Unit III Answers to Extra Practice Questions CHAPTER 9 1. Define the consumption and saving schedules. The consumption schedule shows the relationship between the consumption and disposable income. Graphically this relationship is illustrated with consumption measured on the vertical axis and disposable income measured on the horizontal axis. If the two were equal, the relationship would follow a straight line along the 45-degree line. However, historical data suggest that it is a direct relationship, and that households spend a larger proportion of a small income than of a large disposable income. In other words, consumption falls as a proportion of income as disposable income increases. Since saving is the difference between disposable income and consumption spending, the saving schedule also shows a direct relationship between saving and disposable income. Graphically, it is depicted with saving on the vertical axis and disposable income measured on the horizontal axis. At very low income levels, dissaving is believed to occur and saving increases proportionally as income rises. [text: E pp. 152-153; MA pp. 152-153] 2. Explain how consumption and saving are related to disposable income in the aggregate expenditures model. Consumption and saving are directly related to disposable income in the aggregate expenditures model. Consumption is positively related to disposable income, but is a proportionally greater part of low income than of high income. In fact, at very low income levels it is probable that consumption exceeds income. Since saving is income not spent, it is also directly related to income and will be an increasing proportion of income as income rises. At very low levels of income when consumption exceeds income, saving will be negative or dissaving occurs. [text: E pp. 152-153; MA pp. 152-153]
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Unit III Answers to Extra Practice Questions
CHAPTER 9
1. Define the consumption and saving schedules.
The consumption schedule shows the relationship between the consumption and disposable income. Graphically this relationship is illustrated with consumption measured on the vertical axis and disposable income measured on the horizontal axis. If the two were equal, the relationship would follow a straight line along the 45-degree line. However, historical data suggest that it is a direct relationship, and that households spend a larger proportion of a small income than of a large disposable income. In other words, consumption falls as a proportion of income as disposable income increases.
Since saving is the difference between disposable income and consumption spending, the saving schedule also shows a direct relationship between saving and disposable income. Graphically, it is depicted with saving on the vertical axis and disposable income measured on the horizontal axis. At very low income levels, dissaving is believed to occur and saving increases proportionally as income rises. [text: E pp. 152-153; MA pp. 152-153]
2. Explain how consumption and saving are related to disposable income in the
aggregate expenditures model.
Consumption and saving are directly related to disposable income in the aggregate expenditures model. Consumption is positively related to disposable income, but is a proportionally greater part of low income than of high income. In fact, at very low income levels it is probable that consumption exceeds income.
Since saving is income not spent, it is also directly related to income and will be an increasing proportion of income as income rises. At very low levels of income when consumption exceeds income, saving will be negative or dissaving occurs. [text: E pp. 152-153; MA pp. 152-153]
3. Complete the following table assuming that (a) MPS = 1/5, (b) there is no government and all saving is personal saving.
Level of output
and income Consumption Saving
$250 $260 $___
275 ____ ___
300 ____ ___
325 ____ ___
350 ____ ___
375 ____ ___
400 ____ ___
Level of output
and income Consumption Saving
$250 $260 $�10
275 280 �5
300 300 0
325 320 5
350 340 10
375 360 15
400 380 20
[text: E pp. 152-156; MA pp. 152-156]
4. Complete the following table assuming that (a) MPS = 1/3, (b) there is no government and all saving is personal saving.
Level of output
and income Consumption Saving
$100 $120 $___
130 ____ ___
160 ____ ___
190 ____ ___
220 ____ ___
250 ____ ___
Level of output
and income Consumption Saving
$100 $120 $�20
130 140 �10
160 160 0
190 180 10
220 200 20
250 220 30
[text: E pp. 152-156; MA pp. 152-156]
5. Differentiate between the average propensity to consume and the marginal propensity to consume.
The average propensity to consume is defined as the relationship between the amount consumed relative to the level of income; it is (consumption) / (income). The marginal propensity to consume is a measure relating the change in consumption resulting from a change in income to that change in income; it is (change in consumption) / (change in income). [text: E pp. 154-157; MA pp. 154-157]
6. What are the marginal propensity to consume (MPC) and marginal propensity to save (MPS)? How are the two concepts related? How are the two concepts related to the consumption and saving functions?
The marginal propensity to consume is the ratio of a change in consumption to the change in income which caused that change in consumption. The marginal propensity to save is the ratio of the change in saving to the change in income which caused that change in saving. The sum of the MPC and MPS for any change in disposable income must always equal 1 because any fraction of a change in income which is not consumed is saved. The MPC is the numerical value of the slope of the consumption schedule and the MPS is the numerical value of the slope of the saving schedule. [text: E pp. 156-157; MA pp. 156-157]
7. Suppose a family�s annual disposable income is $8,000 of which it saves $2,000.
(a) What is their APC?
(b) If income rises to $10,000 and they plan to save $2,800, what are MPS and MPC?
(c) Did the family�s APC rise or fall with their increase in income?
(a) APC = .75.
(b) MPS = .4; MPC = .6.
(c) APC fell to .72. [text: E pp. 153-157; MA pp. 153-157]
8. Complete the accompanying table.
Level of output
and income
(GDP = DI) Consumption Saving APC APS MPC MPS
$480 $___ $�8 ____ ____ ___ ___
520 ___ 0 ____ ____ ___ ___
560 ___ 8 ____ ____ ___ ___
600 ___ 16 ____ ____ ___ ___
640 ___ 24 ____ ____ ___ ___
680 ___ 32 ____ ____ ___ ___
720 ___ 40 ____ ____ ___ ___
760 ___ 48 ____ ____ ___ ___
800 ___ 56 ____ ____ ___ ___
(a) Using the below graphs, show the consumption and saving schedules graphically.
(b) Locate the break-even level of income. How is it possible for households to dissave at very low income levels?
(c) If the proportion of total income consumed decreases and the proportion saved increases as income rises, explain both verbally and graphically how the MPC and MPS can be constant at various levels of income.
Level of output
and income
(GDP = DI) Consumption Saving APC APS MPC MPS
$480 $488 $�8 1.02 �0.2 0.8 0.2
520 520 0 1.00 0.0 0.8 0.2
560 552 8 0.99 0.1 0.8 0.2
600 584 16 0.99 0.3 0.8 0.2
640 616 24 0.96 0.4 0.8 0.2
680 648 32 0.95 0.5 0.8 0.2
720 680 40 0.94 0.6 0.8 0.2
760 712 48 0.94 0.6 0.8 0.2
800 744 56 0.93 0.7 0.8 0.2
(a) See graphs below.
(b) The break-even level of income is 520 where saving equals zero. Households dissave by borrowing or by dipping into accumulated savings. [text: E pp. 153-155; MA pp. 153-155]
(c) The MPC and MPS represent the slopes of the consumption and savings schedules respectively. The fact that MPC and MPS are constant means that the schedules will be straight-line graphs. However, the slope can be constant and still not be a constant proportion of income as represented on the
horizontal axis. In fact, the only time the MPC and the APC would be the same would be along lines emanating from the origin.
[text: E pp. 154-155; MA pp. 154-155]
9. Complete the accompanying table.
Level of output
and income
(GDP = DI) Consumption Saving APC APS MPC MPS
$100 $___ $�5 ____ ____ ___ ___
125 ___ 0 ____ ____ ___ ___
150 ___ 5 ____ ____ ___ ___
175 ___ 10 ____ ____ ___ ___
200 ___ 15 ____ ____ ___ ___
225 ___ 20 ____ ____ ___ ___
250 ___ 25 ____ ____ ___ ___
275 ___ 30 ____ ____ ___ ___
300 ___ 35 ____ ____ ___ ___
(a) What is the break-even level of income? How is it possible for households to dissave at very low income levels?
(b) If the proportion of total income consumed decreases and the proportion saved increases as income rises, explain how the MPC and MPS can be constant at various levels of income.
Level of output
and income
(GDP = DI) Consumption Saving APC APS MPC MPS
$100 $105 $�5 1.05 �.05 0.8 0.2
125 125 0 1.00 .00 0.8 0.2
150 145 5 0.97 .03 0.8 0.2
175 165 10 0.94 .06 0.8 0.2
200 185 15 0.925 .075 0.8 0.2
225 205 20 0.91 .09 0.8 0.2
250 225 25 0.90 .10 0.8 0.2
275 245 30 0.89 .11 0.8 0.2
300 265 35 0.88 .12 0.8 0.2
(a) The break-even level of income is 125 where saving equals zero. Households dissave by borrowing or by dipping into accumulated savings. [text: E pp. 152-155; MA: pp. 153-155]
(b) The MPC and MPS represent the slopes of the consumption and savings schedules, respectively. The fact that MPC and MPS are constant means that the schedules will be straight-line graphs. However, the slope can be constant and still not be a constant proportion of income as represented on the horizontal axis. In fact, the only time the MPC and the APC would be the same would be along the 45-degree line where the slope is equal to 1 and the ratio of spending to income is equal to 1 at all levels.
[text: E pp. 153-155; MA pp. 153-155]
10. List five factors that could shift the consumption schedule.
Shifts in the consumption schedule could be caused by any of the nonincome determinants of consumption and saving. This includes changes in any of the following: wealth, expectations, real interest rates, household debt, and taxation. [text: E pp. 156-157; MA pp. 156-157]
11. What is the effect of increase in wealth on the consumption and saving schedules?
When wealth increases, it shifts the consumption schedule upward as people consume more at each level of disposable income. There is an opposite effect on saving. The saving schedule shifts downward at each level of disposable income because people save less. [text: E pp. 156-157; MA pp. 156-157]
New 12. (Consider This) What is a reverse wealth effect? Why did it not have much of an effect on the U.S. economy during the stock market bubble in the 2000�2002 period?
A reverse wealth effect occurs when there is a significant drop in consumer wealth that will shift the
consumption schedule downward. Even though there was a significant loss of consumer wealth in the U.S. stock market decline of 2000�2002, there was little or no reverse wealth effect�consumption spending stayed relatively stable. The reason for this outcome was that there were offsetting factors that keep consumption spending high even as the stock of wealth declined. Consumer spending was little affected by the decline in the stock of wealth. These offsetting factors included the flow of income, which remained high, tax cuts that boosted consumer spending, and lower interest rates. [text: E p. 159; MA p. 159]
13. Other things being constant, what will be the effect of each of the following on disposable income (or GDP)?
(a) An increase in the amount of liquid assets consumers are holding
(b) A sharp rise in stock prices
(c) A rapid upsurge in the rate of technological advance
(d) A sharp increase in the real interest rate
(a) This should increase disposable income because an increase in consumer wealth would lead to an increase in consumer spending which would shift the consumption schedule upward to a higher equilibrium output level.
(b) The probable effect of a sharp rise in stock prices would be to increase shareholder purchases as a result of a rise in wealth, thus shifting the consumption schedule upward and increasing the equilibrium level of GDP. It also could encourage business investment with funds gained by issuing new shares of stock at the now higher prices. This would also tend to increase GDP.
(c) This should increase GDP because of the impact on new investment spending and possible increased consumer purchases of goods having the new technology. The consumption schedule will shift upward and real quantity will rise.
(d) A sharp increase in the real interest rate would limit consumer durables purchases and also limit investment spending. Both of these events would cause a downward shift in the consumption schedule causing a decrease in GDP. One could even argue that higher real interest rates raise production costs and shift the aggregate supply curve leftward as well, further leading to the GDP decline. [text: E pp. 156-158; MA pp. 156-158]
14. Explain the difference between a movement along the consumption schedule and a shift in the consumption schedule.
A movement from one point to another on the consumption schedule is a change in the amount consumed. It is caused solely by a change in disposable income. By contrast, a shift in the consumption schedule is the result of a change in one of the nonincome determinates of consumption such as a change in wealth, expectations, taxation, or household debt. If a household decided to consume more at each level of disposable income, the consumption schedule will shift upward. [text: E pp. 157-158; MA pp. 157-158]
15. Use the graphs below to answer the following questions:
(a) What types of schedules do graphs A and B represent?
