Macroeconomics -- Unit 2
Introduction to Macroeconomics
Ch. 5 -- Government Finance
Ch. 11 -- A Model of the Macroeconomy:
Aggregate Demand and Aggregate Supply
Ch. 7 -- Measuring the Economy: GDP
Ch. 8 -- Macroeconomic Goals: Unemployment and Inflation
Ch. 19 -- Macroeconomic Goal: Economic Growth
Ch. 22 -- Economic Growth in the Less Developed Countries
Suggested Textbook Questions:
Ch. 5: p. 95 12, 14, 15
Ch. 11: pp. 232-3 1, 2, 4, 5, 6, 7, 8, 9, 13
pp. 164 1
Ch. 7: pp. 140-2 1, 2, 3, 4, 5, 6, 7, 8, 9, 11, 12, 13
Ch. 8: pp. 164-5 2, 4, 5, 6, 7, 8, 9, 10, 11, 12
Ch. 19: pp. 395-7 1, 2, 5, 6, 8, 10, 13, 14
Ch. 22: pp. 471-2 1, 2, 3, 4, 5, 6, 7, 9, 11, 15
(See answers to Key Questions in textbook, and answers to other questions in this Coursebook)
Suggested Study Guide Questions:
(Please see the Syllabus section "How to Pass Economics ... #3" before doing these problems)
Ch. 5:
Multiple-Choice Questions - pp. 54 19, 20, 22, 23, 24, 25
Problems - pp. 55-56 5,
Ch. 11:
Multiple-Choice Questions - pp. 227-9 1, 3, 7, 9, 10, 15, 16, 18, 19, 20, 21, 22, 23, 24, 25, 27, 28, 29, 30
Problems - pp. 229-232 1, 3, 6
Ch. 7:
Multiple-Choice Questions - pp. 76-78 1, 2, 3, 5, 7, 8, 9, 10, 11, 12, 13, 14, 18, 19, 20, 21, 23, 24, 25, 26, 27, 28, 29, 30
Problems - pp. 78-80 1, 4, 5
Ch 8:
Multiple-Choice Questions - pp. 88-90 1, 2, 3, 6, 7, 8, 9, 10, 11, 12, 13, 17, 18, 19, 21, 22, 23, 24, 25, 26, 27, 28, 29, 30
Problems - pp. 90-92 1, 3, 5, 6
Ch. 19:
Multiple-Choice Questions - pp. 230-33 1, 2, 3, 4, 5, 6, 7, 11, 12, 13, 18, 19, 20, 21, 24, 25
Problems - pp. 233 3
Ch. 22:
Multiple-Choice Questions - pp. 273-74 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 14, 16
Problems - pp. 274-275 1, 2, 3
OUTLINE -- CHAPTER 5
Government Finance
I. Federal Finance
A. Federal Expenditures1. pensions and income security
2. national defense
3. health
4. interest on the public debt
5. otherB. Federal Tax Revenues
1. personal income tax
2. payroll taxes
3. corporate income tax
4. excise taxesC. State and Local Finance
1. state expenditures and receipts (fig. 5-8)
2. local expenditures an receipts (fig. 5-9)D. Personal Income Tax
1. taxable income
2. progressive taxa. marginal tax rates
b. average tax ratesE. Government Growth
1. ways to measure government size
2. purchases vs. transfer payments
3. growth of government expendituresa. correcting for inflation
b. compared to other sectors
c. growth of transfer payments
OUTLINE -- CHAPTER 11
A Model of the Macro Economy: Aggregate Demand and Supply
I. Introduction
A. Macroeconomics vs. Microeconomics1. definition -- economics
2. definition -- macroeconomics
3. definition -- microeconomicsB. Macroeconomics Issues
1. full employment
2. price stability
3. economic growthC. The Business Cycle (143-146)
1. phases of the cyclea. peak
b. recession
c. trough
d. recovery2. the business cycle and the macro economic issues
3. causes: aggregate expenditures
4. secular trendD. A Model of the Macro Economy: AD and AS
1. chapter 3: D and S
2. chapter 11: AD and AS
II. Aggregate Demand
A. Definition
B. Real Domestic Output and the Price Level
C. Graphically: downsloping -- why?1. wealth effect
2. interest-rate effect
3. foreign purchases effectD. Changes in AD
1. determinates of ADa. C = consumer spending (and saving)1) consumer wealth
2) consumer expectations
3) consumer indebtedness
4) taxesb. I = investment spending
1) interest rates (money supply)
2) profit expectations on investment projects
3) business taxes
4) technology
5) degree of excess capacityc. G = government spending
d. Xn = net export spending1) net income abroad
2) exchange rates2. increase and decrease in AD
III. Aggregate Supply (AS)
A. Definition
B. Graphically1. upsloping
2. shapea. Keynesian (horizontal) range
b. classical (vertical) range
c. intermediate (upsloping) range3. aggregate supply and full employment
C. Changes in AS
1. determinates of ASa. change in input prices1) labor
2) land (OPEC)
3) capital
4) entrepreneurial abilityb. changes in the productivity of resource
1) productivity
2) production
3) productive efficiencyc. legal-institutional environment
1) business taxes and subsidies
2) government regulation (red-tape)2. increase and decrease in AS
III. Macroeconomic Equilibrium
A. Equilibrium1. equilibrium price level
2. equilibrium real domestic outputB. Changes in AD and the Macroeconomic Issues
1. employment
2. inflationa. demand-pull inflation
b. ratchet effect1) graphically
2) causesa) wage contracts
b) morale and
productivity
c) training investments
d) minimum wage
e) monopoly powerC. Changes in AS and the Macroeconomic Issues
a. employment and potential output
b. inflation -- cost-push inflation
c. stagflation
IV. Macroeconomic Policies
A. Stabilization Policies (p. 85)1. definition
2. role of government in market economyB. Demand-Management
1. definition
2. tools -- AD curve shifters (review)a. fiscal policy1) expansionary
2) contractionaryb. monetary policy (pp. 293-294)
1) easy money
2) tight money3. AD policies and the AS curve
C. "Supply-Side Economics" (pp. 354-357)
1. shifting AS -- results
2. AS curve shifters (review)
3. policiesa. removing tax-transfer disincentives
b. reducing the tax wedge
c. government deregulation
V. Historical Review of the U.S. Economy
A. Depression (pp. 206-207)
B. WWII Boom
D. Vietnam War Inflation (pp. 207)
E. Monetary Restraint: 1979 - 1982
F. Aggregate Supply Shocks in the 1970s & Early 1980s: Stagflation (pp. 341-343)1. OPEC and energy prices
2. agricultural shortfalls
3. depreciated dollar
4. demise of wage-price controls
5. productivity decline
6. inflationary expectations and wages
OUTLINE -- CHAPTER 7
Measuring the Economy
I. Introduction
A. Macroeconomics
B. Measuring the Economy's Performance1. real domestic output
2. price level
II. Measuring Real Domestic Output: GDP
A. GDP vs. GNP
B. Definition: GDP1. definitionthe total market value of a final goods and services produced in the economy in one year
2. market value: unit of measure for real domestic output
3. final goods: avoid double countinga. final goods
b. intermediate goods4. produced in one year
a. secondhand sales are not included
b. financial transactions not includedC. GDP and Social Welfare (p.137-139)
1. non-market transactions
2. leisure
3. improved product quality
4. the composition and distribution of output
5. per capita output
6. GDP and the environment
7. the underground economy
8. resource depletion
III. Measuring GDP
A. Introduction -- circular flow model1. two approachesa. expenditures approach
b. income approachB. Expenditures Approach
1. personal consumption expenditures (C)
2. gross private domestic investment (Ig)a. includes:1) all final purchases of machinery, equipment, and tools by businesses
2) all construction
3) changes in inventoriesb. gross vs. net domestic investment (In)
c. net investment and economic growth1) expanding economy
2) static economy
3) declining economy3. government purchases (G)
4. net exports (Xn)C. Income Approach --calculating national income (NI)
1. circular flow: expenditures = income?a. depreciation: consumption of fixed capital
b. indirect business taxes2. resource payments
a. compensation of employees (wages)
b. rent
c. interest
d. profit1) proprietor's income
2) corporate profits
3. National Income to GDPa. indirect business taxes (IBT)
b. depreciation4. Other Social Accounts
a. net domestic product (NDP)
b. national income (NI)
c. personal income (PI)
d. disposable income (DI)
III. Measuring the Price Level
A. Definitions1. nominal GDP
2. real GDPB. Price Index -- GDP Deflator
1. definition
2. calculating a GDP price index
3. using the price indexa. the adjustment process: nominal to real
b. inflating and deflating
CHAPTER 8
Macroeconomic Goals: Unemployment and Inflation
I. Macroeconomic Instability: The Business Cycle
A. Review: Macroeconomic Issues
B. Review: The Business Cycle
C. Review: Maximizing Satisfaction
II. Unemployment
A. What is Unemployment?1. Definition
2. What is the labor force?a. who is included in the labor force
b. who is not in the labor force
c. part-time = employed
d. discouraged workers = not in labor forceB. What Is "Full Employment"?
