Answers to Text Questions and Problems in Chapter 7

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1 Answers to Text Questions and Problems in Chapter 7 Answers to Review Questions 1. A recession is a period in which the economy is growing at a rate significantly below normal, whereas an expansion is a period in which the economy is growing at a rate significantly above normal. The beginning point of a recession is called the peak (the point at which economic activity reaches its highest point and begins to decline), whereas the end point of a recession (and the beginning of the expansion) is called a trough. In postwar Canada, expansions have been longer than recessions on average. 2. The term cycle implies a predictably recurring event. In fact, recessions and expansions are of irregular length and size. This irregularity makes forecasting peaks and troughs quite difficult. 3. Generally, producers of durable goods are affected most by recessions while producers of services and nondurables (like food) are affected least. This suggests that the automobile producer would see its profits reduced the most, the barbershop the least. Boots and shoes are semi-durable, since a pair of shoes may last for several years (and people can put off purchases of these for a while if necessary). Thus the boot manufacturer s losses are likely to fall in between those of the other two firms. 4. The four broad types of unemployment are frictional unemployment, due to the process of matching workers and jobs; structural unemployment, which occurs when workers are unable to fill available jobs; seasonal unemployment, associated with the seasons; and cyclical unemployment, brought about by recession. Frictional unemployment is the least costly. 5. The natural unemployment rate is the sum of structural and frictional unemployment and excludes cyclical unemployment. Thus the natural unemployment rate by definition should not be affected by a recession. Also by definition, the cyclical unemployment rate rises in recession. The inflation rate tends to decline in the period following a recession. 6. Potential output, or potential GDP, is the amount of output the economy can produce when it is using its inputs, such as capital and labour, at normal rates. Because inputs can be used at greater than normal rates for a time (for example, workers can work overtime and machines can be used at night or on weekends), it is possible for the economy to produce an amount exceeding potential output. 7. False. When output equals potential output, the unemployment rate equals the natural unemployment rate. Cyclical unemployment is zero when output equals potential output, but frictional and structural unemployment still exist. 8. By Okun s law, output that is 2% below potential output is associated with cyclical unemployment of 1%, so in that case the overall rate of unemployment (natural plus cyclical) would be 6%. If output is 2% above potential, cyclical unemployment is 1%, so overall unemployment equals 5% 1% = 4%. Answers to Problems 1. Year Output gap as a percentage of Recessionary or expansionary gap Growth rate of real GDP Copyright 2009 McGraw-Hill Ryerson Limited 1

2 potential GDP /981 = -5.20% expansionary /1011 = -4.15% expansionary 2.03% /1140 = 4.74% recessionary 3.13% /1113 = 0% no gap 2.49% /1132 = -2.03% expansionary 3.77% /1177 = -2.04% expansionary 3.98% 2. If actual unemployment in 2000 averaged 6.8% and the natural rate of unemployment was 5.3%, then unemployment was 1.5% above the natural rate, so GDP was 3% below potential. Since GDP was $1056 billion, then potential GDP would have to have been $1056/0.97 = $1089 billion. The recessionary gap would thus have been $33 billion. If the natural rate was instead 7%, then unemployment was 0.2% below the natural rate, so GDP was 0.4% above potential. Then potential GDP would have to have been $1056/1.004 = $1052 billion. The expansionary gap would thus have been $4 billion. 3. (1) In 2006, real GDP is 2% below potential GDP, so cyclical unemployment is 1%. Since the actual unemployment rate is 6%, the natural rate must be 5%. (2) The natural rate equals the actual rate, so cyclical unemployment equals zero and there is no output gap. Thus potential GDP equals 8100, the same as real GDP. (3) Cyclical unemployment equals 4% 4.5% = 0.5%, so by Okun s Law the output is gap is 1%. If real GDP exceeds potential GDP by 1%, we find that real GDP must equal (4) Real GDP is 2% above potential GDP (the output gap is 2%), so cyclical unemployment is 1%. As the natural unemployment rate is 5%, actual unemployment is 4%. Sample Homework Assignment 1. Given the data below on real GDP and potential GDP for the country Theta, determine each of the following: a. The year-to-year growth rates of real GDP. b. The output gap. c. The output gap as a percentage of potential GDP. d. Whether the gap is expansionary or recessionary. Year Real GDP Potential GDP ,500 17, ,200 17, ,500 18, ,200 18, ,600 19, ,000 19, ,400 20, ,900 20, ,600 21, ,600 21,500 Copyright 2009 McGraw-Hill Ryerson Limited 2

