CH-10-12 Economic Growth – Macroeconomics : Book Guide

This Document Contains Chapters 10 to 12 CHAPTER 10 ECONOMIC GROWTH Chapter Overview Economic growth can make the rich richer. It also is a powerful way to make the poor richer too. In this chapter, we looked at how we define and measure economic growth and why growth is so important. Because of compounding, even a small increase in the growth rate will have a large impact on the level of income in the long run. A country that is growing at 3.5 percent, instead of 2 percent, will end up approximately four times richer after 100 years. In order to grow, a country needs to be able to put together the ingredients: savings that can be invested into physical capital, healthy and skilled workers, appropriate technology, and supportive public policies and institutions. All governments face tough trade-offs: How much should the country invest in health, education, and infrastructure? How can the government create a secure legal environment for people to invest? The goal is a positive cycle in which people gain human capital, invent better technology, become more productive at their jobs, get richer and be able to afford more physical capital, and so on. This process is not easy, but it is important. If policy-makers, businesses, and workers come together effectively to build the right environment for investment, their contributions can deliver a foundation for the prosperity of future generations. Learning Objectives LO 10.1 Calculate the growth rate of real GDP per capita, accounting for changes in price levels and population. LO 10.2 Describe the relationship between productivity and growth and discuss the factors that determine productivity. LO 10.3 Explain the difference between a country’s level of income and its rate of growth. LO 10.4 Use the growth accounting framework to describe how technology, labor, and capital contribute to economic growth. LO 10.5 Assess the empirical evidence for and against convergence theory. LO 10.6 Discuss policies that could promote growth and relate them to productivity. LO 10.7 Explain how good governance and economic openness lay the foundation for growth. Chapter Outline WHY ECONOMIC GROWTH MATTERS Economic Growth through the Ages History of World Growth (LO 10.1) Compounding and the Rule of 70 BOX FEATURE: REAL LIFE – WHAT A DIFFERENCE 50 YEARS MAKES: THE STORY OF KOREA AND GHANA Determinants of Productivity Productivity Drives Growth Components of Productivity (LO 10.2) BOX FEATURE: FROM ANOTHER ANGLE – DOES THE PLANET HAVE A MAXIMUM CAPACITY? Rates versus Levels (LO 10.3) Accounting for Growth (LO 10.4) Convergence (LO 10.5) Growth and Public Policy Investment and Savings (LO 10.6) BOX FEATURE: REAL LIFE – PLANNING FOR GROWTH Education and Health Technological Development BOX FEATURE: REAL LIFE – GREEN REVOLUTIONS IN ASIA AND AFRICA Laying the Groundwork: Good Government, Property Rights, and Economic Openness (LO 10.7) The Juggling Act BOX FEATURE: WHAT DO YOU THINK? – SHOULD POOR COUNTRIES BE AS EARTH-FRIENDLY AS RICH ONES? Beyond the Lecture Class Discussion: Good Government, Property Rights, and Profit Incentives vs Communism and Government Ownership (LO 10.1, 10.6) Have your students read the story of the amazing agreement between rural Chinese farmers in 1979. Effectively, the farmers defiantly went against the communist government by giving themselves property rights over output and agreed not to ask the government for aid. What happened to productivity when property rights were introduced? Did competition among the villagers play a role in output as well? Despite the farmers going against communism, what was the government’s ultimate response when they saw productivity increases? Class Discussion: Components of Productivity (LO 10.2) Have students examine labor productivity by country. This OECD site lists GDP per hour worked at current U.S. prices and GDP per hour worked for other countries relative to the U.S. Discuss the following: Why are there differences in labor productivity across countries? What can be done to increase productivity? How do changes in productivity impact growth? Class Discussion: Rates versus Levels (LO 10.3) Have students review this brief article regarding China and its increasing income. Discuss the following: What is the difference between income and the growth rate? How can growth lead to an increase in income? Do you think that China will continue on with a rapid growth rate going forward? Writing Assignment: Good Government, Property Rights, and Economic Openness (LO 10.6) Have students listen to this hour-long podcast of Karol Boudreaux on EconTalk discussing property rights and incentives in Africa. Additionally, consider assigning this brief clip from Tom W. Bell on Learn Liberty discussing property rights. Ask students to write a few paragraphs describing the importance of property rights and good governance to economic growth, using these two sources as examples. Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. 1. What key event sped up economic growth for the world? [LO 10.1] The industrial revolution The invention of the wheel The voyage of Christopher Columbus World War II Feedback: It’s the point in history where we first really say GDP growing faster than the population, which meant increases in per-capita GDP. 2. Physical capital, human capital, technology, and natural resources are components of ________. [LO 10.2] GDP Efficiency Productivity The economy Feedback: Improvements in one or all of these factors is what leads to economic growth. 3. Convergence theory says that…… [LO 10.4] The most developed economies grow the fastest Developing countries will have higher growth rates compared to industrialized countries Developing countries will usually have negative growth rates Growth slows to zero once a country gets all available technology Feedback: Countries will tend to converge when considering rates of growth. It’s easy to have very high rates of growth if you’re currently very small. The theory says that over time, we may expect to see the gap close between rich and poor countries. 4. What is an example of foreign direct investment? [LO 10.5, 10.6] Nike operates a facility in Vietnam United States imports goods from China Germany puts tariffs on French imports United States gives federal tax breaks to a new American firm located in Tennessee Feedback: A firm runs part of its operations in another country. 5. Why are property rights and lack of corruption vital for economic growth? [LO 10.6] They keep taxes low They create the incentives for individuals to start businesses and grow the economy They guarantee the government can own most of the economy They allow individuals to freely take from others Feedback: Without property rights, starting any business is very risky since it could be taken by others, or even the government. With property rights and profit incentives, people will start businesses and grow the economy. Solutions to End-of-Chapter Questions and Problems Review Questions Explain why inflation reduces the real value of nominal GDP per capita. [LO 10.1] Answer: Real GDP per capita is the amount of goods and services produced per person. Nominal GDP per capita is the number of dollars produced per person. Since inflation increases the number of dollars required to purchase goods and services, if a country’s nominal GDP is fixed, inflation will reduce the amount of goods and services that the fixed amount of nominal GDP can purchase. When policy-makers discuss policies that encourage long-run growth in per capita real GDP, they often mention policies aimed at reducing the growth rate in the population. If effective, why might these policies improve long-run growth? Also, what are the potential costs associated with these policies? [LO 10.1] Answer: As can be seen in Equation 10-1, real GDP per capita growth rate = Nominal GDP growth rate – Inflation rate – Population growth rate. If one can keep the nominal GDP growth rate and inflation rate the same while simultaneously reducing the population growth rate, then real GDP per capita growth rate will rise. More intuitively, if one can keep the size of the cake growing at the same rate but reduce the number of people among whom you have to divide up the cake, everyone will get bigger and bigger slices. There are two primary costs. First, the policies that reduce population growth may also reduce nominal GDP at the same time. For example, lower population growth will eventually reduce the amount of labor a country can provide or may reduce the rate of technological innovation or capital accumulation. Second, the policies required to reduce population growth may be considered coercive or a violation of human rights. For example, China’s “one child” policy is often criticized on human rights grounds. Does the rule of 70 predict greater increases in the amount of income for richer or poorer countries when both have the same growth rate? Why? [LO 10.1, 10.3] Answer: The rule of 70 predicts that the amount of time it will take a country’s income to double is dependent only on its growth rate, not on its initial level of income. However, the size of the increase certainly depends on its starting point. For example, two countries with a 7% real per capita growth rate will both have their incomes double in 10 years (70/7 = 10). If one country started with a GDP of $1,000/capita and the other started with a GDP of $10,000/capita, the poor country would have experienced an increase in income from $1,000 to $2,000 per person in 10 years, an increase of $1,000 per person. The rich country would have experienced an increase in income from $10,000 to $20,000 per person in 10 years, an increase of $10,000 per person. Explain why many rich countries are able to continuously grow, even though they already have very high levels of physical and human capital. [LO 10.2] Answer: Rich countries with high levels of physical and human capital are able to continuously grow if they can continuously increase any of the components that lead to productivity growth. First, it is possible that even countries with high levels of physical and human capital can continue to accumulate even higher levels of these factors of production. Second, countries with lots of physical and human capital are well equipped to engage in technological innovation, another component of productivity growth. At a young age, would you rather have a large level of savings or a pool of savings that was increasing at a faster rate? [LO 10.3] Answer: The answer depends on the relative size of the two starting amounts, and on the two growth rates. As a general rule, it is possible that the smaller initial amount of savings growing at a faster rate will end up larger after some long period of time. For example, if you start with $5,000 and the growth rate is 11% per year, then you end up with $114,461.48 after 30 years. If you start with $50,000 (a much larger level) and the growth rate is 2% per year, then you end up with $90,568.08. If the growth rate on the $5,000 is only 9%, then after 30 years you would end up with $66,338.39. If a country’s labor and capital grow at the same rate, is this likely to have the same impact on the growth rate of output? Why or why not? [LO 10.4] Answer: According to the growth accounting equation, the growth rate of output is equal to the growth rate of labor times labor's share of output plus the growth rate of capital times capital's share of output plus the growth rate of technology. Therefore, the impact of labor growth and capital growth on output growth depends on their respective shares of output. For example, suppose both labor and capital grow at 5%, labor's share of output is 60%, and capital's share of output is 40%. The impact on output of the growth in labor is 0.05 × 0.60 = 0.03, or the 5% growth in labor leads to 3% growth in output. The impact of the growth in capital is 0.05 × 0.40 = 0.02, or the 5% growth in capital leads to 2% growth in output. Measuring the growth in technology directly is almost impossible. How does the growth accounting equation allow economists to calculate an implied growth rate for technology? [LO 10.4] Answer: According to the growth accounting equation, the growth rate of output is equal to the growth rate of labor times labor's share of output plus the growth rate of capital times capital's share of output plus the growth rate of technology. We can observe or calculate the growth rate of output, the growth rate of labor, the growth rate of capital, labor's share of output, and capital's share of output. Therefore, we can solve for the implied rate of growth in technology. We cannot easily observe or calculate technology directly. Using the growth rates for countries found in Figure 10-3, is there evidence that poorer countries in Africa and Asia are con-verging to the level of income found in Western Europe? Why or why not? [LO 10.5] Answer: The map shows that over the past 20 years countries in Africa and Asia have grown faster than countries in Western Europe. This suggests that some level of convergence has taken place. Southern states in the United States are, on average, poorer than northern states. Southern states also have higher growth rates in real GDP per capita, on average, than northern states. Use these facts to draw a conclusion about whether the theory of convergence is correct. What other factors should be considered? [LO 10.5] Answer: Convergence theory predicts that different countries or regions will eventually converge to the same growth rate, but not necessarily the same level of income. Countries that start out at a lower income level may grow at a faster rate, but that rate will eventually slow down due to decreasing marginal returns. The level of per capita income in a country is influenced by its savings rate, level of education, and level of technology. Many believe that technology is very costly to create, but cheap to transfer. For example, think of the personal computer: The technology underpinning the personal computer took a generation of time and a ton of money to create. However, now that the personal computer has been created, it is easy for others to purchase and reap the benefits. Given this insight, what