Answers to Text Questions and Problems. Chapter 16. Answers to Review Questions

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1 Answers to Text Questions and Problems Chapter Economists use market values when calculating GDP because this makes it possible to add together different goods and services to get a measure of total output. For example, we can t add together apples, bananas, and shoes, but we can add together their market values. The economic rationale for giving high-value items more weight in GDP than low-value items is that the market price of each item is a measure of the value that its purchasers place on it. For example, a car is probably worth more to the average person than a cheeseburger, and GDP takes this into account through the fact that a $20,000 automobile counts for 5,000 times as much in GDP as a $4 double cheeseburger. 5. This is a normative issue, so there will be various answers. The text points out ways in which GDP fails to measure important aspects of economic well-being such as the value of leisure time, non-market economic activities, environmental quality and resource conservation, quality-of-life indicators such as a low crime rate, and economic inequality. On the other hand, GDP does measure the availability of goods and services and is strongly related to other measures of well-being, such as nutrition, health, and years of schooling. 5. Your mother s contribution to GDP: a. If your mother buys a new car from a U.S. producer, U.S. GDP and consumption both rise by the value of the new car. b. If your mother buys a new car imported from Sweden, U.S. consumption rises by the value of the car and U.S. net exports fall by the value of the car (since U.S. imports rise by the value of the car.) There is therefore no change in U.S. GDP. c. If your mother s car rental business buys a new car from a U.S. producer, U.S. GDP and investment both rise by the value of the car since the purchase of a car by a business counts as investment. d. If your mother s car rental business buys a new car imported from Sweden, U.S. investment rises by the value of the car and U.S. net exports fall by the value of the car (since U.S. imports rise by the value of the car.). There is therefore no change in U.S. GDP. e. If the U.S. government buys a new, domestically produced car for the use of your mother, who has been appointed the ambassador to Sweden, then U.S. GDP and government purchases both increase by the value of the car. 6. The key to this problem is to find the four components of expenditure: a. Consumption expenditures are 600. These already include household purchases of durable goods, so those would not be counted again. b. Investment expenditures are 225. This is the sum of residential construction (100) plus business fixed investment (100) plus inventory investment (change in stocks over the year, or 25). Sales of existing homes and apartments are not counted in investment or GDP.

2 Chapter 17 c. Government purchases are 200. Government payments to retirees are transfers and are not counted. d. Net exports are 25. Net exports equals exports (75) minus imports (50). GDP is the sum of the four components: = The price level measures the cost of a basket of goods and services, relative to a base year. The CPI is one standard measure of the price level. In contrast, the rate of inflation is the annual percentage change in the price level. For example, suppose that the basket of goods and services on which the CPI is based cost $100 in the base year, $150 last year, and $ this year. The price level this year is (=$154.50/$100.00). The inflation rate from last year to this is the percentage increase in the cost of the basket since last year, or 3%. 3. It is important to adjust for inflation when comparing nominal quantities at different points in time because with inflation, increases in nominal quantities may simply reflect higher prices rather than increased production or purchasing power. For example, a 10% increase in a worker s nominal wage implies a 10% increase in purchasing power if prices are unchanged, but no increase in purchasing power if prices have also risen by 10%. The basic method of adjusting for inflation, called deflating the nominal quantity, is to divide a nominal quantity by a price index, such as the CPI. For example, the real wage is equal to the nominal wage divided by a price index and measures the purchasing power of the wage. Unlike nominal wages, real wages at different points in time can be meaningfully compared. 1. Calculating the CPI: a. The cost of the basket in the base year is $200 + $600 + $100 + $50 = $950. In the subsequent year the same basket of goods costs $220 + $640 + $120 + $40 = $1020. The CPI in the subsequent year equals the cost of the basket in that year relative to the base year:. Since the CPI in the base year is 1.000, the rate of inflation (equal to the percentage increase in the CPI) between the base year and the subsequent year is 7.4%. b. The family s nominal income rose by 5%, which is less than the increase in the family s cost of living. The family is thus worse off in terms of real purchasing power.