(b) If in graph A line A2 shifts to A3 because households consume more and this change is not due to changing taxes, then in graph B, what would happen to line B2?
(c) If in graph B, line B2 shifts to B1 because households save less, then in graph A, what will happen to line A2?
(d) In graph A, what has caused the movement from point A to point B on line A2?
(e) If there is a lump-sum tax increase causing line A2 to shift to A1, then in
graph B, what will happen to B2?
(a) Graph A represents the consumption schedule and B represents the saving schedule.
(b) If consumption rises at each level of income, then saving must decline at each level so B2 will shift down.
(c) The situation is the reverse of part (b). Line A2 would rise if B2 falls. Consumption rises when saving falls.
(d) Since it is a movement along the curve rather than a shift in the curve, the level of disposable income must have increased.
(e) A tax increase will lower both consumption and saving schedules because disposable income has been reduced at each level of output. [text: E pp. 157-158; MA pp. 157-158]
16. Describe the relationship shown by the investment demand curve.
The investment demand curve relates investment to the real rate of interest and the expected rate of return. Graphically the interest rate and expected rate of return are measured on the vertical axis and the amount of investment is measured on the horizontal axis. The investment demand curve has a negative slope reflecting the inverse relationship between the interest rate (the price of investing) and the aggregate quantity of investment goods demanded. [text: E pp. 159-161; MA pp. 159-161]
17. Use the following data to answer the questions.
Cumulative amount
Expected rate of investment
of return (billions)
11% $55
10 75
8 90
5 105
3 150
1 190
(a) Explain why this table is essentially an investment demand schedule.
(b) If the interest rate was 8%, how much investment would be undertaken?
(c) Why is there an inverse relationship between the rate of interest and the amount of investment?
(a) The investment demand schedule gives the amount of investment that would be undertaken at various rates of interest. The rate of interest that an investor would be willing to pay for any amount of investment will not exceed its expected rate of net profit. Therefore, the expected rate of profit determines the interest rate (or price) that investors would be willing to pay for various amounts of investment and this is the definition of an investment demand schedule.
(b) $90 billion
(c) The inverse relationship stems from the equality of the expected rate of profit with the interest rate at each level of investment as explained in part (a). There are fewer types of investment that yield a large expected net profit and more and more investments that will yield a lower rate of return. Therefore, at high rates of interest there is a smaller amount of investment that will be undertaken because fewer investments yield an expected return high enough to cover the high interest rate. As the rate declines, more and more investments will yield enough return to cover the lower rates of interest.
[text: E pp. 159-161; MA pp. 159-161]
18. What is the investment-demand curve?
The investment-demand curve shows the relationship between the real interest rate and the level of investment spending. The relationship is an inverse one�the lower the interest rate, the greater the investment spending�which means that the investment-demand curve is downsloping. This curve can also be shifted by five factors that can change the expected rate of return on investment. [text: E pp. 159-161; MA pp. 159-161]
19. List five events that could cause a shift in the investment demand curve.
Five events would result from changes in the determinants of investment demand. For example, changes in the price, cost of operation, or maintenance of particular investment goods could cause the curve to shift; changes in business taxes favoring or penalizing investment could cause it to shift; a technological change favoring new investment could cause a shift; changes in the stock of capital goods on hand will cause the existing demand curve to shift; and changing expectations about future profits from investment would have an effect. [text: E pp. 161-162; MA pp. 161-162]
20. State four factors that explain why investment spending tends to be unstable.
Investment spending is based to a large extent on expectations about future profitability and this can vary significantly from period to period. Technological changes affect investment spending and these changes are not predictable in their timing. Investment goods tend to be long lasting and �lumpy� in nature; that is, once a capital good is purchased it lasts a long time and the expenditure will not be repeated on a frequent, regular basis. Furthermore, this type of expenditure is usually large, so any changes tend to be substantial on a firm-by-firm basis. Expectations and profits are both highly variable. Actual profits may not meet expectations and this can affect expectations in the future. Expectations are also based on many different external factors. [text: E pp. 162-164; MA pp. 162-164]
21. Compare the determinants of consumption with investment. Most economists regard investment as being less stable than consumption. Looking at the determinants of each factor, support this contention.
The nonincome determinants of the consumption schedule are consumer wealth, expectations, real interest rates, household debt, and taxation. The determinants of investment are price of investment goods and their maintenance and operating costs, business taxes, technological change, stock of capital goods on hand, and expectations. Comparing the two lists there are some similarities. For example, both include expectations, related price levels, and relevant taxes. However, the technological change and the stock of capital goods on hand have no analogy in the consumption determinants.
These latter two determinants of investment support the contention of economists that the investment schedule is more unstable than the consumption schedule. Technological change is difficult to predict and certainly its impact would vary depending on the extent of the change. The stock of capital goods on hand is a result of previous investment and because of the nature of most capital goods, they can be made to last for a long period of time. Once new capital spending occurs, it is �lumpy� in the sense that it will not be repeated gradually, but only again when the particular capital good wears out or becomes obsolete. Only the durable goods component of consumption is similar, but most of consumer spending is of the more immediate type such as nondurable goods and services which are primarily related to income and would not vary greatly from period to period for most consumers.
The basic determinant of consumption is the level of income, but nonincome factors include wealth, expectations, real interest rates, household debt, and taxation. Aside from a drastic change in government tax or transfer policies, the consumption schedule is quite stable. That is, changes in disposable income are accompanied by predictable changes in consumption spending. Furthermore the other factors are quite diverse and tend to be self-canceling across the population.
The two basic factors determining the level of investment spending are the expected rate of return and the real interest rate. Since the former is based on
expectations and the latter based to a large extent on monetary policy, there is potential for wide variation. Add to this the fact that investment goods are usually quite durable, and new investment can be postponed depending on expectations, or once it is made there will be a period of time before the new capital goods will need to be replaced. Also the fact that innovations occur irregularly leads to the inability to plan for gradual investment in innovative technology. Finally, actual current profits are often not as expected, so businesses can be expected to shift their investment plans from year to year. [text: E pp. 156-164; MA pp. 156-164]
New22. Whenever there is change in spending real GDP will change by a multiple of the initial change in spending. Explain this multiplier effect.
The economy is characterized by repetitive, continuous flows of expenditures and income through which dollars spent by one group are received as income by another group. Any change in spending will cause a chain reaction where a group whose income changes because of the spending change will in turn have a new level of spending which reflects their new level of income. When their spending increases or decreases, another group will find its income affected. Their spending will change by a fraction of that amount and so on. The end result of the initial change in spending will be several rounds of changes in income and spending so that the final impact on the economy�s GDP is a multiple of the original change in spending. [text: E pp. 164-165; MA pp. 164-165]
New23. Define the multiplier. How is it related to real GDP and the initial change in
spending? How can the multiplier have a negative effect?
The multiplier is simply the ratio of the change in real GDP to the initial change in spending. Multiplying the initial change in spending by the multiplier gives you the amount of change in real GDP. The multiplier effect can work in a positive or a negative direction. An initial increase in spending will result in a larger increase in real GDP, and an initial decrease in spending will result in a larger decrease in real GDP. [text: E p. 164; MA p. 164]
New 24. What are two key facts that serve as the rationale for the multiplier effect? First, the economy has continuous flows of expenditures and income in which income received by one
person comes from money spent by another person who in turn receives income from the spending of
another person, and so forth. Second, any change in income will cause both consumption and saving to vary in the same direction as the initial change in income, and by a fraction of that change. The fraction of the change in income that is spent is called the marginal propensity to consume (MPC). The fraction of the change in income that is saved is called the marginal propensity to save (MPS). The significance of the multiplier is that a small change in investment plans or consumption-saving plans can trigger a much larger change in the equilibrium level of GDP. [text: E pp. 164-165; MA pp. 164-165]
New25. Explain the economic impact of an increase in the multiplier.
The multiplier magnifies the fluctuations in economic activity initiated by changes in investment spending, net exports, government spending, or consumption spending. The larger the multiplier the greater will be the impact of any changes in spending on real GDP. [text: E pp. 164-166; MA pp. 164-166]
New26. What is the relationship between the multiplier and the marginal propensities?
The multiplier is directly related to the marginal propensities. By definition, the multiplier is related to the marginal propensity to save because it equals 1/MPS. Thus, the multiplier and the MPS are inversely related. The multiplier is also related to the marginal propensity to consume because it also equals 1/ (1�MPC). [text: E p. 166; MA p. 166]
New 27. Describe the relationship between the size of the MPC and the multiplier. How does it compare to the relationship between the size of the MPS and the multiplier?
The size of the MPC and the multiplier are directly related. The size of the MPS and the multiplier are
inversely related. In equation form, the multiplier = 1 / MPS, or the multiplier = 1/ (1�MPC). [text: E p. 166; MA p. 166]
New 28. Calculate the multiplier when the MPC is .5, .75, .90. What is the relationship between MPC and the
multiplier? When MPC = .5, the multiplier is 2. When MPC = .75, the multiplier is 4. When MPC = .90, the
multiplier is 10. The relationship between MPC and the multiplier is direct. As the MPC increases, so does the multiplier [multiplier = 1/ MPC]. [text: E p. 166; MA p. 166]
New 29. Calculate the multiplier when the MPS is .5, .25, .10. What is the relationship between MPS and the
multiplier? When MPS = .5, the multiplier is 2. When MPS = .25, the multiplier is 4. When MPS = .10, the
multiplier is 10. The relationship between MPS and the multiplier is inverse. As the MPS decreases, so the multiplier increases [multiplier = 1/ (1-MPS)]. [text: E p. 166; MA p. 166]
New30. How large is the actual multiplier?
The basic multiplier (1/MPS) in the text reflects only the leakage of income into saving. There can also be other leakages of income from taxes or imports. It is better to think of the denominator for the multiplier in more general terms as �the fraction of the change in income which leaks or is diverted from the income stream.� When all these leakages�saving, taxes, and import spending�are added to the denominator of the multiplier, they reduce the size of the multiplier effect. [text: E pp. 166-167; MA pp. 166-167]
New 31. (Last Word) Describe the events �Squaring the Economic Circle� and explain how they illustrate the multiplier.
Humorist Art Buchwald illustrates the multiplier with this funny essay that shows how the effect of one
economic event on one party has an effect on a second party. These effects on the second party, in turn, have an effect on a third party, and so forth, creating a ripple throughout the economy. These related and multiple effects serve to illustrate the multiplier.
Hofberger, a Chevy salesman in Tomcat, VA, called up Littleton of Littleton Menswear & Haberdashery,
and told him that a new Nova had been set aside for Littleton and his wife. Littleton said he was sorry, but he couldn�t buy a car because he and Mrs. Littleton were getting a divorce. Soon afterward, Bedcheck the painter called Hofberger to ask when to begin painting the Hofbergers� home. Hofberger said he couldn�t, because Littleton was getting a divorce, not buying a new car, and, therefore, Hofberger could not afford to paint his house. When Bedcheck went home that evening, he told his wife to return their new television set to Gladstone�s TV store. When she returned it the next day, Gladstone immediately called his travel agent and canceled his trip. He said he couldn�t go because Bedcheck returned the TV set because Hofberger didn�t sell a car to Littleton because Littletons are divorcing. Sandstorm, the travel agent, tore up Gladstone�s plane tickets, and immediately called his banker, Gripsholm, to tell him that he couldn�t pay back his loan that month. When Rudemaker came to the bank to borrow money for a new kitchen for his restaurant, the banker told him that he had no money to lend because Sandstorm had not repaid his loan yet. Rudemaker called his contractor, Eagleton, who had to lay off eight men. General Motors announced it would give a rebate on its new models. Hofberger called Littleton to tell him that he could probably afford a car even with the divorce. Littleton said that he and his wife had made up and were not divorcing. His business, however, was so lousy that he couldn�t afford a car now. His regular customers, Bedcheck, Gladstone, Sandstorm, Gripsholm, Rudemaker, and Eagleton had not been in for over a month. [text: E p. 167; MA p. 167]
CHAPTER 10
New 1. What are the simplifications used in this chapter? The chapter first assumes that there is a �closed� private economy with no international trade. The chapter
then turns to an economy with international trade, or an �open� private economy. Finally, government is included in the final sections of the chapter. When government is included, then the economy will be a mixed economy with both public and private sectors and also an open economy. [text: E p. 172; MA p. 172]
New 2. What is the difference between the investment-demand curve and the investment schedule for the economy?
