according to neoclassical growth theory, is the fundamental cause of economic growth? Neoclassical growth theory is an economic theory that outlines how a steady economic growth rate will be accomplished with the proper amounts of the three driving forces: labor, capital and technology. The theory states that by varying the amounts of labor and capital in the production function, an equilibrium state can be accomplished. When a new technology becomes available, the labor and capital need to be adjusted to maintain growth equilibrium. This theory emphasizes that technology change has a major influence on economic growth, and that technological advances happen by chance. The theory argues that economic growth will not continue unless there continues to be advances in technology. 3. What is the key proposition of new growth theory that makes growth persist? The key proposition that makes growth persist indefinitely in the new growth theory is the assumption that the returns to knowledge and human capital do not diminish. As a result, increases in knowledge do not cause diminishing returns and the incentive to innovate remains high. As people accumulate more knowledge, the incentive to innovate does not fall and so people continue to innovate new and better ways to produce new and better products. This innovation means that economic growth persists indefinitely.

Answers to the review Quiz: Chapter 7 1. Distinguish between physical capital and financial capital and give two examples of each. Page- 164 Physical capital is the actual tools, instruments, machines, buildings and other items that have been produced in the past and are presently used to produce goods and services. Financial capital is the funds that businesses use to acquire their physical capital and to fund their operations. Examples of physical capital are the pizza ovens owned by Pizza Hut and the buildings in which the Pizza Huts are located. Examples of financial capital are the bonds issued by Pizza Hut to buy pizza ovens and the loans Pizza Hut has made to fund their purchases of new buildings. 2. What is the distinction between gross investment and net investment? Gross investment is the total amount spent on new capital. Gross investment is not adjusted for depreciation, which measures the amount of capital that has been used up in a year.Net investment is the change in the capital stock. Net investment equals gross investment minus depreciation. The difference between gross and net investment is depreciation. For example, On January 1, 2010, Ace Bottling Inc. had machines worth $30,000—Ace’s initial capital. During 2010, the market value of Ace’s machines fell by 67 percent— $20,000. After this depreciation, Ace’s machines were valued at $10,000. During 2010, Ace spent $30,000 on new machines. This amount is Ace’s gross investment. By December 31, 2010, Ace Bottling had capital valued at $40,000, so its capital had increased by $10,000. This amount is Ace’s net investment. Ace’s net investment equals its gross investment of $30,000 minus depreciation of its initial capital of $20,000. 3. What are the three main types of markets for financial capital? Loan market is the market where financial organizations (usually banks) provide loans to borrowers and sometimes repackage them (sell them on to investors). For example, in loan markets-Businesses get short term loans to buy inventories or to extend credit to their customers from banks; Households get loans (usually mortgage) to buy new homes, automobiles or home appliances etc. The bond market is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the Secondary market, usually in the form of bonds. A bond is a promise to make specified payments on specified dates. For example, we can buy a WalMart bond that promises to pay $5.00 every year until 2024 and then to make a final payment of $100 in 2025. The buyer of a bond from Wal-Mart makes a loan to the company and is entitled to the payments promised by the bond. The primary goal of the bond market is to provide a mechanism for long term funding of public and private expenditures. Stock market is the market in which shares and stocks of corporations are issued and traded either through exchanges or over-the-counter markets. A stock or share is a certificate of ownership and claim to the firm’s profits. Stock market can be split into two main sections: the primary and secondary market. The primary market is where new issues are first offered, with any subsequent trading going on in the secondary market. The New York Stock Exchange, the London Stock Exchange (in England) are examples of stock markets. 4. Explain the connection between the price of a financial asset and its interest rate.

There is an inverse relationship between the price of a financial asset and its interest rate. When the price of a financial asset rises, its interest rate falls. Similarly, when the interest rate on an asset falls, the price of the asset rises. For example, we’ll consider a bond that promises to pay its holder $5 a year forever. The interest rate on this bond depends on the price of the bond. If we could buy this bond for $50, the interest rate would be 10 percent per year: Interest rate = ($5 / $50) X100= 10 percent. But if the price of this bond increased to $200, its rate of return or interest rate would be only 2.5 percent per year. That is, Interest rate = ($5/ $200) X 100= 2.5 percent. This relationship means that the price of an asset and the interest rate on that asset are determined simultaneously—one implies the other. This relationship also means that if the interest rate on the asset increases, the price of the asset falls, debts become harder to pay, and the net worth of the financial institution falls. 1. What is the loanable funds market? Page- 169 The market for loanable funds is the market in which households, firms, governments, banks, and other financial institutions borrow and lend. It is the aggregate of all the individual financial markets and includes loan markets, bond markets, and stock markets. The real interest rate is determined in this market. 2. Why is the real interest rate the opportunity cost of loanable funds? The real interest rate is the opportunity cost of loanable funds because the real interest rate measures what is forgone by using the funds. If the funds are loaned, then the real interest rate is received. If the funds are borrowed, then the real interest is paid for the funds. The real interest rate forgone when funds are used either to buy consumption goods and services or to invest in new capital goods is the opportunity cost of not saving or not lending those funds. 3. How do firms make investment decisions? To determine the quantity of investment, firms compare the expected profit rate from an investment to the real interest rate. The expected profit from an investment is the benefit from the investment. The real interest rate is the opportunity cost of investment. If the expected profit from an investment exceeds the cost of the real interest rate, then firms make the investment. If the expected profit from an investment is less than the cost of the real interest rate, then firms do not make the investment. 4. What determines the demand for loanable funds and what makes it change? The demand for loanable funds depends on the real interest rate and expected profit. If the real interest rate falls and nothing else changes, the quantity of loanable funds demanded increases and the demand for loanable funds curve shifts rightward. Inversely, if the real interest rate rises and everything else remains the same, the quantity of loanable funds demanded decreases and the demand for loanable funds curve shifts leftward. If the expected profit increases and nothing else changes, the demand for loanable funds increases and the demand for loanable funds curve shifts rightward. Inversely, if the expected profit decreases and everything else remains the same, the demand for loanable funds decreases and the demand for loanable funds curve shifts leftward. To understand the demand for loanable funds more precisely, let’s have an example where Amazon wants to borrow $100 million from a bank. If Amazon expects to get a return of $5 million a year

from this investment before paying interest costs and the interest rate is less than 5 percent a year, Amazon would make a profit, so it takes the investment. But if the interest rate is more than 5 percent a year, Amazon would incur a loss, so it does not take the investment. 5. How do households make saving decisions? The real interest rate: A rise in the real interest rate increases household saving as well as the quantity of loanable funds supplied, vice versa. For example, with a real interest rate of 2 percent a year, a student decides that it is not worth saving much—better to spend the income and take a student loan if funds run out during the semester. But if the real interest rate jumped to 10 percent a year, the payoff from saving would be high enough to encourage him to cut back on spending and increase the amount he saves. Disposable Income: A household’s disposable income is the income earned minus net taxes. So the greater a household’s disposable income, other things remaining the same, the greater is its saving and vice versa. Expected Future Income: The higher a households expected future income, other things remaining the same, the smaller is its saving today and vice versa. Wealth: The higher a household’s wealth, other things remaining the same, the smaller is its saving. If a person’s wealth increases because of a capital gain, the person sees less need to save. Default Risk: Default risk is the risk that a loan will not be repaid. The greater that risk, the higher is the interest rate needed to induce a person to lend and the smaller is the supply of loanable funds. 7. How do changes in the demand for and supply of loanable funds change the real interest rate and quantity of loanable funds? The real interest rate is determined by the supply of loanable funds and the demand for loanable funds. The equilibrium real interest rate is the real interest rate at which the quantity of loanable funds supplied equals the quantity of loanable funds demanded. Changes in the demand for or supply of loanable funds change the equilibrium real interest rate and equilibrium quantity of loanable funds. With an increase in the demand for loanable funds, but no change in the supply of loanable funds, there is a shortage of funds. As borrowers compete for funds, the interest rate rises and lenders increase the quantity of funds supplied. With a decrease in demand for loanable funds but no change in the supply of loanable funds, there is a surplus of funds. Borrowers find it easy to get funds, but lenders are unable to lend all the funds they have available. The real interest rate falls and the quantity of loanable funds decreases. With an increase in the supply for loanable funds, but no change in the demand for loanable funds, there is a surplus of funds. Borrowers find bargains and lenders find themselves accepting a lower interest rate. At the lower interest rate, borrowers find additional investment projects profitable and increase the quantity of loanable funds that they borrow. Exactly opposite thing occurs when the supply of loanable funds decreases.