do you believe will be the growth implications for the United States (traditionally more apt to create new technology) and China (traditionally more apt to adopt technologies created elsewhere)? [LO 10.5, 10.6] Answer: Growth should be slower in a country that has to engage in the creation of new technologies and faster in countries that get to deploy technologies that have already been created elsewhere. Thus, China should grow faster than the U.S. The idea of technology transfer is one reason why economists believe that convergence may be likely to occur between rich and poor countries. How might low rates of saving in the United States limit the accumulation of physical capital? [LO 10.6] Answer: If a country must rely primarily on domestic sources of savings in order to provide funds for investment, a low savings rate will result in a low rate of physical capital accumulation. Domestic savings comes from individuals and firms deciding to save more and spend less, or from the government deciding to increase taxes to pay for government investment spending. It is also possible for a country to use the savings of foreigners to pay for physical capital accumulation. Realizing that poor countries must solve many problems at once has shifted donors away from the idea of giving multiple small payments to the idea of a “Big Push.” This Big Push entails giving a very large sum of money that could be used to fix multiple problems at once. In fact, the amount of money required might be so large that other countries might be the only ones who could afford the donation. What are the trade-offs associated with this idea? [LO 10.6] Answer: There are tradeoffs faced by both the donor country and the recipient country. From the donor country's perspective, a large donation to a developing nation could have great humanitarian benefits, including reducing poverty and encouraging sustainable growth in that country. However, this money could have been used for other purposes within the donor country. Here in the United States, it is a frequent source of contention that the U.S. donates "so much" money to other countries instead of rebuilding our own cities. (Of course, we don't actually donate a large portion of our GDP.) So, the tradeoff is between improving the lives and welfare of foreigners with the opportunity cost of the money. From the recipient's perspective, the benefits of a large donation could be quite dramatic—again, reducing poverty and encouraging sustainable growth. However, receiving a sudden large donation might simultaneously undermine that country's nascent set of institutions. Corruption, for example, might arise, as local officials try to siphon off some of the incoming funds. Also, the developing country might begin pushing for policies that it thinks will attract more foreign funds, rather than pushing for policies that are actually in the country's best interests. How is it possible that Switzerland, a landlocked country with almost no natural resources, is one of the richest countries in the world while the Democratic Republic of the Congo, a huge country with vast deposits of many strategically important minerals, is one of the poorest? [LO 10.2, 10.6, 10.7] Answer: The case of Switzerland vs. the Democratic Republic of the Congo clearly highlights that natural resources are only one component of productivity. All things equal, it is probably better to have more natural resources than less, but when comparing a country with lots of physical capital, human capital, technology, and good governance but few resources (Switzerland) and a country with lots of resources but little human or physical capital, low levels of technology, and a long history of corrupt governance (Democratic Republic of the Congo), we see that natural resources alone generally can’t make up for all of the advantages that the other components of productivity growth bring. Why could a free press be important for economic growth? (Think about the connection between the press and government.) [LO 10.7] Answer: Good governance is an important component of economic growth. A free, independent press serves to promote good government by publicizing government corruption, waste, and fraud. Government officials who run the risk of public exposure are less inclined to engage in behavior detrimental to the economy. Problems and Applications Fill in the blanks in Table 10P-1. [LO 10.1] Answer: The equation used in the text to calculate the real GDP per capita growth rate is: Real GDP per capita growth rate = Nominal GDP growth rate – Inflation rate – Population growth rate Equation 10-1 states that the Real GDP per capita growth rate = Nominal GDP per capita growth rate – Inflation rate – Population growth rate. This equation is an approximation of the exact rate of growth of GDP per capita, and so it results in some errors when calculating this rate. However, the simplified equation is both easy to use and results in small error terms when inflation, nominal GDP growth, and population growth are low, and so it is a useful approximation. Table 10P-2 lists a fictional country’s nominal GDP, real GDP, GDP deflator, and population over two years. [LO 10.1] Use your knowledge from Chapter 25, “The Cost of Living,” to verify that the real GDP figures in Table 10P-2 are accurate. Calculate this country’s real GDP per capita for both 2015 and 2016. Calculate the growth rate in this country’s real GDP per capita between 2015 and 2016. Calculate the growth rates in the nominal GDP, GDP deflator, and the population. Answer: Real GDP (2015 dollars) = Nominal GDP × GDP deflator (2015)/GDP deflator (year of nominal GDP). Real GDP in 2015 = $1,000,000 × 100/100 = $1,000,000. Real GDP in 2016 = $1,050,000 × 100/102 = $1,029,412. Real GDP per capita = Real GDP/Population. For 2015, real GDP per capita = $1,000,000/1,000 = $1,000. For 2016, real GDP per capita = $1,029,412/1,005 = $1,024. The growth rate between any two numbers = [(New – Old)/Old] x 100. Real per capita GDP growth = [(1,024 – 1,000)/1,000] × 100 = 2.4%. The growth rate between any two numbers = [(New – Old)/Old] x 100. Nominal GDP growth = [(1,050,000 – 1,000,000)/1,000,000] × 100 = 5%. The growth in the GDP deflator = [(102 – 100)/100] × 100 = 2%. Population growth = [(1,005 – 1,000)/1,000] × 100 = 0.5%. 3. For each growth rate below, use the rule of 70 to calculate (i) how long it will take incomes to double. [LO 10.2] a. 4 percent. 7 percent. 2.5 percent. 10 percent. 3 percent. Answer: To find the time to double, simply take 70 and divide by the growth rate to find the number of years to double. Years for incomes to double a. 4.0 percent 70/4 = 17.5 years b. 7.0 percent 70/7 = 10 years c. 2.5 percent 70/2.5 = 28 years d. 10 percent 70/10 = 7 years e. 3.0 percent 70/3 = 23.3 years 4. For each part below, determine whether the following actions will increase or decrease productivity, and name the component of productivity that each affects. [LO 10.2] The local government builds a new school. Teachers in the new school hold classes for young students. A manufacturer installs robots on its assembly line. A research team designs a more efficient sys-tem of irrigation. A soda company discovers a new source of underground water that can be used to make its products. A professor writes a new and improved economics textbook. A large number of people have less access to health care. A worker receives on-the-job training to be a mechanic. Answer: The factors that influence labor productivity are physical capital, human capital, technology, and natural resources. The construction of a new school will increase productivity by increasing physical capital. The teaching of classes will increase productivity by increasing human capital. Installing robots on an assembly line will increase productivity by increasing physical capital. The development of a more efficient irrigation system will increase productivity by increasing technology. (Building an irrigation system is investment in physical capital, but taking existing water and capital and making it work better is technology.) The discovery of a new source of water increases productivity by increasing natural resources. A new and improved textbook improves the quality of teaching and learning and thus will eventually increase human capital. Healthier people are more productive, so providing health care increases productivity by increasing human capital. On-the-job training increases productivity by increasing human capital. Which of the countries shown in Table 10P-3 had the highest level of per capita income in 2015? Which had the highest rate of income growth from 2010 to 2015? Do incomes in these countries appear to be converging? [LO 10.3, 10.5] Answer: Artinia had the highest level of per capita income in 2015at $15,854 per person. Chi had the highest rate of growth in per capita income over the five-year period. Growth = (New GDP – Old GDP)/Old GDP, and the calculations are shown below for each country. Convergence is the theory that countries starting at low levels of income will grow at a faster rate than those starting at higher levels. Based on this sample of countries, convergence has not occurred. The two poorest countries in 2010, Boliv and Ghala, also had the lowest levels of GDP per capita growth between 2010 and 2015, so they did not catch up to the richer countries in the sample. Country GDP per capita 2005 GDP per capita 2010 GDP growth Bolivia $3,664 $4,592 (4,592 - 3,664) / 3,664 = 0.253, or 25.3% China $4,102 $7,519 (7,519 - 4,102) / 4,102 = 0.833, or 83.3% Ghana $2,007 $2,615 (2,615 - 2,007) / 2,007 = 0.303, or 30.3% Argentina $10,860 $15,854 (15,854 - 10,860) / 10,860 = 0.460, or 46.0% Brazil $8,603 $11,239 (11,239 - 8,603) / 8,603 = 0.306, or 30.6% In 2015 the median household income in Louisiana was approximately $45,000 per year, while the income per household in Massachusetts was about $69,000. However, suppose the growth rate of per capita real GDP in Louisiana is higher than in Massachusetts (3 percent versus 2 percent). [LO 10.3, 10.5] From the perspective of trying to maximize your income per capita, which state will have higher increases in income over the next few years? From the perspective of trying to maximize your income per capita, which state will have higher increases in income in the long run? Answer: The increase in income will be higher in Massachusetts than Louisiana over the next few years. Although Louisiana is growing at a faster rate, its level of income is much lower. In the first year, Massachusetts will increase income by 2% of $69,000, or $1,380. In the first year, Louisiana will increase income by 3% of $45,000, or $1,350. Given Louisiana’s higher rate of income growth, household income in Louisiana should eventually overtake that of Massachusetts if the differences in growth rates persist. For example, by the time 50 years have passed, Louisiana will have a higher income. This can be calculated as $45,000(1.03)50. Will the three countries in Table 10P-4 converge to the same level of economic development given enough time? [LO 10.3, 10.5] Answer: Yes. Incomes have converged so that they are much more similar in 20 years than they were before. Notice the poorest country is growing the fastest, and the middle country is growing faster than the richest country. This means the bottom two will catch up to, and in fact surpass, the richest country. For example, in 20 years Ansonia will be the richest country. Country Income per capita Real per capita GDP growth rate Real GDP per capita in 20 years Ansonia $5,000 7% 5,000(1.0720) = 19,348 Trumbull $7,500 4.5% 7,500(1.04520) = 18,088 Shelton $10,000 2% 10,000(1.0220) = 14,859 a. Indicate whether each of the following statements is true or false and explain your answer. [LO 10.4] Country A’s labor share is 60 percent, Country B’s labor share is 70 percent, and labor is growing at a rate of 3 percent in both countries. All else the same, Country B has a higher growth rate of output. Country A’s labor share is 40 percent, Country B’s labor share is 70 percent, and labor is growing at a rate of 10 percent in country A and 6 percent in country B. All else the same, Country A has a higher growth rate of output. Labor is growing at a negative rate in country A and a positive rate in country B, so country B must have a higher growth rate of output. Labor and capital are both growing more quickly in Country A than in Country B, so Country A must have a higher growth rate of output. Answer: According to the growth accounting equation, the growth rate of output is equal to the growth rate of labor times labor's share of output plus the growth rate of capital times capital's share of output plus the growth rate of technology. True. The impact on output of the growth in labor in Country A is 0.03 × 0.60 = 0.018, or 1.8%. The impact on output of the growth in labor in Country B is 0.03 × 0.70 = 0.021, or 2.1%. False. The impact on output of the growth in labor in Country A is 0.10 × 0.40 = 0.04, or 4%. The impact on output of the growth in labor in Country B is 0.06 × 0.70 = 0.042, or 4.2%. False. It depends on how fast capital and technology are growing in each country. In Country A, capital and technology could be growing more quickly and this could offset the effect of the negative growth rate in labor. False. It depends on how fast technology is growing in both countries. If Country B has a higher rate of growth in technology, then this can compensate for slower growth in labor and capital. Calculate the implied growth rate of technology in each scenario in Table 10P-5. Assume labor’s share of output is 70 percent and capital’s share of output is 30 percent. [LO 10.4] Answer: According to the growth accounting equation, the growth rate of output is equal to the growth rate of labor times labor's share of output plus the growth rate of capital times capital's share of output plus the growth rate of technology. Therefore the growth rate of output minus the contribution by labor minus the contribution by capital is equal to the implied growth rate of technology. 