The investment-demand curve shows the relationship between the real interest rate and the level of investment spending. The relationship is an inverse one�the lower the interest rate, the greater the investment spending�which means that the investment-demand curve is downsloping. This curve can also be shifted by five factors that can change the expected rate of return on investment.
The investment decisions of individual firms can be aggregated to construct an investment schedule. It shows the amount business firms collectively intend to invest at each possible level of GDP. A simplifying assumption is also made that investment is independent of GDP, so the investment schedule is graphed as a horizontal line across the possible levels of real GDP. [text: E pp. 172-173; MA pp. 172-173]
New 3. Define the equilibrium level of output.
The equilibrium level of output is the level of output whose production will create total income and spending which is just sufficient to purchase that output. [text: E pp. 173-174; MA pp. 172-173]
New 4. Whenever there is change in spending, there will be a change in real GDP. Explain why this is so.
A shift in the investment schedule and/or the consumption schedule indicates that aggregate expenditures have changed. Therefore, the new aggregate expenditures level will not be equal to the original level of aggregate output. Real GDP must expand or contract until aggregate expenditures and aggregate output are once again equal at a new equilibrium. [text: Figure 10.2 E pp. 173-176; MA pp. 173-176]
New 5. Explain the difference between an equilibrium level of GDP and a level of GDP which is in disequilibrium.
If GDP is not in equilibrium, then aggregate expenditures will exceed real GDP or vice versa. If aggregate expenditures exceed real GDP, then businesses will find their inventories reduced below the planned level of inventories. Businesses will therefore expand production to replenish inventories and the economy will not be in equilibrium until the level of planned inventories is met.
On the other hand, if real GDP exceeds aggregate expenditures, then business inventories will be above the level planned. In order to bring inventories down to their planned level, production and output will be reduced until the real GDP is equal to planned aggregate expenditures. [text: E pp. 174-175; MA pp. 174-175]
New 6. In a graph relating private spending (C + Ig) to real gross domestic product (GDP), what does the 45-degree line represent?
The 45-degree line traces out the points where the economy is in equilibrium. That is, it shows where real GDP is equal to private spending. [text: E pp. 175-176; MA pp. 175-176]
New 7. Use the graph below to explain the determination of equilibrium GDP by the aggregate expenditures-domestic output approach. At equilibrium C + Ig = Real GDP ($550 + $50 = $600). Why does the intersection of the aggregate
expenditures schedule and the 45-degree line determine the equilibrium GDP?
Equilibrium occurs where C + Ig = GDP. There is a direct relationship between aggregate expenditures and the level of GDP, but they are equal only where the AE schedule intersects the 45-degree line which shows equality of expenditures and GDP. Where aggregate expenditures exceed GDP, the AE line is above the 45-degree line and output will continue to expand. If aggregate expenditures fall below GDP as would occur at levels above 600, then GDP will contract until the expenditures-output equality is restored.
The 45-degree line in the aggregate expenditures model represents all of the points where aggregate expenditures are equal to real GDP; all of the possible equilibrium levels. [text: E pp. 175-176; MA pp. 175-176]
New 8. Explain why saving equals planned investment at equilibrium GDP.
It is based on the fact that saving is income not consumed. Saving therefore represents a �leakage� or diversion of potential spending from the income-expenditures stream. Consumption falls short of total output by the amount of saving. However, investment spending can be viewed as an �injection� into this income-expenditures stream. If planned investment is equal to the amount of saving at a particular level of GDP, then leakages equal injections and GDP will be in equilibrium. [text: E pp. 176-177; MA pp. 176-177]
New 9. What differentiates the planned equilibrium level of investment from disequilibrium levels of investment? Explain.
Planned investment differs from unplanned investment by the changes in inventories. If inventories exceed the planned level, then producers will want to reduce output. If inventories are less than the planned level, then producers will want to expand output. Only when inventories are at the planned level will there be an equilibrium level of GDP. [text: E pp. 176-177; MA pp. 176-177]
New10. Explain the difference between planned and actual investment in the economy. Why is the distinction important?
Actual investment consists of both planned investment and changes in inventories. Unplanned changes in inventories act as a balancing item which equates the actual amounts saved and invested in any period. At above equilibrium levels of GDP, saving is greater than planned investment, and there will be an unplanned increase in inventories. At below equilibrium levels of GDP, planned investment is greater than saving, and there will be an unplanned decrease in inventories. Equilibrium is achieved when planned investment equals saving, and there are no unplanned changes in inventories. [text: E pp. 176-177; MA pp. 176-177]
New11. What is the relationship between actual investment, planned investment, and saving in an economy? What conditions among these concepts produce equilibrium?
Actual investment consists of both planned and unplanned changes in inventories. It equals saving by definition. Unplanned changes in inventories, however, are the item that helps equate actual investment with saving. Thus, planned investment and saving will only be equal when there are no unplanned changes in inventories. Equilibrium occurs in the economy only when planned investment equals saving. [text: E pp. 176-177; MA pp. 176-177]
12. What is the effect of net exports, either positive or negative, on equilibrium GDP? Positive net exports increase aggregate expenditures beyond what they would be in a closed economy and
thus have an expansionary effect. The multiplier effect also is at work. Positive net exports will lead to a positive change that is greater than the amount of the initial change. Negative net exports decrease aggregate expenditures beyond what they would be in a closed economy and thus have a contractionary effect. The multiplier effect also is at work here. Negative net exports lead to a negative change in equilibrium GDP that is greater than the initial change. [text: E pp. 179-180; MA pp. 179-180]
13. Explain why exports are added to, and imports are subtracted from, aggregate
expenditures in moving from a closed to an open economy.
Exports must be added to aggregate expenditures because they represent sales of current output which would not have been counted elsewhere in summing up total expenditures. Imports must be subtracted from aggregate expenditures because they would be included in any summing of expenditures on final goods and services, but they do not represent goods or services produced here. Thus, to have an accurate estimate of domestic production,
their value must be subtracted from the total expenditures. [text: E pp. 179-180; MA pp. 179-180]
14. Evaluate the statement that �for an open economy the equilibrium GDP always corresponds with an equality of exports and imports.�
This statement would be true only by coincidence, if ever. Equilibrium GDP (in the absence of government) exists when aggregate demand equals aggregate supply (GDP). Aggregate private demand consists of three components: C, Ig, and net exports. There is no reason why net exports must equal zero. The only requirement is that the sum of the three components, C, Ig, and (X � M ) sum to the same value as aggregate supply. At that point GDP will be in equilibrium. C or Ig or X or M or any or all of these can adjust in a situation where disequilibrium exists, but equilibrium doesn�t necessitate net exports of zero. [text: E pp. 179-180; MA pp. 179-180]
15. When international trade is considered, explain how net exports could be either positive or negative additions to aggregate demand. In which case would the impact of net exports be expansionary? Explain.
When exports exceed imports, net exports are a positive addition to aggregate expenditures. When imports exceed exports, net exports are a negative addition to aggregate expenditures because more money is being spent on products from other countries than foreigners are spending on products made in the United States. Rather than adding to aggregate expenditures this latter situation is a leakage from total expenditures. In the case where net exports are positive and growing, their impact would be expansionary. [text: E pp. 179-180; MA pp. 186-188]
16. How does the fact that imports vary directly with GDP affect the stability of the domestic economy?
Actually this fact should help stabilize the domestic economy. During inflationary periods of rapid growth, rising imports should dampen that growth in domestic aggregate demand. During recessionary periods, the decline in
imports should help to offset falling domestic demand as net exports should rise. In other words, a smaller M makes the (X � M ) balance grow. [text: E pp. 179-180; MA pp. 179-180]
17. The data in the first two columns below are for a closed economy. Use this table to answer the following questions.
Real GDP Aggregate Net Aggregate
= DI expenditures Exports Imports exports expenditures
(billions) (billions) (billions) (billions) (billions) (billions)
$100 $120 $10 $15 $___ $___
125 140 10 15 ___ ___
150 160 10 15 ___ ___
175 180 10 15 ___ ___
200 200 10 15 ___ ___
225 220 10 15 ___ ___
250 240 10 15 ___ ___
275 260 10 15 ___ ___
(a) What is the equilibrium GDP for the closed economy?
(b) Including the international trade figures for exports and imports, calculate net exports and determine the equilibrium GDP for an open economy.
(c) What will happen to equilibrium GDP if exports were $5 billion larger at each level of GDP?
(d) What will happen to equilibrium GDP if exports remained at $10 billion, but imports dropped to $5 billion?
(e) What is the size of the multiplier in this economy?
Real GDP Aggregate Net Aggregate
= DI expenditures Exports Imports exports expenditures
(billions) (billions) (billions) (billions) (billions) (billions)
$100 $120 $10 $15 $�5 $115
125 140 10 15 �5 135
150 160 10 15 �5 155
175 180 10 15 �5 175
200 200 10 15 �5 195
225 220 10 15 �5 215
250 240 10 15 �5 235
275 260 10 15 �5 255
(a) For a closed economy, equilibrium GDP = $200 billion.
(b) For an open economy, equilibrium GDP = $175 billion.
(c) Equilibrium GDP would return to $200 billion.
(d) Equilibrium GDP would rise to $225 billion.
(e) When aggregate expenditures change by 5, equilibrium GDP changes by 25 so the multiplier must be 5. [text: E pp. 179-180; MA pp. 179-180]
18. The data in the first two columns below are for a closed economy. Use this table to answer the following questions.
Real GDP Aggregate Net Aggregate
= DI expenditures Exports Imports exports expenditures
(billions) (billions) (billions) (billions) (billions) (billions)
$ 80 $100 $15 $5 $___ $___
120 130 15 5 ___ ___
160 160 15 5 ___ ___
200 190 15 5 ___ ___
240 220 15 5 ___ ___
280 250 15 5 ___ ___
320 280 15 5 ___ ___
360 310 15 5 ___ ___
(a) What is the equilibrium GDP for the closed economy?
(b) Including the international trade figures for exports and imports, calculate net exports and determine the equilibrium GDP for an open economy.
(c) What will happen to equilibrium GDP if exports were $10 billion larger at each level of GDP?
(d) What will happen to equilibrium GDP if exports remained at $15 billion, but imports rose to $15 billion?
(e) What is the size of the multiplier in this economy?
Real GDP Aggregate Net Aggregate
= DI expenditures Exports Imports exports expenditures
(billions) (billions) (billions) (billions) (billions) (billions)
$ 80 $100 $15 $5 $10 $110
120 130 15 5 10 140
160 160 15 5 10 170
200 190 15 5 10 200
240 220 15 5 10 230
280 250 15 5 10 260
320 280 15 5 10 290
360 310 15 5 10 320
(a) For a closed economy, equilibrium GDP = $160 billion.
(b) For an open economy, equilibrium GDP = $200 billion.
(c) Equilibrium GDP would rise to $240 billion.
(d) Equilibrium GDP would fall to $160 billion.
(e) When aggregate expenditures change by 10, equilibrium GDP changes by 40 so the multiplier must be 8. [text: E pp. 179-180; MA pp. 179-180]
19. Explain the relationship between net exports and the following factors: prosperity abroad, tariffs on American exports abroad, depreciation of the American dollar on foreign exchange markets.
Prosperity abroad improves net exports because it means foreigners will buy more U.S. exports.
Tariffs on American exports abroad will initially decrease net exports as it makes American products more expensive to foreigners. (If the U.S. later retaliates with tariffs of its own, the effect is less certain.)