1. How does a government budget surplus or deficit influence the market for loanable funds? Page- 172

A government budget surplus increases the supply of loanable funds. The real interest rate falls, which decreases household saving and decreases the quantity of private funds supplied. The lower real interest rate increases the quantity of loanable funds demanded, and increases investment. A government budget deficit increases the demand for loanable funds. The real interest rate rises, which increases household saving and increases the quantity of private funds supplied. But the higher real interest rate decreases investment and the quantity of loanable funds demanded by firms to finance investment. 2. What is the crowding-out effect and how does it work? The tendency for a government budget deficit to raise the real interest rate and decrease investment is called the crowding-out effect. An increase in the government budget deficit increases the demand for loanable funds. As a result the real interest rate rises. The rise in the real interest rate decreases ―crowds out‖—investment. The crowding-out effect does not decrease investment by the full amount of the government budget deficit because the higher real interest rate induces an increase in private saving that partly contributes toward financing the deficit. 3. What is the Ricardo-Barro effect and how does it modify the crowding-out effect? The Ricardo-Barro Effect tells that government budget, whether in surplus or deficit, has no effect on either the real interest rate or investment. Barro says that taxpayers are rational. They can see that a budget deficit today means that future taxes will be higher and future disposable incomes will be smaller. With smaller expected future disposable incomes, saving increases today. Private saving and the private supply of loanable funds increase to match the quantity of loanable funds demanded by the government. So the budget deficit has no effect on either the real interest rate or investment. Most economists regard the Ricardo-Barro view as extreme. But there might be some change in private saving that goes in the direction suggested by the Ricardo- Barro effect that lessens the crowding-out effect. 1. Why do loanable funds flow among countries? Page- 175 Loanable funds flow among countries because lenders are searching for the highest (risk-adjusted) real interest rate and borrowers are searching for the lowest (risk-adjusted) real interest rate. For example, if a U.S. supplier of loanable funds can earn a higher interest rate in Tokyo than in New York, funds supplied in Japan will increase and funds supplied in the United States will decrease— funds will flow from the United States to Japan. If a U.S. demander of loanable funds can pay a lower interest rate in Paris than in New York, the demand for funds in France will increase and the demand for funds in the United States will decrease—funds will flow from France to the United States.

2. What determines the demand for and supply of loanable funds in an individual economy? The demand for and supply of loanable funds in an economy with international lending and borrowing depend on the same factors as in an economy without international lending and borrowing with one exception: If, at the world real interest rate, the country has a surplus of funds, it can lend

the surplus to the rest of the world while if, at the world real interest rate, the country has a shortage of funds, it can borrow from the rest of the world. 3. What happens if a country has a shortage of loanable funds at the world real interest rate? If a country has a shortage of loanable funds at the world real interest rate, it borrows from other nations and becomes an international borrower. 4. What happens if a country has a surplus of loanable funds at the world interest rate? If a country has a surplus of loanable funds at the world real interest rate, it loans to other nations and becomes an international lender. 5. How is a government budget deficit financed in an open economy? A government budget deficit increases the demand for loanable funds. In an open economy, the increase in the demand for loanable funds means the country lends less to the rest of the world (if it initially was an international lender) or borrows more from the rest of the world (if it initially was an international borrower). These changes in lending or borrowing finance the budget deficit.

Review Quiz Answers-Chapter 8 1. What makes something money? What functions does money perform? Why do you think packs of chewing gum don’t serve as money? Page- 186 Money is any object that is generally accepted as payment for goods and services and repayment of debts in a given socio-economic context or country. Money has three functions: medium of exchange (money is accepted in exchange for goods and services), unit of account (prices are quoted in terms of money), and store of value (money can be held and exchanged for goods and services later). Packs of chewing gum do not function as money because they are not particularly good as a store of value—gum deteriorates. Additionally, packs of gum are not generally accepted in exchange for goods and services, so packs of gum are not a medium of exchange. 2. What are the problems that arise when a commodity is used as money? Commodities are not used as money because of several problems. Many commodities are bulky. And many commodities change in value over time. Using as money a commodity that changes in value would be awkward. Prices would change simply because the commodity’s value changed. Additionally, using a commodity as money has a higher opportunity cost than do currency and bank deposits because the commodity has alternative uses that must be foregone. 3. What are the main components of money in the United States today? The main components of money in the United States today are currency and deposits at banks and other depository institutions. 4. What are the official measures of money? Are all the measures really money?

The official measures of money are M1 and M2. M1 includes paper currency and coins, plus publicly held checking accounts. Other forms of M1 currency are: traveler's checks, automatic transfer service accounts, and credit union accounts. It does not include currency held by banks, and it does not include currency and checking deposits owned by the U.S. government. M2 includes M1, plus saving deposits, small time deposits, non-institutional money market deposits and other deposits. All of the components of M1 are truly money because all the components serve as a means of payment. Some of the components of M2 are not truly money because they are not a means of payment. (For instance, funds at money market mutual funds cannot be used as a means of payment for small purchases.) But all of these ―non-money‖ assets are highly liquid so they are operationally similar to money. 5. Why are checks and credit cards not money? Checks and credit cards are not money because they are not a means of payment. A check is a legal document that provides a promise of payment from one person to another. It is possible to write a check against a transaction account that has not enough or even no money in it - there is no way for the person who receives the check to know that it is good until up to several days after they have deposited it . So when a person accepts check, he/she takes it on the risk that his/her account might not be credited. On the other hand, a check simply is an order of transfer of money from one account to another account. That is why checks are not considered as money. A credit card is a plastic card issued by a bank, business, etc., for the purchase of goods or services on credit. So credit card purchase is a loan, a promise to pay back in the future. The loan is a mechanism in which money will be transferred from the buyer’s account to the seller’s account, but the loan is not money itself. When the buyer repays the loan, it will be in the form of money. Now, if we consider the loan as money and the payment of the loan as money we're essentially counting the same transaction twice. That’s why credit card is no considered as money. 1. What are depository institutions? Page -189 Depository institutions are financial firms that take deposits from households and firms. They then make loans available to other households and firms. 2. What are the functions of depository institutions? Depository institutions have four major economic functions: They create liquidity, pool risk, lower the cost of borrowing, and lower the cost of monitoring borrowers. 3. How do depository institutions balance risk and return? Banks collect deposits from the depositors and provide them interest. Then they give loans to depositors, invest these deposits or buy securities which provide the banks more interest than that paid to depositors. Thus banks earn a higher return by using the funds they acquire from their depositors to buy higher-yielding, riskier assets such as loans. But these assets are risky. If the loans fail, then the bank might not have sufficient funds to repay their depositors. If the bank undertakes too much risk, then its depositors might rush to withdraw their deposits, which would cause the bank to fail. But if the bank forgoes all risky assets its profit will be much lower. So the bank must balance its search for higher return against the risk earning the return entails. 4. How do depository institutions create liquidity, pool risks, and lower the cost of borrowing?

Liquidity is the property of being easily convertible into a means of payment without loss in value. Depository institutions create liquidity when they offer deposits that can be withdrawn as money at short (or no) notice and then use these deposits to make long-term loans. Depository institutions pool risk because they use funds obtained from many depositors to make loans to many borrowers. As a result, if a borrower defaults, no one depositor bears the entire loss because the loss is spread over all depositors. By spreading the risk, depository institutions are pooling risk. Depository institutions lower the cost of borrowing because they specialize in borrowing. For instance, a firm that wants to borrow a large sum of money need only visit one depository institution to arrange such a loan. In the absence of depository institutions, the firm would need to undertake many transactions with many lenders, which would be a costly process. 5. How have depository institutions made innovations that have influenced the composition of money? Checking deposits at thrift institutions such as S&L’s savings banks, and credit unions are examples of deposits that were created by innovations in the 1980s and 1990s. These deposits have become an increasingly large percentage of M1. Savings deposits have decreased as a percentage of M2, while time deposits and money market mutual funds have increased, and checking deposits at commercial banks have become a decreasing percentage of M1. 1. What is the central bank of the United States and what functions does it perform? Page- 193 The Federal Reserve System (usually called the Fed) is the central bank of the United States. The Federal Reserve's most primary function is to control inflation without triggering a recession. In addition to that, the Fed has three other less visible, but no less critical, functions:   

Supervise the nation’s banking system to protect consumers. Maintain the stability of the financial markets and constrain potential crises. Be the central bank for other banks, the U.S. Government, and foreign banks.