0.03 - (0.70 × 0.02) - (0.30 × 0.02) = 0.01, or 1.0% 0.042 - (0.70 × 0.03) - (0.30 × 0.03) = 0.012, or 1.2% 0.03 - (0.70 × 0.01) - (0.30 × 0.05) = 0.008, or 0.8% 0.042 - (0.70 × 0.01) - (0.30 × 0.04) = 0.023, or 2.3% For each of the following examples, state whether this activity would likely hinder or promote economic growth, and name a component of productivity each produces or reduces. [LO 10.2, 10.6] Not requiring students to attend school. Granting patents on new inventions. Building a solid infrastructure system. Allowing local rivers and streams to become polluted. Answer: The factors that influence labor productivity are physical capital, human capital, technology, and natural resources. Not requiring students to attend school will hinder growth by reducing the accumulation of human capital. Granting patents on new inventions will likely increase growth by encouraging the invention of new technology. Building a solid infrastructure system will increase growth by increasing physical capital. Allowing local rivers and streams to become polluted will reduce growth by reducing natural resources. 11. Policy-makers in the U.S. government have long tried to write laws that encourage growth in per capita real GDP. These laws typically do one of three things, as listed below. For each of the three points, name a law or government program with that intention. [LO 10.6] They encourage firms to invest more in research and development in order to boost technology. They encourage individuals to save more in order to boost the physical capital stock. They encourage individuals to invest more in education in order to boost the stock of human capital. Answer: Obviously there are many possible answers here. A handful of correct answers are presented, but others exist. The government grants patents for inventions. Companies get tax credits for R&D costs. Government agencies like the National Institute of Health and the National Science Foundation directly provide grants for scientific research. The government often provides lower tax rates on income earned through savings. Programs like 401K or IRA retirement savings plans, health savings accounts, and 529 education savings accounts provide incentives for saving for specific purposes. Public schools and universities provide education at a subsidized price. The government provides loans such as Perkins or Stafford loans for attending college. The GI Bill provides education subsidies for veterans. 12. Name the type of institution that is responsible for promoting a stable environment for the economy regarding each of the following situations. [LO 10.7] a. Someone steals your car, but is caught. b. You claim that your employer violated the terms of your employment contract. Answer: a. The police department promotes a stable economy by allowing people to safely buy goods (like cars) without worrying as much about losing the ability to enjoy your purchase. b. The court system promotes a stable economy by allowing contracts to be written and enforced. CHAPTER 11 AGGREGATE EXPENDITURE Chapter Overview Keeping the economy running at capacity is one of the most important concerns of economics. A well-running economy doesn’t just mean more production—it also generates income and jobs. But sometimes the economy fails to operate as well as it could. Our focus here has been on problems connected to aggregate demand. In order to understand why aggregate demand and fiscal policy behave the way that they do, we developed a model of aggregate expenditure in the economy. We first outlined the drivers of aggregate expenditure and then used a simplified model to show how the drivers work. That helped show why even an economy with plentiful productive resources can still get stalled and not operate at its full potential. The aggregate expenditure equilibrium model is the main building block for understanding the demand side of the macro economy. In the next chapter, we connect aggregate demand to aggregate supply to see a broader range of options available to policymakers. Learning Objectives LO 11.1 Identify the factors that affect the consumption component of aggregate expenditure. LO 11.2 Identify the factors that affect the investment component of aggregate expenditure. LO 11.3 Identify the factors that affect the government spending component of aggregate expenditure. LO 11.4 Identify the factors that affect the net exports component of aggregate expenditure. LO 11.5 Describe autonomous expenditure and outline the simplifications made in the aggregate expenditure model. LO 11.6 Describe the difference between planned and actual aggregate expenditure and show their relationship graphically. LO 11.7 Show how to find equilibrium aggregate expenditure when given the relationship between planned aggregate expenditure and actual aggregate expenditure. LO 11.8 Explain the importance of the aggregate expenditure equilibrium model to understanding the behavior of the economy. LO 11.9 Illustrate how any initial change in aggregate expenditure can have a multiplier effect on the overall level of aggregate expenditure. Chapter Outline THE BIG CRASH The Components of Aggregate Expenditure Consumption (LO 11.1) BOX FEATURE: REAL LIFE – THE WEALTHY HAND-TO-MOUTH Investment (LO 11.2) Government Spending (LO 11.3) Net Exports (LO 11.4) Autonomous Expenditure and Simplifying Assumptions (LO 11.5) Aggregate Expenditure Equilibrium and the Keynesian Cross Actual versus Planned Aggregate Expenditure (LO 11.6) Keynesian Equilibrium (LO 11.7) Output Gaps (LO 11.8) The Multiplier Effect (LO 11.9) BOX FEATURE: REAL LIFE – THE GREAT 2009 MULTIPLIER DEBATE Beyond the Lecture Class Media: The Spending Multiplier – Keeping Austin Weird (LO 11.9) Have students watch the following video, which details efforts in Austin, Texas to “Keep Austin Weird”. The idea is to make sure the businesses in town stay local and unique, and to encourage residents to buy from local mom and pop stores instead of large chain stores. 1. How can purchasing goods from large national chain stores reduce the effectiveness of the multiplier on the local economy? Class Media: The Spending Multiplier – Can Destruction be a Good Thing be Forcing Spending? The Broken Window Fallacy (LO 11.9) Have students watch the following video, which illustrates a strange scenario. A hooligan destroys a window in a bakery, but the townspeople decide it is a good thing since the baker must pay a glass repairman, and the glass repairman spends money on food, etc. In essence, they think the hooligan stimulated the economy. This is called the broken window fallacy. Have your students think of other examples of the broken window fallacies. Why do you think the broken window fallacy never seems to go away? The answer may be because the victims are “invisible”. Who are the invisible victims of the broken window fallacy when the baker has to spend money to repair his window? Class Discussion: Expenditures that are Autonomous (or not) (LO 11.5, 11.6) Recall that Consumption has both an autonomous expenditure component and a nonautonomous expenditure component. Have students come up with examples of spending in their lives that is autonomous and not affected by income changes. There is certainly room for disagreement and interpretation here – for example, “food” may be autonomous if we only consider meals made at home, but “restaurant meals” could likely be nonautonomous. Class Discussion: Government Spending as a Percentage of Aggregate Expenditures (LO 11.3) Recall that the Aggregate Expenditure (AE) function is C + I + G + NX. Have your students discuss the following questions. What would happen if G became a larger portion or AE? What could cause this? Can higher levels of G result in lower levels of C, I, or NX (a form of crowding out)? Is it always better to have lower levels of G and have market activities determine most of AE through C, I, and NX? Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. As a note, you may realize that the clicker questions in this chapter are more difficult than many other chapters. 1. How does disposable income affect consumption? [LO 11.1] Consumers will only spend if they have a certain amount of disposable income Higher levels of disposable income will lead to higher levels of consumption Consumption remains constant even as disposable income increases Higher income will decrease consumption since people will save more to pay taxes Feedback: Note that even with no income, there is still some autonomous consumption. People have to spend some money to survive, even with no income. 2. What is true regarding the Investment (I) component of aggregate expenditure? [LO 11.2] Higher businesses taxes lead to higher investment Investment tends to remain constant as firm profitability changes due to people enrolled in auto-investing plans through their work There is an inverse relationship between interest rates and investment If expected future probability increases, firms will invest less Feedback: This is because firms have to borrow to invest and grow. If it becomes expensive to borrow with a high interest rate, firms will invest less. 3. In the aggregate expenditure model, equilibrium occurs when… [LO 11.7] aggregate expenditure = government spending net exports = 0 unplanned inventories reach their maximum actual expenditures = planned expenditures Feedback: This is a result of unplanned inventory being equal to 0. Actual expenditures equal output. 4. If equilibrium aggregate expenditure is above the level needed for full employment, we will see ____________ and __________. [LO 11.8] inflationary gap; decrease in inventories inflationary gap; increase in inventories recessionary gap; decrease in inventories recessionary gap; increase in inventories Feedback: inflationary gap since we are above full employment. Inventories will go down since expenditures are greater than production. 5. How can the aggregate expenditure model be used to build the aggregate demand curve? [LO 11.7, 11.8] Plotting the 45 degree line intersecting with various levels of government spending Plotting recessionary gaps and the increases in spending needed to close them Plotting the (Y, P) pairs that correspond to equilibrium at various price levels Plotting the changes in slope on the expenditure function that occur when the MPC changes Feedback: At each price level P, we get a new AE curve that will have a new equilibrium Y. We can plot (Y,P) combinations from this to get the AD curve. Solutions to End-of-Chapter Questions and Problems Review Questions What effect does an increase in current income have on current consumption? What effect does an increase in expected future income have on current consumption? [LO 11.1] Answer: If current income increases, then current consumption will also increase. People are likely to spend part of the extra income on consumption and save the rest. If expected future income increases, then current consumption will increase. People are likely to spend a little bit more of their current income and save a little bit less due to the expectation of higher income in the future. What effect does an increase in the interest rate have on current consumption? What effect does an increase in wealth have on current consumption? [LO 11.1] Answer: If interest rates increase, then it becomes more expensive to borrow. Consumers are likely to spend less on big purchases that require borrowing such as new cars and new houses. Additionally, consumers may be inclined to save a little bit more due to the higher interest earned on saving. If wealth increases, then consumers are likely to spend a little bit more and save a little bit less out of their current income. This is because they have a larger stock of wealth (in the form of financial assets or real estate) that they can draw on for retirement or other expenses, and therefore they feel less of a need to add to that stock of wealth by saving a greater amount of current income. How does a change in expected profitability affect aggregate investment? How does a change in business taxes affect aggregate investment? [LO 11.2] Answer: If firms expect profit to increase in the future, they are likely to increase aggregate investment by choosing to replace or upgrade existing equipment or expand productive capacity. If business taxes increase, then this is likely to decrease aggregate investment. Higher taxes will reduce profitability and therefore make purchases of new equipment and buildings less attractive. How does a change in the interest rate affect aggregate investment? What if firms prefer to pay for investment spending out of retained earnings? Does a change in the interest rate still affect aggregate investment? [LO 11.2] Answer: When firms take out loans to pay for capital improvements, any increase in the interest rate will decrease aggregate investment because it is more costly to borrow. When firms prefer to pay for investment spending out of retained earnings, any increase in the interest rate will decrease aggregate investment. This is because the retained earnings are likely to be accumulated in a bank account that pays interest. Therefore, when the interest rate goes up, the opportunity cost of spending the accumulated funds also goes up, and investment spending is likely to fall. Does the amount of government spending in an economy respond directly to changes in aggregate income, wealth, or interest rates? Does it respond indirectly to changes in these variables? [LO 11.3] Answer: There is no direct relationship between government spending and aggregate income, wealth, or interest rates, meaning a change in one of these variables does not automatically change government spending. The U.S. Congress and the president determine government spending each year as part of the budget process. A change in one of these variables may have an indirect effect on government spending. If changes in income, wealth, or interest rates are linked to a severe recession, then the government may feel compelled to change government spending and enact a specific policy to stimulate economic activity. What are government transfer payments? Are they included as part of the government spending component of GDP? [LO 11.3] Answer: Government transfer payments include payments for unemployment compensation, Social Security benefits, and food assistance. Government transfer payments do not count as part of the government