Depreciation of the American dollar should lead to improved net exports as foreigners will find the purchasing power of their money rising relative to goods priced in American dollars. Conversely, Americans will find foreign goods more expensive in terms of the dollars they need to exchange for foreign currency to buy foreign goods, so exports rise and imports fall. [text: E p. 181; MA p. 181]
20. Describe the probable impact of an increase in government spending assuming no change in taxes or private spending and less than full-employment output.
Assuming no change in taxes or private spending, the probable effect of an increase in government spending will be expansionary. Furthermore, the government spending increase will be multiplied in terms of its impact on equilibrium GDP. The simple multiplier in this case should equal the reciprocal of the marginal propensity to save. [text: E p. 182; MA p. 182]
21. Identify the relationship between GDP, taxes, and disposable income.
Disposable income consists partly of income earned by resources used in producing the GDP minus the total taxes levied on productive incomes at the various production stages. Depreciation allowances and corporate retained earnings are also deducted from GDP and transfer payments are added to arrive at the figure for disposable income. [text: E pp. 182-185; MA pp. 182-185]
22. �If taxes and government spending are increased by the same amount, there will still be a positive effect on equilibrium GDP.� Explain.
The initial impact of government spending is to increase aggregate demand directly by the amount of the increase in spending. Beyond that, spending is increased in successive rounds of increased incomes that result by a fraction equal to the marginal propensity to consume. This MPC-induced spending which results from the increased government purchases will be exactly offset by the tax increase whose initial impact is to reduce disposable income rather than aggregate demand directly. Thus, government spending has an initial direct effect equal to the amount of the increase in G which will not be offset. [text: E pp. 182-185; MA pp. 182-185]
23. Compare and contrast the recessionary gap and the inflationary gap.
A recessionary gap is the amount by which aggregate expenditures fall short of the noninflationary full-employment level of GDP. Real GDP will be below full-employment real GDP by a multiple amount of the recessionary gap. An inflationary gap, on the other hand, is the amount by which aggregate expenditures exceeds the noninflationary full-employment level of GDP. This
gap will cause demand-pull inflation as nominal GDP rises to meet the higher level of aggregate expenditures, but real GDP is already at its full-employment level. [text: E pp. 185-187; MA pp. 185-187]
24. If there is a recessionary gap of $100 billion and the MPC is 0.80, by how much must taxes be reduced to eliminate the recessionary gap?
If the MPC is 0.80, then the MPS is 0.20 and the multiplier is equal to 5. Thus to reduce a gap of $100 billion, taxes must be reduced by $25 billion, which is equivalent to saying that disposable income rises by $25 billion. An increase in income of $25 billion will cause an initial change in spending of $20 billion (or 0.8 × $25) and this multiplied by 5 will result in an increase in GDP of $100 billion which is the amount of the recessionary gap. [text: E pp. 185-187; MA pp. 185-187]
25. Assume the level of investment is $8 billion and independent of the level of total output. Complete the following table and determine the equilibrium level of output and income which the private sector of this closed economy would provide:
Possible employment Real GDP = DI Consumption Saving
levels (millions) (billions) (billions) (billions)
80 $120 $122 $___
90 130 130 ___
100 140 138 ___
110 150 146 ___
120 160 154 ___
130 170 162 ___
140 180 170 ___
150 190 178 ___
160 200 186 ___
(a) If this economy has a labor force of 140 million, will there be a recessionary or inflationary gap? Explain the consequences of this gap.
(b) If the labor force is 110 million, will there be an inflationary or recessionary gap? Explain the consequences of this gap.
(c) What are the sizes of the MPC, MPS, and multiplier in this economy?
(d) Using the multiplier concept, give the increase in equilibrium GDP that would occur if the level of investment increased from $8 billion to $10 billion.
Possible employment Real GDP = DI Consumption Saving
levels (millions) (billions) (billions) (billions)
80 $120 $122 $−2
90 130 130 0
100 140 138 2
110 150 146 4
120 160 154 6
130 170 162 8
140 180 170 10
150 190 178 12
160 200 186 14
(a) At the 140-million employment level, aggregate expenditures will be $178 billion and output will be $180 billion. Therefore, there exists a recessionary gap of $2 billion. Producers plan output to match anticipated aggregate expenditures. If expenditures fall below this level of $180 billion, then producer inventories will be greater than planned and they will reduce output until the actual inventories equal planned inventories for that level of output.
(b) At the 110-million employment level, aggregate expenditures will be $154 billion and output will be $150 billion. An inflationary gap exists because aggregate expenditures exceeds full-employment output and producers will attempt to expand output thinking full employment has not been reached. Expansion takes place because the level of planned output was set to match anticipated spending. Since aggregate spending exceeded this level of $150 billion, producer inventories will be lower than planned and they will increase output to replenish these inventories.
(c) Consumption changes by $8 billion for every $10 billion change in DI. Therefore, the MPC is 8/10 or 0.8. MPS = 0.2. Multiplier will be 1/.2 = 5.
(d) If investment spending rises by $2 billion, then equilibrium GDP should rise by 5 x $2 billion or $10 billion. [text: E pp. 185-187; MA pp. 185-187]
26. Assume the level of investment is $8 billion and independent of the level of total output. Complete the following table and determine the equilibrium level of output and income which the private sector of this closed economy would provide:
Possible employment Real GDP = DI Consumption Saving
levels (millions) (billions) (billions) (billions)
50 $ 80 $ 83 $___
60 90 90 ___
70 100 97 ___
80 110 104 ___
90 120 111 ___
100 130 118 ___
110 140 125 ___
120 150 132 ___
130 160 139 ___
(a) If this economy has a labor force of 110 million, will there be a recessionary or inflationary gap? Explain the consequences of this gap.
(b) If the labor force is 80 million, will there be an inflationary or recessionary gap? Explain the consequences of this gap.
(c) What are the sizes of the MPC, MPS, and multiplier in this economy?
(d) Using the multiplier concept, give the increase in equilibrium GDP that would occur if the level of investment increased from $8 billion to $10 billion.
Possible employment Real GDP = DI Consumption Saving
levels (millions) (billions) (billions) (billions)
50 $ 80 $ 83 $−3
60 90 90 0
70 100 97 3
80 110 104 6
90 120 111 9
100 130 118 12
110 140 125 15
120 150 132 18
130 160 139 21
(a) At the 110-million employment level, aggregate expenditures will be $132 billion and full-employment output will be $140 billion. Therefore, there exists a recessionary gap of $7 billion. Producers plan output to match anticipated aggregate expenditures. If expenditures fall below this level of $140 billion, then producer inventories will be greater than planned and they will reduce output until the actual inventories equal planned inventories for that level of output.
(b) At the 80-million employment level, aggregate expenditures will be $112 billion and full-employment output will be $110 billion. An inflationary gap exists because aggregate expenditures exceeds full-employment output and producers will attempt to expand output thinking full employment has not been reached. Expansion takes place because the level of planned output was set to match anticipated spending. Since aggregate spending exceeded this level
of $110 billion, producer inventories will be lower than planned and they will increase output to replenish these inventories.
(c) Consumption changes by $7 billion for every $10 billion change in DI. Therefore, the MPC is 7/10 or 0.7. MPS = 0.3, multiplier will be 1/.3 = 3 1/3.
(d) If investment spending rises by $2 billion, then equilibrium GDP should rise by 3 1/3 x $2 billion or $6 2/3 billion. [text: E pp. 185-187; MA pp. 185-187]
27. Refer to the following table to answer the questions. (1) (2) (3) Possible levels Real domestic Aggregate Expenditures, of employment, output, (Ca + Ig + Xn + G) millions billions billions 45 $250 $260 50 275 280 55 300 300 60 325 320 65 350 340 (a) If full employment in this economy is 65 million, will there be an inflationary or recessionary gap?
What will be the consequence of this gap? By how much would aggregate expenditures in column 3 have to change at each level of GDP to eliminate the inflationary or recessionary gap? Explain.
(b) Will there be an inflationary or recessionary gap if the full-employment level of output is $250 billion? Explain the consequences. By how much would aggregate expenditures in column 3 have to change at each level of GDP to eliminate the inflationary or recessionary gap? Explain.
(c) Assuming that investment, net exports, and government expenditures do not change with changes in real GDP, what are the sizes of the MPC, the MPS, and the multiplier?
(a) A recessionary gap. Equilibrium GDP is $300 billion, while full employment GDP is $350 billion.
Employment will be 10 million less than at full employment. Aggregate expenditures would have to increase by $10 billion (= $350 billion � $340 billion) at each level of GDP to eliminate the recessionary gap.
(b) An inflationary gap. Aggregate expenditures will be excessive, causing demand-pull inflation. Aggregate expenditures would have to fall by $10 billion (= $260 billion � $250 billion) at each level of GDP to eliminate the inflationary gap.
(c) MPC = .8 (= $20 billion/$25 billion); MPS = .2 (= 1 �.8); multiplier = 5 (= 1/.2). [text: E pp. 185-187; MA pp. 185-187]
28. Use the table below to answer the following questions:
Real GDP C
$500 $495
510 504
520 513
530 522
540 531
550 540
560 549
(a) What is the size of the multiplier in this economy?
(b) If taxes were zero, government purchases were $5, investment is $3, and net exports are zero, what is the equilibrium GDP?
(c) If taxes are $10, government purchases are $10, investment is $6, and net exports are zero, what is the equilibrium GDP?
(d) Assume investment is $50, taxes are $50, and net exports and government purchases are each zero. The full-employment level of GDP is $545. How much of a reduction in taxes is needed to eliminate the recessionary gap?
(e) Assume that investment, net exports, and taxes are zero. Government purchases are $30 and the full-employment GDP without inflation is $530. By how much must government spending be reduced to eliminate the inflationary gap?
(a) To find the MPC compare the change in C with the change in GDP to get 9/10 or 0.9; this means the MPS is 0.1 and the multiplier will be 1/.1 or 10.
(b) Find the point where aggregate expenditures equals GDP. Aggregate expenditures will include C plus investment and government purchases which together equal $8. Adding $8 to C at every level gives an equilibrium GDP of $530 (= 522 + 8).
(c) If taxes are $10, GDP is reduced by $10 at every level to result in disposable income. Since the MPC is 0.9, we can calculate C at every level by reducing each level of C by $9 (.9 x $10). This will result in aggregate expenditures of $520 (504 + 10 + 6) and an equilibrium GDP of $520.
(d) If taxes are $50 and the MPC is 0.9, C will be reduced at every level by $45. Currently, the equilibrium GDP will be $500 (495 � 45 + 50 = AE). To increase it by $45 will require an increase in consumer spending of $45. To achieve an increase in consumer spending of $45 requires an increase in disposable income of $50. Therefore, taxes must be reduced from $50 to zero.
(e) In this case the equilibrium nominal GDP will be $560. To reduce it to $530, aggregate expenditures must be reduced by $30, hence government purchases must be reduced by $30. [text: E pp. 174-187; MA pp. 174-187]
29. Use the table below to answer the following questions:
Real GDP C
$300 $290
310 298
320 306
330 314
340 322
350 330
360 338
(a) What is the size of the multiplier in this economy?
(b) If taxes were zero, government purchases were $10, investment $6, and net exports are zero, what is the equilibrium GDP?
(c) If taxes are $5, government purchases are $10, investment is $6, and net exports are zero, what is the equilibrium GDP?
(d) Assume investment is $50, taxes are $50, net exports and government purchases are each zero. The full-employment level of GDP is $340. How much of a reduction in taxes is needed to eliminate the recessionary gap?
(e) Assume that investment, net exports, and taxes are zero. Government purchases are $30 and the full-employment GDP without inflation is $330. By how much must government spending be reduced to eliminate the inflationary gap?
(a) To find the MPC compare the change in C with the change in GDP to get 8/10 or 0.8; this means the MPS is 0.2 and the multiplier will be 1/.2 or 5.
(b) Find the point where aggregate expenditures equals GDP. Aggregate expenditures will include C plus investment and government purchases which together equal $16. Adding $16 to C at every level gives an equilibrium GDP of 330 (= 314 + 16).