3 2. According to Okun s law, if a country s output gap grows by an amount equal to 4% of potential output, its cyclical unemployment rate will grow by how much? Multiple Choice Quiz 1. A period in which the economy is growing at a rate that is significantly above normal is called a(n) a. expansion. b. recession. c. depression. d. peak. e. contraction. 2. The low point of economic activity prior to a recovery is called a(n) a. expansion. b. depression. c. peak. d. trough. e. contraction. 3. Which of the following is not an indicator of short-term economic fluctuations? a. Unemployment. b. Inflation. c. Sales of durable goods. d. GDP. e. Average labour productivity. 4. The amount of real GDP an economy can produce when using its resources at normal rates is called a. potential output. b. expansion output. c. the output gap. d. normal GDP. e. employment potential. 5. A positive output gap (when actual output is below potential) is called a(n) a. expansionary gap. b. recessionary gap. c. depressionary gap. d. contractionary gap. e. inflationary gap. 6. The natural rate of unemployment is the level of unemployment at which a. unemployment is zero. b. cyclical unemployment equals frictional unemployment. c. all unemployment is structural. d. there is an expansionary gap. e. cyclical unemployment equals zero. Copyright 2009 McGraw-Hill Ryerson Limited 3

4 7. Okun s law states that each extra percentage point of cyclical unemployment is associated with about a percentage-point increase in the output gap. a. one b. two c. three d. four e. five 8. The difference between the actual unemployment rate and the natural rate of unemployment is unemployment. a. structural b. frictional c. cyclical d. seasonal e. potential 9. Over the period since 1947, the highest unemployment rate during recessions in Canada has a. increased. b. decreased. c. remained constant. d. fluctuated dramatically. e. fluctuated slightly. 10. The all-time record for the duration of a Canadian economic expansion was set in a b c d e Problems/Short Answer 1. Given the data below on real GDP and potential GDP for the country Theta, determine each of the following: a. The year-to-year growth rates of real GDP. b. The output gap. c. The output gap as a percentage of potential GDP. d. Whether the gap is expansionary or recessionary. Year Real GDP Potential GDP ,000 19, ,400 20, ,900 20, ,600 21, ,600 21, According to Okun s law, if a country s cyclical unemployment rate grows by 3%, its output gap will grow by how much? Copyright 2009 McGraw-Hill Ryerson Limited 4

5 Answer Key to Extra Questions in Instructor s Manual Sample Homework Assignment 1a. The year-to-year growth rates of real GDP: % % % % % % % % % b. The output gap: c. The output gap as a percentage of potential GDP: d. Whether the gap is expansionary or recessionary: 2000 expansionary 2001 expansionary 2002 expansionary 2003 recessionary Copyright 2009 McGraw-Hill Ryerson Limited 5

6 2. 2% recessionary 2005 recessionary 2006 recessionary 2007 recessionary 2008 recessionary 2009 expansionary Multiple Choice 1. a 2. d 3. e 4. a 5. b 6. e 7. b 8. c 9. a 10. a Problems/Short Answer 1a. The year-to-year growth rates of real GDP: % % % % b. The output gap: c. The output gap as a percentage of potential GDP: d. Whether the gap is expansionary or recessionary: 2004 recessionary Copyright 2009 McGraw-Hill Ryerson Limited 6

7 2. 6% recessionary 2006 recessionary 2007 recessionary 2008 expansionary Copyright 2009 McGraw-Hill Ryerson Limited 7