19. The Pigou or real-balance effect is a mechanism by which an increase in the real money supplyresulting from a fall in the price level can influence aggregate demand through increasingautonomous expenditure. The Keynes effect on the other hand, is the normal channel by which anexpansion in the real money supply reduces interest rates and increases equilibrium output. Becausethe price level is plotted on the vertical axis, the inclusion of a real-balance effect into the economywill not in itself shift the AD curve but will affect the movement along the AD curve, i.e., the slope.The slope of the AD curve is determined by how effective changes in real balances resulting fromchanges in the price level will be in influencing equilibrium output in the IS-LM model. As Figure 7-E shows, if the reduction in prices from P0 to P1 is associated with both an expansion of the realmoney supply and autonomous spending, both the IS and LM curves will shift rightward andequilibrium output will rise to Y2 instead of Y1. This implies the flatter AD curve in the bottomframe.Note that with the real-balance effect, an increase in the nominal money supply (all else beingequal) will result in a greater horizontal shift of the AD curve as well.

Figure 7-E

210.The real-balance effect was a counter-argument to the Keynesian observation that if autonomousplanned spending was very unresponsive to changes in the interest rate (steep or vertical IS curve) orif interest rates became unresponsive to changes in the real money supply (flat LM curve), monetaryimpotence resulted. The Keynesian response was that the deflationary process which increasedhousehold real wealth may indeed make the AD curve steeper because of two effects associatedwith deflation. First, households, seeing falling prices, may postpone planned autonomous spending inexpectation of prices falling further (the expectations effect). Secondly, the deflation tends toredistribute wealth from debtors, who usually have a high propensity to consume, to creditors, whousually have a lower marginal propensity to consume. This has the effect of reducing total aggregateconsumption, since for every dollar redistributed, a smaller fraction of it will be consumed (theredistribution effect). The aggregate demand curve will be steeper when these effects are presentbecause the falling price level will produce smaller changes in autonomous planned spending andincome.

11.(a) The equation of the LM curve is r = [Y 3(Ms/P)]/300. Substituting this into the IS equationgives Y = k{A0 50[Y 3(Ms/P)]/300}. Substituting in the given values of k, A0, and Ms and solvingfor Y gives the equation of the AD curve: Y = 2880 + (720/P). Thus, when P = 1, Y = 3600, and whenP = 2, Y = 3240.

(b) Substituting the LM equation above into the new IS curve with the real-balance effect gives Y= k{A0 + d(Ms/P) 50[Y 3(Ms/P)]/300}. Substituting in the given values of k, A0, d, and Ms andsolving for Y gives the equation of the AD curve: Y = 4114 + (1286/P). The effectiveness of real-money-supply expansion caused by a reduction of prices is now greater. When P = 1, Y = 5400, andwhen P = 2, Y = 4757. The AD curve becomes flatter with the inclusion of the real balance effect.

Chapter 8

1. The SP curve shows the level of real output that producers are willing to supply at every rate ofinflation. It is derived directly from the aggregate demand and supply model of Chapter 7. However, itsimply represents combinations of output level and inflation rate consistent with equilibrium in theAD-SAS model and cannot by itself determine an equilibrium rate of inflation and output level; thus,another relationship is needed to determine where the economy is along the SP curve. Thisrelationship is given by the definition that nominal GDP is equal to the price level times real GDP (X= PY). This implies that nominal GDP growth must be the sum of the inflation rate and real GDPgrowth (x = p + y). Because there always exists an inflation rate and level of output that satisfy thisgrowth equation at every given rate of nominal GDP growth, the combination of inflation rate andoutput level that is on both the SP curve and that satisfies the growth equation represents the short-runequilibrium of the economy. Starting from a position of long-run equilibrium, an acceleration innominal GDP growth must be divided between an increase in the inflation rate and real output growth.This suggests that the economys short-run equilibrium position must move up and along the SPcurve. Similarly, the economy will move downward along the SP curve in response to a decelerationin nominal GDP growth.

2. Because the growth equation is a definitional relationship, its always true that any given growthrate of nominal GDP must be divided between the inflation rate and real GDP growth (x = p + y). Ifnominal GDP growth exceeds the rate of inflation (x > p), then it necessarily follows that the growthrate of real GDP must be positive (y = x p > 0), and the level of output is growing at a positive rate.Although this situation is consistent with a short-run equilibrium for the economy, long-runequilibrium requires that the growth rate of real output be zero, i.e., it requires a constant real outputlevel, and accurate expectations of inflation. Therefore, changes in inflationary expectations will

3adjust the economy until nominal GDP growth is completely used up by inflation (x = p and y = 0),and the actual and expected inflation rates are equal (i.e., where Y = YN).