(c) If taxes are $5, GDP is reduced by $5 at every level to result in disposable income. Since the MPC is 0.8, we can calculate C at every level by reducing
each level of C by $4 (.8 x $5). This will result in aggregate expenditures of $310 (294 + 10 + 6) and an equilibrium GDP of $310.
(d) If taxes are $50 and the MPC is 0.8, C will be reduced at every level by $40. Currently the equilibrium GDP will be $300 (290 � 40 + 50 = AE). To increase it by $40 will require an increase in consumer spending of $40. To achieve an increase in consumer spending of $40 requires an increase in disposable income of $50. Therefore, taxes must be reduced from $50 to zero.
(e) In this case the equilibrium nominal GDP will be $360. To reduce it to $330, aggregate expenditures must be reduced by $30, hence government purchases must be reduced by $30. [text: E pp. 174-187; MA pp. 174-187]
30. Discuss an historical application of a recessionary gap and an historical application of an inflationary gap in the United States.
The recession of 2001 is an example of a recessionary gap. Throughout the mid- to late 19990s there was strong economic growth in the economy. This growth ended with the bursting of the stock market bubble in 2000, an increase in the number of new Internet firms that went bankrupt, and with increasing levels of household debt. In March 2001 the economy moved into recession. The unemployment rate rose. Aggregate expenditures were insufficient to achieve full-employment GDP.
The U.S. inflation of the late 1980s is an example of an inflationary gap. Aggregate spending was greater than the full-employment output. The price level rose from 1.9 percent in 1986 to 4.8 percent in 1989. The recession of 1990 and 1991 help close the inflationary gap. [text: E pp. 186-187; MA pp. 186-187]
31. What are four shortcomings of the aggregate expenditures model?
First, although the model can account for demand-pull inflation, it does not indicate how much the price level will rise when aggregate expenditures are greater than the productive capacity of the economy. Second, the aggregate expenditure model does not explain why demand-pull inflation can occur before the economy reaches its full-employment level of output. Third, the
aggregate expenditures model does not explain why the economy can expand beyond its full-employment level of output. Fourth, the aggregate expenditures model does not account for cost-push inflation. [text: E pp. 187-188; MA pp. 187-188]
32. (Advanced analysis) Suppose that the linear equation for consumption in a hypothetical economy is C = 50 + 0.9 Y. Also suppose that income (Y ) is $400. Determine the following: (a) MPC; (b) MPS; (c) level of consumption; (d) APC; (e) APS.
MPC = 0.9; MPS = 0.1; At Y = 400, C = $410; At Y = $400, APC = 410/400 = 1.025; and APS = (�.025). [text: E pp. 177-178; MA pp. 177-178]
33. (Advanced analysis) Assume the following output-income and saving data for the private sector of the economy.
Real GDP (Y) Consumption (C)
$240 $244
260 260
280 276
300 292
320 308
340 324
360 340
380 356
400 372
(a) Describe the consumption schedule in equation form.
(b) Assuming net investment is $5 billion and independent of the level of GDP, what will be the equilibrium level of GDP?
(c) Assuming net investment of $15 billion and independent of the level of GDP, what will be the equilibrium level of GDP?
(d) Using your answers to (a) and (b), find the size of the multiplier.
(e) Check your answer using the MPC embodied in these data.
(a) C = 60 + 0.8Y
(b) Equilibrium GDP = $325 (where S = I )
(c) When I = $15, GDP rises to $375 because that is where S = I.
(d) When I rose by $10, GDP rose by $50. Therefore, M = 50/10 = 5.
(e) The MPC would be 0.8 or 4/5 because C changes by 20 when GDP changes by 25. Therefore MPC = 20/25 or 0.8 and the MPS = 0.2 which makes the multiplier 1/.2 or 5, the same result found in part (d). [text: E pp. 173-178; MA pp. 173-178]
34. (Advanced analysis) Assume the consumption schedule for the economy is such that C = 50 + 0.8Y. Assume further that investment and net exports are autonomous or independent of the level of income and gross investment is 40 and net exports equal �10. Recall that in equilibrium, Y = C + Ig + Xn.
(a) Calculate the equilibrium level of income for this economy.
(b) What will happen to equilibrium Y if gross investment falls to 20? What does this tell us about the size of the multiplier?
(a) Equilibrium GDP is 400 = (50 = 0.8Y) + 40 + (�10)
(b) If gross investment falls by 20, GDP will fall by 100 because the multiplier is 1/.2 or 5 and 5 x 20 = 100 decline. The new equilibrium would be 300. [text: E pp. 179-180; MA pp. 179-180]
35. (Advanced analysis) Assume that without any taxes the consumption schedule for an economy is as shown in the table:
GDP (billions) Consumption (billions)
$ 200 $ 240
400 400
600 560
800 720
1,000 880
1,200 1,040
1,400 1,200
(a) Graph the consumption schedule and note the size of the MPC and multiplier using the below graph.
(b) Assume a lump-sum regressive tax of $10 billion is imposed at all levels of GDP. Calculate the tax rate at each level of GDP and graph the resulting consumption schedule. Compare the MPC and the multiplier with the pretax consumption schedule. MPC and the multiplier are unchanged.
(c) Explain why a proportional or progressive tax system would contribute to greater economic stability as compared with the regressive lump-sum tax. Demonstrate graphically using a 10% proportional tax.
(a) The size of the MPC = 160/200 = 0.80. See graph below.
(b) The tax rate will be regressive: At $400, 2.5%; at $600, 1.67%; at $800, 1.25%; at $1000, 1%; at $1200, 0.835%; at $1400, 0.71%.
(c) A proportional or progressive tax system would not take such a big bite out of low incomes as a regressive tax system does, and as incomes rose it would take out more proportionately than a regressive, lump-sum tax does. Thus, proportional or progressive taxes leave more disposable income for
spending during low-income periods and would reduce disposable income and spending during expansionary phases. See graph below. [text: E pp. 182-185; MA pp. 182-185]
New36. (Last Word) Explain Say�s law.
Say�s law, attributed to the 19th-century French economist, is that �supply creates its own demand.� Essentially, this theory states that people engage in production in order to be able to buy or demand other things. Whatever one earns from production, one expects to spend on goods and services of equivalent value. Thus, supply (production) has created its own demand. [text: E p. 177; MA p. 177]
New37. (Last Word) �If production results in income and income is the source of spending, it would seem that the production of a full-employment economy would automatically guarantee enough spending to sustain itself. How, then, can unemployment occur?� Explain.
The statement is a restatement of Say�s law. The fallacy in this statement is that not all income has to be spent during the production period. Just because it is a source of spending does not mean it will all be spent. Some may be saved
and although some of this saving might be channeled back into spending through investment in capital goods, this investment may not occur during the same time period if investors do not expect to make an economic return on their investment. [text: E p. 177; MA p. 177]
New38. (Last Word) What two events undermined the theory that supply creates its own demand?
First, the Great Depression of the 1930s resulted in a sharp decline in production and high rates of unemployment over a ten-year period. This event was inconsistent with the classical theory that suggests that unemployment is only temporary. Second, John Maynard Keynes developed an aggregate expenditures theory that countered Say�s law and explained why unemployment and underspending can occur in an economy. Keynes� modern employment theory suggests that the macroeconomy was inherently unstable and subject to fluctuations in output and employment because of the downward inflexibility of wages and prices and lack of synchronization between investment and saving decisions. [text: E p. 177; MA p. 177]
New39. (Last Word) Contrast the classical and Keynesian views of unemployment.
The classical view theorizes that unemployment will not persist because prices and wages are flexible. If a temporary surplus occurs in one sector of the economy, prices of that sector�s goods will fall until the quantity demanded is brought into equilibrium with the quantity supplied again. If necessary, wages in that sector will also fluctuate in response to the change in demand, falling when demand is down and rising when demand increases.
The Keynesian view, on the other hand, believes that full employment is by no means a consistent result of the market system. Cyclical unemployment is likely to persist without intervention from the government to raise aggregate expenditures. This view counteracts the classical view by stating that wages and prices are not flexible in a downward direction. Also, saving and investment plans can be at odds and can result in fluctuations in total output, total income, employment, and the price level. [text: E p. 177; MA p. 177]
CHAPTER 11
1. Why is there a need for an aggregate demand and aggregate supply model of the economy? Why can�t the supply and demand model for a single product explain developments in the economy?
The basic reason for an aggregate model is that there are thousands of individual products in an economy.
Single product supply and demand model does not explain: (1) why prices in general rise or fall; (2) what determines the level of aggregate output; and (3) what determines changes in the level of aggregate output. The aggregate model is needed to explain these changes. It simplifies the analysis of prices by combining the prices of all individual goods and services into one aggregate price level. It simplifies the analysis of quantities by combining the equilibrium quantities of all individual goods and services into a singe entity called the real domestic output. [text: E pp. 193-206; MA pp. 193-206]
2. What is the aggregate demand curve? What is the characteristic its slope?
The aggregate demand curve shows the relationship between the price level and real domestic output (real GDP). It shows the amounts of real output that domestic consumers, businesses, government, and foreign buyers collectively desire to purchase at each price level. As the price level increases, the amount of real domestic output purchased will decrease, so the aggregate demand curve is downsloping. [text: E pp. 193-195; MA pp. 193-195]
3. What is the difference in the explanation of the shape of the aggregate demand curve and a single product demand curve? After all, both demand curves show an inverse relationship between price and quantity.
The aggregate demand curve shows an inverse relationship between the price level (the general level of all
prices) and real domestic output (the equilibrium quantity of all products). The explanation of this inverse relationship is based on the real-balances effect, the interest-rate effect, and the foreign-purchases effect. In this case, as the price level rises, the quantity of real domestic output decreases.
The supply and demand model for a particular product shows an inverse relationship between the price of
that product and the quantity of that product. The explanation for the inverse relationship between price and quantity in the demand for a single product is based on the substitution and income effects. The substitution effect is not applicable to the aggregate case because there is no substitute for all products in the economy. Also, the income effect is not applicable to the aggregate case because income now varies with aggregate output. [text: E pp. 193-195; MA pp. 193-195]
4. Explain the three reasons given for the downward slope of the aggregate
demand curve.
The three reasons given are the real-balances effect, the interest-rate effect, and the foreign purchases effect.
The real-balances effect refers to the idea that a higher price level will reduce the purchasing power of the population�s accumulated financial assets. Because of the decline in value of such assets, people will feel poorer and will reduce their spending. Conversely, as the price level falls the opposite will occur.
The interest-rate effect assumes that as the price level rises so will interest rates, and rising interest rates will reduce certain kinds of spending such as consumption spending on durable goods and investment spending.
The foreign purchases effect assumes that if the price level rises in the U.S. relative to that in foreign countries, Americans will increase spending on imports at the expense of domestically produced goods and services, and foreigners will reduce purchases of U.S. goods. In other words, net exports decline. [text: E pp. 193-195; MA pp. 193-195]
5. The determinants of aggregate demand �determine� the location of the aggregate demand curve. Explain three of the four basic determinants of aggregate demand.
The four basic determinants of aggregate demand are found in Figure 11.2 in the text. They are a change in consumer spending, a change in investment spending, a change in government spending, and a change in net export spending. Explanations for each follow.
A change in consumer spending could occur as a result of an increase or decrease in consumer wealth resulting from factors such as increased stock values. It could also be caused by a change in consumer expectations about the future, a change in the level of household indebtedness, or a change in personal taxes.
Changes in investment spending may occur as a result of changes in the interest rate (not related to changes in the price level), changes in profit expectations having to do with predictions about future returns on possible projects, changes in business taxes, technological improvements which induce more capital investment, and the degree of existing excess capacity.
Government spending might change for any of a number of reasons, including a change in priorities resulting from a change in elected officials.
Net export spending can change for two nonprice-level-related reasons such as rising or falling national incomes in other countries and exchange rate changes unrelated to domestic price levels. [text: E pp. 195-197; MA pp. 195-197]
6. Identify the ways in which each of the following determinants would have to change if each was causing a decrease in aggregate demand: consumer wealth, consumer expectations, business taxes, national income in countries abroad, exchange rates.