1. achieving the potential outputa. NOT absolute maximum
b. graphically1) production possibilities curve
2) AD - AS Model2. Types of Unemployment
a. frictional unemployment
b. structural unemployment
c. cyclical unemployment -- business cycle3. "full employment rate of unemployment" includes:
a. frictional unemployment
b. structural unemployment4. why?: potential output is still achieved
5. changes in the full employment rate of unemploymentC. costs of unemployment
1. GDP gap
2. unequal burdensa. occupation
b. age
c. race
d. gender
e. duration3. non economic costs
III. What is Inflation?
A. The Meaning of Inflation
B. Measuring Inflation1. price index - reviewa. GNP deflator
b. CPI -- consumer price index2. calculating inflation
3. rule of 70C. Causes: Theories of Inflation
1. demand-pull inflationa. Keynesian range
b. intermediate range
c. Classical range2. cost-push (supply-side) inflation
D. Effects of Inflation
1. redistributive effects
a. fixed nominal income receivers
b. savers
c. debtors and creditors
d. anticipated inflation2. output effects
a. stimulus of demand-pull inflation
b. cost-push inflation and unemployment
c. hyperinflation and breakdown
Chapter 19
Macroeconomic Goal: Economic Growth
I. Introduction
A. Macroeconomic Goals
B. Review: Economic Growth1. definition from chapter 2
2. production possibilities
3. economics: maximizing satisfaction
4. causes
II. Two (Three) Definitions
A. Increasing our ABILITY to Produce1. production possibilities curve
2. AD and AS modelB. Increasing Real GDP
1. production possibilities curve
2. AD and AS model
3. increasing GDP per capitaC. GDP per capita
III. Ingredients of Economic Growth
A. Supply Factors: Increasing Potential Output1. more and better resources:a. land
b. human: labor and entrepreneurs
c. capital2. technology
3. graphsB. Demand Factors: Achieving Potential Output
1. AD determinates
2. graphsC. Productive Efficiency Factors
IV. United States Growth
A. The Facts
B. But:1. improved products and services
2. added leisure
V. Accounting for Growth
A. Inputs (quantity) vs. Productivity (quality)1. Quantity of Labor
2. Technological Advance
3. Quantity of Capitala. role of saving
b. Production Possibilities Curve4. Education and Training
5. Resource Allocation
6. Scale EconomiesB. Detriments to Growth
C. Other Factors
D. Aggregate Demand, Instability, and Growth
VI. The Productivity GROWTH Slowdown
A. Significance1. standard of living
2. inflation
3. world marketsB. Causes of the Slowdown
1. labor qualitya. decline in experience level
b. less able workers
c. slowing of increased educational attainment2. technological progress
3. Investmenta. low saving rate
b. import competition
c. regulation
d. reduced infrastructure spending4. energy prices
5. industrial relations
VII. Is Growth Desirable? (Last Word)
A. The Anti-Growth View1. pollution
2. problem resolution?
3. growth and "the good life"B. In defense of Growth
1. living standards
2. growth and the environment
3. poverty reduction
VIII. Growth Policies
A. Demand-Side Policies
B. Supply-Side Policies
C. Industrial and Other Policies
Chapter 22
Economic Growth in the Less Developed Countries (LDCs)
I. The Rich and the Poor
A. The industrially Advanced Countries (IACs)
B. The Less Developed Countries
II. Characteristics of the LDCs
III. Growth, Decline, and Income gaps
A. Miracles and Disasters
B. Growing Absolute Gaps
IV. Breaking the Poverty Barrier
A. Natural Resources
B. Human Resources
C. Capital Accumulation
D. Technological Advance
E. Sociocultural and Institutional Factors
V. The Vicious Circle
VI. The Role of Government
A. Positive Role1. law and order
2. lack of entrepreneurship
3. infrastructure
4. forced saving and investment
5. socio-institutional problemsB. Public Sector Problems
V. Role of the IACs
A. Expanding Trade
B. Foreign Aid
C. Private Capital Flows
UNIT 2
Suggested Textbook Questions
A N S W E R S
Ch. 5: p. 95 12, 14, 15
5-12 Explain how government might manipulate its expenditures and tax revenues to reduce (a) unemployment and (b) the rate of inflation.
(a) To reduce unemployment, government must increase total or aggregate spending in the economy to encourage more production and employment. It can do so by increasing its own spending on goods and services and, by reducing taxes, inducing the population to spend more. Reduced taxes on businesses might also have a supply-side effect, allowing businesses to produce more as a result of the lower tax cost burden. Monetary authorities should be encouraged to increase the supply of money and credit available.
(b) To reduce the rate of inflation, government should reduce aggregate spending for goods and services in the economy. It can do so by decreasing its own spending and/or by increasing taxes, which would induce consumers to spend less. It could also encourage a monetary authorities to reduce the supply of money and credit.
If both inflation and unemployment are problems at the same time, in other words, the economy is suffering from "stagflation", the government stabilization policy to follow is less clear. The only clear direction in that case would be to enact policies that would encourage investment spending, in hopes of increasing productivity and encouraging increased future output and employment levels.
514 What is the most important source of revenue and the major type of expenditure at the Federal level? At the state level? At the local level?
At the Federal level, the most important source of revenue is the personal income tax. The main expenditure is for income security.
At the state level the most important sources of revenue are sales, excise, and gross receipts taxes followed by personal income taxes. The main expenditures are for public welfare, with education running a very close second.
At the local level the most important source of revenue is, by far, property taxes. Education is by far the most important expenditure.
5-15 (Key Question) Suppose in Fiscalville there is no tax on the first $10,000 of income, but earnings between $10,000 and $20,000 are taxed at 20 percent and income between $20,000 and $30,000 at 30 percent. Any income above $30,000 is taxed at 40 percent. If your income is $50,000, how much in taxes will you pay? Determine your marginal and average tax rates. Is this a progressive tax?
Answers to Key Questions appear in the text.
Ch. 11: pp. 232-3 1, 2, 4, 5, 6, 7, 8, 9, 13
pp. 164 1
111 Why is the aggregate demand curve downsloping? Specify how your explanation differs from the rationale behind the downsloping demand curve for a single product.
The aggregate demand (AD) curve shows that as the price level drops, purchases of real domestic output increase. The AD curve slopes downward for three reasons. The first is the interestrate effect. We assume the supply of money to be fixed. When the price level increases, more money is needed to make purchases and pay for inputs. With the money supply fixed, the increased demand for it will drive up its price, the rate of interest. These higher rates will decrease the buying of goods with borrowed money, thus decreasing the amount of real output demanded.
The second reason is the wealth or real balances effect. As the price level rises, the real value --the purchasing power-- of money and other accumulated financial assets (bonds, for instance) will decrease. People will therefore become poorer in real terms and decrease the quantity demanded of real output.
The third reason is the foreign purchases effect. As the United States' price level rises relative to other countries, Americans will buy more abroad in preference to their own output. At the same time foreigners, finding American goods and services relatively more expensive, will decrease their buying of American exports. Thus, with increased imports and decreased exports, American net exports decrease and so, therefore, does the quantity demanded of American real output.