2. What is the monetary base and how does it relate to the Fed’s balance sheet? The monetary base is the total amount of a currency that is either circulated in the hands of the public or in the commercial bank deposits held in the central bank's reserves. That is, monetary base is the sum of Federal Reserve notes, coins issued by Treasury, and depository institutions’ deposits at the Fed. For example, suppose country Z has 600 million currency units circulating in the public and its central bank has 10 billion currency units in reserve as part of deposits from many commercial banks. In this case, the monetary base for country Z is 10.6 billion currency units. The Fed’s assets are the sources of the monetary base. When the Fed changes the monetary base, the quantity of money and interest rate also changes. Aside from coins, the rest of the monetary base consists of Federal Reserve liabilities. Federal Reserve notes and depository institutions’ deposits are liabilities of the Federal Reserve. 3. What are the Fed’s three policy tools? The Federal Reserve has three policy tools: required reserve ratio, last resort loans, and open market operations.

Open market operation: An open market operation (also known as OMO) is an activity by a central bank to buy or sell government bonds on the open market. When the Fed buys securities from a commercial bank (let A), it pays for the securities by placing the total amount of money in the A’s deposit account at the Fed. Thus it creates bank reserves. The Fed’s assets and liabilities increase, and the commercial bank exchanges securities for reserves. If the Fed sells government securities to the A in the open market, A pays for the securities by using of its reserve deposit at the Fed. Both the Fed’s assets and liabilities decrease. As A has used reserves to buy securities, bank reserves diminishes. Last Resort Loans: The Fed is the lender of last resort, which means that if a bank is short of reserves, it can borrow from the Fed. But the Fed sets the interest rate on last resort loans and this interest rate is called the discount rate. Required Reserve Ratio: The required reserve ratio is the minimum percentage of deposits that depository institutions are required to hold as reserves. If the Fed finds out that a bank is lending more, it commands the bank to hold more reserve. For this, the bank must cut its lending. Opposite thing happens when the bank is lending less. 4. What is the Federal Open Market Committee and what are its main functions? The Federal Open market Committee (FOMC) is the main policy-making group within the Federal Reserve System. It consists of twelve members—the chairman and the six members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis. The Federal Open Market Committee (FOMC) meets about eight times a years, on average every six weeks The primary purpose of the Federal Open Market Committee is to direct open market operations, the buying and selling of U.S. Treasury securities. The FOMC also reviews economic and financial conditions, determines the appropriate stance of monetary policy, and assesses the risks to its longrun goals of price stability and sustainable economic growth. 5. How does an open market operation change the monetary base? An open market operation (also known as OMO) is an activity by a central bank to buy or sell government bonds on the open market. When the Fed buys securities, it pays for them with newly created bank reserves. When the Fed sells securities, the Fed is paid with reserves held by banks. So open market operations directly influence the reserves of banks. Changes in the amount of reserves of banks also bring changes in the Fed’s assets and liabilities. We know that, Fed’s assets are the sources of the monetary base and monetary base also depends on Fed’s liabilities. So in cases, Fed’s assets and liabilities is related. That is how an open market operation changes the monetary base. 1. How do banks create money? Page- 195 Banks create deposits by making loans. And we know that deposits are money. They do create money by printing Federal Reserve Bank notes. They even don’t lend existing money. This is checkbook money; promise to pay from the bank to the account holder. By writing a check, or using a credit card, we exchange these promises. And doing so, we accept it as money and it works like money. For example, when I buy a home, bank gives me a loan for 1 million dollars. Bank does not really give me physical cash, but it has already provided me a checkbook or credit card so that I can make

expense. So now, I write a check to the seller. Seller takes the check to the bank and the bank deposits it to the seller account. Here, bank switches the "promise to pay" from my account to his account, but did not yet paid a penny. After this transaction I owe the bank 1 million dollars plus interest. Here, the bank did not have 1 million dollars. But when I asked for it, it created a promise. And through my checkbook or credit card I completed a transaction and at the end, things were done as if the economy had that extra 1 million dollars. Now if the seller, who has 1 million dollars in his account thinks to buy a car, he will usually do it by writing checks or using credit cards. And the bank will still not pay a penny. Yet the economy will feel the existence of extra 1 million dollars. This is how banks create money. If I withdraw the loaned money in physical cash/currency, then the loan still exists (as an asset to the bank and liability to the borrower) but the added bank deposits go away. That’s why, bank always try to avoid giving loans by physical cash.

2. What limits the quantity of money that the banking system can create? The quantity of money that banks can create is limited by three factors: The Monetary Base-The monetary base is the sum of Federal Reserve notes, coins, and banks’ deposits at the Fed. The size of the monetary base limits the total quantity of money that the banking system can create because- Banks have desired reserves & Households and firms have desired currency holdings. Both these desired holdings of monetary base depend on the quantity of money. Desired Reserves- A bank’s desired reserves are the reserves that it plans to hold. The minimum quantity of reserves that a bank must hold is called required reserves. The quantity of desired reserves depends on the level of deposits and is determined by the desired reserve ratio—the ratio of reserves to deposits that the banks plan to hold. Desired Currency Holding- People holds some fraction of their money as currency. So when the total quantity of money increases, so does the quantity of currency that people plan to hold. Because desired currency holding increases when deposits increase, currency leaves the banks when they make loans and increase deposits. This leakage of reserves into currency is called the currency drain. The ratio of currency to deposits is the currency drain ratio. 3. A bank manager tells you that she doesn’t create money. She just lends the money that people deposit. Explain why she’s wrong. Though the manager does not see the entire process, nonetheless the loans the manager makes create more deposits and more money. When he makes a loan, the deposits at his bank do not change. And, when the loan is spent, the recipient selling the goods or services that have been purchased will deposit part or all of the proceeds in his or her bank. When the recipient makes this deposit, the total amount of the nation’s deposits increase and, because deposits are part of the nation’s money, the quantity of money also increases. However, actions of other economic agents also affect the creation of money. For example, if people decide to hold less currency and more deposits, the immediate effect on the quantity of money is nil. But over time the quantity of money increases because banks gain excess reserves, which are then loaned and then deposited, thereby creating additional deposits and increasing the quantity of money.

1. What are the main influences on the quantity of real money that people and businesses plan to hold? Page-199 The main influences on the quantity of real money that people and businesses plan to hold depend on four factors: The Price Level: A rise in the price level increases the quantity of nominal money but doesn’t change the quantity of real money that people plan to hold. Nominal money is the quantity of money measured in a particular currency and is directly proportional to the price level. For example, if I hold $20 to buy your weekly movies and soda, I will increase my money holding to $22 if the prices of movies and soda—and my wage rate—increase by 10 percent. The nominal interest rate: The opportunity cost of holding money is the cost that could be realized if money were invested instead of held. In other words, it is the interest rate that money is earning in a chosen investment. Typically, it is the interest rate that is set on a bond, particularly a government bond. A rise in the nominal interest rate on other assets decreases the quantity of real money that people plan to hold. Real GDP: The quantity of money that households and firms plan to hold depends on the amount they are spending. An increase in real GDP increases the demand for real money, because more real GDP implies more transactions and an increase in the demand for money to finance the transactions. For example, I hold an average of $20 to finance my weekly purchases of movies and soda. Now if the prices of these goods and of all other goods remain constant but my income increases, I will have the capability to buy more goods and services and I will also keep a larger amount of money on my pocket to finance my higher volume of expenditure. Financial Innovation: Financial innovation that lowers the cost of switching between money and interest-bearing assets decreases the quantity of real money that people plan to hold. Financial innovations include: Daily interest checking deposits, Automatic transfers between checking and saving deposits, Automatic teller machines, Credit cards and debit cards, Internet banking and bill paying etc. 2. How does a change in the nominal interest rate change the quantity of money demanded? Illustrate the effect by using the demand for money curve. An increase in the nominal interest rate decreases the quantity of real money demanded. The slope of the demand for money curve shows how the quantity of real money demanded depends on the nominal interest rate. An increase in the nominal interest rate results in a movement upward along the demand for money curve; a decrease in the nominal interest rate results in a movement downward along the demand for money curve as illustrated by the arrow in right Figure.