3. The two principal factors that determine how fast an economy adjusts to its new long-runequilibrium position are (1) the slope of the SP curve and (2) the speed at which expected inflationadjusts to actual inflation. The slope of the SP curve represents the responsiveness of real output toinflation. The SP curve slopes upward because some raw materials prices are highly sensitive to thelevel of aggregate demand and because producers tend to raise prices more rapidly when aggregatedemand is high. If the tendency of firms to raise prices during expansions is small, which implies aflatter SP line, then an increase in nominal GDP growth will raise output by much more than the rateof inflation. With backward-looking inflationary expectations, small changes in actual inflation willcause small movements in expected inflation. As a result, the vertical upward shifts of the SP curve ineach period will be small as well, and this will lengthen the time real output can remain above its longrun natural level. Similarly, for any given slope of the SP curve, if inflationary expectations adjustslowly (i.e., small j value in the adaptive-expectations formula), then the increase in inflation arisingfrom an acceleration in nominal GDP growth will also result in small vertical shifts in the SP curve ineach period of adjustment. Recall that overshooting in the adjustment loop occurs because inflationreaches the long-run rate before inflation expectations have correctly adjusted to the actual rate. Thus,slower adjusting inflationary expectations implies a larger degree of overshooting during theadjustment process. This suggests that, while a flatter SP curve lengthens the adjustment time bycausing a flatter loop, slow adjusting inflationary expectations lengthen the adjustment time bycausing a taller loop. With a given slope and speed of expected inflation adjustment (j value), thespeed at which the economy adjusts to long-run equilibrium depends on the size of the acceleration ordeceleration of nominal GDP growth itself. In the case of disinflationary policy, it is clear that asudden cold turkey nominal GDP deceleration quickly reduces the rate of inflation, but at theexpense of a more severe recession than a more gradual deceleration. The policy implication here isthat a quicker adjustment is desirable only if the costs of a gradual movement away from the currentcondition of the economy (e.g., high inflation) sufficiently outweighs the costs associated with a fasteradjustment to long-run equilibrium.

4. The SP curve graphically represents the level of real output that can be sustained at an inflation rategenerated from a continuous expansion (or contraction) of aggregate demand. Thus, the SP curve willonly slope upward if nominal wages are not completely and immediately flexible. Starting from a long-run equilibrium, if nominal wage contracts incorporate an expected rate of inflation less than the actualrate, then the growth rate of prices, or the inflation rate (p), will be greater than the growth rate ofnominal wages (w). Thus, the growth rate of real wages (w p) will be negative, implying that thelevel of real wages (W/P) will fall below its original equilibrium level. Therefore, the reason why theeconomy is able to be on the SP curve and above the natural level of output when inflation expectationsare below the actual inflation rate is that the real wage will be lower than the long-run equilibrium realwage.

5. The inflation rate that workers expect during nominal wage contract negotiations is precisely thegrowth rate of nominal wages incorporated into the contracts. With backward-looking expectations,any acceleration in nominal GDP growth will cause an initial acceleration of inflation and beaccompanied by an increase in the expected inflation rate in the next period that wage contracts arerenegotiated. This will push up the growth rate of nominal wages and shift the SP curve upward,reflecting the fact that firms will supply less output at the higher nominal wage rates. In the short run,because the growth equation (x = p + y) must be satisfied, the lower growth rate of real output mustbe accompanied by a further increase in the inflation rate to maintain the same growth rate of nominalGDP. As the expected inflation rate adjusts to the actual rate of inflation in the long run, output will

4remain at its natural level while the long-run equilibrium inflation rate will be equal to the new highergrowth rate of nominal GDP. Note that even if the increase in the expected inflation rate were due toautonomous causes instead of an expansion of aggregate demand, the actual inflation rate wouldstill increase in the short run for the same reason. However, the long run effects in this case willdepend on any further changes in inflation expectations and the response of policymakers.