These reasons for the downsloping AD curve have nothing to do with the reasons for the downsloping single-product demand curve. In the case of the dropping price of a single product, the consumer with a constant money income substitutes more of the now relatively cheaper product for those whose prices have not changed. Also, the consumer has become richer in real terms, because of the lower price of the one product, and can buy more of it and all other products. But with the AD curve, moving down the curve means all prices are dropping --the price level is dropping. Therefore, the single-product substitution effect does not apply. Also, whereas when dealing with the demand for a single product the consumer's income is assumed to be fixed, the AD curve specifically excludes this assumption. Movement down the AD curve indicates lower prices but, with regard to the circular flow of economic activity, it also indicates lower incomes. If prices are dropping, so must the receipts or revenues or incomes of the sellers. Thus, a decline in the price level does not necessarily imply an increase in the nominal income of the economy as a whole.
112 Explain the shape of the aggregate supply curve, accounting for the differences between the horizontal, intermediate, and vertical ranges of the curve.
In the horizontal range of the aggregate supply (AS) curve, the economy is in a severe recession, so that there is a large GDP gap --much excess capacity-- because of deficient aggregate demand (AD). In these circumstances, AD can increase without pulling the price level upward.
In the intermediate, or upsloping, range of the AS curve, the economy is clearly in the recovery phase of the business cycle and the price level moves up more and more as AD increases. The economy as a whole nears the full employment level of output, as some firms, some industries, are at or close enough to their capacity production that they believe they can --or are forced to-- raise their prices to equate the quantity they supply with increasing demand. Moreover, some essential inputs are fully employed --some skilled labor, certain raw materials-- and firms must bid against each other in order to increase their production. Thus, costs --and prices-- start to rise in the economy, pushing up the price level as full employment is reached.
In the vertical range of the AS curve, absolute full capacity has been reached; the economy, by definition, cannot produce any more (not until, through economic growth, the potential output of the economy has increased). Since the economy has attained its potential, any further increase in AD cannot be met by an increase in output. Therefore, the increase in AD results only in pure demandpull inflation.
114 (Key Question) Suppose that aggregate demand and supply for a hypothetical economy are as shown below:
Amount of Amount of
real domestic Price real domestic
output demanded, level output supplied,
billions (price index) billions
$ 100 300 $ 400
200 250 400
300 200 300
400 150 200
500 150 100
(a) Use these sets of data to graph the aggregate demand and supply curves. What will be the equilibrium price level and level of real domestic output in this hypothetical economy? Is the equilibrium real output also the absolute fullcapacity real output? Explain.
(b) Why will a price level of 150 not be an equilibrium price level in this economy? Why not 250?
(c) Suppose that buyers desire to purchase $200 billion of extra real domestic output at each price level. What factors might cause this change in aggregate demand? What is the new equilibrium price level and level of real output? Over which range of the aggregate supply curve --horizontal, intermediate, or vertical-- has equilibrium changed?
Answers to Key Questions appear in the text.
115 (Key Question) Suppose that the hypothetical economy in question 4 had the following relationship between its real domestic output and the input quantities necessary for producing that level of output:
Real
Input domestic
quantity output
150.0 400
112.5 300
75.0 200
(a) What is the level of productivity in this economy?
(b) What is the per unit cost of production if the price of each input is $2?
(c) Assume that the input price increases from $2 to $3 with no accompanying change in productivity. What is the new per unit cost of production? In what direction did the $1 increase in input price push the aggregate supply curve? What effect would this shift in aggregate supply have upon the price level and the level of real output?
(d) Suppose that the increase in input price had not occurred but instead that productivity had increased by 100 percent. What would be the new per unit cost of production? What effect would this change in per unit production cost have on the aggregate supply curve? What effect would this shift in aggregate supply have on the price level and the level of real output?
Answers to Key Questions appear in the text.
116 Will an increase in the American price level relative to price levels in other nations shift our aggregate demand curve? If so, in what direction? Explain. Will a decline in the dollar price of foreign currencies shift the American aggregate supply curve rightward or simply move the economy along an existing aggregate supply curve? Explain.
An increase in the American price level does not shift the American AD curve. What does happen is that because of the foreign purchases effect, there will be a decline in American net exports and, consequently, movement up along the American AD curve, resulting in a decline in the aggregate quantity demanded of American real output.
A decline in the dollar price of foreign currencies will decrease the price of imported inputs, thereby decreasing the per unit cost of producing American real output. This will shift the American AS curve to the right (and not merely move the economy along an existing AS curve).
117 (Key Question) What effects would each of the following have on aggregate demand or aggregate supply? In each case use a diagram to show the expected effects on the equilibrium price level and level of real output. Assume all other things remain constant.
(a) A widespread fear of depression on the part of consumers
(b) A large purchase of wheat by Russia
(c) A $1 increase in the excise tax on cigarettes
(d) A reduction in interest rates at each price level
(e) A cut in Federal spending for health care
(f) The expectation of a rapid rise in the price level
(g) The complete disintegration of OPEC, causing oil prices to fall by onehalf
(h) A 10 percent reduction in personal income tax rates
(i) An increase in labor productivity
(j) A 12 percent increase in nominal wages
(k) Depreciation in the international value of the dollar
(l) A sharp decline in the national incomes of our western European trading partners
(m) A decline in the percentage of the American labor force which is unionized
Answers to Key Questions appear in the text.
118 What is the relationship between the production possibilities curve discussed in Chapter 2 and the aggregate supply curve discussed in this chapter?
A given AS curve shows how much will be produced at each and every price level up to the full employment output level. Beyond this point, the economy at present does not have the resources and technology to produce more. A movement to the right of the AS curve is brought about, in effect, by the same factors that cause a production possibilities curve to shift to the right.
119 (Key Question) Other things being equal, what effect will each of the following have on the equilibrium price level and level of real output:
(a) An increase in aggregate demand in the vertical range of aggregate supply
(b) An increase in aggregate supply (assume prices and wages are flexible)
(c) An equal increase in both aggregate demand and aggregate supply
(d) A reduction in aggregate demand in the horizontal range of aggregate supply
(e) An increase in aggregate demand and a decrease in aggregate supply
(f) A decrease in aggregate demand in the intermediate range of aggregate supply (assume prices and wages are inflexible downward)
Answers to Key Questions appear in the text.
1113 "Unemployment can be caused by a leftward shift of aggregate demand or a leftward shift of aggregate supply." Do you agree? Explain. In each case specify pricelevel effects.
Assuming the economy was not operating in the vertical range of the AS curve, the statement is true. In either case, the new point of intersection is to the left of the previous position, denoting a decrease in real domestic output and, therefore, assuming no change in productivity, necessarily an increase in unemployment.
However, assuming complete flexibility of prices and wages, the decrease in AD will result in a lower price level, whereas the decrease in AS will result in a higher price level. From the point of view of price stability, therefore, the decrease in AD is preferable. If the economy were in the horizontal range initially, there would be no price changes in either case.
pp. 164 1
81 (Key Question) What are the major phases of the business cycle? How long do business cycles last? How do seasonal variations and secular trends complicate measurement of the business cycle? Why does the business cycle affect output and employment in durable goods industries more severely than in industries producing nondurables?
Answers to Key Questions appear in the text.
Ch. 7: pp. 140-2 1, 2, 3, 4, 5, 6, 7, 8, 9, 11, 12, 13
71 "National income statistics are a powerful tool of economic understanding and analysis." Explain this statement. "An economy's output is its income." Do you agree?
These statistics reveal what is happening in the economy as a whole from one period to the next. Simply to gather statistics that show GDP is now so many trillion dollars or that gross investment is so many billions is not useful. But to be able to compare these aggregates from one period to the next is useful. Such comparisons enable policymakers to adjust their policies. For instance, if the gatherers of the statistics report that investment is down by 10 percent and GDP by 1 percent from one threemonth period to the next, the government will have a very strong indication that a recession is at hand and that measures to boost the economy are called for.
The quotation is true. Everything that is produced is sold, even if the "selling" in the case of inventory, is to the producing firm itself. Since the same amount of money is paid out by the buyers of the economy's output as is received by the sellers as income (looking only at a private- sector economy at this point), "an economy's output is its income."
72 (Key Question) Why do national income accountants include only final goods in measuring total output? How do GNP and GDP differ? How do GDP and NDP differ?
Answers to Key Questions appear in the text.
73 What is the difference between gross private domestic investment and net private domestic investment? If you were to determine net domestic product through the expenditures approach, which of these two measures of investment spending would be appropriate? Explain.