3. How does a change in real GDP change the demand for money? Illustrate the effect by using the demand for money curve. A change in real GDP changes the demand for money. An increase in real GDP increases the demand for money and shifts the demand for curve for real money rightward from MD0 to MD1 as shown in the figure. A decrease in real GDP or a financial innovation decreases the demand for money and shifts the demand curve leftward from MD0 to MD1 as shown in the figure. 3. How is money market equilibrium determined in the short run and in the long run? Money market equilibrium occurs when the quantity of money demanded equals the quantity of money supplied. The adjustments that occur to bring money market equilibrium are fundamentally different in the short run and the long run. For Short-Run Equilibrium The quantity of money supplied is determined by the actions of the banks and the Fed. As the central bank adjusts the quantity of money, the interest rate changes accordingly. Here, the Fed uses open market operations to make the quantity of real money supplied $3.0 trillion and the supply of money curve MS. With demand for money curve MD, the equilibrium interest rate is 5 percent a year. If the interest rate were 4 percent a year, people would want to hold more money than is available. They would sell bonds, bid down their price, and the interest rate would rise. If the interest rate were 6 percent a year, people would want to hold less money than is available. They would buy bonds, bid up their price, and the interest rate would fall. 4. How does a change in the supply of money change the interest rate in the short run? In the short-run equilibrium, if the Central bank increases the quantity of money, people find themselves holding more money than the quantity demanded. With a surplus of money holding, people enter the loan able funds market and buy bonds. The increase in demand for bonds raises the price of a bond and lowers the interest rate If the central bank decreases the quantity of money, people find themselves holding less money than the

quantity demanded. They now enter the loan able funds market to sell bonds. The decrease in the demand for bonds lowers their price and raises the interest rate. Figure illustrates the effects of the changes in the quantity of money that we’ve just described. When the supply of money curve shifts rightward from MS0 to MS1, the interest rate falls to 4 percent a year; when the supply of money curve shifts leftward to MS2, the interest rate rises to 6 percent a year. 1. What is the quantity theory of money? Page- 201 Quantity theory of money is an economic theory which proposes a positive relationship between changes in the money supply and the long-term price of goods. It states that increasing the amount of money in the economy will eventually lead to an equal percentage rise in the prices of products and services. The calculation behind the quantity theory of money is based upon Fisher Equation: Calculated as: M X V= P X Y Where: M represents the money supply. V represents the velocity of money. P represents the average price level. Y represents real GDP 2. How is the velocity of circulation calculated? The velocity of circulation is the average number of times a dollar of money is used annually to buy of the goods and services that make up GDP. The velocity of circulation equals nominal GDP divided by the quantity of money. We know, GDP= P X Y where, P is the price level & Y is the real GDP. So the velocity of circulation, V, is determined by the equation V= PY/ M where, M is the quantity of money. For example, if GDP is $1,000 billion (PY = $1,000 billion) and the quantity of money is $250 billion, then the velocity of circulation is 4. 3. What is the equation of exchange? Can it be wrong? Equation of exchange is an economic equation that showcases the relationship between money supply, velocity of money, the price level and an index of expenditures. The equation of exchange is the formula that MV = PY, where M is the quantity of money, V is the velocity of circulation, P is the price level, and Y is real GDP. The equation of exchange is always true by definition because the velocity of circulation is defined as PY/M.

Review Quiz Answers-Chapter 9 What is the foreign exchange market and what prices are determined in this market? The foreign exchange market is the market in which the currency of one country is exchanged for the currency of another country. The exchange rate, the price at which one currency is exchanged for another, is the price determined in the foreign exchange market. Distinguish between appreciation and depreciation of the dollar. The U.S. dollar appreciates when it rises in value against a foreign currency. The U.S. dollar depreciates when it falls in value against a foreign currency. What is the distinction between the nominal exchange rate and the real exchange rate? The nominal exchange rate is the value of the U.S. dollar expressed in units of foreign currency per U.S. dollar. It measures how many units of a foreign currency are necessary to buy one U.S. dollar. The real exchange rate is the relative price of U.S-produced goods and services to foreign-produced goods and services. It measures how many units of foreign-produced GDP one unit of U.S.-produced GDP buys. 1. What are the influences on the demand for U.S. dollars in the foreign exchange market? The quantity of U.S. dollars demanded in the foreign exchange market is the amount that traders plan to buy during a given time period at a given exchange rate. The demand for U.S. dollars depends on mainly four main factors: The exchange rate: Other things remaining the same, the higher the exchange rate, the smaller is the quantity of U.S. dollars demanded in the foreign exchange market. For example, if the price of the U.S. dollar rises from 100 yen to 120 yen but nothing else changes, the quantity of U.S. dollars that people plan to buy in the foreign exchange market decreases. A fall in the exchange rate makes exports more competitive and imports more expensive. World demand for U.S. exports: The larger the value of U.S. exports, the larger is the quantity of U.S. dollars demanded in the foreign exchange market. But the value of U.S. exports depends on the prices of U.S.-produced goods and services expressed in the currency of the foreign buyer. And these prices depend on the exchange rate. The lower the exchange rate, other things remaining the same, the lower are the prices of U.S.-produced goods and services to foreigners and the greater is the volume of U.S. exports. So if the exchange rate falls (and other influences remain the same), the quantity of U.S. dollars demanded in the foreign exchange market increases. The interest rate in the United State and other countries: Increased interest rates for a particular country attract foreign investors due to the increased rate of return from investments. This causes an increase in demand for domestic currency in order to purchase the investments, causing the currency to appreciate in value. Conversely, a lower interest rate makes it relatively less attractive to save money in that country. Therefore there will be less demand for the currency causing a fall in its value. A simple example- A US investor, Jane, wants to place 100 dollars into a savings account with either a domestic or a foreign bank. The US bank’s interest rate is 5.25%. In New Zealand it is 7.25%. In considering the best investment after a year, Jane can get back $105.25 investing in US but $107.25 in New Zealand. Opening an account and ―lending‖ money to a New Zealand bank is the investment option that achieves the biggest return for Jane. In order to purchase the country's assets (stocks or

bonds), Jane will have to convert her domestic currency (USD) to the target country's currency (NZD) which increases the demand for NZD currency and make it more valuable. The expected future exchange rate: The lower the exchange rate today, other things remaining the same, the greater is the expected profit from holding U.S. dollars and the greater is the quantity of U.S. dollars demanded in the foreign exchange market today. For example, Mizuho Bank, a Japanese bank, expects the exchange rate to be 120 yen per U.S. dollar at the end of the year. If today’s exchange rate is also 120 yen per U.S. dollar, Mizuho Bank expects no profit from buying U.S. dollars and holding them until the end of the year. But if today’s exchange rate is 100 yen per U.S. dollar and Mizuho Bank buys U.S. dollars, it expects to sell those dollars at the end of the year for 120 yen per dollar and make a profit of 20 yen per U.S. dollar. 2. Provide an example of the exports effect on the demand for U.S. dollars. The exports effect is the result that the larger the value of U.S. exports, the larger the quantity of dollars demanded for purchasing those exports from U.S. firms. When the exchange rate for U.S. dollars falls, U.S. exports become cheaper relative to other countries’ goods and services so the volume of U.S. exports increases, which increases the demand for U.S. dollars needed to finance their purchase. So if the exchange rate falls (and other influences remain the same), the quantity of U.S. dollars demanded in the foreign exchange market increases. 3. What are the influences on the supply of U.S. dollars in the foreign exchange market? The quantity of U.S. dollars supplied in the foreign exchange market is the amount that traders plan to sell during a given time period at a given exchange rate. This quantity depends on many factors, but the main ones areThe exchange rate: Other things remaining the same, the higher the exchange rate, the greater is the quantity of U.S. dollars supplied in the foreign exchange market. For example, if the exchange rate rises from 100 yen to 120 yen per U.S. dollar and other things remain the same, the quantity of U.S. dollars that people plan to sell in the foreign exchange market increases. A fall in the exchange rate makes exports more competitive and imports more expensive. U.S. demand for imports: The larger the value of U.S. imports, the larger is the quantity of U.S. dollars supplied in the foreign exchange market. But the value of U.S. imports depends on the prices of foreign-produced goods and services expressed in U.S. dollars. These prices depend on the exchange rate. The higher the exchange rate, other things remaining the same, the lower are the prices of foreign-produced goods and services to Americans and the greater is the volume of U.S. imports. So if the exchange rate rises (and other influences remain the same), the quantity of U.S. dollars supplied in the foreign exchange market increases. Interest rates in the U.S and other countries: Other things remaining the same, if the interest rates in the U.S rise, the supply of foreign currency in the U.S will also rise, because an increased interest rate will attract foreign investors to invest in that country to yield more profit. Now the investors must convert their currency to the USD, thus increasing the supply of foreign currency. Exactly opposite thing will happen, if the interest rate in another country will rise. The supply of foreign currency will fall in the U.S and will rise in that country. The supply of domestic currency (USD) will rise in that country, because now the investors from U.S will try to invest in that economy. The expected future exchange rate: The higher the exchange rate today, other things remaining the same, the larger is the expected profit from selling U.S. dollars today and holding foreign currencies, so the greater is the quantity of U.S. dollars supplied.