spending component of GDP because they do not directly result in the production of new goods or services. Transfer payments involve the transfer of money from the government to individuals in the economy who are eligible to receive the payment under a specific government policy. The government obtains the funds it needs to make the transfer payments from tax revenue and government borrowing, so technically government transfer payments are transfers of money from one group of people in the economy to another, with the government acting as the middleman. When the individuals receiving the payments spend the income, then there is an impact on GDP. Payments to military personnel or public school teachers count as part of government spending because the government is paying people to provide a new service. What happens to the level of net exports in an economy when income in that economy increases? What happens to the level of net exports in an economy when income in other economies increases? [LO 11.4] Answer: Net exports is equal to the value of exports minus the value of imports. When income in the economy increases, the level of net exports will decrease. With higher levels of income, consumption spending is higher and some of this spending represents imports. Higher import spending reduces net exports. When income in other economies increases, the level of net exports will increase. When foreigners have more income, they spend more, and some of this is on our exports. You read in the paper that the dollar has strengthened in value relative to the euro. How is this change in the exchange rate value of the dollar likely to affect exports to Europe and imports from Europe? [LO 11.4] Answer: If the dollar has strengthened in value, then this is like the exchange rate changing from $1.10 per euro to $1.06 per euro. In this case, people pay fewer dollars for a euro, so the euro has lost value relative to the dollar, meaning the dollar has gained value relative to the euro. When the dollar becomes stronger in value, this will decrease exports to Europe and increase imports from Europe. When the value of the dollar is stronger, Europeans receive fewer dollars per euro ($1.06 vs. $1.10), so U.S. goods are relatively more expensive. When the dollar is stronger, people in the U.S. can buy euros for fewer dollars, so European goods are relatively cheaper. Which components of aggregate expenditure do not directly depend on current income? [LO 11.5] Answer: Investment: Investment includes spending on new capital, new houses, and inventory accumulation. The determinants of investment are the factors that change the benefits and costs of adding new physical capital—expected profitability, the interest rate, and business taxes. Government spending: Government spending is determined by Congress and the president based on what they think citizens need. Consumption: Consumption depends directly on income—when people have more income, they spend more. Net exports: Net exports depend directly on income because some of the extra consumption spending will be spent on imports. The investment category of GDP measures three different types of expenditures. What are they? Why is planned investment sometimes different from actual investment? [LO 11.6] Answer: Investment measures spending by firms on new goods and services, and includes spending on new capital, new houses, and inventory accumulation. Purchases of stocks and bonds are a type of financial investment, and this does not count in the investment spending category of GDP. When firms or people purchase stocks, they are converting one type of asset (money) to another type (stock), and this does not count as new production. Unexpected changes in demand will cause planned investment to differ from actual investment. For example, suppose a firm produces 10 units, plans to sell 8, and plans to put the extra 2 in inventory. If this all happens, then planned investment equals actual investment (the value of the 2 extra units). If they only sell 7, then they will add 3 to inventory and actual investment (the value of the 3 units) is greater than planned investment (the value of the 2 units). What causes a movement along the planned aggregate expenditure curve? What causes the planned aggregate expenditure curve to shift? [LO 11.6] Answer: The planned aggregate expenditure line illustrates the relationship between planned aggregate expenditure (on the vertical axis) and output/income (on the horizontal axis). When income rises, so does expenditure and output, and this leads to an upward movement along the planned expenditure line. Changes in nonincome determinants of aggregate expenditure such as government spending, interest rates, and business optimism cause the planned aggregate expenditure line to shift. For example, if businesses are more optimistic, then they will increase investment spending and this will lead to an increase in planned aggregate expenditure at the given level of output—the PAE line will shift upwards. In a Keynesian equilibrium will the economy always be producing at its level of potential output? Why or why not? [LO 11.7] Answer: The economy does not always produce at its level of potential output. Firms do not choose to produce the most they can at a given price. Instead, they produce what they can sell at a given price. When demand is weak and prices do not immediately fall, firms end up producing only what is demanded. Firms will choose to reduce output in response to weak demand to avoid unwanted inventory accumulation. Suppose planned aggregate expenditure is greater than actual aggregate expenditure. In this case, what do you think will happen to output over time? [LO 11.7] Answer: If actual aggregate expenditure is less than planned aggregate expenditure, then actual investment is less than planned investment. In this case, firms must be adding less output to inventory than was planned, meaning they are selling more than they expected. Firms will have an incentive to increase output. Suppose the economy is experiencing a recessionary output gap. What has happened to planned aggregate expenditure? What might have caused this change? [LO 11.8] Answer: If the economy is in a recessionary gap, then the current level of equilibrium output is below potential output. In this case, the planned aggregate expenditure line shifted down due to a change in some nonincome determinant such as an increase in interest rates, a drop in consumer or firm optimism, an increase in taxes, or a decrease in government spending. Suppose that an increase in business confidence increases investment expenditure by one million dollars. How do you expect this increase in investment expenditure to affect equilibrium output? Will equilibrium output increase by exactly one million, more than one million, or less than one million? [LO 11.9] Answer: Equilibrium output will increase by more than one million dollars due to the multiplier effect. A multiplier effect occurs because of an increase in consumer spending that occurs when spending by one person causes others to earn more income and therefore spend more too, increasing the impact on the economy of the initial spending. In this case, when firms increase spending by one million dollars, this will increase income by one million dollars and cause consumption spending to rise by some amount that depends on the marginal propensity to consume. This process will repeat itself as firms produce more output in response to the extra spending, and this in turn leads to more consumption spending. Define the relationship between the expenditure multiplier and the marginal propensity to consume. If the marginal propensity to consume increases, what happens to the expenditure multiplier? [LO 11.9] Answer: Equilibrium output will increase by more than one million dollars due to the multiplier effect. A multiplier effect occurs because of an increase in consumer spending that occurs when spending by one person causes others to earn more income and therefore spend more too, increasing the impact on the economy of the initial spending. In this case, when firms increase spending by one million dollars, this will increase income by one million dollars and cause consumption spending to rise by some amount that depends on the marginal propensity to consume. This process will repeat itself as firms produce more output in response to the extra spending, and this in turn leads to more consumption spending. Problems and Applications “People who earn more income tend to have higher levels of consumption spending, so the value of their marginal propensity to consume must be greater than that of lower income people.” Do you think this is a true statement? Why or why not? [LO 11.1] Answer: John consumes 90% of his income and saves 10% of his income. His consumption is 0.9 × $32,000 = $28,800 and his saving is 0.1 × $32,000 = $3,200. Nancy consumes 80% of her income and saves 20% of her income. Her consumption is 0.8 × $88,000 = $70,400 and her saving is 0.2 × $88,000 = $17,600. This statement is false. A person like Nancy with a higher level of income can have a lower marginal propensity to consume but still have a larger overall level of consumption spending. This is true because her income is so much higher than John’s. Even if her marginal propensity to consume was 0.50, she would still have a higher level of consumption spending than John. Do you think there is a predictable relationship between the business cycle and aggregate investment spending? Why or why not? [LO 11.2] Answer: When the economy is in a recession, spending on goods and services falls, so firms will reduce production. Because firms are producing less output, they don't need to hire as many workers and this causes unemployment to rise. Rising unemployment leads to a reduction in income. Firms will be less likely to purchase new equipment and expand their productive capacity because planned aggregate expenditure has fallen. During a recession, aggregate investment spending falls. During an expansion, aggregate investment spending rises. “During a recession more people qualify for unemployment insurance. This will increase the government spending category of GDP and help reduce the severity of the recession.” Do you agree with this statement? Why or why not? [LO 11.3] Answer: Unemployment insurance is a government program that provides cash benefits to eligible workers who have lost their jobs. The purpose of the program is to reduce the severity of recessions. When people lose their jobs during a recession, their income falls and this causes consumption to fall. The cash benefits from the government act as temporary income and this causes consumption to rise. Note the cash benefit is typically not more than 50% of the worker’s lost salary and the benefits can only be collected for 26 weeks during normal times. The cash benefits are government transfer payments and, therefore, they do not count as part of the government spending category. “When one country in the world falls into a recession, this tends to cause other countries to also fall into a recession.” Do you agree with this statement? Why or why not? [LO 11.4] Answer: When a country falls into recession, the levels of output and income will decrease. Because firms are producing fewer goods, they need fewer workers and unemployment will increase. The reduction in income will reduce consumption spending. People will spend less on domestically produced goods and on imported goods, so imports will fall. When imports fall, net exports will increase because net exports is equal to exports minus imports. Given imports to the country in recession have fallen, exports from the trade partners will fall. This will reduce the level of production and income in the trade partners’ countries. When one country in the world fall into a recession, this tends to cause other countries to also fall into a recession, given the importance of global trade. For each of the following shocks, identify what component(s) of planned aggregate expenditure is/are directly affected and in which direction. [LO 11.1, 11.2, 11.3, 11.4] a. Tax rates increase. China experiences an economic boom. People become more optimistic regarding their future prospects. Congress decides to increase funding for education. German fashion designs become popular among celebrities Answer: When income tax rates increase, disposable income will fall, consumption will fall, and planned aggregate expenditure will fall. When China experiences an economic boom, it will buy more goods from other countries. Our net exports will rise. When people become more optimistic regarding their future prospects, they are likely to consume more and save less. Consumption will increase. When Congress decides to increase funding for education, government spending will increase. When German fashion designs become popular among celebrities, spending on imported clothing will rise. Net exports will decrease. 