Gross private domestic investment less depreciation is net private domestic investment. Depreciation is the value of all the physical capital --machines, equipment, buildings-- used up in producing the year's output.
Since net domestic product is gross domestic product less depreciation, in determining net domestic product through the expenditures approach it would be appropriate to use the investment measure that excludes depreciation, that is, net private domestic investment.
74 Why are changes in inventories included as part of investment spending? Suppose inventories declined by $1 billion during 1996. How would this affect the size of gross private domestic investment and gross domestic product in 1996? Explain.
Anything produced by business that has not been sold during the accounting period is something in which business has invested --even if the "investment" is involuntary, as often is the case with inventories. But all inventories in the hands of business are expected eventually to be used by business --for instance, a pile of bricks for extending a factory building-- or to be sold --for instance, a can of beans on the supermarket shelf. While in the hands of business both the bricks and the beans are equally assets to the business, something in which business has invested.
If inventories declined by $1 billion in 1996, $1 billion would be subtracted from both gross private domestic investment and gross domestic product. A decline in inventories indicates that goods produced in a previous year have been used up in this year's production. If $1 billion is not subtracted as stated, then $1 billion of goods produced in a previous year would be counted as having been produced in 1996, leading to an overstatement of 1996's production.
75 (Key Question) Use the concepts of gross and net investment to distinguish between an expanding, a static, and a declining economy. "In 1933 net private domestic investment was minus $6 billion. This means in that particular year the economy produced no capital goods at all." Do you agree? Explain: "Though net investment can be positive, negative, or zero, it is quite impossible for gross investment to be less than zero."
Answers to Key Questions appear in the text.
76 Define net exports. Explain how the United States[ exports and imports each affect domestic production. Suppose foreigners spend $7 billion on American exports in a given year and Americans spend $5 billion on imports from abroad in the same year. What is the amount of America[s net exports? Explain how net exports might be a negative amount.
Net exports are a country's exports of goods and services less its imports of goods and services. United States' exports are as much a part of the nation's production as are the expenditures of its own consumers on goods and services made in the United States. Therefore, United States' exports must be counted as part of GDP. On the other hand, imports, being produced in foreign countries, are part of those countries' GDPs. When Americans buy imports, these expenditures must be subtracted from the United States' GDP, for these expenditures are not made on United States' production.
If American exports are $7 billion and imports are $5 billion, then American net exports are +$2 billion. If the figures are reversed, so that Americans export $5 billion and import $7 billion, then net exports are $2 billion --a negative amount. For this to come about, Americans must either decrease their holdings of foreign currencies by $2 billion, or borrow $2 billion from foreigners --or do a bit of both. (Another option is to sell back to foreigners some of the previous American investments abroad.)
77 (Key Question) The following is a list of domestic output and national income figures for a given year. All figures are in billions. The ensuing questions ask you to determine the major national income measures by both the expenditure and income methods. Answers derived by each approach should be the same.
Personal consumption expenditures $245
Net American income earned abroad 4
Transfer payments 12
Rents 14
Consumption of fixed capital 27
(depreciation)
Social security contributions 20
Interest 13
Proprietors' income 33
Net exports 11
Dividends 16
Compensation of employees 223
Indirect business taxes 18
Undistributed corporate profits 21
Personal taxes 26
Corporate income taxes 19
Corporate profits 56
Government purchases 72
Net private domestic investment 33
Personal saving 20
(a) Using the above data, determine GDP and NDP by both the expenditure and income methods.
(b) Now determine NI (1) by making the required additions and subtractions from GDP, and (2) by adding up the types of income which comprise NI.
(c) Make those adjustments of NI required in deriving PI.
(d) Make the required adjustments from PI (as determined in 7c) to obtain DI.
Answers to Key Questions appear in the text.
78 Given the following national income accounting data, compute (a) GDP, (b) NDP, (c) NI. All figures are in billions.
Compensation of employees $194.2
U.S. exports of goods and services 17.8
Consumption of fixed capital 11.8
Government purchases of goods and services 59.4
Indirect business taxes 14.4
Net private domestic investment 52.1
Transfer payments 13.9
U.S. imports of goods and services 16.5
Personal taxes 40.5
Net foreign factor income earned in U.S. 2.2
Personal consumption expenditures 219.1
(a) Personal consumption expenditures (C) $219.1
Government purchases (G) 59.4
Gross private domestic investment (Ig ) 63.9
(52.1 + 11.8)
Net exports (Xn) (17.8 4 16.5) 1.3
Gross domestic product (GDP) $353.7
(b) Consumption of fixed capital 11.8
Net domestic product (NDP) $341.9
(c) Net foreign factor income earned in U.S. +2.2
Indirect business taxes 14.4
National income (NI) $329.7
79 Why do national income accountants compare the market value of the total outputs in various years rather than actual physical volumes of production? Explain. What problem is posed by any comparison over time of the market values of various total outputs? How is this problem resolved?
If it is impossible to add oranges and apples, as the saying goes, it is surely even more impossible to add oranges and, say, computers. If the production of oranges increases by 100 percent and that of computers by 10 percent, it does not make any sense to add the 100 percent to the 10 percent, then divide by 2 to get the average and say total production has increased by 55 percent.
Since oranges and computers have different values, the quantities of each commodity are multiplied by their values or prices. Adding together all the results of the price times quantity figures leads to the aggregate figure showing the total value of all the final goods and services produced in the economy. Thus, to return to oranges and computers, if the value of orange production increases by 100 percent from $100 million to $200 million while that of computers increases 10 percent from $2 billion to $2.2 billion, we can see that total production has increased from $2.1 billion (= $100 million + $2 billion) to $2.4 billion (= $200 million + $2.2 billion). This is an increase of 14.29 percent [= ($2.4 billion $2.1 billion)/$2.1 billion)]--and not the 55 percent incorrectly derived earlier.
However, comparing market values over time of various total outputs does have the disadvantage that prices change. If the market value in year 2 is 10 percent greater than in year 1, we cannot say the economy's production has increased 10 percent. It depends on what has been happening to prices; on whether the economy has been experiencing inflation or deflation.
To resolve this problem, statisticians deflate (in the case of inflation) or inflate (in the case of deflation) the value figures for the total output so that only "real" changes in production are recorded. To do this, each item is assigned a "weight" corresponding to its relative importance in the economy. Housing, for example, is given a high weight because of its importance in the average budget. A book of matches would be given a very low weight. Thus, the price of housing increasing by 5 percent has a much greater effect on the price index used to compare prices from one year to the next than would the price of a book of matches increasing by 100 percent.
In the United States, the base year for the current GDP price index is 1987; that is, the price level index is set at 100 for 1987. If, then, it is calculated that the average level of prices has increased by 3.8 percent by 1988, the nominal (priceunadjusted) GDP figure for 1988 will be divided by 1.038 to deflate the 1988 GDP so that it may be expressed in real terms, that is, in terms of the constant dollars of the base year, 1987.
711 (Key Question) The following table shows nominal GDP and an appropriate price index for a group of selected years. Compute real GDP. Indicate in each calculation whether you are inflating or deflating the nominal GDP data.
Normal Price level
GDP, index, Real
billions percent GDP
Year billions (1987 = 100) billions
1959 $494.2 25.6 $______
1964 648.0 27.7 $______
1967 814.3 30.3 $______
1973 1349.6 41.3 $______
1978 2232.7 60.3 $______
1988 4900.4 103.9 $______
Answers to Key Questions appear in the text.
712 Which of the following are actually included in deriving this year's GDP? Explain your answer in each case.
(a) Interest on an AT&T bond
(b) Social security payments received by a retired factory worker
(c) The services of a painter in painting the family home
(d) The income of a dentist
(e) The money received by Smith when he sells a 1983 Chevrolet to Jones
(f) The monthly allowance which a college student receives from home
(g) Rent received on a twobedroom apartment
(h) The money received by Mac when he resells this year's model Plymouth to Ed
(I) Interest received on government bonds
(j) A 2hour decline in the length of the workweek
(k) The purchase of an AT&T bond
(l) A $2 billion increase in business inventories
(m) The purchase of 100 shares of GM common stock
(n) The purchase of an insurance policy
(a) Included. Income received by the bondholder for the services derived by the corporation for the loan of money.