4. Provide an example of the imports effect on the supply of U.S. dollars. The imports effect is the result that the larger the value of U.S. imports, the larger the quantity of dollars supplied for purchasing those imports from foreign firms. When the exchange rate for U.S. dollars rises foreign imports become cheaper relative to U.S. produced goods and services so the volume of U.S. imports increases, which increases the supply of U.S. dollars to exchange for foreign currency to finance the purchase of the imports. So if the exchange rate rises (and other influences remain the same), the quantity of U.S. dollars supplied in the foreign exchange market increases. This change increases demand for foreign imports, which increases the supply of U.S. dollars to exchange for foreign currency to finance the purchase of imports, all else held constant. 5. How is the equilibrium exchange rate determined? The equilibrium exchange rate is the exchange rate that sets the quantity of U.S. dollars demanded equal to the quantity of U.S. dollars supplied. At the equilibrium exchange rate there is neither a shortage nor a surplus of U.S. dollars. To determine the equilibrium exchange rate we need to combine the supply and demand curves in a single graph. The intersection points determine the market exchange rate and the quantity of dollars supplied and demanded to United States. In our graph, the demand curve is D and the Supply Curve is S. The intersection point of Demand and Supply curve is A. The point R1 refers to a specific exchange rate per U.S dollar at which there is neither a shortage nor a surplus of U.S. dollars and the exchange rate remains constant. The point Q1 refers the quantity demanded and the quantity supplied at R1 exchange rate. 6. What happens if there is a shortage or a surplus of U.S. dollars in the foreign exchange market? If there is a shortage of U.S. dollars, the quantity of U.S. dollars demanded exceeds the quantity supplied. In this case, foreign exchange dealers who are selling dollars set a higher price and those who are buying dollars and could not find any to buy at the lower price will pay the higher price. As long as there is a shortage, this upward pressure on the price automatically forces the price higher to its equilibrium. If there is a surplus of U.S. dollars, the quantity of U.S. dollars demanded is less than the quantity supplied. In this case, foreign exchange dealers who are selling dollars and could not sell at the higher price set a lower price and those who are buying dollars will buy at the lower price. As long as there is a surplus, this downward pressure on the price automatically forces the price lower to its equilibrium.

1. Why does the demand for U.S. dollars change? Page -221 Three factors change the demand for U.S. dollars: the world demand for U.S. exports, the interest rate in the United States and other countries, and the expected future exchange rate. If world demand for U.S. exports increases, the demand for U.S. dollars increases. If the interest rate in the United States rises relative to interest rates in other countries, the demand for U.S. dollars increases. And if the expected future exchange rate rises, the demand for U.S. dollars increases.

2. Why does the supply of U.S. dollars change? Three factors change the supply of U.S. dollars: U.S. demand for imports, the interest rate in the United States and other countries, and the expected future exchange rate. If U.S. demand for imports increases, the supply of U.S. dollars increases. If the interest rate in the United States falls relative to interest rates in other countries, the supply of U.S. dollars increases. And if the expected future exchange rate falls, the supply of U.S. dollars increases. 3. What makes the U.S. dollar exchange rate fluctuate? Changes in the demand for U.S. dollars and the supply of U.S. dollars lead to fluctuations in the U.S. dollar exchange rate. Because the demand for dollars and the supply of dollars generally change at the same time and in opposite directions, exchange rate fluctuations are frequently large. 4. What is interest rate parity and what happens when this condition doesn’t hold? Interest rate parity occurs when the rate of return earned by a unit of currency is the same in different nations. If the rate of return for the U.S. dollar is higher than that for, say, the Japanese yen, interest rate parity does not occur. In this case people will generally expect the value of the dollar to fall against the yen (that is, the U.S. dollar is expected to depreciate over time) so that interest rate parity is restored because the rate of return earned by a unit of currency is the same in both nations. 5. What is purchasing power parity and what happens when this condition doesn’t hold? Purchasing power parity occurs when a unit of money buys the same amount of goods and services in different nations. If prices of goods and services are higher in the United States than the (exchange rate adjusted) prices of goods and services in, say, Japan, purchasing power parity does not occur because a unit of currency buys less in the United States than in Japan. The demand for U.S. dollars decreases and the supply of U.S. dollars increases so that the value of the dollar falls against the yen to restore purchasing power parity.

6. What determines the real exchange rate and the nominal exchange rate in the short run? In the short run, the nominal U.S. exchange rate is determined in the foreign exchange market as the exchange rate that sets the quantity of U.S. dollars demanded equal to the quantity of U.S. dollars supplied. The real exchange between the United States and Japan, RER, equals E X P/P* where P is the U.S. price level, P* is the Japanese price level, and E is the nominal exchange rate in yen per dollar. In the short run, changes in the nominal exchange rate bring an equal change in the real exchange rate. 7. What determines the real exchange rate and the nominal exchange rate in the long run? In the long run, the real exchange rate is determined by demand and supply in the goods market. Identical goods in the United States and Japan sell for the same price once adjusted for the (nominal) exchange rate. The prices of goods that are not identical are determined by the supply and demand for them. In the long run, the nominal exchange rate is equal to RER X P*/P. Changes in the real exchange rate and changes in the price levels change the nominal exchange rate. In the long run, the price level is determined by the quantity of money. So changes in the U.S. or the Japanese quantity of money change the nominal exchange rate. 1. What is a flexible exchange rate and how does it work? Page-224 A flexible exchange rate is an exchange rate that is determined by demand and supply in the foreign exchange market with no direct intervention by the central bank. Most countries, including the United States, Australia, Japan, United Kingdom, Brazil etc. operate a flexible exchange rate. But even a flexible exchange rate is influenced by central bank actions. If the Fed raises the U.S. interest rate and other countries keep their interest rates unchanged, the demand for U.S. dollars increases, the supply of U.S. dollars decreases, and the exchange rate rises. (Similarly, if the Fed lowers the U.S. interest rate, the demand for U.S. dollars decreases, the supply increases, and the exchange rate falls.) In a flexible exchange rate regime, when the central bank changes the interest rate, its purpose is not usually to influence the exchange rate, but to achieve some other monetary policy objective. 2. What is a fixed exchange rate and how is its value fixed? A fixed exchange rate is an exchange rate that is determined by a decision of the government or the central bank and is achieved by central bank intervention in the foreign exchange market to block the unregulated forces of demand and supply. Active intervention in the foreign exchange market is required to achieve a fixed exchange rate. If a central bank wanted to hold the exchange rate steady in the presence of diminished demand for its currency, the central bank props up demand by buying its currency in the foreign exchange market to keep the exchange rate from falling. If the demand for its currency increases, the central bank increases the supply by selling its currency and keeps the exchange rate from rising. Let’s see an example where Fed wanted to fix the U.S. dollar exchange rate against the Japanese yen. Suppose the Fed wants the exchange rate to be steady at 100 yen per U.S. dollar. If the exchange rate rises above 100 yen, the Fed sells dollars. If the exchange rate falls below 100 yen, the Fed buys dollars. By these actions, the Fed keeps the exchange rate close to its target rate of 100 yen per U.S. dollar.