6. The first step in the development of the SP model was to establish the relationship between outputand inflation that is implied by the aggregate demand and supply model in Chapter 7. The result wasthe upward-sloping SP curve which relates the level of output firms are willing to supply to the rate ofinflation. The second step was to use the definition that nominal GDP growth is equal to the sum ofthe inflation rate and growth rate of real GDP to determine precisely where the economy is on the SPcurve in each period. The SAS-AD model of Chapter 7 assumed nominal wages eventually adjustedto clear the labor market following aggregate demand expansion without specifying how theyadjusted. This chapter considers alternative methods by which workers form expectations of inflation.Instead of imposing forward-looking rational formation of expectations, the SP model assumes themore realistic backward-looking adaptive expectations approach. The essential difference betweenthese methods of expectation formation is that under the adaptive approach the expected rate ofinflation in the SP model is the inflation rate that workers expect at the time long-term wagecontracts are negotiated. Any change in the day-to-day inflation expectation of workers during theperiod the wage contract is binding is irrelevant since such changes in expectations cannot alternominal wages until the contract expires.

7. Backward-looking expectations imply that workers and firms form their expectations based onevents that have already occurred instead of predictions of the future. The text lists two importantreasons why rational firms and workers may form their expectations of inflation by looking backwardrather than forward. First, there is no reason to believe that an acceleration in nominal GDP growthwill be permanent, so that workers and firms may take the precautionary measure of waiting beforeacting on the change immediately. Second, rational workers and firms find it beneficial to enter intolong-term wage and price agreements. Since this implies that wages and prices adjust gradually,workers form their expectations based on this slow adjustment process following an acceleration innominal GDP growth.

8. Before the 1960s, the behavior of the inflation rate was mainly procyclical along the SP curve.However, the acceleration of nominal GDP growth that began in 1964 eventually led to asimultaneous acceleration of inflation and a falling output ratio (Y/YN) by 1969. The dynamic SPmodel explains this puzzling observation with the inflationadjustment loop. The acceleration ofnominal GDP initially boosted both the output ratio and the inflation rate, but by 1969 expectedinflation had not yet caught up with actual inflation so that the inflation rate overshot its long-runequilibrium level. The second classic demonstration of the SP model was the disinflation of the1980s. The cold turkey reduction of nominal GDP growth in 198182 pushed the economy througha counterclockwise loop and resulted in the immediate reduction of the inflation rate at the expense ofthe severest recession and highest unemployment rates of the post-war era.

9. The dynamic analysis of demand and supply shocks in Chapter 8 converted the static AD-SASframework into a dynamic model of the output level and the inflation rate. Through the incorporationof adaptive expectations, the dynamic SP model demonstrates that the degree of price and wageflexibility and the rate at which expectations of inflation adjust to the actual inflation rate play animportant role in generating inflation loops. This causes any permanent acceleration in aggregatedemand or supply shocks to generate fluctuations in the rate of unemployment and inflation.Furthermore, the short-run effects of inflation and unemployment, following a supply shock, depend

5on the nominal GDP growth response of policymakers. Therefore, the SP model does offer anexplanation for the cause of the highly variable rate of inflation (Puzzle 2); however, becausefluctuations in the output ratio generate cyclical unemployment, the SP model is able to explain thevariability of the unemployment rate (Puzzle 1) but not its high rate. That is addressed in Chapter 12sdiscussion of the natural rate of unemployment.

10.(a) A simultaneous rise in the rate of inflation and fall in the output ratio implies that there is asupply shock or an increase in the expected inflation rate which shifts the SP curve leftward with afixed nominal GDP growth rate. These movements are pure supply inflations and classic examplesof them include the food and energy supply shocks of 197374, along with the removal of pricecontrols in 1974, and the supply shocks of the late 1970s. Stagflation in 196970 provides anexample of an adjustment loop that did not involve supply shocks. (b) A constant inflation rateassociated with an increase in the output ratio implies that the SP curve shifted rightward with asimultaneous increase in demand caused by an acceleration in nominal GDP growth. The classicexample of this was the extinguishing policy of the Fed following the price control program of 197174. The economys experience over the period 199396 also displays constant inflation accompanyinga rising output ratio. (c) A simultaneous increase in both output and inflation implies that there is anacceleration in nominal GDP growth along a stable SP curve. These movements are pure demandinflations, and examples include the 196366 tax cuts and the beginning of Vietnam wartimespending, and the second-wind reacceleration of inflation in 198789. A classic example of ademand deflation is the deceleration of nominal GDP growth which triggered the 198182recession.

11.In a demand-induced inflation, if an increase in the expected rate of inflation is fully incorporatedinto labor contacts, then there will be an increase in the growth rate of nominal wages. Firms willrespond by reducing the output they are willing to supply at every given rate of inflation, and the SPcurve will shift upward.Supply shocks will have the same effect on the SP curve. The essentialdifference, however, is that supply shocks move the economy along a given labor supply curve (whichcorresponds to a lower production function) at every price level(assuming no real-wage rigidities),while an increase in the nominal wage rate moves the economy along a given labor demand function(which corresponds to the original production function) at every price level. Although the two effectsare distinct, they may be related. If a supply shock is expected to be permanent, higher expectations ofinflation could continue to shift the SP curve upward and result in a permanently higher rate ofinflation.