6. Which of the following would be classified as an autonomous change to planned aggregate expenditure? [LO 11.5] Interest rates in an economy decrease. Current income in an economy increases. Domestic goods become more expensive relative to foreign goods. Congress decides to undertake an infrastructure repair project. Answer: An autonomous change to planned aggregate expenditure is a change that is independent of current income. Changes in autonomous spending shift the planned aggregate expenditure curve. A decrease in interest rates will increase planned aggregate expenditure. If domestic goods become more expensive relative to foreign goods, then people will prefer to buy imported goods. Planned aggregate expenditure will decrease. If Congress decides to undertake an infrastructure repair project, then government spending will increase and this will cause planned aggregate expenditure to increase. Consider the planned expenditure curve in Figure 11P-1. What is the level of autonomous expenditure in this economy? [LO 11.5, 11.6] Answer: Autonomous expenditure is the level of expenditure in the economy when output (Y) is equal to zero because it represents spending independent of income. This is found by looking at the point where the planned aggregate expenditure curve (PAE) intersects the vertical axis. Autonomous expenditure is equal to $100 billion. Draw a planned aggregate expenditure curve as described in the chapter. Then show what happens to the planned aggregate expenditure curve in each of the following scenarios. [LO 11.6] Government spending increases. Business taxes increase. Aggregate income decreases. Answer: Planned aggregate expenditure is equal to the sum of consumption spending, planned investment spending, government spending, and net exports: PAE = C + I + G + NX. An increase in government spending will shift the PAE curve upwards. Equilibrium output will increase. An increase in business taxes will reduce planned investment spending and the PAE curve will shift downwards. Equilibrium output will decrease. A decrease in aggregate income causes a downward movement along the PAE curve and not a shift of the curve. A shift is caused by a change in autonomous expenditure. Draw a planned aggregate expenditure curve for an economy where autonomous expenditure is $500 billion and the marginal propensity to consume is equal to 0.75. [LO 11.6] Answer: If autonomous expenditure is $200 billion, then the planned aggregate expenditure curve intersects the vertical axis at the point (0, 200). The marginal propensity to consume measures the amount by which consumption increases when income (Y) increases. If income increases by 100 and the MPC is 0.50, then consumption will increase by 50. When consumption increases by $50 billion, then so does planned aggregate expenditure. The second point on the curve is (100, 250). The remaining points are (200, 300), (300, 350), (400, 400), and (500, 450). Consider the data presented in Table 11P-1. [LO 11.7] What is the marginal propensity to consume for households in this economy? Based on the assumptions of our aggregate expenditure model, fill in the columns for planned investment, government spending, and net exports. What is this type of expenditure called? For each level of actual aggregate expenditure, calculate unplanned inventory investment. What is the equilibrium level of aggregate expenditure in this economy? How do you know? For each level of actual aggregate expenditure, label the future output tendency as “increase,” “decrease,” or “same” based on what you expect to happen to future output. What relationship does this categorization have to your answer in part d? Answer: The marginal propensity to consume measures the amount by which consumption will increase when income increases. The marginal propensity to consume is calculated as the change in consumption divided by the change in income. From the table, observe that as income increases by 50 (400 – 350), consumption increases by 20 (220 – 200). The MPC is therefore 20/50, or 0.40. The aggregate expenditure model assumes that planned investment, government spending, and net exports are fixed at the given amounts. This type of spending is called autonomous spending because it is independent of changes in income. When income changes, we assume planned investment, government spending, and net exports do not change. This assumption is made to make the model easier to understand. Planned aggregate expenditure is equal to C + I + G + NX and these values are recorded in the table above. For example, at an income level of Y = 350: C + I + G + NX = 200 + 60 + 90 + 60 = $410 billion. If people spend $410 billion and production is only $350 billion, then unplanned inventory investment is equal to 350 – 410 = -$60 billion. The equilibrium level of aggregate expenditure is Y = $450 billion. At this level of output, Y = C + I + G + NX and unplanned inventory investment is equal to zero. Inventory investment measures the change in the stock of inventory. If unplanned inventory investment is negative, then production is less than sales and firms are depleting their stock of inventory. In this case, the tendency will be to increase output. When unplanned inventory investment is negative, then production is greater than sales and firms will tend to decrease output in upcoming months. At the equilibrium level of output, firms have no tendency to change output and unplanned inventory investment is equal to zero. 11. Suppose that an economy is at an aggregate expenditure equilibrium at an output level of $300 billion. [LO 11.7] Show this point on a planned versus actual aggregate expenditure graph. Label a point on the planned aggregate expenditure curve where the economy will decrease its output next year. (To do this, pick a specific level of output that makes sense.) Label a point on the planned aggregate expenditure curve where the economy will increase its output next year. (To do this, pick a specific level of output that makes sense.) Answer: Output is at its equilibrium level if planned aggregate expenditure is equal to actual aggregate expenditure. Graphically, this means the planned aggregate expenditure curve (PAE) intersects the PAE = Y line. Equilibrium output is $300 billion. From the PAE curve, planned aggregate expenditure is equal to $250 billion at an output level of $200 billion. Because planned expenditure is greater than actual expenditure, output in the economy will increase in the upcoming year. From the PAE curve, planned aggregate expenditure is equal to $350 billion at an output level of $400 billion. Because planned expenditure is less than actual expenditure, output in the economy will decrease in the upcoming year. 12. Consider the data presented in Table 11P-2. [LO 11.7, 11.8] For each level of actual aggregate expenditure, calculate unplanned inventory investment. What is the equilibrium level of aggregate expenditure in this economy? How do you know? Suppose that planned investment increases by $50 billion. What is the new equilibrium level of aggregate expenditure in this economy? What is the marginal propensity to consume in this economy? What is the expenditure multiplier in this economy? Answer: The aggregate expenditure model assumes that planned investment, government spending, and net exports are fixed at the given amounts. This type of spending is called autonomous spending because it is independent of changes in income. When income changes, we assume planned investment, government spending, and net exports do not change. This assumption is made to make the model easier to understand. a. Planned aggregate expenditure is equal to C + I + G + NX and these values are recorded in the table above. For example, at an income level of Y = 500: C + I + G + NX = 300 + 150 + 100 + 50 = $600 billion. If people spend $600 billion and production is only $500 billion, then unplanned inventory investment is equal to 600 – 500 = -$100 billion. The equilibrium level of aggregate expenditure is Y = $700 billion. At this level of output, Y = C + I + G + NX and unplanned inventory investment is equal to zero. If planned investment spending increases by $50 billion, then the new equilibrium level of aggregate expenditure is Y = $800 billion. You could redo the numbers in the table to find this new level of equilibrium output, as is shown below. You could also calculate the expenditure multiplier and find the new equilibrium level of aggregate expenditure, as is explained in part f below. The marginal propensity to consume measures the amount by which consumption will increase when income increases. The marginal propensity to consume is calculated as the change in consumption divided by the change in income. From the table, observe that as income increases by 100 (600 – 500), consumption increases by 50 (350–- 300). The MPC is therefore 50/100, or 0.50. The expenditure multiplier is calculated as 1/(1 – MPC), or 1/(1 – 0.50) = 2. This means that for every dollar increase in autonomous expenditure, equilibrium output will increase by $2. Note that when planned investment spending increased by $50 billion, equilibrium output increased by $100 billion. 13. Consider the graph in Figure 11P-2, where the full-employment level of output is given by YFE and is the equilibrium level of aggregate expenditure for curve PAE1. [LO 11.8] Which planned aggregate expenditure curve will result in a recessionary output gap? Label the size of the recessionary output gap on the graph. Which planned aggregate expenditure curve will result in an inflationary output gap? Label the size of the inflationary output gap on the graph. Answer: If planned aggregate expenditure is given by PAE3 in the diagram above, this economy is in a recessionary output gap. In this equilibrium, the economy is producing $200 billion less than its full-employment level of output. The size of the output gap is given by the difference between the current equilibrium level ($300 billion) and the full-employment output level ($500 billion). If planned aggregate expenditure is given by PAE2 in the diagram above, this economy is in an inflationary output gap. In this equilibrium, the economy is producing $200 billion more than its full-employment level of output. 14. Consider the graph in Figure 11P-3. [LO 11.9] What is the expenditure multiplier in this economy? What is the marginal propensity to consume in this economy? Answer: The expenditure multiplier measures the change in equilibrium output caused by a change in autonomous expenditure. The change in autonomous expenditure is given by the vertical shift in the PAE curve. For any income level, the vertical distance between the two PAE lines is $150 billion. When the PAE line shifts upwards, equilibrium output increases from $500 billion to $800 billion, an increase of $300 billion. Therefore, the expenditure multiplier is equal to $300 billion/$150 billion, or 2. The marginal propensity to consume measures the change in consumption resulting from a change in income. The slope of the PAE curve is the marginal propensity to consume because when income increases, consumption increases and this causes the upward movement along the PAE line, given that all other expenditure is assumed to be autonomous. Looking at PAE1, when income increases from $500 billion to $800 billion, planned aggregate expenditure increases from $500 billion to $650 billion. The marginal propensity to consume equals the change in consumption, $150 billion, divided by the change in income, $300 billion, or 0.50. 15. In each of the following scenarios, describe and calculate the overall effect on aggregate expenditure. [LO 11.9] A recent stock market boom has increased household wealth by $20 billion, which increases consumption by $12 billion, and the marginal propensity to consume in the economy is equal to 0.6. Rising interest rates reduce domestic consumption by $4 billion and reduce investment by $7 billion, and the marginal propensity to consume in the economy is equal to 0.7. Answer: If household wealth increases by $20 billion and this increases consumption by $12 billion, then the change in autonomous expenditure is $12 billion. If the marginal propensity to consume in the economy is equal to 0.6, then the expenditure multiplier is equal to 1/(1 – 0.6), or 2.5. Therefore, the change in aggregate expenditure is equal to $12 billion × 2.5, or $30 billion. If rising interest rates reduce domestic consumption by $4 billion and reduce investment by $7 billion, then the change in autonomous expenditure is -$11 billion. If the marginal propensity to consume in the economy is equal to 0.7, then the expenditure multiplier is equal to 1/(1 – 0.7), or 3.33. Therefore, the change in aggregate expenditure is equal to $11 billion × 3.33, or -$36.6 billion. . CHAPTER 12 AGGREGATE DEMAND AND AGGREGATE SUPPLY Chapter Overview In this chapter, we created a model of the whole economy. This model is relatively simple, yet ambitious. It helps us to understand what drives key macroeconomics outcomes such as prices, unemployment, and GDP. The aggregate demand and aggregate supply model breaks the economy down into two sides. The demand side is composed of all the components of expenditure in the economy: consumption, investment, government spending, and net exports. The aggregate demand curve identifies the relationship between overall price levels and aggregate demand in the economy. On the supply side of the economy, the aggregate supply curve identifies the relationship between overall price levels and total production in the economy. In the short run the economy responds to changes in the price level by increasing or decreasing output, so the short-run aggregate supply curve is upward-sloping. In the long run, production is determined by the availability of inputs for production and the technology to convert inputs to outputs. In the long run, there is no relationship between the price level and output. The long-run equilibrium occurs at the intersection of the aggregate demand and long-run aggregate supply curves. We used the model of aggregate demand and aggregate supply to understand the recession that engulfed the United States after the housing bubble popped in 2007, shifting the aggregate demand curve to the left. We also used it to understand the government’s response, a stimulus package whose aim was to shift the aggregate demand curve back out and stimulate output and employment. In the next chapter, we’ll talk about policy responses to economic shocks in more depth and explore the different effects of spending versus taxes. Learning Objectives LO 12.1 Show how the aggregate expenditure equilibrium model can be used to trace out the aggregate demand curve and understand why the aggregate demand curve slopes downward. LO 12.2 List factors that could cause the aggregate demand curve to shift. LO 12.3 Explain how changes in government spending and taxes can have a multiplier effect on aggregate demand. LO 12.4 Explain the difference between the short and long run in the economy. LO 12.5 Demonstrate a shift in the short-run aggregate supply curve and list factors that cause it to shift. LO 12.6 Demonstrate a shift in the long-run aggregate supply curve and list factors that cause it to shift. LO 12.7 Explain the short-run and long-run effects of a shift in aggregate demand. LO 12.8 Explain the short-run and long-run effects of a shift in aggregate supply. LO 12.9 Use the AD/AS framework to determine whether an observed change in output and prices