3. What is a crawling peg and how does it work? A crawling peg is an exchange rate that follows a path determined by a decision of the government or the central bank and is achieved in a similar way to a fixed exchange rate by central bank intervention in the foreign exchange market. A crawling peg works like a fixed exchange rate except that the target value changes. The target might change at fixed intervals (daily, weekly, monthly) or at random intervals. The Fed has never operated a crawling peg, but some prominent countries do use this system. When China abandoned its fixed exchange rate, it replaced it with a crawling peg. Developing countries might use a crawling peg as a method of trying to control inflation—of keeping the inflation rate close to target. The ideal crawling peg sets a target for the exchange rate equal to the equilibrium exchange rate 4. How has China operated in the foreign exchange market, why, and with what effect? From 1997 until 2005, the People’s Bank of China fixed the Chinese Yuan exchange rate. Over this time, the demand for the Yuan increased, so the People’s Bank of China supplied additional Yuan to keep the exchange rate constant. By supplying Yuan, the People’s Bank acquired large amounts of foreign currency. In addition, by fixing its exchange rate China essentially pegged its inflation rate to equal the U.S. inflation rate. Since 2005 the Yuan has been allowed to appreciate slightly as the People’s Bank moved to a crawling peg exchange rate policy. The exchange rate has not been allowed to change much, so over the long run the Chinese inflation rate remains closely tied to U.S. inflation. 1. What are the transactions that the balance of payments accounts record? Page-229 A country’s balance of payments is a record of all transactions made between one particular country and all other countries during a specified period of time. It records the country’s international trading, borrowing, and lending in three accounts. A negative balance of payments means that more money is flowing out of the country than coming in, and vice versa. The current account records payments for imports of goods and services from abroad, receipts from exports of goods and services sold abroad, net interest paid abroad, and net transfers (such as foreign aid payments). The current account balance equals the sum of exports minus imports, net interest income, and net transfers. The official settlements account records the change in U.S. official reserves, which are the government’s holdings of foreign currency. If U.S. official reserves increase, the official settlements account balance is negative. The capital and financial account records foreign investment in the United States minus U.S. investment abroad.(This account also has a statistical discrepancy that arises from errors and omissions in measuring international capital transactions.) The sum of the balances on the three accounts always equals zero. 2. How are net exports and the government sector balance linked? A net export is the value of exports of goods and services minus the value of imports of goods and services. Net exports is equal to the sum of government sector surplus or deficit plus the private sector surplus or deficit. The government sector balance is equal to net taxes minus government expenditure on goods and services. If the government sector balance is negative, then the government sector has a deficit, that is, a budget deficit. So if the government budget deficit increases and the private sector balance, which equals saving minus investment, do not change, the value of net exports becomes more negative.

Review Quiz Answers-Chapter 10 Why aggregate supply curve is vertical in the long run? The aggregate supply curve illustrates the quantity of goods and services firms sell at any price level. In the long run, the aggregate supply curve is vertical, whereas in the short run, the aggregate supply curve is upward sloping. In the long run, an economy's production of goods and services depends on the supplies of labor, capital, and natural resources and on the available technology to turn these factors of production into goods and services. Since the price level doesn't affect the long run components of real GDP, the long run aggregate supply curve is vertical. The only thing that affects the long run supply of goods and services is the economy’s labor, capital, natural resources, and technology. Why aggregate supply curve is upward sloping in the short run? Aggregate supply behaves differently in the short and long run because in the long run, the price level does not affect production, but in the short run it does. The upward slope of the short run curve is due to the fact that an increase in the overall level of prices increases the quantity of goods and services supplied and conversely a decrease in the price level tends to reduce the quantity of goods and services supplied. Changes in long run aggregate supply curve: The long-run aggregate supply curve is shifted due to changes by any factor other than the price level. Two broad determinant categories include: Resource Quantity: This determinant is the quantity of the resources--labor, capital, land, and entrepreneurship--that the economy has available for production. If the economy has more resources, aggregate supply increases and the long-run aggregate supply curve shifts rightward. With fewer resources, aggregate supply decreases and the long-run aggregate supply curve shifts leftward. Specific determinants in this category include population growth, labor force participation, capital investment, and exploration. Resource Quality: This determinant is the quality of resources, especially technology and education. If the quality of labor, capital, land, and entrepreneurship change, then aggregate supply changes and the long-run aggregate supply curve shifts. An improved quality increases aggregate supply, triggering a rightward shift of the long-run aggregate supply curve, and a decline in quality decreases aggregate supply, generating a leftward shift of the long-run aggregate supply curve. Changes in short run aggregate supply curve: Any factor that shifts the long-run aggregate supply curve will also shift the shortrun aggregate supply curve, as both curves represent a relationship between the price level and the quantity of real GDP supplied. Another important variable that affects the position of the short run aggregate supply curve is the expected price level. When people change their expectations of price level, the short run aggregate supply curve shifts. When the price level increases, it reduces the quantities of goods and services supplied and the short run AS curve shifts to the left. Conversely, a decrease in the expected price level raises the quantity of goods and services supplied, it shifts the short run AS curve to the right.

Review Quiz Answers-Chapter 11 1. If the price level and the money wage rate rise by the same percentage, what happens to the quantity of real GDP supplied? Along which aggregate supply curve does the economy move? If the price level and the money wage rate rise by the same percentage, there is no change in the quantity of real GDP supplied and a movement occurs up along the LAS curve. 2. If the price level rises and the money wage rate remains constant, what happens to the quantity of real GDP supplied? Along which aggregate supply curve does the economy move? If the price level rises and the money wage rate remain constant the quantity of real GDP supplied increases and the economy moves along the SAS curve. 3. If potential GDP increases, what happens to aggregate supply? Does the LAS curve shift or is there a movement along the LAS curve? Does the SAS curve shift or is there a movement along the SAS curve? If potential GDP increases both long-run aggregate supply and short-run aggregate supply increase and the LAS curve and SAS curve shift rightward. 4. If the money wage rate rises and potential GDP remains the same, does the LAS curve or the SAS curve shift or is there a movement along the LAS curve or the SAS curve? If the money wage rate rises and potential GDP remains the same there is a decrease in short-run aggregate supply and no change in long-run aggregate supply. The SAS curve shifts leftward and the LAS curve is unchanged. 1. What does the aggregate demand curve show? What factors change and what factors remain the same when there is a movement along the aggregate demand curve? The aggregate demand curve shows the relationship between the quantity of real GDP demanded and the price level when other influences on expenditure plans remain the same. When there is a movement along the aggregate demand curve, the price level changes and other factors such as expectations, fiscal and monetary policy, and the world economy remain the same. 2. Why does the aggregate demand curve slope downward? The aggregate demand curve slopes downward because of the wealth effect and substitution effects. First, a rise in the price level decreases real wealth, which brings an increase in saving and a decrease in spending—the wealth effect. Second, a rise in the price level raises the interest rate, which decreases borrowing and spending—an inter temporal substitution effect as people decrease current spending in favor of future spending—and increases the price of domestic goods and services relative to foreign goods and services, which decreases exports and increases imports—an international substitution effect. 3. How do changes in expectations, fiscal policy and monetary policy, and the world economy change aggregate demand and the aggregate demand curve? Aggregate demand increases and the AD curve shifts rightward if: expected future income, expected future inflation, or expected future profits increase; government expenditures increase or taxes are cut; the quantity of money increases and the interest rate is cut; the foreign exchange rate falls; or foreigners’ income increases. The reverse changes decrease aggregate demand and shift the AD curve leftward. 1. Does economic growth result from increases in aggregate demand, short-run aggregate supply, or long-run aggregate supply?

Economic growth results from increases in long-run aggregate supply. Economic growth occurs because the quantity of labor increases, capital is accumulated and there are technological advances over time. All three of these factors increase potential GDP and shift the LAS curve rightward. 2.Does inflation result from increases in aggregate demand, short-run aggregate supply, or longrun aggregate supply? Inflation results from increases in aggregate demand that exceeds the increase in long run aggregate supply. As the aggregate demand curve shifts rightward the price level rises. Increases in AD that exceed increases in LAS produce inflation. 3. Describe three types of short-run macroeconomic equilibrium. Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied. There are three types of short-run equilibrium: below full-employment equilibrium where a recessionary gap exists with real GDP less than potential GDP; above fullemployment equilibrium where an inflationary gap exists with real GDP greater than potential GDP; fullemployment equilibrium where no gap exists and real GDP equals potential GDP. 4. How do fluctuations in aggregate demand and short-run aggregate supply bring fluctuations in real GDP around potential GDP? Fluctuations in aggregate demand with no change in short-run aggregate supply bring fluctuations in real GDP around potential GDP. For instance, starting from full employment, a decrease in aggregate demand decreases the price level and real GDP and creates a recessionary gap. In the long run the money wage rate (and the money prices of other resources) falls so that short-run aggregate supply increases and the economy return to its full employment equilibrium. Starting from full employment, a decrease in shortrun aggregate supply decreases real GDP and raises the price level. The fall in real GDP combined with a rise in the price level is a phenomenon called stagflation. 1. What are the defining features of classical macroeconomics and what policies do classical macroeconomists recommend? Classical macroeconomists believe that the economy is self-regulating and always at full employment. Classical macroeconomists assert that the proper government policy is to minimize the disincentive effects of taxes on employment, investment, and technological change. 2. What are the defining features of Keynesian macroeconomics and what policies do Keynesian macroeconomists recommend? Keynesian macroeconomists believe that if the economy was left alone, it would rarely operate at full employment. To achieve and maintain full employment the economy needs active help from fiscal and monetary policy. Aggregate demand fluctuations combined with a very sticky money wage rate are the major sources the business cycle. Keynesian macroeconomists assert that active fiscal and monetary policy, designed to offset fluctuations in aggregate demand, are the proper government policies. 3. What are the defining features of monetarist macroeconomics and what policies do monetarist macroeconomists recommend? Monetarist macroeconomists believe that the economy is self-regulating and will typically operate at full employment if monetary policy is not erratic and the money growth rate is kept steady. The major source of business cycle fluctuations are similar to the Keynesian view, that is, changes in aggregate demand combined with a sticky money wage rate. However, according to monetarist macroeconomists, the changes in aggregate demand are the result of fluctuations in the growth rate of money caused by the