To decrease aggregate demand, consumer wealth would have to fall. For example, a decline in real estate values or a stock market decline would cause a decrease in consumer wealth. If consumers expected prices to fall in the future, or a recession which creates insecurity about jobs, they might cut back on spending now. If business taxes were raised, or some present tax breaks eliminated or reduced, this could reduce business investment spending which, in turn, reduces aggregate demand. When national income abroad is falling, U.S. exports will decline, which reduces the net export spending component of aggregate demand. A dollar appreciation will cause a decline in net exports as U.S. exports become more expensive to foreigners and foreign imports become less expensive to holders of American dollars. [text: E pp. 195-197; MA pp. 195-197]
New 7. Define aggregate supply. Describe the characteristics of the aggregate supply curve from long-run and short-run perspectives.
The aggregate supply is a curve that shows the total quantity of goods and services that will be produced (supplied) at different price levels. In the long run, the aggregate supply curve is vertical at the full-employment level of output for the economy because the rise in wages and other inputs will match changes in the price level. In the short run, the aggregate supply curve is upsloping because nominal wages and input prices adjust only slowly to changes in the price level. With this curve, an increase in the price level increases real output and a decrease in the price level reduces real output. [text: E pp. 197-198; MA pp. 197-198]
8. Explain the three major factors that can cause a shift in aggregate supply. That is, explain the three major determinants of supply.
The determinants of supply include changes in input prices, productivity, and the legal-institutional environment. Included as factors behind changes in input prices are availability of domestic resources, prices of imported resources (particularly energy resources), and changes in market power of resource suppliers. Included as factors related to the legal-institutional environment are business taxes and subsidies and government regulation. [text: E pp. 199-201; MA pp. 199-201]
9. Describe the change in aggregate supply that should result from each of the following changes in determinants. Assume that nothing else is changing besides the identified change. (Use �Decrease� or �Increase.�) (a) A rise in the average price of inputs; (b) An increase in worker productivity; (c) Government antipollution regulations become stricter; (d) A new subsidy program is enacted for new business investment in productive equipment; (e) Energy prices decline.
(a) Decrease; (b) Increase; (c) Decrease (unless the increase in antipollution device production outweighs the decline in production caused by the increased cost of the regulations); (d) Increase; (e) Increase [text: E pp. 199-201; MA pp. 199-201]
10. Prepare a list of events that would shift the aggregate supply curve leftward.
Students should list examples that fit the determinants indicated in Figure 11.5. Some possibilities are a rise in the prices of domestic resources, an increase in wages beyond any rise in productivity, an increase in the prices of imported resources, declining rate of productivity without corresponding wage concessions, rising business taxes, reduction in research and development efforts, and more government regulation which adds to production costs. [text: E pp. 199-201; MA pp. 199-201]
11. Prepare a list of government tax or spending policy options that would tend to shift the aggregate supply curve rightward.
Tax cuts or rebates in any area which would improve productivity. For example, tax credits for investment in new capital goods or buildings, tax credits for education and training.
Tax breaks for various types of natural resource exploration and development especially for resources important in energy and construction industries.
Reducing or eliminating tariffs on imported resources.
Tax penalties for companies which grant inflationary wage increases. [text: E pp. 199-201; MA pp. 199-201]
12. What determines the equilibrium price level and the level of real domestic output in the aggregate demand-aggregate supply model?
The interaction of aggregate supply and aggregate demand will determine the equilibrium. The price and quantity levels where aggregate demand and aggregate supply are equal will be the equilibrium levels of price and quantity. In a graphical illustration such as Figure 11.7, it is where the two curves intersect. [text: E pp. 201-203; MA pp. 201-203]
13. Suppose that a hypothetical economy has the following relationship between its real domestic output and the input quantities necessary for producing that level of output.
Input quantity Real domestic output
400 800
300 600
100 200
(a) What is the level of productivity in this economy?
(b) What is the unit cost of production if the price of each input is $2.00?
(c) If the input price decreases from $2 to $1.50, what is the new per unit cost of production? In what direction would the aggregate supply curve move? What effect would this shift have on the price level and the level of real domestic output if the economy is initially operating in the intermediate range?
(d) Suppose that instead of the input price decreasing, the productivity had increased by 25%. What will be the new unit cost of production? In what direction would the aggregate supply curve move? What effect would this shift have on the equilibrium price and output level if the economy?
(a) The level of productivity is 2 output units per input unit.
(b) Since productivity is 2 units of output per input unit, the cost of production per unit is 2 units/$2 or $1 per unit of output. (Total input cost/output) = PUPC. [($2 x 400)/800] = $1.
(c) The unit cost will decline from $1/unit to $.75/unit. The aggregate supply curve has moved rightward and the level of prices has declined while the level of real domestic output has increased.
(d) If productivity rose by 25%, then there would be 1.25 units produced per $1 of input costs. The unit cost of production would be $.80/unit. The aggregate supply curve would move in the same direction with similar effects to (c) above. However, the cost reduction is not quite as great so the real GDP would not rise as much as (c) nor would the price level decline by as much as (c). [text: E pp. 200-201, 205-206; MA pp. 200-201, 205-206]
14. Suppose the aggregate demand and supply schedules for a hypothetical economy are as shown below:
Amount of real
Amount of real domestic Price level domestic output
output demanded, billions (price index) supplied, billions
$ 200 300 $800
400 250 800
600 200 600
800 150 400
1,000 100 200
(a) Use these sets of data to graph the aggregate demand and supply curves on the below graph.
(b) What will be the equilibrium price and output level in this hypothetical economy? Is it also the full-employment level of output? Explain.
(c) Why won�t the 150 index be the equilibrium price level? Why won�t the 250 index be the equilibrium price level?
(d) Suppose demand increases by $400 billion at each price level. What will be the new equilibrium price and output levels?
(e) What factors might cause a change in aggregate demand?
(a) See graph below.
(b) The equilibrium GDP is $600 billion and price level 200. There is not enough information given to determine whether or not this is the full-employment level of output.
(c) At 150, the aggregate demand would exceed aggregate supply and prices would be bid up. At price level 250, aggregate supply would exceed aggregate demand and the resulting surpluses would cause prices to be bid downward toward the equilibrium level of 200.
(d) The new equilibrium price and output level will be 250 and $800 billion respectively on the schedule shown.
(e) Look at Figure 11.2, Determinants of Aggregate Demand, to help with this answer. An increase in consumer wealth, expected future inflation, decline in household indebtedness, or decreased personal taxes could increase the consumer spending component of aggregate demand. Investment spending might increase as a result of lower interest rates, expectations of improved profits in the future, decline in business taxes, new and improved technology, or
decline in excess capacity. Government spending might increase for a variety of reasons. Net export spending could increase as a result of improved economic conditions abroad or a depreciation in the American dollar. [text: E pp. 201-204; MA pp. 201-204]
15. Suppose the aggregate demand and supply schedules for a hypothetical economy are as shown below:
Amount of real
Amount of real domestic Price level domestic output
output demanded, billions (price index) supplied, billions
$ 60 350 $240
120 300 240
180 250 180
240 200 120
300 150 60
(a) What will be the equilibrium price and output level in this hypothetical economy? Is it also the full-employment level of output? Explain.
(b) Why won�t the 200 index be the equilibrium price level? Why won�t the 300 index be the equilibrium price level?
(c) Suppose demand increases by $120 billion at each price level. What will be the new equilibrium price and output levels?
(d) List five factors that might cause a change in aggregate demand.
(a) The equilibrium GDP is $180 billion and price level 250. There is not enough information given to determine whether or not this is the full-employment level of output, but there is no reason why it should be one way or the other.
(b) At 200, the aggregate demand would exceed aggregate supply and prices would be bid up. At price level 300, aggregate supply would exceed aggregate demand and the resulting surpluses would cause prices to be bid downward toward the equilibrium level of 250.
(c) The new equilibrium price and output level will be 300 and $240 billion respectively on the schedule shown.
(d) Look at Figure 11.3, Determinants of Aggregate Demand, to help with this answer. (1) An increase in consumer wealth, (2) expected future inflation, (3) decline in household indebtedness, or (4) decreased personal taxes could increase the consumer spending component of aggregate demand, (5) investment spending might increase as a result of lower interest rates, (6) expectations of improved profits in the future, (7) decline in business taxes, (8) new and improved technology, or (9) decline in excess capacity. Government spending might increase for a variety of reasons. (10) Net export spending could increase as a result of improved economic conditions abroad or from a depreciation in the American dollar.
[text: E pp. 201-204; MA pp. 201-204]
16. Describe each of the following outcomes in terms of shifts in aggregate demand or aggregate supply curves.
(a) A recession deepens while the rate of inflation increases
(b) The price level rises sharply while real output and employment increase
(c) The price level falls, but the unemployment rate rises
(d) Real output rises, unemployment rate falls, and the price level rises
(a) The aggregate supply curve has shifted to the left causing the price level to rise and output and employment levels to fall.
(b) The aggregate demand curve has shifted to the right.
(c) The aggregate demand curve has shifted leftward.
(d) The aggregate demand curve has shifted rightward. [text: E pp. 203-206; MA pp. 203-206]
17. What is the effect of the multiplier when aggregate demand increases and there is a large increase in the price level? What happens when there only is a small increase in the price level?
The multiplier effect is weakened with price level changes. In the vertical range of aggregate supply, an
increase in aggregate demand only produces in increase in the price level but no increase in real output. In the intermediate range, the increase in aggregate demand raises the price level and real output, but real output does not increase by as much as it would have if there had been no price level increase (as would be the case in the horizontal range). The conclusion is that the more the price level increases, the less effect any increase in aggregate demand will have in increasing real GDP. [text: E p. 203; MA p. 203]
18. In the table below are aggregate demand and supply schedules.
Real domestic output
Price level Demanded Supplied
(1) (2) (3) (4)
250 1,400 1,900 2,000
225 1,500 2,000 2,000
200 1,600 2,100 1,900
175 1,700 2,200 1,700
150 1,800 2,300 1,400
125 1,900 2,400 1,000
100 2,000 2,500 500
(a) On the graph below, plot the aggregate demand curve shown in columns (1) and (2) in the above table, and label this curve AD1.
(b) On the graph below, plot the aggregate supply curve shown in columns (1) and (4) in the above table; and label this curve AS.
(c) What is the level of equilibrium real domestic output and price level?
(d) Now assume that aggregate demand changes. Use columns (1) and (3) to plot the new aggregate demand curve; and label this curve AD2.
(e) What is the new level of equilibrium real domestic output and price level?
(a) See below graph.
(b) See below graph.
(c) 1,700; 175
(d) See below graph.
(e) 2,000; 225 [text: E pp. 201-203; MA pp. 201-203]
New19. Use this aggregate demand�aggregate supply schedule for a hypothetical economy to answer the following questions.
Real domestic Real domestic
output demanded output supplied
(in billions) Price level (in billions)
$3000 350 $9000
$4000 300 $8000
$5000 250 $7000
$6000 200 $6000
$7000 150 $5000
$8000 100 $4000
(a) What will be the equilibrium price level and quantity of real domestic output? (b) If the quantity of real domestic output demanded increased by $2000 at each price level, what will be
the new equilibrium price level and quantity of real domestic output? (c) Using the original data from the table, if the quantity of real domestic output demanded increased by
$5000 and the quantity of real domestic output supplied increased by $1000 at each price level, what would the new equilibrium price level and quantity of real domestic output be?