(b) Excluded. A transfer payment from taxpayers for which no service is rendered (in this year).
(c) Excluded. Not a market transaction. If any payment is made, it will be within the family.
(d) Included. Payment for a final service. You cannot pass on a tooth extraction!
(e) Excluded. Secondhand sales are not counted; the car was not produced in this year.
(f) Excluded. A private transfer payment; simply a transfer of income from one private individual to another for which no transaction in the market occurs.
(g) Included. Payment for the final service of housing.
(h) Excluded. The production of the car had already been counted at the time of the initial sale.
(i) Excluded. Treated in effect as a transfer payment, since much government spending yields no productive assets to the economy.
(j) Excluded. The effect of the decline will be counted, but the change in the workweek itself is not the production of a final good or service or a payment for work done.
(k) Excluded. A noninvestment transaction; it is merely the transfer of ownership of financial assets. (If AT&T uses the money from the sale of a new bond to carry out an investment in real physical assets, that will be counted.)
(l) Included. The increase in inventories could only occur as a result of increased production.
(m) Excluded. Merely the transfer of ownership of existing financial assets.
(n) Included. Insurance is a final service. If bought by a household, it will be shown as consumption; if bought by a business, as investment --as a cost added to its real investment in physical capital.
7-13 (Last Word) What is the CPI? How does it differ from the GDP deflator? What are the shortcomings of the CPI in accurately measuring inflation?
The CPI or Consumer Price Index measures changes in the prices of a "market basket" of some 300 goods and services purchased by typical urban consumers as determined by a survey of urban household spending patterns. It is the most widely reported measure of inflation.
It differs from the GDP deflator in two major respects. First, the CPI measures changes in prices of consumer goods and services as defined above, whereas the GDP deflator measures changes in prices of a more comprehensive group of goods and services --broader than only consumer goods and services, since the GDP includes all production. Second, the CPI is a "fixed-weight" price index. Once the weight of items in the market basket is determined for the base period, that weight remains the same. For example if 20 percent of consumer spending was for housing in the base period, then housing expenditures receive a 20 percent weight until a new base period is used (approximately every ten years). The GDP deflator is not a fixed-weight price index which, means that the weights assigned to various prices would change each period to reflect the changing composition of GDP. If auto production is a declining proportion of total production, then less weight would be assigned to auto prices when the deflator is calculated for the new year.
There are at least four problems in using the CPI to accurately measure inflation. First, spending patterns change over the years, so the base-period weights may no longer be an accurate reflection of consumer spending. Second, new products may become popular after the base period measure, or their prices may drop significantly, making them more available to consumers. This may mean that the initial weight assigned to products such as computers may be understated, and, therefore, as their prices drop, they are not given adequate representation in the CPI, causing inflation to be overstated. Third, higher prices may include quality improvements, but the CPI does not capture the improved quality, only the price change which overstates inflation for such items. Fourth, the CPI survey does not fully account for price discounts and special sales, which attract many consumer purchases. If regular prices, rather than sale prices, are measured, inflation is overstated to the extent that consumers buy sale items.
Ch. 8: pp. 164-5 2, 4, 5, 6, 7, 8, 9, 10, 11, 12
82 Why is it difficult to determine the fullemployment unemployment rate? Why is it difficult to distinguish between frictional, structural, and cyclical unemployment? Why is unemployment an economic problem? What are the consequences of the "GDP gap"? What are the noneconomic effects of unemployment?
The fullemployment unemployment rate or the natural rate of unemployment is achieved when there is no cyclical unemployment but only frictional and structural unemployment. Since it is not easy to distinguish between these three types and since the unavoidable minimum of frictional and structural unemployment is itself changing, it is difficult to determine the fullemployment unemployment rate. For example, a person who quits a job in search of a better one would normally be considered frictionally unemployed. But suppose the former job then disappears completely because the firm is in a declining industry and can no longer make money. Our stilljobless worker could now be considered structurally unemployed. And then suppose the economy slips into a severe recession so that our worker cannot find any job and has become cyclically unemployed. To complicate things further, the unavoidable minimums of frictional and structural unemployment have increased in the past thirty years as the labor force structure has changed. In other words, there is no automatic label on the type of unemployment when someone is counted as unemployed.
Unemployment is an economic problem because of the concept of opportunity cost. Quite apart from any idea of consideration for others, unemployment is a total economic waste: A unit of labor resource that could be engaged in production is sitting idle.
The "GDP gap" is the difference between what the economy could produce --its potential GDP--and what it is producing --its actual GDP. The consequence is that what is not produced --the amount represented by the gap --is lost forever. Moreover, to the extent that this lost production represents capital goods, the potential production for the future is impaired. Future economic growth will be less.
The noneconomic effects of unemployment include the sense of failure created in the parents and in their children, the feeling of being useless to society, of no longer belonging.
84 Given that there exists an unemployment compensation program which provides income for those out of work, why worry about unemployment?
The unemployment compensation program merely gives the unemployed enough funds for basic needs. Furthermore, many of the unemployed do not qualify for unemployment benefits. The programs apply only to those workers who were covered by the insurance, and this may be as few as one-third of those without jobs. Most of the unemployed get no sense of selfworth or accomplishment out of drawing this compensation. Moreover, from the economic point of view, unemployment is a total waste of resources; when the unemployed go back to work, nothing is forgone except undesired leisure. Finally, unemployment could be inflationary and costly to taxpayers: The unemployed are producing nothing --their supply is zero-- but the compensation helps keep demand in the economy high.
85 (Key Question) Use the following data to calculate (a) the size of the labor force and (b) the official unemployment rate. Total population, 500; population under 16 years of age and institutionalized, 120; not in labor force, 150; unemployed, 23; parttime workers looking for fulltime jobs, 10.
Answers to Key Questions appear in the text.
86 Explain how an increase in your nominal income and a decrease in your real income might occur simultaneously. Who loses from inflation? From unemployment? If you had to choose between (a) full employment with a 6 percent annual rate of inflation or (b) price stability with an 8 percent unemployment rate, which would you select? Why?
If my nominal income increases by 10 percent while the cost of living increases by 15 percent then my real income has decreased from 100 to 95.65 (= 110/1.15). Alternatively expressed, my real income has decreased by 4.35 percent (= 100 95.65). Generally, whenever the cost of living increases faster than my nominal income, my real income decreases.
The losers from inflation are those on incomes fixed in nominal terms or, at least, those with incomes that do not increase as fast as the rate of inflation. In the worst recession since the Great Depression, those who lost the most from unemployment were, in descending order, blacks (who also suffer the most in good times), teenagers, and bluecollar workers generally. In addition to the specific groups who lose the most, the economy as a whole loses in terms of the living standards of its members because of the lost production.
Choosing between (a) and (b) is truly a Hobson's choice! But if one must choose, it would probably be (b) because with inflation at zero, I know the central bank will have no cause to raise interest rates and cut off the economic expansion needed to get unemployment down from the unforgivable 8 percent. If I chose (a), I know we would not stay at full employment because the central bank would be raising interest rates to choke off demand to get inflation down from 6 percent. And we might soon have stagflation --increasing unemployment in the presence of high inflation.
87 (Key Question) If the price index was 110 last year and is 121 this year, what was this year's rate of inflation? What is the "rule of 70"? How long would it take for the price level to double if inflation persisted at (a) 2, (b) 5, and (c) 10 percent per year?
Answers to Key Questions appear in the text.
88 Carefully describe the relationship between total spending and the levels of output and employment. Explain the relationship between the price level and increases in total spending as the economy moves from substantial unemployment to moderate unemployment, to full employment, and, finally, to absolute capacity.
As total spending rises and falls so does output and employment. Cyclical unemployment is caused by a deficiency in total spending in the economy. If this deficiency begins to disappear --as total spending increases-- output increases and unemployment decreases.
With substantial unemployment, an increase in total spending can occur without any increase in the price level. After a while (range 2 in Figure 8-7), if total spending continues to increase and unemployment to decrease, the price level will start to rise, because some sectors will begin to experience full employment and a demand for resources rising faster than their supply in that sector. This price level increase will become more and more pronounced as full employment is approached. The economy may reach the formal definition of full employment and still be able to produce more by working overtime, for example. Finally, at absolute capacity, when, by definition, no more can be produced, any further increase in total spending will be entirely inflationary (range 3 in Figure 8-7).