Federal Reserve. Monetarists assert that the proper government policies are low taxes, to avoid the disincentive effects stressed by classical macroeconomists, and steady monetary growth. 1. Which components of aggregate expenditure are influenced by real GDP? Consumption expenditure and imports are influenced by real GDP. Both increase when real GDP increases. 2. Define and explain how we calculate the marginal propensity to consume and the marginal propensity to save. The marginal propensity to consume is the proportion of an increase in disposable income that is consumed. In terms of a formula, the marginal propensity to consume, or MPC, equals C/ YD. where means ―change in.‖ The marginal propensity to save is the proportion of an increase in disposable income that is saved. In terms of a formula, the marginal propensity to save, or MPS, equals S/ YD. The sum of the MPC and the MPS is 1.0. 3. How do we calculate the effects of real GDP on consumption expenditure and imports by using the marginal propensity to consume and the marginal propensity to import? The effects of real GDP on consumption expenditure and imports are determined respectively by the marginal propensity to consume and the marginal propensity to import. In particular, the effect of a change in real GDP on consumption expenditure equals the marginal propensity to consume multiplied by the change in disposable income. Similarly, the effect of a change in real GDP on imports equals the marginal propensity to import multiplied by the change in real GDP. 1. What is the relationship between aggregate planned expenditure and real GDP at equilibrium expenditure? Equilibrium expenditure occurs when aggregate planned expenditure equals real GDP. 2. How does equilibrium expenditure come about? What adjusts to achieve equilibrium? Equilibrium expenditure results from adjustments in real GDP. For instance, if aggregate planned expenditure exceeds real GDP, firms find that their inventories are below their targets. In response, firms increase production to meet their inventory targets,. And, as production increases, real GDP increases. The increase in real GDP increases aggregate planned expenditure. Eventually real GDP increases sufficiently so that it equals aggregate planned expenditure and, at that point, equilibrium expenditure occurs. 3. If real GDP and aggregate expenditure are less than equilibrium expenditure, what happens to firms’ inventories? How do firms change their production? And what happens to real GDP? If real GDP and aggregate expenditure are less than their equilibrium levels, an unplanned decrease in inventories occurs. The unplanned decrease in inventories leads firms to increase production to restore inventories to their planned levels. The increase in production increases real GDP. 4. If real GDP and aggregate expenditure are greater than equilibrium expenditure, what happens to firms’ inventories? How do firms change their production? And what happens to real GDP? If real GDP and aggregate expenditure are greater than their equilibrium levels, an unplanned increase in inventories occurs. The unplanned increase in inventories leads firms to decrease production to restore inventories to their planned levels. The decrease in production decreases real GDP.

1. What is the multiplier? What does it determine? Why does it matter? The multiplier is the amount by which a change in autonomous expenditure is multiplied to determine the change in equilibrium expenditure and real GDP. A change in autonomous expenditure changes real GDP by an amount determined by the multiplier. The multiplier matters because it tells us how much a change in autonomous expenditure changes equilibrium expenditure and real GDP. 2. How do the marginal propensity to consume, the marginal propensity to import, and the income tax rate influence the multiplier? The marginal propensity to consume, the marginal propensity to import, and the income tax rate all influence the magnitude of the multiplier. The multiplier is smaller when the marginal propensity to consume is smaller, when the marginal propensity to import is larger, and when the income tax rate is larger. 3. How do fluctuations in autonomous expenditure influence real GDP? Fluctuations in autonomous expenditure bring business cycle turning points. When autonomous expenditure changes, the economy moves from one phase of the business cycle to the next phase. For example, if autonomous expenditure decreases, equilibrium expenditure and real GDP decrease and, as a result, the economy enters the recession phase of the business cycle. 1. How does a change in the price level influence the AE curve and the AD curve? A change in the price level shifts the AE curve and creates a movement along the AD curve. 2. If autonomous expenditure increases with no change in the price level, what happens to the AE curve and the AD curve? Which curve shifts by an amount that is determined by the multiplier and why? A change in autonomous expenditure with no change in the price level shifts both the AE curve and the AD curve. The AE curve shifts by an amount equal to the change in autonomous expenditure. The multiplier determines the magnitude of the shift in the AD curve. The AD curve shifts by an amount equal to the change in autonomous expenditure multiplied by the multiplier. 3. How does an increase in autonomous expenditure change real GDP in the short run? Does real GDP change by the same amount as the change in aggregate demand? Why or why not? In the short run, an increase in aggregate expenditure increases real GDP. However, the increase in real GDP is less than the increase in aggregate demand because the price level rises. The more the price level rises (the steeper the SAS curve) the smaller the increase in real GDP. 4. How does real GDP change in the long run when autonomous expenditure increases? Does real GDP change by the same amount as the change in aggregate demand? Why or why not? In the long run, an increase in aggregate expenditure has no effect on real GDP, that is, real GDP does not change. The change in real GDP—zero—is less than the change in aggregate demand. The change in real GDP is nil because, in the long run, the economy returns to its full-employment equilibrium. In the long run, an increase in aggregate expenditure raises the price level but has no effect on real GDP.

Chapter 12-Review Quiz Answers 1. What is Demand Pull inflation? A term used in Keynesian economics to describe the scenario that occurs when price levels rises because of an imbalance in the aggregate supply and demand. When the aggregate demand in an economy strongly outweighs the aggregate supply, prices increase. This type of inflation is a result of strong consumer demand. When many individuals are trying to purchase the same good, the price will inevitably increase. When this happens across the entire economy for all goods, it is known as demand-pull inflation. What causes Demand pull inflation? Factors for creating demand pull inflation are the same factors that increase aggregate demand. Tax cut: A cut in the tax by the government increases the disposable income of the people. So now the people have more money to spend. So they buy more goods and services and thus demand for goods and services increase. Cut in the interest rate: If Fed decreases the interest rate; the people will now borrow more money from the bank to increase their expenditure on goods and services. So their spending will rise more than before and this will eventually increase aggregate demand. Increase in the quantity of money: When the government has a budget deficit, it finances by selling bonds. The Fed buys some of these bonds. When the Fed buys bonds, it creates more money. In this situation, the quantity of money increases and so does the aggregate demand. Increase in exports: An increase in exports increases the quantity of money in the whole economy. This creates aggregate demand. Increase in government expenditure: As the government spends more in any particular segment of the economy, it drives up demand. For example, military spending raises prices for military equipment. Other factors: Once people expect inflation, they will buy things now before prices go up further in the future. This increases demand, which then created demand-pull inflation. Strong brand sometimes also create demand pull inflation because it also creates demand. Marketing can create high demand for certain products, a form of asset inflation. A great example is Apple products, including the iPod, iPad and iPhone. 2. What must happen to create a demand-pull inflation spiral? When aggregate demand increases, a new aggregate demand curved is created shifting the aggregate demand rightward. The real GDP increases and the price level rises. This eventually takes the economy to an above full-employment equilibrium. At above full-employment equilibrium, there is a shortage of labor. So the money wage rate rises which decreases the short-run aggregate supply. The decrease in the short-run aggregate supply decreases real GDP and takes it to the same level as it was before. The price level further rises. If nothing else changes the price level eventually stops rising. To create a demand-pull inflation spiral, aggregate demand must persistently increase, and the only way in which aggregate demand can persistently increase is if the quantity of money persistently increases. 3. What is cost push inflation? Cost push inflation is a phenomenon in which the general price levels rise (inflation) due to increases in the cost of wages and raw materials when the aggregate demand is constant.