(a) 200 and $6000
(b) 250 and $7000 (c) 300 and $9000 [text: E pp. 201-206; MA pp. 201-206]
20. What are five reasons for the downward price-level inflexibility, especially as it pertains to wages and prices?
First, wage contracts will fix wages for the length of the contract period, so it is difficult to cut wages until the contract is renegotiated. Also, wages and salaries of nonunion workers are typically adjusted just once a year. Second, some businesses may pay efficiency wages that are designed to get the maximum work effort out of employees. Cutting such wages may cause morale problems and reduce productivity, so businesses are hesitant to make these cuts. Third, the minimum wage sets a legal minimum that employers must pay for low-skilled workers. Fourth, there are menu costs of changing prices. Repricing or reprinting prices can be costly and be disruptive to customers. Businesses are reluctant to make such changes. Fifth, there is the fear of a price war. If one business starts cutting prices then other businesses can follow suit to maintain market share. Businesses may decide to maintain prices rather than risk starting a price war. [text: E pp. 203-205; MA pp. 203-205]
21. Is the downward price inflexibility applicable to today�s economy? Why or why not?
Some economists give many reasons for the downward price-level inflexibility in the economy. They note that the price level has not declined since one year in the 1950s despite the fact that there have been many recessions since then. Also, there are a number of reasons for price-level inflexibility that include long-term wage contracts, the payment of efficiency wages, a minimum wage, the menu cost of making price changes, and fear of price wars.
Other economists argue that downward price inflexibility is not applicable to today�s economy because union power has diminished over the years and the 1981�1982 recession showed that wages could be cut in major industries. Also, foreign competition reduces monopoly power in certain industries and keeps firms from resisting price cuts. The past forces that caused price-level inflexibility
have declined according to these economists. [text: E pp. 203-205; MA pp. 203-205]
New22. (Consider This) What is the ratchet effect? How does it apply to price level changes in the economy as aggregate demand changes?
A ratchet effect allows movement in one direction but not movement back. Some economists argue that when aggregate demand increases, there will be an increase in the price level, but when aggregate demand decreases, there is downward price inflexibility that prevents the price level from falling. They note that the price level has not declined since one year in the 1950s despite the fact that there have been many recessions since then. So a higher price level remains even when aggregate demand falls. [text: E p. 205; MA p. 205]
23. Explain �cost-push� inflation using aggregate demand-aggregate supply analysis.
�Cost-push� inflation using the AD-AS analysis could be explained by a leftward shift in the aggregate supply curve. If aggregate supply decreases in this manner, it will intersect the aggregate demand curve at a lower real GDP and a higher price level since the aggregate demand curve is downward sloping. This view suggests that prices might rise even if aggregate demand has not increased. The more traditional view has been that inflation is caused by increases in aggregate demand at or near the full-employment level of GDP. [text: E pp. 205-206; MA pp. 205-206]
24. Some economists argue that it is easier to resolve demand-pull inflation than it is cost-push inflation. Use the aggregate demand and aggregate supply model to explain this assertion.
By shifting aggregate demand leftward when the equilibrium occurs in the intermediate or classical range, the inflation rate should fall. This assumes that the price-level increase was due to demand factors only. It is possible to decrease aggregate demand by using tax policies which decrease consumer
or business spending, or by using monetary policies which tighten the availability of credit for spending.
However, the factors which cause leftward shifts in the aggregate supply schedule (see Figure 11.5) are not as easy for government policy to control. Government cannot quickly change worker demands for higher wages; it cannot quickly increase productivity which would also bring down production costs; it cannot control the price of imported resources. These three factors have contributed much to cost-push inflation in the past, and help to illustrate the difficulty in controlling cost-push inflation. [text: E pp. 203-205; MA pp. 203-205]
25. Suppose an economic advisor to the President recommended a personal income tax increase. Indicate the expected effects on aggregate demand and on aggregate supply.
The advisor would recommend this in hopes of dampening consumer demand and lessening demand-pull inflation. This should happen as consumers find themselves with less disposable income. However, at the same time there may be some less desirable effects on aggregate supply. For example, workers might demand higher wages to compensate for the higher taxes. Higher taxes may cause lessened work incentives which could cause a decline in productivity and, therefore, a rise in production costs. In other words, while raising personal taxes seems to be a correct policy for dampening demand and demand-pull inflation, it may have an offsetting effect on supply which could cause cost-push inflation. [text: E p. 203; MA p. 203]
26. Use an aggregate demand-aggregate supply analysis to explain the impact of the public�s expectations of severe inflation on real domestic output and the price level.
The answer depends partly on where the economy is at the beginning of this change. Assuming that inflation was already a problem, then increased expectations would cause the demand curve to shift further rightward, adding to the demand-pull type of inflation.
The effect on aggregate supply would also be to worsen inflation from the cost-push perspective. People would want higher wages and salaries now to compensate them for the expected inflation of the future. Unless productivity rose at the same rate, these demands for higher incomes would push up labor costs of production which would shift the supply curve to the left. As this happens the new equilibrium would be not only at a higher level of inflation, but also at a lower level of employment. In other words, this leftward shift could offset any possible increase caused by the rightward shift in aggregate demand. The only certainty is that expectations of severe inflation add to the probability of severe inflation because of the behavior of consumers and wage earners. [text: E pp. 203-205; MA pp. 203-205]
27. (Last Word) Why was unemployment in Europe so high in recent years? There are two basic perspectives on the reasons for high European unemployment rates. First, there are
high natural rates of unemployment that is due to frictional and structural unemployment. This results from government policies and union contracts that increase the costs of hiring and reduce the cost of being unemployed. Among the policies that affect these high costs are high minimum wages, generous welfare benefits for the unemployed, restrictions against firings that discourage firms from employing workers, long periods for paid vacation and holidays, high worker absenteeism that reduces productivity, and the high costs of paying for fringe benefits that discourages hiring. Second, there is deficient aggregate demand. European governments worried too much about inflation and have not enacted monetary or fiscal policies that expand the economy. If such policies had been enacted, aggregate demand would expand and unemployment rates would fall, without the threat of inflation because there is excess capacity in the economy. [text: E p. 207; MA p. 207]
C. Appendix Questions
28. How can the aggregate demand curve be derived from the aggregate expenditures model?
29. Explain the relationship between the aggregate expenditures model in graph (A) below and the aggregate demand-aggregate supply model in graph (B)
below. In other words, explain how points 1, 2, and 3 are related to points 1', 2', and 3'.
30. How does the aggregate expenditures analysis differ from the aggregate demand-aggregate supply analysis?
31. Why does aggregate demand shift outward by a greater amount than the
initial change in spending?
Graph Graph
32. Explain the relationship between the aggregate expenditures model in graph (A) below and the aggregate demand-aggregate supply model in graph (B)
below where aggregate demand is shifting while the price level remains constant.
(A) (B)
D. Answers to Appendix Questions
28. How can the aggregate demand curve be derived from the aggregate
expenditures model?
The aggregate demand curve is derived from the intersections of the aggregate-expenditures curves and the 45-degree curve. As the price level falls, the aggregate expenditures curve shifts upward and the equilibrium real GDP increases, but as the price level rises, the aggregate expenditures curve shifts downward and the equilibrium real GDP decreases. The inverse relationship between the price level and equilibrium real GDP is the aggregate demand curve.
Note that for the aggregate-expenditure model that a decrease in the price level: (1) increases the value of wealth; thus increasing the consumption schedule. A decrease in the price level decreases the interest rate, thus increasing the investment schedule. A decrease in the price level decreases imports and increases exports, thus increasing net exports expenditures. Thus a decrease in the price level will increase aggregate expenditures (and real domestic output) because of these changes in wealth, interest rates, and net exports. These three effects are also the ones that define the inverse relationship between the price level and real domestic output in the aggregate demand curve. [text: E pp. 211-212; MA pp. 211-212]
29. Explain the relationship between the aggregate expenditures model in graph (A) below and the aggregate demand-aggregate supply model in graph (B)
Graph Graph
below. In other words, explain how points 1, 2, and 3 are related to points 1', 2', and 3'.
Through the real-balances, interest-rate, and foreign purchases effects, the consumption, investment, and net exports schedules and therefore the aggregate expenditures schedule will rise when the price level declines and fall when the price level increases. If the aggregate expenditure schedule is at (C + Ig + Xn)2 when the price level is P2, we can combine that price level and the equilibrium output, GDP2, to determine one point (2') on the aggregate demand curve. A lower price level such as P1 shifts aggregate expenditures to (C + Ig + Xn)1, providing us with point 1' on the aggregate demand curve. Similarly, a higher price level at P3 shifts aggregate expenditures down to (C + Ig + Xn)3 so P3 and GDP3 yield another point on the aggregate demand curve at 3'. [text: E pp. 211-212; MA pp. 211-212]
30. How does the aggregate expenditures analysis differ from the aggregate demand-aggregate supply analysis?
The aggregate expenditures analysis assumes a constant price level. Output measures are in terms of real GDP and real income. The aggregate demand-aggregate supply model shows the relationship between real GDP and the price level. The Keynesian model ignores price level effects of increased aggregate expenditures. In contrast, the AD-AS model indicates that the price level will rise as aggregate demand rises in the intermediate or vertical ranges of aggregate supply. [text: E pp. 211-212; MA pp. 211-212]
31. Why does aggregate demand shift outward by a greater amount than the
initial change in spending?
The basic reason is because of the multiplier. As shown by the aggregate expenditures model, an initial increase in spending times the multiplier will be the amount that aggregate expenditures shift upward. The size of this total increase will also be the amount of the shift of the aggregate demand curve outward. Thus, the shift of the aggregate demand curve will be equal to the initial change in spending times the multiplier. [text: E p. 212; MA p. 212]
32. Explain the relationship between the aggregate expenditures model in graph (A) below and the aggregate demand-aggregate supply model in graph (B) below where aggregate demand is shifting while the price level remains constant.
(A) (B)
In (A) we assume that some determinant of consumption, investment, or net exports other than the price level shifts the aggregate expenditures schedule from (C + Ig + Xn)1 to (C + Ig + Xn)2, thereby increasing real domestic output from GDP1 to GDP2. In (B) we find that the aggregate demand counterpart of this is a rightward shift of the aggregate demand curve from AD1 to AD2 which is just sufficient to show the same increase in real output as in the expenditures-output model. [text: E p. 212; MA p. 212]
CHAPTER 16
1. What is the basic difference between the short run and long run as these terms relate to macroeconomics? Why does this difference occur?
The short run is a period in which nominal wages (and other input prices) do not fully adjust as the price level changes. The long-run is a period in which nominal wages are fully responsive to changes in the price level. Nominal wages tend to remain fixed in the short run as the price level increases because workers may not be fully aware of how inflation has eroded real wages. Also many workers are under fixed contracts for several year periods. As a consequence of these factors, nominal wages do not change immediately with changes in the price level. [text: E pp. 292-293; MA pp. 292-293]
2. Complete the table below.
Price Index Nominal Wage Real Wage
Per hour
100 $10 $_____
97 10 _____
94 10 _____
91 10 _____
88 10 _____
85 10 _____
Price Index Nominal Wage Real Wage
Per hour
100 $10 $10.00
97 10 10.31
94 10 10.64
91 10 10.99
88 10 11.36
85 10 11.76
[text: E p. 293; MA p. 293]
3. Complete the table below.
Price Index Nominal Wage Real Wage
Per hour
100 $10 $_____
103 10 _____
106 10 _____
109 10 _____
112 10 _____
115 10 _____
Price Index Nominal Wage Real Wage
Per hour
100 $10 $10.00
103 10 9.71
106 10 9.43
109 10 9.17
112 10 8.93
115 10 8.70
[text: E p. 293; MA p. 293]
4. Assume that one year the nominal wage for a worker is $12 per hour and there is no inflation. The next year the nominal wage stays the same but the rate of inflation is 10 percent. What is the new real wage after taking inflation into account? What nominal wage would workers ask for to keep their real wage equal to what it was the first year?
The first year the nominal wage and the real wage are the same: $12 per hour. The second year the nominal wage is $12, but the real wage is now $10.91. (To obtain this number you take the $12 nominal wage and divided it by 1.10, which is the 10 percent inflation expressed as price index in hundredths.) To compensate for inflation, workers would want the nominal wage of $12 to increase by 10 percent, or rise to $13.20 [$12 + ($12 x 1.10) = $13.20]. This increase in the nominal wage to $13.20 would make the new real wage ($13.20/1.10 = $12) equal to the original $12 real wage. [text: E p. 293; MA p. 293]
5. Assume that one year the nominal wage for a worker is $15 per hour and there is no inflation. The next year the nominal wage stays the same but the rate of inflation is 8 percent. What is the new real wage after taking inflation into
account? What nominal wage would workers ask for to keep their real wage equal to what it was the first year?