12.The statement is inaccurate in two important ways. First, a supply shock that lasts for only oneperiod will cause the SP curve to shift back to its original position only if inflationary expectationsremain constant. If the expected rate of inflation responds to the one-shot increase in the actualinflation rate, then the SP curve after the supply shock ends will be higher than the original SP curve,implying a permanent acceleration of inflation and a lower output ratio (assuming a neutral nominalGDP growth policy). Second, if the one-period supply shock were permanent and if inflationaryexpectations were to remain constant, then the output ratio and the inflation rate would return to theiroriginal equilibrium values. However, without a counteracting downward-shifting SP curvecharacteristic of temporary supply shocks, the supply shocks direct effect of lowering the naturallevel of output and increasing the level of prices would remain. Furthermore, if policymakers respondto the one-period supply shock with an accommodating or neutral policy, then the original level ofoutput would not be attainable at the same rate of inflation.

6Appendix to Chapter 8

1. (a) p = [p-1 + g ( Y -1 + x ) + z]/(1 + g), Y = Y -1 + x p.(b) x = x yN = 11 5 = 6. In the long-run p = x = 6.(c) (i) x = 6, p = [2 + (0 + 6)]/2 = 4, Y = 0 + 6 4 = 2.

(ii) x = 2, p = [4 + (2 + 2)]/2 = 4, Y = 2 + 2 4 = 0.(iii) x = 2, p = [4 + (0 + 2)]/2 = 3, Y = 0 + 2 3 = 1.

(d) For year 2, set x = 2: p = [4 + (2 + 2)]/2 = 4, Y = 2 + 2 4 = 0.For year 3, set x = 4: p = [4 + (0 + 4)]/2 = 4, Y = 0 + 4 4 = 0.

2. (a) x = 9, p = [9 + 2 (0 + 9) 3]/3 = 8, Y = 0 + 9 8 = 1.(b) This implies that the output ratio will be fixed at Y = 0. since Y = Y -1 = 0, x = p. Thus, we

have p = [9 + 2 (0 + p) 3]/3 3p = 6 + 2p p = 6.(c) This implies that p = 9. Thus, 9 = [9 + 2 (0 + x ) 3]/3 x = 10.5, Y = 0 + 10.5 9 = 1.5.(d) Since Y = Y -1 = 0 for an accommodating policy, x = p. Thus p = [6 + 2 (0 + p)]/3 3p = 6

+ 2p p = 6.

Chapter 9

1. This statement incorporates several important concepts developed over the last few chapters. Firstis the straightforward idea that an acceleration in the rate if nominal GDP growth will increase theinflation rate and, to the extent that the demand shock was unexpected, unanticipated inflation.Second is the important role of distinguishing between the real and nominal rate of interest indetermining the costs of unanticipated inflation. Because unanticipated inflation is not incorporatedinto fixed nominal interest loans, it will redistribute wealth from wealthy creditors to middle-classdebtors by reducing their real interest income. Finally, the fact that every dollar of real income that isredistributed will increase the consumption of the middle class by more than the fall in consumptionby the wealthy implies that aggregate consumption will increase as a result of this redistribution ofwealth. Therefore, the net effect of the unanticipated inflation will be further to aggravate inflation byfurther increasing nominal GDP growth through consumption spending.

2. This is a false statement. First, it does not explicitly recognize the distinction between the costs ofunanticipated inflation and the costs of anticipated inflation. Indexation is no cure for inflation itself;it is simply designed to eliminate the costs of unanticipated inflation, i.e., it is designed to protectsavers from a redistribution of their wealth to debtors. It does so by making expectations of inflationirrelevant to the individual decision-making process and to the inflation-unemployment process. Itmay even introduce more efficiency into the system by freeing resources previously devoted tocomputing expectations and overcoming uncertainty. However, indexation does nothing to protectindividuals from the costs of anticipated inflation resulting from the shoe-leather cost of lower realbalances and the possible change in relative prices. Furthermore, indexation will likely magnify thesensitivity of prices to both demand and supply shocks by causing aggregate demand and supply tobecome less responsive to price changes and thus making the AD and SAS curves steeper. This isshown in Figure 9-A, where, in the left frame, a given supply shock along the steeper ADs curverather than the flatter ADf curve increases the volatility of prices by (P2 P1). The same result holdstrue for demand shocks along a steeper SAS curve (right frame of Figure 9-A). Therefore, indexationmay actually worsen the costs of anticipated inflation. Note, however, that with indexation the

7fluctuations in aggregate output that accompany supply and demand shocks will be smaller than theywould be in the absence of indexation.

