Cosumnes River College Principles of Macroeconomics Problem Set 11 Will Not Be Collected

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1 Name: Solutions Cosumnes River College Principles of Macroeconomics Problem Set 11 Will Not Be Collected Fall 2015 Prof. Dowell Instructions: This problem set will not be collected. You should still work the problems though, as this will help you in preparing for the final exam. Solutions will be posted on Friday, 12/11/15 1. Differentiate between frictional unemployment, structural unemployment, and cyclical unemployment. Frictional unemployment represents short-term unemployment that results from job changes or the search of recent graduates for long-term, career-oriented employment. Structural unemployment represents long-term labor displacement that results from a lack of necessary skills or educational requirements. Individuals must be retrained to meet new employment requirements. Cyclical unemployment is a measure of job losses that result from cyclical downturns in the economy. During a recessionary period, businesses typically lay off employees until sales and production needs increase during expansionary periods. 2. Why do the Classical economists argue that excessive unemployment won t persist in an economy for very long? They argue that wages will always adjust to ensure equilibrium in the labor market. 3. Use the graph below to answer the following: Principles of Macroeconomics: Problem Set 11 Solutions Page 1

2 a. Suppose there is a decrease in the fertility rate and this causes some men and women to place a lower value on their time spent in non-market activities. How will this affect the labor market? The labor supply curve will move to the right. b. If the labor demand curve were to shift to the left as depicted and wages are sticky what will be the result in the labor market? There will be unemployment of 75 million workers. c. If the labor demand curve were to shift to the left as depicted and firms enter into social, or implicit, contracts with workers not to cut wages what will be the wage rate and the level of employment. The wage rate will remain at $12 and the employment level will be 75 million workers. 4. Graphically illustrate and describe the principle of sticky wages. What are some causes of inflexible or sticky wages? The principle of sticky wages is illustrated in the following figure. Assume the initial equilibrium market wage was W0 and quantities demanded and supplied were L0. If the demand for labor declined from D0 to D1 and the wage rate remains stuck at W0, then quantities supplied (L0) would exceed quantities demanded (L2). This excess level of quantities supplied is a measure of unemployment. Inflexible wage rates are a result of social or implicit contracts and explicit unionmanagement contract agreements. 5. Define what economists mean by the term NAIRU. NAIRU is the non-accelerating inflation rate of unemployment (i.e., the value of the employment rate where the curve depicting the relationship between the change in the inflation rate and the unemployment rate crosses zero. Principles of Macroeconomics: Problem Set 11 Solutions Page 2

3 6. Explain the efficiency wage theory. Why would a firm be willing to pay an efficient wage? The efficiency wage theory states that productivity increases as wages increase, so firms may be willing to pay above the market-clearing wage. The benefits the firm may receive include lower turnover, improved morale, and less shirking. 7. Use the graph below to answer the following: a. How does an unemployment rate of U 1 compare to the natural rate of unemployment? U 1 is equal to the natural rate of unemployment. b. Suppose the economy is at Point A, what will be the effect in the short run of an increase in money supply? Where will this move the economy? In the short-run, this will move the economy to point C with a higher inflation rate and a lower unemployment rate. c. Suppose the economy is at Point C, what could possibly move the economy to Point D? This could have been caused by a rightward shift in the AS curve. 8. If aggregate demand increases and expectations regarding inflation remain constant, what impact if any does this have on the short-run Phillips curve? The short-run Phillips curve does not move. However, the economy would move along the curve. 9. Define the exchange rate. The exchange rate is the price of one country's currency in terms of another country's currency; the ratio at which two currencies are traded for each other. Principles of Macroeconomics: Problem Set 11 Solutions Page 3

4 10. Give a basic definition of the balance of payments. The balance of payments is the record of a nation's transactions in goods, services, and assets with the rest of the world; also the record of a country's sources (supply) of and uses (demand) for foreign exchange. 11. Using the table below, calculate the balance on current account: (1) Net exports of goods $ (2) Net export of services (3) Net investment income (4) Net transfer payments - 50 The balance on current account is the sum of 1,2,3, and 4. This yields - $150 billion. 12. All other things equal what should happen to the value of Japanese yen if there is an increased appetite by Americans for Japanese-produced cars? Does this make Japanese cars more expensive or less expensive? Why? The increased demand for Japanese-produced cars will increase the demand for the Japanese yen and cause it to appreciate. This effectively means that Japanese cars will become more expensive to American consumers. Principles of Macroeconomics: Problem Set 11 Solutions Page 4

5 13. If the current account is in surplus what must be true about the capital account? Why? The capital account would have to be in deficit. The reason is that the excess foreign currency that was not used to purchase goods will be used to purchase capital goods. 14. Identify whether each of the following would lead to an appreciation or depreciation of the dollar. In each case, explain why the currency either appreciates or depreciates. a. U.S. citizens switch from buying stock in British companies to buying stock in U.S. companies. This causes the supply of dollars to decrease in the foreign exchange markets and the value of the dollar to appreciate. b. The inflation rate in the United States increases relative to the inflation rate in England. An increase in the inflation rate in the United States relative to England causes the demand for dollars in the foreign exchange markets to decrease and the supply of dollars in the foreign exchange markets to increase. This leads to a depreciation of the dollar. c. The money supply is increased in the United States. An increase in the money supply leads to lower interest rates, which reduces the demand for dollars in the foreign exchange markets and increases the supply of dollars in the foreign exchange markets. This leads to a depreciation of the dollar.. d. Income in the United States increases. When income in the United States increases, the supply of dollars increases in the foreign exchange markets. This leads to a depreciation of the dollar. 15. Compare and contrast the impact on the economy of an increase in government spending in a closed economy to that of an open economy. Explain. The increase in government spending will cause a larger change in a closed economy than in an open economy because some of the increase in income domestically is siphoned off to imports which is income that leaves the country. 16. Why is it true that when the prices of a country's imports increase, the prices of domestic goods may increase in response? Provide two explanations. First, an increase in the prices of imported inputs will shift a country's aggregate supply curve to the left. This will cause an increase in the domestic price level. Second, if import prices rise relative to domestic prices, households will tend to substitute domestically produced goods and services for imports. This is equivalent to a rightward shift of the aggregate demand curve. If the economy is operating on the vertical part of the aggregate supply curve, the overall domestic price level will rise. Principles of Macroeconomics: Problem Set 11 Solutions Page 5

6 17. In Polynomia, real GDP increased by 8% and the population increased by 3% in What can we say about economic growth and the standard of living for this country? We can say that economic growth and the standard of living both increased. 18. Explain how an economy can grow without increases in the labor force and physical capital. Increases in productivity allow the same amount of resources to produce more. Hence, an increase in productivity causes economic growth, even without increasing labor and/or capital. 19. If the capital stock remains fixed but the labor forces increases what is likely to be true about the productivity of this new labor? This is likely to reduce the productivity of labor since each worker will have less capital to work with. 20. Explain the three different ways an increase in GDP can come about. An increase in GDP can come about in three ways: (1) through an increase in labor, (2) through an increase in physical or human capital, or (3) through an increase in the amount of product produced by each unit of capital or labor. 21. List and discuss three tax laws which have been used to stimulate investment. One was the investment tax credit, which provided a tax reduction for firms that invest in new capital equipment. Second, there was a law which was designed to give firms the opportunity to reduce their taxes by using artificially rapid rates of depreciation for purposes of calculating taxable profits. Another provision was the passage of a law to cut the rate of taxation of income earned in the form of capital gains. Lastly and more recently there have also been decreases in the overall tax rates and in dividend taxes. Principles of Macroeconomics: Problem Set 11 Solutions Page 6