was due to a demand shock or a supply shock. LO 12.10 Describe the policy options the government can use to counteract supply and demand shocks. Chapter Outline “POP!” GOES THE BUBBLE Tying it All Together Aggregate Demand The Aggregate Demand Curve (LO 12.1) Shifting the Aggregate Demand Curve (LO 12.2) The Multiplier and Shifts in Aggregate Demand (LO 12.3) BOX FEATURE: FROM ANOTHER ANGLE – SAVE . . . NO, SPEND! Aggregate Supply The Difference between Short-Run and Long-Run Aggregate Supply (LO 12.4) Shifts in the Short-Run Aggregate Supply Curve (LO 12.5) Shifts in the Long-Run Aggregate Supply Curve (LO 12.6) Economic Fluctuations Effects of a Shift in Aggregate Demand (LO 12.7) Effects of a Shift in Aggregate Supply (LO 12.8) Comparing Demand and Supply Shocks (LO 12.9) BOX FEATURE: REAL LIFE – THE KOBE EARTHQUAKE AND AGGREGATE SUPPLY The Role of Public Policy (LO 12.10) Government Spending to Counter Negative Demand Shocks Government Spending to Counter Negative Supply Shocks Beyond the Lecture Reading Assignment: Shifting the Aggregate Demand Curve (LO 12.2) Have students read this Economix blog article, which discusses the impact of U.S. home values on aggregate demand. Ask students to consider the impact of the drop in U.S. home values and the impact of a potential housing recovery on aggregate demand. Class Discussion: Shifting the Aggregate Demand Curve and Shifts in the Short-Run Aggregate Supply Curve (LO 12.2, LO 12.4) Show students the website and examine changes in gasoline prices over time. You may want to discuss changes in gasoline prices from 1970-2000 as well. Discuss the following: How do changes in gasoline prices impact aggregate demand, other things constant? How do changes in gasoline prices impact aggregate supply, other things constant? What is the likely impact on price level and equilibrium GDP? Class Media and Discussion: Reasons Against Using Government Spending and Intervention to Steer the Economy (LO 12.8) Show your students this video which gives presents a pro Laissez-Faire (hands off) approach to the economy. How can government action create economic bubbles? Can government intervention create more economic volatility (wild ups and downs) rather than smoothing them out? Can government bailouts, programs, and spending create incentives for individuals and firms to act differently? For example, take more risks or borrow more money? Class Discussion: The Role of Public Policy (LO 12.8) Have students view this brief clip below from the TV show The Colbert Report. In the clip, the use of Keynesian policy to counteract recessions and depressions is discussed. Discuss the following: How can fiscal policy be employed to potentially counteract a recession or depression? Does the way in which the government employs fiscal policy matter? In other words, are some fiscal stimulus packages better than others? What do you think about fiscal policy during the 1930’s? Did the government do too much, too little, or just enough? Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. 1. Which of the following GDP components does NOT contribute to the downward slope of the aggregate demand curve? [LO 12.1] C I G NX Feedback: This is because government spending is independent of price level. 2. Which of the following would cause a rightward shift in AD? [LO 12.2] A decrease in consumer confidence A decrease in government spending A decrease in tariffs on foreign goods A decrease in the interest rate Feedback: A decrease in the interest rate would cause higher investment at any price level, thus giving us the rightward shift in AD. Note that a reduction in tariffs would increase imports, and therefore decrease NX, causing a decrease in AD. 3. Which of the following would cause an increase (rightward shift) in LRAS? [LO 12.5] Depreciation and breaking down of capital Reduction in the size of the labor force Discovery of a new energy source An increase in the price level Feedback: Careful! [D] is not correct since the LRAS is vertical. In the long run, output decisions are based on inputs rather than price level. 4. Suppose there is a positive demand shock. What is the short run effect? [LO 12.6] increase in output, increase in prices increase in output, no change in prices no change in output, increase in prices no change in output, no change in prices 5. Suppose there is a positive demand shock. What is the long run effect? [LO 12.6] increase in output, increase in prices increase in output, no change in prices no change in output, increase in prices no change in output, no change in prices Feedback: In the long run, the SRAS curve will adjust back so the AD and SRAS intersect again at the LRAS curve (potential output). This is a leftward SRAS shift. Thus, the output goes back to the previous level, but we have higher price levels. Solutions to End-of-Chapter Questions and Problems Review Questions Identify the four components of aggregate demand. Explain the relationship between aggregate demand and the price level. [LO 12.1] Answer: Aggregate demand is made up of consumption, investment, government spending, and net exports. There is a negative relationship between aggregate demand and the price level because when the price level rises, planned aggregate expenditure will decrease, causing firms to decrease production of goods and services. A rise in the price level reduces the real value of income and wealth, so consumption falls. When the price level rises, the interest rate also tends to rise, so investment spending will fall because it is more expensive to borrow. When the price level rises, domestic goods are more expensive, so exports, and hence net exports, will fall. The demand curves for individual goods are typically downward-sloping, due both to the substitution effect as well as to the income effect. Why does the substitution effect not affect the aggregate demand curve? [LO 12.1] Answer: The demand curve for an individual good is downward-sloping because an increase in the price of the good will reduce the amount of the good purchased, assuming the prices of all other goods remain the same. When the price of the good rises, other goods become relatively cheaper and people have an incentive to substitute towards another similar good. The aggregate demand curve is downward-sloping because an increase in the price level (or the price index) will reduce the real value of income and wealth, and people will reduce the quantity of goods and services purchased. In this case there is no substitution effect because the overall price level is rising, so we are thinking about the effect of a change in overall purchasing power, and not the effect of a change in relative prices that causes people to substitute away from one good and towards another. What is the relationship between the equilibrium level of aggregate expenditure in an economy and the aggregate demand curve? According to the aggregate expenditure equilibrium model, why does the aggregate demand curve slope downward? [LO 12.1] Answer: When the price level rises, the planned aggregate expenditure line shifts downwards because the higher price level reduces the real value of income and wealth so there is less consumption spending. Our exports are also more expensive, so there is less net export spending. The decrease in planned aggregate expenditure causes firms to decrease production of goods and services. This explains why the aggregate demand curve slopes downwards. What effect does rising business optimism and confidence have on the aggregate demand curve? What effect does falling optimism and confidence in business prospects have on the aggregate demand curve? [LO 12.2] Answer: Aggregate demand is the sum of the four spending sectors (consumption, investment, government spending, and net exports). When consumers have more confidence (consumption) and when business optimism rises (investment), the aggregate demand curve will shift to the right, representing an increase in aggregate demand. When consumers have less confidence (consumption) and when business optimism falls (investment), the aggregate demand curve will shift to the left, representing a decrease in aggregate demand. List several events that could cause a “demand-side” recession (i.e., a recession caused by a fall in aggregate demand). [LO 12.2] Answer: Anything that causes C, I, G, or NX to fall will result in a demand side recession. These things include, but are not limited to: a collapse in wealth due to a stock market or housing market crash, a fall in consumer or business confidence, a fall in government spending, an increase in taxes, an increase in interest rates, or a collapse in foreign demand for a country’s exports. Everything else equal, which will have a larger effect on aggregate demand and GDP: a $100 million reduction in taxes or a $100 million increase in government spending? Is everything else equal in practice? Why or why not? [LO 12.3] Answer: The $100 million increase in government spending will have a larger effect because planned aggregate expenditure will initially rise by the full $100 million. When taxes are cut by $100 million, this will cause disposable income to rise by $100 million and consumption will rise by less than $100 million because the MPC is less than 1. For example, if the MPC is 0.9, then the $100 million tax cut will increase consumption spending (and therefore planned aggregate expenditure) by an initial amount of $90 million. Suppose the economy is in a recession and the president wants to stimulate production and create jobs. To do this, he has decided to increase government spending. Some of his economic advisors are suggesting the marginal propensity to consume (MPC) has a value of 0.9 and others are suggesting the value is 0.8. How will this difference in the value of the MPC affect the president’s decision regarding the dollar amount of the increase in government spending? [LO 12.3] Answer: The expenditure multiplier is equal to 1/(1 - MPC). If the MPC has a value of 0.9, then the expenditure multiplier is equal to 10. If the MPC has a value of 0.8, then the expenditure multiplier is equal to 5. If the president believes the MPC has a value of 0.9, then he will choose to increase government spending by less than the amount he would choose if he believed the MPC had a value of 0.8. With an MPC of 0.9, any given increase in government spending will increase output (GDP) by a factor of 10, as opposed to a factor of 5 with an MPC of 0.8. Therefore, the change in government spending does not need to be as large. Which typically can change faster: the components of aggregate demand or the components of aggregate supply? Explain. [LO 12.4] Answer: Typically, the components of AD can change faster than the components of AS. A person can make a quick decision about whether to buy a new car (C). A business can make a quick decision about whether to build a new plant (I). The government can make a quick decision about whether to spend more money. Increasing the number of workers, the amount of capital, or the level of technology in a country, all of which affect AS, takes a long time to occur. The only component of AS that can change somewhat quickly is price expectations, but even this can be somewhat slow due to wage and price stickiness. Explain the difference between sticky wages and sticky prices. How do these two ideas explain the upward slope of the short-run aggregate supply curve? Why don’t sticky wages or sticky prices affect the long-run aggregate supply curve? [LO 12.4] Answer: Sticky wages are contracts that keep wages fixed between businesses and workers, while sticky prices are contracts that keep prices fixed between businesses and their suppliers. The SRAS is upward-sloping because as prices of a firm’s products rise, it is willing to supply more if its input costs are not rising at the same time. Thus, in the presence of sticky wages and prices, the SRAS is upward-sloping. Sticky wages and prices don’t affect the LRAS because eventually every contract expires and firms, workers, and consumers renegotiate prices. Thus, prices and wages are only sticky in the short run, not in the long run. In the long run, prices and wages will adjust and output will be equal to potential output, so the LRAS is vertical. List several events that could cause a “supply-side” recession (i.e., a recession caused by a fall in aggregate supply). [LO 12.5] Answer: Anything that reduces L, K, or technology, or increases the prices of inputs can cause a supply side recession. Examples include, but are not limited to, famine, migration, war, large increases in oil or food prices, and significant increases in corporate taxes. In the late 1990s, the United States experienced very high GDP growth, record low unemployment rates, and virtually nonexistent inflation. Based on the conclusions of the AD/AS model, what could explain this combination of good economic results? [LO 12.5, 12.6] Answer: High GDP growth and low unemployment must mean that AD or AS was shifting to the right. However, if AD were shifting right, there should be upward pressure on prices, but instead the late 90s experienced almost no inflation. A shift right in either SRAS or LRAS, on the other hand, would cause output to rise while putting downward pressure on prices. So, the boom of the late 90s must have been the result of a rightward shift in SRAS or LRAS. While lots of things can cause a shift in AS, the most likely culprit in the late 90s was an increase in technology as the Internet spread throughout the economy. Why is long-run economic growth generally positive rather than negative? [LO 12.5] Answer: Long-run changes in output are driven by changes in the LRAS. The primary components of LRAS are L, K, and technology. While all three of these can either rise or fall, at least with technology, this component tends to go only one direction. Once something is discovered or invented, it is rarely forgotten, so technology causes economic output to steadily grow. Of course, it is possible for technology to go backwards. The dark ages represented a long period of time in Europe where, for a variety of reasons, things were forgotten. Thus, economic growth stagnated and potentially even reversed for many centuries. More