Figure 9-A

3. (a) The expected rate of interest is calculated by using the expected rate of inflation. Thus, fromthe definition of the expected real interest rate, we have r e = i pe = 10% 5% = 5%.

(b) Since the actual real interest rate is calculated from the actual inflation rate, we need thegrowth equation, introduced in Chapter 8, to determine the actual inflation rate: x = p + y p = x y = 8% 2% = 6%. Therefore, the real rate of interest is r = i p = 10% 6% = 4%.

4. Yes. The relationship between the real and nominal interest rate is given by i = r + p. If therewere a reduction in the growth rate of the nominal money supply, the resulting upward pressure on thereal interest rate could be, given a sufficiently steep aggregate supply curve, completely matched bythe resulting deflation of prices. Therefore, nominal interest rates may remain stable or even fall as thereal interest rate rises.

5. The actual unemployment rate has three components: turnover (frictional) and mismatch(structural), which make up the natural rate of unemployment, and cyclical. From Okuns Law, thisrelationship can be expressed as U = UN h Y or U UN = h Y . Thus, an acceleration in nominal GDPgrowth through stimulative monetary or fiscal policy will be able to raise Y temporarily above zero,and thus lower the actual rate of unemployment below its natural rate. This temporary situation ariseswhen the expected rate of inflation (pe) is fixed, so that an acceleration of nominal GDP growth willincrease both the inflation rate and output ratio along a given SP curve (p = pe + g Y + z). Becausesubsequent adjustments of the expected rate of inflation will eventually leave the economy at itsoriginal level of Y in the long-run, stimulative demand policies will cause permanent inflationwithout being able permanently to reduce the actual rate of unemployment below its natural rate.

6. The three types of unemployment are turnover, mismatch, and cyclical. As mentioned in theanswer to the previous question, stimulative demand policies will only be successful in temporarilyreducing the cyclical component of the unemployment rate. However, if the unemployment isturnover, then stimulative demand policies may have little or no effect on the rate of unemployment.The type of government policies pursued to reduce the rate of mismatch unemployment greatlydepends on the specific factors which prevent willing workers from filling available job vacancies. Ifthe mismatch unemployment arises from the lack of skills, then the available policy options of the

8government include the promotion of better public education, subsidies for firms to train unskilledworkers, and more government-financed training programs. If the mismatch unemployment arisesfrom the immobility of the labor force, then the government can (1) offer a better employment service;(2) subsidize displaced workers to move to where jobs are available; and (3) move the jobs to thepeople by establishing industrial enterprise zones which promote the relocation of factories. Theturnover component of unemployment is the least severe of the three types of unemployment andmainly consists of individuals involved in job search. The government policies that may reduce theturnover unemployment rate include establishing better employment agencies which provide betterinformation to shorten the search period, and reducing the economic incentives which prolong searchactivity. However, the elimination of productive search activity is not desirable. Note also thatbecause mismatch and turnover unemployment are not mutually exclusive, government programsdesigned to reduce one may actually increase the other. For example, policies designed to promote agreater mobility of labor and lower the mismatch unemployment rate may encourage more individualsto quit their current jobs to search for better ones, and this increases the turnover unemployment rate.

7. The analysis of inflation in Chapter 8 deals with the effects of demand and supply shocks inexplaining fluctuations in the output ratio and the inflation rate. Because the cyclical component ofunemployment is negatively influenced by fluctuations in the output ratio, these destabilizing demandand supply shocks also explain fluctuations in the unemployment rate. Therefore, Chapter 8 offers asolution to the first macroeconomic puzzle regarding the variability of the unemployment rate.The purpose of the analysis in Chapter 12 is to explain why the unemployment rate is higher thanzero. It does this by first noting that the principal cause of the high actual rate of unemployment is ahigh natural rate of unemployment. Then it provides a detailed discussion of the causes of the highnatural rate by decomposing it into mismatch and turnover unemployment. Although discretionarymonetary and fiscal policy can be used to reduce the variability of the unemployment rate, onlypolicies directly affecting the structural and institutional environment of the economy can help inreducing the natural rate of unemployment.

Chapter 10

1. (a) If each new worker were as productive as the average worker currently in the United States,there would be no effect on GDP per capita. If immigrants were more productive, GDP per capitawould rise; if immigrants were less productive, GDP per capita would decline.