At a given price level, the higher the cost of production, the smaller is the amount that firms are willing to produce. So if the money wage rate rises or if the prices of raw materials (for example, oil) rise, firms decrease their supply of goods and services. Aggregate supply decreases, and the short-run aggregate supply curve shifts leftward. Because there are fewer goods being produced (supply weakens) and demand for these goods remains consistent, the prices of finished goods increase (inflation). For example, when the oil price increases in a soda-bottling plant, the costs of bottling soda increase. These higher costs decrease the supply of soda, increasing its price and decreasing the quantity produced. The soda plant lays off some workers. This situation persists until either the Fed increases aggregate demand or the price of oil falls. If the Fed increases aggregate demand, the demand for soda increases and so does its price. The higher price of soda brings higher profits, and the bottling plant increases its production. The soda factory rehires the laid-off workers. 4. What must happen to create cost push inflation spiral? When the price of any raw material of production (such as oil) increases, the cost of production becomes higher which decreases short-run aggregate supply. The short run aggregate supply curve shifts leftward. This increases the price level and decreases the real GDP. Now that the real GDP is less than potential GDP, a recessionary gap is created and the economy is below full-employment equilibrium. In this case, unemployment rises above its natural rate. Now, Fed is required to restore the full employment again. To do so, Fed increases the quantity of money (suppose by cutting the interest rate). This increases the aggregate demand; a new aggregate demand curve is created shifting the aggregate demand rightward. The price level further rises thus restoring the full employment. If this process continues-a cost push inflation spiral results. 5. What is stagflation and why does cost push inflation cause stagflation? Stagflation is an economic condition that occurs when the economic experiences the combination of inflation & unemployment with decreasing real GDP. Simply Stagflation is a situation when the economy isn't growing but prices are, which is not a good situation for a country to be in. Cost-push inflation is a prime cause of stagflation. It occurs when there is a increase in the money wage rate as well as prices of raw materials. This increase effect decreases the short-run aggregate supply. As a result, the price level rises and the real GDP falls. When real GDP falls, unemployment rises above its natural rate. Thus the economy faces inflation, unemployment and decreasing real GDP- stagflation occurs. 6. How does expected inflation occur? If inflation is expected, the fluctuations in real GDP that accompany demand-pull and cost-push inflation don’t occur. Instead, inflation proceeds as it does in the long run, with real GDP equal to potential GDP and unemployment at its natural rate. Expected increases in aggregate demand or expected decreases in aggregate supply create expected inflation because they change the expected price level. For example, in anticipation of an increase in aggregate demand, the money wage rate rises by the same percentage as the price level is expected to rise. With the correct expectation, real GDP remains equal to potential GDP and unemployment remains at its natural rate. 7. How do real GDP and the price level change if the forecast of inflation is incorrect? If the actual inflation rate exceeds the forecasted inflation rate, the price level rises by more than expected and real GDP exceeds potential GDP. If the actual inflation rate falls short of the expected inflation rate, the price level rises by less than expected and real GDP is less than potential GDP.

What is Phillips curve and what does it explain? An economic concept developed by A. W. Phillips stating that inflation and unemployment have a stable and inverse relationship. According to the Phillips curve, the lower an economy's rate of unemployment, there is a high inflation in that economy and the higher the economy’s rate of unemployment, there is a low inflation in that economy. The general logic behind this concept is that, when an economy is facing low unemployment (high employment) the workers now have a high utilization of the labor market. In this case, workers have more leverage and options (as lots of people are looking to hire them). This causes employers raise wages to attract and retain employees (now workers have more bargaining power on wages because firms are competing against other firms for qualified workers). An increase in the wages increases the buying power of the workers. So workers now have more ability to spend on goods and services. So the demand for goods and services increases. When there is an increase in the goods and services, it will eventually increase the utilization of all the factors of production (land, capital, entrepreneurship and of course labor). So that’s going to lower unemployment even more. When the cycle continues for a couple of times, there will be a situation when unemployment rate is close to zero and the factors of production are already being highly utilized (factories are running at close to full capacity and the labor market is even at full capacity). In this context, increasing buying power increases demand but there is less capacity to production, it will eventually cause prices to go up. 1. How would you use the Phillips curve to illustrate an unexpected change in inflation? An unexpected change in inflation results in a movement along the short-run Phillips curve. In particular, an unexpected increase in the inflation rate lowers the unemployment rate and an unexpected decrease in the inflation rate raises the unemployment rate. 2. If the expected inflation rate increases by 10 percentage points, how do the short-run Phillips curve and the long-run Phillips curve change? A 10 percentage point increase in the expected inflation rate shifts the short-run Phillips curve vertically upward by 10 percentage points. (Each point on the new short-run Phillips curve lies 10 percentage points above the point on the old Phillips curve directly below it). A 10 percentage point increase in the expected inflation rate does not change the long-run Phillips curve. 3. If the natural unemployment rate increases, what happens to the short run Phillips curve and the long-run Phillips curve? An increase in the natural unemployment rate shifts both the short-run and long-run Phillips curves rightward by an amount equal to the increase in the natural unemployment rate. 1. Explain the mainstream theory of the business cycle. Mainstream business cycle theory attributes business cycles to fluctuations in aggregate demand growth. According to the mainstream view, potential GDP grows steadily and aggregate demand, while generally growing slightly faster that potential GDP, at times grows more slowly than potential GDP and at other times grows significantly more rapidly than potential GDP. When aggregate demand grows more slowly than potential GDP, the price level falls below its expected level and the economy slides into a recession so that real GDP is less than potential GDP. When aggregate demand grows more rapidly than potential GDP, the price level rises above its expected level and the economy moves into a strong expansion accompanied by inflation. 2. What are the four varieties of the mainstream theory of the business cycle and how do they differ?

The four varieties of the mainstream theory are the Keynesian cycle theory, the monetarist cycle theory, the new classical cycle theory, and the new Keynesian cycle theory. These theories differ according to the factors they believe are the most responsible for causing fluctuations in the growth of aggregate demand. Keynesian cycle theory asserts that fluctuations in aggregate demand growth are the result of fluctuations in investment driven by fluctuations in business confidence. Monetarist cycle theory says that fluctuations in both investment and consumption expenditure lead to fluctuations in aggregate demand growth and that the basic source of the fluctuations in investment and consumption expenditure is fluctuations in the growth rate of the quantity of money. New classical cycle theory claims that the money wage rate and the position of the short-run aggregate supply curve are determined by the rational expectation of the price level, which in turn is determined by potential GDP and the expected aggregate demand. As a result, only unexpected changes in aggregate demand growth lead to business cycles. Finally, New Keynesian cycle theory says that money wage rates and the position of the short-run aggregate supply are determined by rational expectations of the price level from the past. As a result, both expected and unexpected fluctuations in aggregate demand growth lead to business cycles. 3. According to RBC theory, what is the source of the business cycle? What is the role of fluctuations in the rate of technological change? Real business cycle theory is a class of theories explored first by John Muth (1961), and associated most with Robert Lucas. The idea is to study business cycles with the assumption that random fluctuations in the productivity are the main source of economic fluctuations. And these fluctuations are driven entirely by technology shocks rather than by monetary shocks or changes in expectations. These fluctuations also might have other sources such as international disturbances, climate fluctuations or natural disasters. Fluctuations in the rate of technological change are the impulse that creates the business cycle. The impulse in RBC theory is the growth rate of productivity that results from technological change. 4. According to RBC theory, how does a fall in productivity growth influence investment demand, the market for loanable funds, the real interest rate, the demand for labor, the supply of labor, employment, and the real wage rate? According to real business cycle theory, technological change makes some existing human capital obsolete and temporary decreases productivity. Firms expect the future profits to fall and see their labor productivity falling. So the initial effect of a temporary fall in productivity decreases investment demand as well as demand for labor. The decrease in investment demand decreases the demand for loanable funds and lowers the real interest rate. Via the inter-temporal substitution effect, the lower real interest rate decreases the supply of labor (the when to work decision). Because both the demand for labor and the supply of labor decrease, employment decreases. The real wage rate also falls because the decrease in the demand for labor exceeds the decrease in the supply of labor. 5. What are the main criticisms of RBC theory and how do its supporters defend it? Critics of the real business cycle theory level three criticisms at it: 1) the money wage rate is sticky, and to assume otherwise is at odds with a clear fact; 2) the inter-temporal substitution effect is too weak a force to account for large fluctuations in labor supply and so, small changes in the real wage rate cannot account for large changes in employment; and, 3) measured productivity shocks are likely to be caused by changes in aggregate demand as by technological change. If aggregate demand fluctuations cause the fluctuations in productivity, then the traditional aggregate demand theories are needed to explain them. Fluctuations in productivity do not cause the business cycle but are caused by it. Real business cycle supporters respond that 1) the real business cycle theory is consistent with the facts about economic growth and it explains the facts about business cycles; and 2) real business cycle theory is consistent with a wide range of microeconomic evidence about labor supply, labor demand, investment demand, and information on the distribution of income between labor and capital.