recently, in Cambodia in the late 1970s, the Khmer Rouge dictatorship actively destroyed the country’s existing modern technology, significantly reducing GDP (as well as resulting in the deaths of roughly 2 million citizens.) Explain the mechanism through which the economy adjusts in the short run and the long run when consumer confidence falls. [LO 12.6] Answer: When consumer confidence falls, in the short run, aggregate demand will shift to the left, reducing equilibrium GDP and the price level. In the long run, the lower price level resulting from reduced aggregate demand will lower costs, increasing the aggregate supply curve and shifting it to the right. Suppose a country is in the midst of an economic boom and is running large budget surpluses. The president suggests that due to the good economic conditions, the time is ripe for a large tax cut. What are the arguments for and against this position? [LO 12.6, 12.8] Answer: The fact that the country is experiencing a boom should lead one to believe that the economy is at or above its usual long-run equilibrium. The president is suggesting that the country now further stimulate the economy by cutting taxes. This will push AD to the right and increase output even further. However, this higher level of output is above LRAS, so it is not sustainable. SRAS will eventually shift left bringing the economy back to its original level of output but with much higher prices. Cutting taxes in an economic boom can’t produce a long-run increase in output and will only serve to overheat an already booming economy. While the president’s suggestion might sound right, this is actually poor macroeconomic policy. Suppose a country is in the midst of a serious recession, with high unemployment and large government deficits. The president suggests that in times like this the government has the obligation to “tighten its belt” and cut spending, since so many families around the country have to do the same thing. Do you agree with the president? Why or why not? [LO 12.6, 12.8] Answer: The fact that the country is experiencing a recession should lead one to believe that the economy is below its usual long-run equilibrium. The president is suggesting that the country now further restrain the economy by raising taxes and cutting spending. This will push AD to the left and decrease output even further. While the president’s suggestion might sound right, this is actually poor macroeconomic policy. Using the aggregate demand and aggregate supply model, explain the difference between a one-year drought and permanent climate change. What happens to the price level and output in the short run and in the long run for each type of shock? [LO 12.5, 12.6, 12.8] Answer: A one-year drought raises the price of inputs to the production of food, shifting the SRAS to the left, raising prices, and reducing output. However, when crop yields recover during the next growing season, SRAS will shift back to the right to its original position, bringing the economy back to long-run equilibrium. (If producers anticipate a return to normal crop yields before they actually arrive, the SRAS may actually shift back even earlier.) A permanent change in the growing climate that makes producing food harder will shift LRAS (and SRAS) to the left. Since the LRAS shifts, prices are permanently higher and output is permanently lower. A government official observes that there has been a short-run increase in the price level. Is it possible for her to determine whether this was caused by a demand shock or a supply shock? Why or why not? [LO 12.9] Answer: This was caused by a positive demand shock or a negative supply shock. A positive demand shock will increase aggregate demand—the aggregate demand curve will shift to the right, causing firms to increase production and the price level. A negative supply shock will decrease short-run aggregate supply; the short-run aggregate supply curve will shift to the left as firms increase prices and production falls. negative demand shock would shift the aggregate demand curve to the left and the price level would fall. A positive supply shock would shift the short-run aggregate supply curve to the right and the price level would fall. A government official observes that there has been a long-run increase in the price level but no change in the level of potential output. Is it possible for her to determine whether this was caused by a demand shock or a supply shock? Why or why not? [LO 12.9] Answer: This was caused by a positive demand shock. A positive demand shock will increase aggregate demand; the aggregate demand curve will shift to the right, causing firms to increase production and the price level. In the long run, the prices of inputs and the wages of workers will increase, causing the short-run aggregate supply curve to shift to the left. The price level will increase further and output will return to potential. negative supply shock will decrease short-run aggregate supply; the short-run aggregate supply curve will shift to the left as firms increase prices and production falls. Assuming this is a temporary supply shock, in the long run, the short-run aggregate supply curve will shift back to the right, causing the price level and output to return to their initial long-run levels. A negative demand shock would shift the aggregate demand curve to the left and the price level would fall. In the long run, the prices of inputs and the wages of workers will decrease, causing the short-run aggregate supply curve to shift to the right. The price level will decrease further and output will return to potential. A positive supply shock will increase short-run aggregate supply; the short-run aggregate supply curve will shift to the right as firms decrease prices and production rises. Assuming this is a temporary supply shock, in the long run, the short-run aggregate supply curve will shift back to the left, causing the price level and output to return to their initial long-run levels. Why does the government have a harder time counteracting shifts in AS than in AD? [LO 12.8, 12.10] Answer: The main problem is that leftward shifts in AS both raise prices and reduce output. Standard policies can only cure one of these two problems at a time. If the government raises spending or cuts taxes, output can be restored, but at the cost of even more upward pressure on prices. If the government cuts spending or raises taxes, prices can be restored to their previous levels, but output falls even further. Whenever AD or AS shifts, putting the economy out of long-run equilibrium, AS has a natural tendency to shift in such a way as to bring the economy back into long-run equilibrium. If the economy always eventually comes back to long-run equilibrium, why would the government ever try to implement policies to bring the economy into equilibrium through government means? [LO 12.10] Answer: There are two reasons. First, when AD shifts the economy experiences a short-run change in output and both a short-run and long-run change in prices. The appropriate government response can eliminate the long-run shift in prices. Second, negative shifts in AS or AD cause a reduction in output and a corresponding increase in unemployment. The natural return to full unemployment may take a long time and government action can speed up the process reducing suffering. Problems and Applications 1. Is there a negative, positive, or no relationship between the price level and the following components of aggregate demand? [LO 12.1] a. Consumption. Investment. Government spending. Net exports. Answer: Negative relationship: An increase in the price level will reduce the real value of income and wealth and, therefore, consumption spending falls. Negative relationship: When the price level increases, interest rates also tend to increase, leading to a decrease in investment spending because it is more expensive for firms to borrow. No effect: A change in the price level has no direct effect on government spending. Negative relationship: An increase in the price level causes domestic goods to be relatively more expensive than imports, leading to an increase in import spending and a decrease in net export spending. If the government cuts taxes, what components of aggregate demand are affected? [LO 12.1] Answer: A cut in personal income taxes or sales taxes will increase consumption spending because disposable income will increase. A cut in capital gains taxes or corporate income taxes is likely to increase investment spending because profit will increase. Governments make their decisions about taxing and spending together as part of fiscal policy, and as a general rule are not required to reduce spending just because they reduce taxes. Exports of goods are typically not taxed. Some imported goods are subject to tariffs, but a change in the tariff on a particular good is not likely to be large enough to have a significant impact on imports as a whole. Consider the planned aggregate expenditure lines in Figure 12P-1. [LO 12.1] Suppose that the planned aggregate expenditure lines correspond to price levels of 100, 110, and 120. Which line corresponds to which price level? Use the information in the expenditure diagram to trace out the aggregate demand curve for this economy. Answer: Planned aggregate expenditure line PAE1 corresponds to a price level of 80, planned aggregate expenditure line PAE2 corresponds to a price level of 120, and planned aggregate expenditure line PAE3 corresponds to a price level of 160. As the price level rises, the planned aggregate expenditure line shifts downwards due to a reduction in consumption, investment, and net export spending. By plotting the three price level— output pairs (160, $40 billion), (120, $60 billion), and (80, $80 billion)—we trace out the aggregate demand curve. 4. For each of the following shocks, say whether it is a demand-side shock or a supply-side shock. [LO 12.2, 12.5] Consumer confidence falls. Government spending increases. The price of foreign goods increases. The price of oil increases. A cyclone destroys manufacturing plants. Answer: Demand-side shock: Consumption spending will fall and the AD curve will shift left. Demand-side shock: Government spending is one of the four components of AD, so the AD curve will shift right. Demand-side shock: Foreign goods are now relatively more expensive, so imports will fall as people switch to relatively cheaper domestic goods. The AD curve will shift right. Supply-side shock: Oil is an input to production, so production cost will rise and the SRAS will shift left. Supply-side shock: Manufacturing plants represent capital, a component of LRAS, so LRAS and SRAS will shift left. In the late 1990s, the U.S. experienced a technology boom. In part the boom was due to a revolution in communication technology that resulted in a massive expansion of the Internet; in part the boom was due to households and firms purchasing new computer equipment in anticipation of Y2K. What two curves of the model would be affected by these events? [LO 12.2, 12.5] Answer: The revolution in technology affects AS because the new technology allows firms to produce more goods and services. LRAS and SRAS will shift to the right, increasing output and decreasing the price level. The purchase of consumer electronics and office equipment in anticipation of Y2K affects AD because both consumption spending and investment spending will increase. An increase in AD will increase output and the price level. Thus, both factors will increase GDP, but they will have an opposite effect on the price level. Suppose the marginal propensity to consume (MPC) is either 0.75, 0.80, or 0.90. [LO 12.3] For each value of the MPC, calculate the expenditure multiplier, or the impact of a one-dollar increase in government spending on GDP. For each value of the MPC, calculate the impact on GDP of a $250 million increase in government spending. Explain the relationship between the MPC and the impact of a change in government spending on GDP. Answer: The expenditure multiplier is equal to 1/(1 - MPC). The impact on GDP (or the change in GDP) = the change in government spending times the expenditure multiplier. MPC Impact on GDP 0.75 4 × $250 = $1,000 0.80 5 × $250 = $1,250 0.90 10 × $250 = $2,500 a. The larger the value of the MPC, the larger the expenditure multiplier, and the larger the impact on GDP. This is because people spend a greater portion of any additional income. 7. Suppose the marginal propensity to consume (MPC) is either 0.75, 0.80, or 0.90. [LO 12.3] For each value of the MPC, calculate the impact of a one-dollar decrease in taxes on GDP. For each value of the MPC, calculate the impact on GDP of a $250 million decrease in taxes. Explain the relationship between the MPC and the impact of a change in taxes on GDP. Answer: The impact of a one-dollar decrease in taxes is equal to MPC/(1 - MPC). Impact of a one-dollar decrease in taxes The impact on GDP (or the change in GDP) = the change in taxes times the impact of a one-dollar change in taxes. Note that when taxes decrease, then GDP will increase. MPC Impact on GDP 0.75 3 × $250 = $750 0.80 4 × $250 = $1,000 0.90 9 × $250 = $2,250 The larger the value of the MPC, the larger the impact on GDP of a one-dollar change in taxes. This is because people spend a greater portion of any additional income. 8. Say whether the following statements are true or false. [LO 12.4] In the long run, prices don’t affect output. In the short run, prices may affect output. Answer: True. Long-run equilibrium is determined by the intersection of AD and the LRAS curve. The LRAS curve is vertical, indicating that prices do not affect output over the long-run but instead are determined by factors of production such as L, K, and technology. True. Short-run equilibrium is determined by the intersection of AD and SRAS. Both of these curves show a clear connection between prices and output. On the demand side, prices affect output due to the wealth effect, interest rate effect, and foreign purchases effect. On the supply side, prices affect output due to sticky prices and sticky wages. 