(b) There would be an increase in the amount of capital in the economy because of thegovernment surplus (tight fiscal policy) and the lower interest rate (easy monetary policy). Thisincrease in the growth of capital per worker will cause an increase in the rate of growth of real GDPper person.

(c) There would be an increase in both individual and business saving, causing a temporaryincrease in the rate of growth of capital per worker and the rate of growth of real GDP per person untilthe economy adusts to its new steady state.

(d) The value of the autonomous factor (the residual) would increase. Even without changingthe amount of labor or the amount of capital, the level of real output would increase. Thus, the rate ofgrowth of real GDP per person would increase.

(e) There would be an increase in the rate of growth of capital per worker, causing an increase inthe rate of growth of real GDP per person.

92. The original Harrod-Domar model of economic growth was developed in two fundamental steps.First, the identity that saving equals investment (S = I ) was combined with the definition ofinvestment to arrive at an identity relating the level of national saving to the growth rate of capital andthe capital depreciation rate: S = [( K/K) + d]K. Second, the steady-state condition that the growthrate of capital stock must equal the population growth rate (k = n) was incorporated to develop thetheoretical steady-state condition that the saving per unit of capital equals the sum of the populationgrowth rate and the depreciation rate: sY/K = n + d. However, this model was said to have knife-edge stability in that there was no equilibrating forces guiding the seemingly independent factors tobe consistent with the steady-state condition. Solow solved this problem by incorporating the per-person production functionY/N = f (K/N) into the model and recognizing that when K/N is growingfaster than Y/N, the capital needed to equip new workers with the same capital per worker as existingworkers and to cover the depreciation of capital is in excess of total saving, so that K/N will eventuallyfall until (K/N) = 0 and the steady state condition is satisfied. Thus, the important aspect that theproduction function added was the property of diminishing returns to the capital-labor ratio.

3. According to the Solow growth model, the growth rate of real output must be equal to thepopulation growth rate in the steady state. Thus, an increase in the growth rate of the population (n)causes the growth rate of output (y) to rise by exactly the same amount after the economy reachesits new steady state.However, what matters to the new steady-state level of Y/N depends on therelative growth rates of population and output during the transitional period between steady states.From an initial steady-state equilibrium at Point E (Figure 10-A), an increase in the population growthrate at each level of K/N implies that it will take a greater capital-labor ratio to maintain the same Y/Nratio in the steady state. This will rotate the steady state investment line counterclockwise from (n +d)K/N to (n' + d)K/N and cause the growth rate of output to be temporarily lower than the populationgrowth rate. Finally, as the economy reaches the new steady state at Point E' , the population andoutput growth rates are once again equal, although higher than their original rates, and (Y/N)0 falls to(Y/N)1.

4. The term technological growth factor or technological change was criticized for prejudgingthe sources of growth. There are many cases that involve the growth of output relative to the growth ininputs unrelated to technological change. Therefore, the term residual or multi-factorproductivity is preferred. Some of the sources of residual growth not related to technological changeinclude greater education changes in demographic composition, a movement of the labor force awayfrom rural labor and to industrial labor, the effects of externalities such as crime and pollution,advances in research and innovation, and improvements in labor quality.

10

Figure 10-A

5. Yes. In fact, production functions are usually assumed to be characterized by both diminishingreturns and constant returns to scale (e.g., the Cobb-Douglas production function). A productionfunction has the property of diminishing marginal returns when the employment of each additionalunit of one of the input factors, while holding the others constant, reduces the amount by which totaloutput increases (i.e., the marginal product of that input factor). However, the concept of constantreturns to scale implies that if all of the input factors are increased by a certain proportion, then theoutput level will rise by exactly that same proportion. In mathematical terms, functions of this type arecalled homogeneous of degree one or linearly homogeneous. To see these relationships moreclearly, consider the standard Cobb-Douglas production function: Y = AKbN1-b, b < 1. Because thecapital elasticity of real GDP, b, is less than one, every unit increase in the capital stock while holdingthe quantity of labor fixed will increase output by less, i.e., the change in output falls as the capitalstock continues to rise. Thus, this production function exhibits diminishing returns in capital, and thesame result is true of changes in the quantity of labor. However, because the labor elasticity of realGDP is (1 b), every one percent increase in both capital and labor will increase the level of outputby b + 1(1 b) = 1 percent. Thus, this production function also exhibits constant returns to scale.Note also that while these two concepts are identical in functions of one independent variable, theyare generally two distinct concepts.