3 2. Inflation rates for the years 1991 through 2000 are presented below. Year CPI Inflation Rate (%) Inflation rates were relatively low throughout the 1990s, but lower at the end of the decade than at the beginning. 4. Using the CPI data from problem 2, the real entry-level wage for college graduates in 1997 was (using as the base period). Since the real wage fell by 8% between 1990 and 1997, the $8.50 real wage in 1997 was 92% of the real wage in 1990, i.e = (0.92)(real wage in 1990) Real wage in 1990 = $9.24 (using as the base period) Let W1990 stand for the nominal wage in Then, if we deflate the nominal wage by the CPI, we have. Solving for W1990 gives us a nominal wage in 1990 of $ The role of expected inflation in determining nominal interest rates: a. Inflation is expected to be ( )/100 = 10% in the first year and ( )/110 = 10% in the second year. If Frank charges Sarah a 12% nominal interest rate, he will earn a real return of 2% per year (12% nominal interest rate 10% inflation rate). b. To ensure a 2% annual return on the loan, Frank and Sarah should agree that Sara will pay a nominal interest rate in each year equal to 2% plus whatever the inflation rate turns out to be. For example, if inflation turns out to be 8% during the first year and 10% during the second year, Sarah should pay 10% nominal interest in the first year and 12% in the second year. Chapter The costs of a high unemployment rate include economic costs (e.g. loss of output), psychological costs (e.g., depression and loss of self-esteem on the part of unemployed workers), and social costs (e.g., increases in crime). There is much debate regarding the effects of increased government assistance. For instance, more generous government benefits would probably increase the economic costs to society of unemployment, as unemployed workers would face less incentive to find work quickly. However, these costs would be borne less by the

4 unemployed themselves and more by taxpayers thus spreading the burden among more people. Increased government support would probably reduce some psychological costs (anxiety about feeding one s family) and increase others (loss of self-esteem induced by taking charity ). Some social costs, such as the costs of crime, would probably be reduced by providing a higher level of income support to the unemployed. 7. Three types of unemployment are: 1. Frictional unemployment: the short-term unemployment associated with the process of matching workers with jobs in a dynamic, heterogeneous labor market. 2. Structural unemployment: the long-term and chronic unemployment that exists even when the economy is producing at a normal rate. Structural unemployment results from factors such as language barriers, discrimination, structural features of the labor market, lack of skills, or long-term mismatches between the skills workers have and the available jobs 3. Cyclical unemployment: the extra unemployment that occurs during periods of recession. Frictional unemployment is probably the least costly type of unemployment since it is usually of short duration and often economically beneficial, being part of the process by which productive matches of workers and jobs are formed. 6. In the sample of 65 people, the 10 children under age sixteen, the 10 retired people, the 5 fulltime homemakers, the 5 full-time students, and the 2 disabled people are not in the labor force. Of the remaining 33 people, 30 people are employed (either part-time or full-time). This leaves three people who do not have jobs but would like to work. One of these three people has not looked for work for three months and so is counted as not in the labor force rather than unemployed; the other two people are unemployed. Thus, we have the following: 33 people are not in the labor force; 32 people are in the labor force; The participation rate equals 32/65 = 49%; 30 people are employed; 2 people are unemployed; the unemployment rate equals 2/32 = 6.25%. 8. Understanding different types of unemployment: a. Structural. Ted s skills are mismatched with existing employment opportunities. b. Cyclical. Alice s unemployment is temporary and associated with a recession. c. Structural. Lance lacks the skills to land a long-term, stable job. d. Frictional. Gwen s change of location forced her to look for a new match with an employer. After a short time searching she found a new job. e. Frictional. Tao s unemployment results from the process of searching for the best match between a job and his skills. f. Frictional. The delay in taking a new job arises because Karen is trying to find the best opportunity, not because work is unavailable.

5 10. Data on duration of unemployment for selected years from are presented below. (Source: Table 44, Economic Report of the President 2008.) Year Duration of unemployment Less than 5 weeks 5-14 weeks 27 weeks and over % 31% 14% % 31% 17% % 27% 24% % 29% 19% % 30% 15% % 31% 14% % 30% 14% % 30% 12% % 30% 10% % 32% 10% % 32% 13% % 29% 20% % 29% 20% % 30% 20% % 32% 17% % 32% 17% % 32% 16% % 31% 14% % 31% 12% % 32% 11% % 32% 12% % 31% 18% % 30% 22% % 29% 22% % 30% 20% % 30% 18% a. These data suggest that frictional and structural unemployment are relatively more important when the economy is not in recession. For example, in the recovery after the recession, the percentage of those unemployed less than 5 weeks (a measure of frictional unemployment) plus the percentage of those unemployed more than 27 weeks (a measure of structural unemployment) rose from 53% in 1982 to 59% in b. The and recessions show the same pattern: long-term unemployment rose during the recession and then gradually fell. This did not happen in the 2001 recession or in the years that followed.