89 Explain how "hyperinflation" might lead to a depression.
With inflation running into the double, triple, quadruple, or even greater number of digits per year, it makes little sense to save. The only sensible thing to do with money is to spend it before its value is cut in half within a month, a week, or a day. This very fact of everyone trying to spend as fast as possible will speed the inflationary spiral and cause people to spend more and more time trying to figure out what goods are most likely to go up fastest in price. More and more people will turn away from productive activity, because wages and salaries are not keeping up with inflation. Instead, they will spend their time speculating, transferring goods already in existence and producing nothing.
Eventually, money may become worthless. No one will work for money. Barter and living by one's wits become the only means of survival. Production falls for this reason and also because investment in productive capital practically ceases. Unemployment soars. A massive depression is at hand.
810 Evaluate as accurately as you can how each of the following individuals would be affected by unanticipated inflation of 10 percent per year:
(a) A pensioned railroad worker
(b) A departmentstore clerk
(c) A UAW assemblyline worker
(d) A heavily indebted farmer
(e) A retired business executive whose current income comes entirely from interest on government bonds
(f) The owner of an independent smalltown department store
(a) Assuming the pensioned railway worker has no other income and that the pension is not indexed against inflation, the retired worker's real income would decrease by approximately 10 percent of its former value.
(b) Assuming the clerk was unionized and the contract had over a year to run, the clerk's real income would decrease in the same manner as the pensioner. However, the clerk could expect to recoup at least part of the loss at contract renewal time. In the more likely event of the clerk not being unionized, the clerk's real income would decrease, possibly by as much as the pensioned railroad worker.
(c) Since the UAW worker is unionized, the loss in the first year would be the same as in (b) but we can be sure --barring a deep recession-- that the loss will be made up at contract renewal time plus the usual real increase that may or may not be related to increased productivity. If the contract had a cost-of-living allowance clause in it, the wage would automatically be raised at the end of the year to cover the loss in purchasing power. Next year's wage would rise by 10 percent.
(d) If the inflation is also in the price the farmer gets for his products, he could gain. But more likely the price increases are mostly in what he buys, since farm machinery, fertilizer, etc., tend to be sold by less competitive sellers with more power to raise their prices. The farmer faces a lot of competition and has to rely on the market price to go up --the farmer has little control over prices on an individual basis. Moreover, if interest rates on the farmer's new debts have gone up with the prices, the farmer could be even worse off. The other side of the coin is that if no new borrowing is necessary, the inflation will reduce the real burden of the farmer's debt, because the purchasing power declines on the fixed payments he contracted to make before inflation.
(e) The retired executive is in the same boat as the pensioned railroad worker, except that the executive's income from the bonds or other interest bearing assets is probably greater than that of the worker from the pension. The increase in inflation has most probably been accompanied by rising interest rates, with a proportional drop in the price of bonds. Therefore, the retired executive would suffer a capital loss if he or she decided to cash in some of the bonds at this time and the fixed interest received on these existing bonds is worth less in terms of purchasing power. In other words, the executive, although wealthier than the retired worker, may be affected just as much or more from inflation.
(f) Assuming the store owner's prices and revenues have been keeping pace with inflation, his or her real income will not change unless the costs have risen more than the product prices.
811 A noted television comedian once defined inflation as follows: "Inflation? That means your money today won't buy as much as it would have during the depression when you didn't have any." Is his definition accurate?
Yes (even if it may not be a very formal definition).
8-12 (Last Word) Suppose that stock prices fall by 10 percent in the stock market. All else being equal, are these lower stock prices likely to cause a decrease in real GDP? How might these lower prices forecast a decline in real GDP? Are stock prices always reliable predictors of recessions?
GDP could be reduced if stock owners feel significantly poorer and reduce their spending on goods and services, including investment in real capital goods. However, research indicates that downturns in the stockmarket have not had major impacts on GDP.
A fall in stock prices might signal a change in expectations. Evidence does suggest that there is a link between falling stock prices and future recessions. However, this is only one factor related to predicting recessions and, by itself, a fall in stock prices is not a reliable predictor of recession.
Ch. 19: pp. 395-7 1, 2, 5, 6, 8, 10, 13, 14
191 Why is economic growth important? Explain why the difference between a 2.5 percent and a 3.0 percent annual growth rate might be of great significance.
Economic growth means a higher standard of living, provided population does not grow even faster. And if it does, then economic growth is even more important, for the standard of living will be dropping until growth forges ahead.
Economic growth allows the lessening of poverty without an outright redistribution of wealth. In other words, out of the growing income generated by economic growth it is possible to channel a larger proportion to the less welloff, while still allowing the wealthy enough of an increase in income that they will not actively resist the redistribution.
If population is growing at 2.5 percent a year --and it is in some of the poorest nations-- then a 2.5 percent growth rate of real GDP means no change in living standards. A 3.0 percent growth rate means a gradual rise in living standards. For a wealthy nation, such as the United States, with a GDP in the neighborhood of $3 trillion, the 0.5 percentage point difference between 2.5 and 3.0 percent amounts to $15 billion a year, or approximately $150 per family.
192 (Key Question) What are the major causes of economic growth? "There are both a demand and a supply side to economic growth." Explain. Illustrate the operation of both sets of factors in terms of the production possibilities curve.
Answers to Key Questions appear in the text.
195 (Key Question) To what extent have increases in our real GDP been the result of more labor inputs? Of increasing labor productivity? Discuss the factors which contribute to productivity growth in order of their quantitative importance.
Answers to Key Questions appear in the text.
196 Using examples, explain how changes in the allocation of labor can affect labor productivity.
Three examples follow:
1. Many people moved out of low productivity employment on farms to higher productivity manufacturing jobs in towns and cities, especially in the earlier years of this century.
2. Discrimination against women and minorities lessened, so that they could move out of low productivity jobs in which they had been segregated.
3. The longrun movement toward freer trade, which removes protection from many industries, causes a shift of employment into jobs where the U.S. has a comparative advantage, thus using its labor force more efficiently and more productively. For example, workers may have lost jobs in T.V. production, but over time more workers are employed in pharmaceuticals and electronics, which are higher productivity jobs.
These three examples all deal with the movement out of low productivity jobs --by choice or force of circumstance-- to higher productivity jobs. Inevitably this movement increases the overall productivity of the nation.
198 (Key Question) Account for the recent slowdown in the United States' rate of productivity growth. What are the consequences of this slowdown? "Most of the factors which contributed to poor productivity growth in the 1970s are now behind us and are unlikely to recur in the near future." Do you agree?
Answers to Key Questions appear in the text.
1910 Comment on the following statements:
(a) "Technological advance is destined to play a more important role in economic growth in the future than it has in the past."
(b) "Nations headed by dictators on average have faster growth rates than democratic nations."
(c) "Many public capital goods are complementary to private capital goods."
(d) "Racial and gender discrimination are impediments to productivity growth."
(a) The statement is probably true. The population growth rate in the United States has decreased since the 1950s and so, therefore, has the rate of increase of the labor force. There will in the future be less contribution to economic growth from increases in the quantity of labor. The improvement in education and training has slackened, and it is questionable whether it will pick up again. Economies of scale are not a likely source of future economic growth. Indeed, downsizing in the future is more probable than the reverse. The great boost to economic growth that came from improved resource allocation as most of the farm population moved to city jobs may not be repeated. This leaves only technological advance and the quantity of capital. These two will have to increase together for economic growth to continue. Finally, the increasing importance of the service and information sectors include industries whose productivity will be enhanced greatly by technological improvement.
(b) This is a statement that may have been more true in the past than it is in the present. In a manufacturing age, a strong central authority could focus production on output goals and, particularly, on investment at the expense of consumption. Under a dictator, capital investment and education could be a priority in developing countries which would lead to a rapid rate of economic growth. Manufacturing industries would benefit from a top-down management style where assembly-line production did not require thoughtful input from workers. A dictatorship does not, however, contribute much to the growth of a more developed economy in a post-industrial age where worker input is important and where economic growth cannot be achieved simply by commanding resources to be allocated to one industry to another. In today's economy, productivity depends as much or more on the quality of resources as on the quantity; independent innovative teamwork is often required, and this kind of information production does not flourish in a dictatorship.