6. The most important factor in determining the level of private investment in an economy is thelevel of national saving, which is composed of personal, business, and government saving. Thus, thefederal budget deficit and the current account deficit play a very important role in determining futureeconomic growth. The federal budget deficit influences growth because it directly influences nationalsaving. The current account deficit matters because a buildup of debt to foreigners will reduce thefuture output available by requiring future Americans to pay an increasing fraction of their income asinterest to foreigners.

Chapter 11

1. Labors share of national income is (W/P)/(Y/N). That labors share of national income is less than1 implies that the average real wage (W/P) is less than average labor productivity (Y/N). This meansthat a portion of labors average productivity accrues to owners of other factors of production ascompensation for their contribution to the production of output.

2. If firms are unwilling to lay off workers during business cycle recessions and hire them backduring expansions, the level of employment will be less variable than output over the business cycle.This will cause the growth of labor productivity (y n) to be procyclical. During recessions outputwill fall by a larger relative amount than employment, causing (Y/N) to decline, while duringexpansions output will rise relatively more than employment and (Y/N) will rise.

3. No single explanation (or even reasonable combination of single explanations) has been offered toexplain the slowdown in U.S. productivity that is compatible with the available data. Thus, attempts toexplain the U.S. slowdown using reductions in R&D expenditure, of labor force quality, or energyprices, simply do not offer much in the way of robust explanations. Thurows point is that the currentU.S. economy is so complex and the various regions and industries are so vastly different that it isunlikely that a single explanation can suffice.

11

4. Some people feel that the steady increase in foreign trade, frequently called the globalization ofthe world economy, has the effect of creating competition between foreign workers and domesticworkers. To the extent that this is true, it would directly slow the growth of the real wage, andindirectly, as in the bottom frame of Figure 11-8, slow the growth rate of productivity.

5. (a) An increase in investment in public infrastructure and private capital would raise capital perworker and labor productivity. This would shift the labor demand curve upward and, given no changein the labor supply curve, cause the real wage rate to rise. Thus the change in labor productivitycauses the rise in the real wage rate.

(b) A reduction in the flow of immigrants to the United States will shift the labor supply curve tothe left and, with no change in the labor demand curve, cause the real wage rate to rise. With workersnow more costly to employ, firms will reduce their level of employment. With fewer workersemployed, capital per worker and output per worker will be greater. This case differs from that in (a),however, because here the increase in real wages is the cause rather than the result of the rising laborproductivity.

Chapter 12

1. The fundamental problem with these two statements is that neither accurately represents the trueburden of the public debt. The true burden that arises from the debt is that it absorbs national savingand thus reduces the funds available for private investment. If the government deficit financesconsumption goods rather than investment goods, the public debt will lower the current stock ofcapital and thus reduce the economys ability to support a higher level of consumption and a higherstandard of living in the future. The second fundamental flaw with both of these statements is thatthey fail to distinguish between government debt that is domestically held and government debt that isheld by foreigners. If the debt is domestically held, the second statements criticism of the first is validbecause the interest payments on the debt involve a transfer of income among domestic citizens, i.e.,we owe it to ourselves; however, the second statement ignores the possibility of the debt being heldby foreigners. The analysis of debt held by foreigners is similar to that held by domestic residents inthat it depends on whether the debt is used to finance government purchases of consumption orinvestment goods. Also, the foreign debt has the added burden of transferring real resources awayfrom the domestic economy to finance the interest payments on the foreign debt, and this will reducefuture growth in real consumption.

2. The Barro-Ricardo equivalence theorem holds that any deficit-financed tax cut will increasecurrent private saving instead of current consumption because of the implied future tax liabilityrequired to pay off the interest on the debt. Because the time horizon or the implied future taxes islikely to be much longer than the lifetime of those receiving the tax cuts, Barro stressed theimportance of the bequest motive. The central assumption here is that if the current generation caresabout the burden of future taxes on their children, they will increase their current saving and pass italong as bequests to their children. The prediction of the Barro-Ricardo equivalence theorem is verydifferent from the standard Keynesian analysis in that it denies that government bonds represent netwealth, so that tax-based discretionary fiscal policies will be completely ineffective in influencing thelevel of aggregate demand, output, and employment. However, this proposition ignores theobservation that individuals may be liquidity constrained and face imperfect capital markets.