9. Say whether the following statements are true or false. [LO 12.4] If the prices of all final goods and services are sticky, then the short-run aggregate supply (SRAS) curve is horizontal at the given price level. If the prices of inputs and wages are not fixed by contracts, and instead adjust more quickly to demand and supply shocks, then the SRAS curve is more vertical. Answer: This is true. If all prices are sticky, then the price level is fixed, and the SRAS is a horizontal line at the current price level. This is true. If the prices of inputs and wages adjust more quickly, then the price level will rise and fall more quickly for any given change in output. If prices and wages were perfectly flexible, then output would never deviate from potential because changes in aggregate demand would result in price changes and not output changes. “Fracking” is a newly invented technology that allows drillers to extract significantly larger quantities of natural gas from existing deposits than was previously possible. How is this discovery likely to affect the economy? (Hint: Think about whether this will have a short-run or long-run effect.) [LO 12.5, 12.6] Answer: Higher supplies of natural gas will lead to lower natural gas prices. (In fact, nominal natural gas prices in 2016 were about 75% lower than their peak in 2008.) Natural gas is an input to production. A reduction in its price will cause the short-run and long-run aggregate supply curves to shift to the right, assuming this is a permanent change and not a temporary change. This will increase output and reduce the price level. Throughout the nineteenth and twentieth centuries, the U.S. economy experienced frequent ups and downs, but over the past 200 years, the real GDP in the United States rose from roughly $8.2 billion to over $16.1 trillion, an increase by a factor of nearly 2,000 times. This growth represents a change in which curve? [LO 12.6] Answer: Output can increase temporarily due to shifts in AD, but long-run changes in output can be achieved only by LRAS shifting to the right. Among the obvious explanations for this growth are a large increase in the labor force due to natural growth and immigration; a large increase in capital due to investments by both private industry and the government; and the discovery of a huge number of new technologies during the Industrial Revolution, the age of electricity, and the Information Age. Suppose that a statement by the chair of the Federal Reserve Board about the state of the economy causes a loss of consumer confidence. What will be the long-run impact on the economy if the government allows the economy to adjust without a policy response? [LO 12.7] a. Output will fall below its initial level in the long run and the price level will decline. Output will return to its initial level in the long run, but the price level will be lower. Output will return to its initial level in the long run, but the price level will be higher. Output will rise above its initial level in the long run and the price level will rise. Answer: b. A loss in consumer confidence is an example of a negative demand shock. The reduction in consumer spending will shift the AD curve to the left, causing production and the price level to fall. In the long run, prices of inputs and wages of workers will fall, leading to a further reduction in the price level. The SRAS curve will shift to the right and production will return to its initial long-run level. 13. For each of the following situations, use an AD/AS model to describe what happens to price levels and output in the United States in the short run. In each case, assume the economy starts in long- and short-run equilibrium, and describe the appropriate shifts in the AS or AD curves. [LO 12.7, 12.8] A stock market crash reduces people’s wealth. The spread of democracy around the world increases consumer confidence in the United States. The European economy crashes. The United States enters into an arms race with China, resulting in a significant increase in military spending.Page 766 A revolution in Iran results in a significant reduction in the world’s supply of oil. Terrorist activities temporarily halt the ability of Americans to engage in certain productive activities such as transportation and finance. Intel develops a new computer chip that is faster and cheaper than previous chips. A summer of perfect weather in the Midwest leads to record harvests of corn, wheat, and soybeans. Answer: A stock market crash reduces wealth and therefore consumption spending, shifting the AD curve to the left. Output falls and the price level falls. A rise in consumer confidence increases consumption spending, shifting the AD curve to the right. Output rises and the price level rises. A crash in the European economy reduces their consumption spending, and therefore reduces our exports, shifting the AD curve to the left. Output falls and the price level falls. An arms race increases government spending, shifting the AD curve to the right. Output rises and the price level rises. A reduction in the world's supply of oil increases oil prices and therefore production costs, shifting the AS curve to the left. Output falls and the price level rises. If terrorist activities disrupt the transportation of goods and services and financial market activity, there is a temporary reduction in firms' ability to produce goods and services, so the AS curve shifts to the left. Output falls and there is an increase in the price level. The new chip is an example of an increase in technology that will increase production, shifting the AS curve to the right. Output rises and the price level will fall. The perfect weather is an example of a temporary increase in production. This will shift the AS curve to the right. Output rises and there is a decrease in the price level. 14. For each of the following scenarios, say whether the shock was a demand-side shock, a supply-side shock, or a combination of both shocks. [LO 12.9] The price level and GDP both fell. GDP then increased, but the price level fell even further. In the long run, the economy had the same level of output but a higher price level. In the short run, the price level increased, but GDP fell. In the long run, GDP increased, and the price level fell. In the long run, GDP increased, and the price level was constant. Answer: For the price level and GDP to fall, the AD curve must shift to the left. For GDP to then rise with the price level falling further, the SRAS curve must shift to the right. This is an example of a negative demand shock followed by a positive supply shock. First, the AD curve must have shifted to the right. Then the SRAS curve shifted to the left to move the economy back to long-run equilibrium at the previous output but a higher price level. This is an example of a combination of both shocks. For the price level to rise and GDP to fall in the short run, the SRAS curve must have shifted to the left. This is an example of a supply-side shock. If GDP changes in the long run, there must be a shift in LRAS. If the LRAS curve shifts to the right (along with a corresponding change in SRAS), output will rise and the price level will fall. This is an example of a supply-side shock. If GDP changes in the long run, there must be a shift in LRAS. As in part d, if the LRAS curve shifts to the right (along with a corresponding change in SRAS), output will rise and the price level will fall. In order to get a long-run increase in output but no change in the price level, AD must shift to the right as well. This is an example of a combination of both shocks. In 2009, during the height of the U.S. financial crisis, real GDP fell 3.5 percent, and the Consumer Price Index fell from 215.3 to 214.9. Was this recession likely caused by a shift in aggregate demand or aggregate supply? [LO 12.9] Answer: The data indicate a decrease in production and a decrease in the price level. This is consistent with the AD curve shifting to the left. Thus, this recession appears to have been caused by a fall in aggregate demand. (A reduction in wealth due to the collapse in housing prices would cause a fall in aggregate demand, for example.) In 1974, GDP fell by 0.6 percent, and inflation increased from 6.2 percent to 11.0 percent. Was this recession likely caused by a shift in aggregate demand or aggregate supply? [LO 12.9] Answer: The data indicate a decrease in production and an increase in the price level. Thus, this recession appears to be caused by a decrease in aggregate supply. (Oil prices skyrocketed during this time period due to the Arab oil embargo.) For questions 17–20, use an AD/AS model to answer the following questions. In each case assume the economy starts in long- and short-run equilibrium, and show the appropriate shifts in the AS or AD curves. Suppose a stock market crash reduces people’s wealth. [LO 12.7, 12.8, 12.10] Show what happens to price levels and output in the U.S. in the short run. Suppose the government takes no action to help the economy. What happens to price levels and output in the long run? Suppose, instead, the government decides to take action to help the economy. What action(s) would you recommend? Why? If the U.S. government makes the appropriate policy response, what happens to price levels and output in the long run? Answer: A stock market crash reduces the real value of income and wealth, causing a reduction in consumption spending and a shift of the AD curve to the left. Output falls and the price level falls. In the long run, input prices and wages of workers will decrease, causing SRAS to shift to the right to move the economy back to long-run equilibrium at the previous level of output but a lower price level. Cutting taxes or raising government spending will shift AD back to the right. AD shifts back to the right. If exactly the right amount of government help is provided, the economy returns to long-run equilibrium at the same output and price level as before the crash. Suppose the spread of democracy around the world increases consumer confidence in the United States. [LO 12.7, 12.8, 12.10] Show what happens to price levels and output in the United States in the short run. Suppose the government takes no action to help the economy. What happens to price levels and output in the long run? Suppose, instead, the government decides to take action to help the economy. What action(s) would you recommend? Why? If the U.S. government makes the appropriate policy response, what happens to price levels and output in the long run? Answer: A rise in consumer confidence increases consumption spending, shifting the AD curve to the right. Output rises and the price level rises. In the long run, input prices and wages of workers will increase, causing SRAS to shift to the left to move the economy back to long-run equilibrium at the previous level of output but a higher price level. Raising taxes or cutting government spending will shift AD back to the left. AD shifts back to the left. If exactly the right amount of government restraint is provided, the economy returns to long-run equilibrium at the same output and price level as before the confidence boom. Suppose a revolution in Iran results in a significant reduction in the world’s supply of oil. [LO 12.8, 12.10] Show what happens to price levels and out-put in the United States in the short run. Suppose the government takes no action to help the economy. What happens to price levels and output in the long run? Suppose, instead, the government decides to take action to help the economy. What action(s) would you recommend? Why? If the U.S. government makes the appropriate policy response, what happens to price levels and output in the long run? Answer: A reduction in the world supply of oil will increase oil prices and production cost, shifting the SRAS curve to the left. Output falls and the price level rises. In the long run, world oil supplies will adjust and return to their previous level. The reduction in oil prices shifts the SRAS curve to the right to move the economy back to longrun equilibrium at the previous level of output and price level. Raising taxes or cutting government spending will shift AD to the left, leading to a further drop in output but a reduction in the price level. Cutting taxes or raising government spending will shift AD to the right, leading to a further increase in the price level but an increase in output and, therefore, a reduction in the level of unemployment. Unlike recessions caused by shifts in AD, government responses to recessions caused by shifts in AS can’t cure all of the problems at the same time. AD shifts to the right. This shift will lead to an increase in the price level and output will return to its long-run initial value. Suppose a summer of perfect weather in the Midwest leads to record harvests of corn, wheat, and soybeans. [LO 12.8, 12.10] What happens to price levels and output in the United States in the short run? Suppose the government takes no action to help the economy. Show what happens to price levels and output in the long run. If the U.S. government reacts to the record harvests by increasing taxes or decreasing spending, what happens to price levels and output in the long run? What is the problem associated with the government reacting to the record harvests by increasing taxes or decreasing spending? Answer: The perfect weather is an example of a temporary increase in production. This will shift the SRAS curve to the right. Output rises and the price level falls. In the long run, SRAS will shift back to the left once the perfect weather is over. The price level and output will return to their initial levels. If the government reduces spending or increases taxes, then AD shifts to the left. Output will return to its initial level and the price level will be lower. An increase in taxes or a decrease in spending will bring output back to long-run equilibrium, but deflationary pressure will increase. The reduction in output will increase unemployment. When the government changes fiscal policy in response to a decrease in aggregate demand, they are able to reduce unemployment and reduce deflationary pressure. Responding to supply shocks is more difficult because the government cannot simultaneously reduce unemployment and deflationary pressure. Solution Manual for Macroeconomics Dean Karlan, Jonathan Morduch 9781259813436