(c) Public capital goods are not only complementary, but necessary, to private capital goods. For private investment to be profitable, an excellent infrastructure is required for information dissemination, communications, and transportation. Public investment in environmental protection, education, water and sewer systems will also contribute to the return on private capital. Without this public investment, private investment will be less profitable and will tend to be directed to those countries or regions where public capital is a priority.
(d) The definition of racial and gender discrimination confirms this statement. Discrimination in the workplace occurs when less qualified individuals are given jobs instead of others who are rejected based on their gender or race, even though they have superior qualifications for the job. When this is the case, productivity is sacrificed in favor of the employer's desire to discriminate and the economy sacrifices productivity growth.
19-13 Suppose you are the chair of the Council of Economic Advisers and have been asked to prepare a set of proposals for increasing the productivity of American workers as a way to raise our rate of economic growth. What would you put on your list? What impediments would you envision in accomplishing your policies?
Looking at the three listed categories of growth policies, one might propose the following:
(1) Lowering interest rates to promote high levels of investment spending which, in turn, increases capital accumulation, which makes workers more productive
(2) Lowering tax rates on saving and business investment to encourage investment, which would achieve the desired result as mentioned in (1) while at the same time raising taxes on consumption
(3) Promoting high-productivity industries by subsidies, increasing government spending on basic research in high-technology areas, and increasing expenditures on basic education and apprenticeship skill training.
Impediments to accomplishing these policies would be both political and economic. On the economic side, using monetary policy to lower interest rates can have the unintended effect of increasing consumption and inflation, which could offset the positive incentives toward investment from lower interest rates. Any tax cuts or increased government spending programs could worsen an already serious deficit situation unless the government were willing to cut spending or raise taxes in other areas. To the extent that any increase in government investment crowds out private investment, there is another problem.
On the political front, the proposed tax cuts and some of the spending subsidies could be labeled "pro-business' which is often an unpopular label politically. Likewise, an increase in consumption taxes would undoubtedly be difficult to pass. Finally, given the current budget deficit, any of these programs could be very unpopular unless the government should reform the way it "keeps its books' and develops a separate capital budget for capital spending programs, including those on education and training.
19-14 (Last Word) Do you think economic growth is desirable? Explain your position on this issue.
Using the Last Word as a guide, either a "yes" or "no" answer is acceptable here. On the antigrowth side, there are the arguments that growth results in pollution, global warming, ozone depletion, and other environmental problems. Poverty and discrimination continue to be problems despite impressive growth records in the U.S. Growth produces more goods but a decline in the quality of life for many in terms of worker burnout, alienated employees, and insecurity as new technology creates job displacement. High stress can impair physical and mental health.
On the pro-growth side, the primary argument is that living standards improve and lifestyles are better for the vast majority. Growth enables a society to improve the nation's infrastructure which enhances the ability to care for all, including the less fortunate. And ironically, growth may make environmental protection more possible rather than less. Workers are better off in growing economies with improved working conditions, more leisure, and more time for self-fulfillment.
Ch. 22: pp. 471-2 1, 2, 3, 4, 5, 6, 7, 9, 11, 15
391 What are the characteristics of an LDC? List the avenues of economic development available to such a nation. State and explain the obstacles which face LDCs in breaking the poverty barrier. Use the "vicious circle of poverty" to outline in detail steps an LDC might take to initiate economic development.
Less developed countries have relatively small industrial sectors, a significant portion of resources employed in agriculture, and exports consisting primarily of unprocessed agricultural goods and raw materials. Illiteracy rates and rates of unemployment and population growth are often high, and there is usually a critical shortage of capital equipment, leading to the use of laborintensive production methods and low productivity levels.
In order to achieve high rates of economic growth, LDCs, like IACs, must allocate existing resources more efficiently; invest in improving the productivity of labor and expanding the base of capital; and adopt new types of production methods.
The LDCs face a complex assortment of obstacles in attaining economic prosperity. The operation of the socalled vicious circle of poverty means that the potential for economic growth is often severely hampered by the problems associated with current poverty. In particular, low levels of savings and investment restrict capital accumulation, limiting growth in labor productivity and in real incomes.
Low real income levels, coupled with the large family sizes associated with rapid population growth, cause saving rates to be low in most LDCs. The lack of domestic saving is often exacerbated by the foreign flight of financial capital, as citizens seek to shield their savings from the uncertainty created by unstable political and economic circumstances within these countries.
Rapid population growth requires high rates of capital formation to maintain current per capita supplies, but even when savings are found to fund private capital accumulation, more will likely be needed to supplement the inadequate public infrastructure. Private investment is further hampered by a shortage of entrepreneurs willing to take on associated risks. The perceived benefits of capital formation are often limited by political and economic volatility, low domestic demand for nonagricultural goods, the difficulties producers face competing in foreign markets, shortages of skilled labor (worsened by the brain drain of trained workers to the IACs), and deficiencies in the existing public infrastructure.
Because of these obstacles, per capita supplies of real capital do not increase rapidly. Combined with low rates of investment in human capital and the exhaustion of natural resources often associated with rapid population growth, this leads to low productivity levels. The relative abundance of labor also causes high unemployment rates in urban areas and underemployment in rural areas.
While productivity levels can be increased through the adoption of new types of technology, new methods usually require large amounts of capital and skilled labor, which most LDCs do not possess. Furthermore, inhabitants of LDCs are often not receptive to new production techniques, especially in rural areas. Traditional attitudes extend far beyond the sphere of production. On a more general level, growth in many LDCs is hampered by a series of sociocultural and institutional obstacles whose significance should not be underestimated. The costs of political and economic instability have already been mentioned. Religious beliefs, while offering spiritual comforts to the impoverished, often contribute to rapid population growth and social stratification; beliefs that foster the socalled "capricious universe" doctrine may also detract from accumulative behavior. The lack of institutional and national development can cause widespread corruption and graft, the imposition of inefficient and inequitable tax systems, and the possibility of destructive civil discord. Quasifeudal systems of land ownership provide even further economic disincentives for the mass of rural populations.
Given this lengthy catalogue of impediments to development, it seems impossible that any LDC could ever overcome them! Yet success stories do exist. The historical development of the IACs and the recent experiences of the newly industrialized countries in the Pacific Rim represent the most celebrated examples. The circle of poverty was broken in both cases through significant rates of savings that were used for rapid capital accumulation. Coupled with moderate rates of population growth, this capital accumulation led to increases in both labor productivity and output; eventually, these countries reached a point at which the development process became selfsustaining through the high saving rates associated with large incomes.
392 Explain how the absolute per capita income gap between rich and poor nations might increase, even though per capita GDP is growing faster in LDCs than it is in IACs.
Because base incomes are so much higher in IACs than in LDCs, slower growth as a proportion of GDP in these countries can still translate into higher absolute gains in per capita living standards, causing the absolute per capita income gap between IACs and LDCs to increase rather than decline. For example, 1 percent of $10,000 per capita is more than 3 percent of $2,000 per capita.
39-3 (Key Question) Assume an LDC and an IAC currently have real per capita outputs of $500 and $5000 respectively. If both nations realize a 3 percent increase in their real per capita outputs, by how much will the per capita output gap change?
Answers to Key Questions appear in the text.
394 Discuss and evaluate:
(a) "The path to economic development has been clearly blazed by American capitalism. It is only for the LDCs to follow this trail."
(b) "Economic inequality is conducive to saving, and saving is the prerequisite of investment. Therefore, greater inequality in the income distribution of the LDCs would be a spur to capital accumulation and growth."
(c) "The IACs fear the complications from oversaving; the LDCs bear the yoke of undersaving."
(d) ""The core of development involves changing human beings more than it does altering a nation's physical environment."
(e) "America's 'foreign aid' program is a sham. In reality it represents neocolonialism --a means by which the LDCs can be nominally free in a political sense but remain totally subservient in an economic sense."
(f) "Poverty and freedom cannot persist side by side; one must triumph over the other."
(g) "The biggest obstacle facing poor nations in their quest for economic development is the lack of capital goods."