3. The solvency condition places a limit on how much the debt-to-GDP ratio can feasibly grow byconcluding that the government can only continue to finance its deficits by issuing more debt if thegrowth rate of real output equals or exceeds the real interest rate on the bonds. This condition implies

12

that if the real interest rate exceeds real output growth, then financing the interest payments on theexisting debt by issuing more debt cannot be sustained forever. Thus, because current debt financingimplies that the eventual money financing will have to cover even larger interest payments on thenational debt, debt financing today may eventually be more inflationary than money financing today.

Figure 12-A

4. The short-run and long-run effects of a government budget deficit greatly depend on how thedeficit is financed. As specified by the government budget constraint, the two fundamental methodsavailable to finance the total government budget deficit are bond (or debt) financing and moneyfinancing. The essential difference is that when an increase in government expenditures is financed bybonds, IS 1 shifts outward to IS 2 and private spending is crowded out by an increase in the interestrate from r 1 to r 2 along LM1 in Figure 11-A. However, money financing has a greater effect on theexpansion of output, since both the IS and LM curves shift outward, so that the crowding-out effectcaused by higher interest rates is diminished or completely eliminated. In Figure 12-A, the shifts ofIS 1 to IS 2 and LM1 to LM2 are shown holding the interest constant at r 1. It is for this reason thatmoney financing is recommended when the economy is weak while bond financing is recommendedwhen the economy is strong. The alternative methods of deficit financing also have different effects inthe long-run as well. Because bond-financed deficits that are not used for purchase of investmentgoods will reduce total productive investment spending, they impose the burden of lower futureeconomic growth. On the other hand, although deficits financed by money creation avoid this burdenof crowding out private investment, they could impose significant costs to society by causing anacceleration of inflation.

5. The fact that real GDP rose after the Reagan tax cuts does not confirm the validity of supply-sideanalysis because it fails to specify whether the tax cuts and the increase in real GDP were linked ashypothesized by the supply-side economists. To determine this, it matters a great deal what happenedto the saving rate, labor productivity growth, the real interest rate, and the budget deficit. Supply-sideeconomists predicted that the tax cuts would lead to an increased saving rate, which would reduce realinterest rates and fund productivity-enhancing investment, and that the cuts would be self-financingbecause they would stimulate enough additional production to generate the income from which moretaxes would be collected even at a lower tax rate. The mere fact that real GDP grew following the taxcuts is not sufficient to tell us whether the growth proceeded as expected by the supply-siders. It ispossible, for instance, that the real GDP grew not from any boost to the supply-side of the economy,but rather that it resulted from a boost to aggregate demand as predicted in the simple Keynesian

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model. The Keynesian growth process, however, is much different than that envisioned by the supply-siders. In fact, it appears that the growth that occurred following the tax cuts is better explained by thesimple Keynesian theory of income determination than by the theories of supply-side economics. Thesaving rate failed to rise, labor productivity growth failed to increase, and the real interest rate and thebudget deficit both rose, all of which support a Keynesian rather than supply-side explanation of thegrowth that followed the Reagan tax cuts.

Chapter 18

1. Inflation was curtailed by stringent price controls, and interest rates were pegged by the Fed.

2. Federal Reserve action led to reduced interest rates, which stimulated housing and automobilepurchases.

3. In an attempt to curb the 195657 acceleration of inflation, the Fed allowed interest rates to rise.This led to the recession of 195758, during which unemployment rose to its highest postwar level.

4. The monetarists pessimism that activist policy would do more harm than good was reinforced bythe following events of the 1960s: the long legislative lags for both fiscal and monetary policy, failureof the income-tax surcharge to slow the economy, and overly tight monetary policys adverse effect onthe economy.

5. The Fed began targeting the money supply, rather than interest rates, so instability in private andgovernment spending resulted in interest-rate instability.

6. The oil and food supply shocks caused inflation and unemployment to be positively correlated,while the short-run Phillips curve predicted a negative correlation.

7. The triangle refers to demand shocks, supply shocks, and the expectations-adjusted Phillips curve.The development of the expectations-adjusted Phillips curve, coupled with the natural-rate hypothesis,and demand and supply shocks was a response to the supply shocks of the 1970s. As noted in theanswer to the previous question, the standard Phillips curve was unable to explain the direct relationbetween the unemployment rate and inflation that occurred during the supply shocks.

8. The Fed appeared to be following an unannounced policy of targeting real GDP growththroughout much of the 1980s. In the 1990s, it has targeted the rate of unemployment, trying to keep itclose to its natural rate. But the Fed also monitors inflation. If inflation is not accelerating,unemployment is not above its natural rate.

9. Foreign trade makes up a much greater share of the GDP of European countries than of the U.S.,but the share of net exports in U.S. GDP has been growing.