(h) "A high per capita GDP does not necessarily identify an industrially advanced nation."
(a) The first statement is false. The modern process of economic development was pioneered by Great Britain during the Industrial Revolution in the latter half of the eighteenth century. At this time the North American colonies --later the United States and Canada-- engaged in trade with Britain much like that between modern LDCs and IACs, exporting primarily raw materials in return for imported manufactured goods. It was only in the nineteenth century that the United States, along with other nascent IACs, underwent a process of industrialization similar to that of Great Britain.
The second statement is also false. Countries that have successfully undergone rapid industrialization in recent years have not all followed the model of decentralized development provided by the history of American capitalism. Citing the most obvious example, postwar Japan underwent a highly successful process of economic development in which government planning and coordination played a central role.
(b) Increases in inequality will raise domestic saving only if the foreign flight of financial capital can be stemmed. Forced government saving can be just as effective in stimulating capital investment, as long as problems associated with public sector decision making can be overcome. Increasing inequality also has effects on general incentives to work and engage in risktaking. While some inequality of income can stimulate economic activity, excessive concentrations of wealth can also hinder the development process, worsening the cycle of poverty for a large portion of the country's population.
While theory provides some arguments concerning the desirability of income inequality in stimulating development, much empirical evidence conflicts with this view. For example, newly industrialized countries, such as Taiwan, South Korea, Singapore, and Hong Kong all exhibit low levels of income inequality in comparison to most other LDCs.
(c) Because of the higher incomes in IACs, average propensities to save are also relatively high. While these high rates of saving are essential in supporting rapid capital accumulation, they represent a leakage of potential spending from the incomeexpenditures stream and dampen output and employment in the short run. Low incomes in the LDCs, on the other hand, mean that average propensities to save are relatively low, limiting the potential for capital accumulation and productivity growth. The problems IACs face because of high saving rates are shortterm and subject to amelioration; the problem of undersaving for LDCs is a crucial longterm restriction on the potential for economic growth.
(d) Changes in prevailing social, cultural, and institutional patterns in LDCs are probably the most significant prerequisite of economic development. Countries have managed in the past to initiate development in the face of tremendous shortages of physical resources --for example, many economies ravaged by the Second World War-- but accomplishing this feat in the absence of amenable socio-cultural and institutional circumstances is a virtual impossibility.
(e) There is no doubt that bilateral foreign aid, such as that provided by the United States, is often made for selfserving as well as altruistic reasons. The Food for Peace program can be viewed as a component of domestic agricultural policy, and other types of "tied" aid benefit American producers. While these forms of aid can sometimes have overtones of neocolonialism, it is hard to imagine that these aspects represent the overriding purpose of American foreign aid. If LDCs are economically dependent on IACs, this is more often the result of existing trade patterns, external debt, and foreign corporate ownership.
(f) This statement reflects a popular and potentially insidious view that political freedoms can be guaranteed only after the process of development has been completed. If it is correct, then the inhabitants of LDCs face a double burden --economic deprivation and the certainty of political repression. But if freedom is defined in terms of basic civil liberties, then thankfully it is not universally valid. While repressive measures are an all too common feature in many LDCs, some lowincome countries have managed to maintain political freedoms. Examples of LDCs in which citizens have enjoyed basic civil liberties --if not always fullfledged democratic rights-- include India, Jamaica and other Caribbean countries, Tanzania, and Botswana. Wellinformed students will be able to add other countries to this list.
(g) While shortages of physical capital are a serious problem in LDCs, the mere augmentation of existing stocks of capital is not sufficient to guarantee development. Sociocultural and institution impediments to productivity growth, especially the lack of entrepreneurs willing to utilize this physical capital, can nullify the benefits of capital accumulation.
(h) Some oilexporting countries such as Saudi Arabia and Kuwait have achieved high real standards of living without experiencing widescale industrialization. Governments in these countries realize that unless they diversify their economies, living standards will fall once existing oil deposits are depleted. These nations are making concerted efforts to industrialize in order to escape this fate.
395 Explain how population growth might be an impediment to economic growth. How would you define the optimal population of a country?
High rates of population growth mean that increases in per capita GDP --the most important measure of improving living standards-- are much lower than the growth of GDP itself. Higher rates of investment are needed to increase per capita supplies of physical capital, and the fact that there is a large proportion of dependent young people in the population makes it more difficult to set aside savings for capital accumulation. In many countries with large populations, continued population growth leads to the overuse of existing natural resources, including land, thus reducing living standards, especially in rural areas. The resulting migration to urban centers, when coupled with rapid internal growth in cities, leads to urban overcrowding and all its attendant problems.
There are many possible answers to this question, depending on one's general outlook. If the achievement of high living standards is the main goal of a country, then its optimal population occurs where the average product of labor reaches its highest point. Members of a religiously minded society, however, might view human life as being so sacrosanct that they see a country's optimal population as being the largest that its resources can support --in other words, where the average product of labor has been driven down to a subsistence level. Other answers are also possible.
39-6 (Key Question) Contrast the "demographic transition" view of population with the traditional view that slower population growth is a prerequisite for rising living standards in the LDCs.
Answers to Key Questions appear in the text.
397 Much of the initial investment in an LDC must be devoted to infrastructure which does not directly or immediately lead to a greater production of goods and services. What bearing might this have on the degree of inflation which results as government finances capital accumulation through the creating and spending of new money?
If an LDC government finances the expansion of public infrastructure through the printing of money, the increase in the spending will largely translate into inflation rather than increases in real income. If the country has already reached its potential level of output, real income will not change in the short run and the additional spending will only lead to higher prices. The fact that scarce resources are being devoted to investment in infrastructure means less will be available for other purposes. In other words, most if not all of the investment is being financed by imposing an inflationary tax on the rest of the economy.
399 "The nature of the problems faced by the LDCs creates a bias in favor of governmentally directed as opposed to a decentralized development process." Do you agree? Why or why not?
Many LDCs face a severe shortage of private savings and entrepreneurs as well as weak incentives to make private investments. Therefore, governments often find it necessary to intervene directly in the capital accumulation process rather than depend on private initiatives. The usual method of achieving this goal is by channeling tax revenues into public investments. However, this process can often be impeded by ineffective tax systems and difficulties in choosing efficient investment projects. A less orthodox method, with severe longterm costs, is the creation of inflation, which represents an involuntary tax on the country's citizens. While the social circumstances in many LDCs seem to require significant government economic intervention, this intervention is by no means assured of success.
3911 What types of products do the LDCs export? Use the law of comparative advantage to explain the character of these exports.
LDCs export primarily raw materials and agricultural goods to IACs in return for imported manufactured goods and services. This pattern of trade follows from the law of comparative advantage. As far as the extraction of nonrenewable resources is concerned, past depletion of deposits in the IACs has meant that LDCs are often the lowestcost producers of these goods. As for renewable resources such as agricultural products, the production of these goods is usually labor intensive. The large pools of lowwage labor in LDCs give them a comparative advantage in many of these products.
It is important to note that the law of comparative advantage does not necessarily consign LDCs to be "hewers of wood and drawers of water" forever. The production of many manufactured goods is also fairly laborintensive, giving LDCs an opportunity to become lowcost producers and hence exporters of these products. Many have already begun to develop thriving manufacturing sectors based on this cost advantage, and if trade barriers in IACs continue to be lowered this trend will be intensified.
39-15 (Last Word) Explain how civil wars, population growth, and public policy decisions have contributed to periodic famines in Africa.
Civil conflicts divert resources from civilian uses, destroy institutions, and complicate the distribution of famine and developmental aid. They also discourage investment in the productive sector due to the uncertain political and economic base. Population in Africa is growing more rapidly than food production, and this grim arithmetic suggests declining living standards and per capita food supplies. Population growth also contributes to ecological degradation, which depresses the ability to produce food still further. Finally, public policy decisions have exacerbated the problem. The average African government spends four times as much on armaments as it does on agriculture. Governments frequently control food prices at low levels, which discourages production and encourages wasteful consumption. Dependence on foreign aid complicates the problem still further by providing temporary relief from food shortages and discouraging local self-sufficiency. Finally, the sub-Saharan African nations are burdened by large-scale external debt, forcing them to cut back on domestic spending programs and further worsening their economic conditions.