The first year the nominal wage and the real wage are the same: $15 per hour. The second year the nominal wage is still $15, but the real wage is now $13.76. (To obtain this number you take the $15 nominal wage and divided it by 1.08, which is the 8 percent inflation expressed as price index in hundredths). To compensate for inflation, workers would want the nominal wage of $15 to increase by 8 percent, or rise to $16.20 [$15 + ($15 x 1.08) = $16.20]. This nominal wage of $16.20 would make the new real wage ($16.20/1.08 = $15) equal to the original $15 real wage. [text: E p. 293; MA p. 293]
6. Describe the characteristics of the short-run aggregate supply curve. Explain what happens to: (1) nominal wages; (2) real wages; (3) employment; (4) output; (5) revenues; and, (6) profits as the price level increases from the full-employment level of output. Then explain what happens to these variables as the price level decreases from the full-employment-level of output.
The short-run aggregate supply curve will be an upsloping curve with the price level on the vertical axis and real domestic output on the horizontal axis. The initial level of output will be the full-employment level of output.
As the price level increases from the full-employment level of output, revenues to the firm increase because nominal wages are fixed, and the profits for firms will rise. Firms will have an incentive to increase output and employment (hiring temporary or part-time workers or paying for overtime), so real GDP will increase and unemployment will fall below its natural rate.
As the price level decreases from the full-employment level of output, revenues to the firm decrease and because nominal wages are fixed, the profits for firms will decrease. Firms will have an incentive to decrease output and employment, so real GDP will decrease and employment will fall below its natural rate. [text: E pp. 293-294; MA pp. 293-294]
7. Suppose the potential level of real domestic output (Q) for a hypothetical economy is $250 and the price level (P) initially is 100. Use the following short-run aggregate supply schedules below to answer the questions.
AS (P = 100) AS (P = 110) AS (P = 90)
P Q P Q P Q
110 280 110 250 110 310
100 250 100 220 100 280
90 220 90 190 90 250
(a) What will be the short-run level of real GDP if the price level rises unexpectedly from 100 to 110 because of an increase in aggregate demand? Falls unexpectedly from 100 to 90 because of a decrease in aggregate demand? Explain each situation.
(b) What will be the long-run level of real GDP when the price level rises from 100 to 110? Falls from 100 to 90? Explain each situation.
(c) Show the circumstances described in (a) and (b) on the graph below and derive the long-run aggregate supply curve.
(a) In the short run, the table reports that real GDP will rise to 280 when the price level rises from 100 to 110. If it were to fall unexpectedly, then the real GDP would fall to 220 temporarily. (a) In other words, short-run changes are only temporary responses to changes in aggregate demand.
(b) In the long run, the wages and resource prices adapt to the changes in the price level so that business profits will return to their original level and the motivation to expand or contract output will disappear. The long-run real GDP will be 250 according to the figures listed in the above table.
(c) See graphs below. [text: E, pp. 293-294; MA pp. 293-294]
8. Suppose the potential level of real domestic output (Q) for a hypothetical economy is $160 and the price level (P) initially is 200. Use the following short-run aggregate supply schedules to answer the questions.
AS (P = 200) AS (P = 210) AS (P = 190)
P Q P Q P Q
210 190 210 160 210 220
200 160 200 130 200 190
190 130 190 100 190 160
(a) What will be the short-run level of real GDP if the price level rises unexpectedly from 200 to 210 because of an increase in aggregate demand? Falls unexpectedly from 200 to 190 because of a decrease in aggregate demand? Explain each situation.
(b) What will be the long-run level of real GDP when the price level rises from 200 to 210? Falls from 200 to 190? Explain each situation.
(a) In the short run, the table reports that real GDP will rise to 190 when the price level rises from 200 to 210. If it were to fall unexpectedly, then the real GDP would fall to 130 temporarily. (a) In other words, short-run changes are only temporary responses to changes in aggregate demand.
(b) In the long run, the wages and resource prices adapt to the changes in the price level so that business profits will return to their original level and the motivation to expand or contract output will disappear. The long-run real GDP will be 160 according to the figures listed in the above table. [text: E, pp. 293-294; MA pp. 293-294]
9. Describe the characteristics of the long-run aggregate supply curve. Explain how changes in the price level affect the short-run aggregate supply curve and the long-run aggregate supply curve.
The long-run aggregate supply curve will be vertical at the full-employment level of output. Changes in the price level will not affect the full-employment level of output in the long-run. Changes in the short-run aggregate supply curve will define the long-run aggregate supply curve at the full-employment level of output.
With the short-run aggregate supply curve, as the price level increases from the full-employment level of output along the curve, revenues to the firm increase because nominal wages are fixed, and the profits for firms will rise. Firms will have an incentive to increase output and employment (hiring temporary or part-time workers or paying for overtime), so real GDP will increase and unemployment will fall below its natural rate. This situation is a short-run one because nominal wages (and other input prices) will eventually increase and shift the short-run aggregate supply curve to the left. The new equilibrium will return to the full-employment level of output, but at a higher price level.
Conversely, as the price level decreases from the full-employment level of output, revenues to the firm decrease and because nominal wages are fixed, the profits for firms will decrease. Firms will have an incentive to decrease output and employment, so real GDP will decrease and employment will fall below its natural rate. This situation is a short-run one because nominal wages (and other input prices) will eventually decrease and shift the short-run aggregate supply curve to the right. The new equilibrium will return to the full-employment level of output, but at a lower price level. [text: E pp. 293-294; MA pp. 293-294]
10. What is the long-run equilibrium in the extended aggregate demand and aggregate supply model?
The equilibrium GDP and price level occur at the intersection of the aggregate demand curve, the long-run aggregate supply curve, and the short-run aggregate supply curve. The output level will be at the full-employment level of output. [text: E p. 294; MA p. 294]
11. Describe the process that occurs with demand-pull inflation in the extended aggregate demand and aggregate supply model.
Assume that the economy is initially in equilibrium at the full-employment level of real output. If the price level rises because of an increase in aggregate demand, then this event will cause a movement along the short-run aggregate supply curve. The revenues and profits of firms increase because nominal wages and the prices of other resources are fixed. Employment and output will increase beyond the full-employment level to a temporary equilibrium. In the long-run, once workers and resource suppliers realize that the price level has risen they will want higher prices for their resources. When these higher payments are made, the short-run aggregate supply curve will shift to the left. This change will eventually result in a new equilibrium at a higher price level with real output and employment returning to its full-employment level. [text: E pp. 295; MA p. 295]
12. Describe cost-push inflation in the extended aggregate demand and aggregate supply model. Explain the policy dilemma for government policy if they take no action or use monetary and fiscal policy to counter the cost-push inflation.
Assume that the economy is initially in equilibrium at the full-employment level of real output. Also assume that there is a major increase in the price of a major resource (e.g., oil) for the economy. In this case, the price level rises because of a decrease in the short-run aggregate supply curve caused by this increase in the price of a major resource. This cost-push event will cause a movement
along the aggregate demand curve to a short-run equilibrium at a higher price level, but lower level of output.
If the government takes no action to counter the inflation, then a recession will occur that will lead to higher levels of unemployment. At some point, the price of the major resource that caused the inflation will decline along with nominal wages (because of the recession), so that the short-run aggregate supply curve shifts back to its original position.
If the government tries to counter the cost-push inflation and recession by using stimulative monetary and fiscal policies, it will shift the aggregate demand curve to the right. The action will increase employment and real output to its full-employment level, but the price level will now be even higher. The higher price level is likely to kick off another round of demands to increase nominal wages that will cause another leftward shift in the short-run aggregate supply curve. Thus, an inflationary spiral can result from government actions to increase aggregate demand to counter cost-push inflation. [text: E p. 296; MA p. 296]
13. Differentiate between �demand-pull� and �cost-push� inflation in the basic aggregate demand and aggregate supply model.
Demand-pull inflation occurs when an increase in aggregate demand pulls up the price level. Graphically, the demand curve is shifting rightward in the intermediate or classical range of the aggregate supply curve. Cost-push inflation is a result of aggregate supply decreasing relative to aggregate demand. Graphically, the aggregate supply curve would be shifting leftward, intersecting the aggregate demand curve at a higher level of prices. [text: E pp. 295-296; MA pp. 295-296]
14. Explain what happens in the extended aggregate demand and aggregate supply model when there is a recession.
With a recession, the aggregate demand curve will decrease or shift left. As the price level decreases from the full-employment level of output, revenues to the firm decrease, and because nominal wages are fixed, the profits for firms will decrease. Firms will have an incentive to decrease output and employment (to reduce labor cost), so real GDP will decrease and employment will fall below its natural rate. This situation is a short-run one, however, because nominal wages (and other input prices) will eventually decrease and shift the short-run aggregate supply curve to the right. The new equilibrium will return to the full-employment level of output but be at a lower price level. [text: E pp. 296-297; MA pp. 296-297]
15. What are three significant generalizations supported by results from the extended AD-AS model?
First, under normal circumstances, there is a short-run tradeoff between the rate of inflation and the rate of unemployment. Second, aggregate supply shocks can cause both higher rates of inflation and higher rates of unemployment. Third, there is no significant tradeoff between inflation and unemployment over longer periods of time. [text: E p. 297; MA p. 297]
16. What is the Phillips Curve? What concept does it illustrate?
The Phillips Curve shows the relationship between the unemployment rate and the rate of inflation. The relationship is an inverse one, so there is a short-run tradeoff between the unemployment rate and the rate of inflation. For example, if the unemployment rate increases by 1% then the inflation rate might decline by .5%. The concept was developed by A.W. Phillips in Great Britain based on empirical observation of the relationship between unemployment and inflation in that nation. Modern economists reject the idea of a stable, predictable Phillips Curve, although many economists do agree that there is a short-run tradeoff between unemployment and inflation. [text: E pp. 297-298; MA pp. 297-298]
17. Explain the Phillips Curve concept and construct an example of the curve on the below graph.
The Phillips Curve concept shows a stable inverse relationship between the rate of unemployment and the rate of inflation. It is based on the idea that as aggregate demand increases in the horizontal range of the aggregate supply curve, unemployment will decline as real GDP rises without an inflationary effect. However, as aggregate demand continues to grow and the unemployment rate approaches full-employment, the price level and real GDP
will increase. Finally, at the point of full capacity, only the price level will rise as potential real GDP has been achieved. See graph below. [text: E pp. 297-298; MA pp. 297-298]
18. If the Phillips Curve exists in reality, what dilemma does this create for fiscal and monetary policies? Explain.
The dilemma is that an expansionary fiscal and monetary policy aimed at reducing unemployment may cause inflation, and vice versa for policies aimed at reducing inflation. If there truly is a tradeoff, then successful elimination of unemployment cannot be accomplished without creation of inflation; likewise, stable prices occur only in the presence of some unemployment. [text E pp. 297-299; MA pp. 297-299]
19. What is stagflation and what was one of its causes in the 1970s and early 1980s?
Stagflation is the presence of both inflation and unemployment over a period of time such as occurred in the 1972�1974 and 1977�1980 periods. The major cause appears to be a series of adverse aggregate supply shocks that shifted the economy's short-run aggregate supply curve to the left. One of the major shocks was the quadrupling of oil prices by the Organization of Petroleum Exporting Countries (OPEC) that significantly increased energy prices. Other shocks included severe agricultural shortfalls around the world, the depreciation
of the dollar, wage and price increases after wage-price controls were removed, and a decline in productivity. [text E pp. 299-300; MA pp. 299-300]
20. Assume the following information is relevant for an advanced economy over a three-year period. Describe in detail the macroeconomic situation faced by this society. Is cost-push inflation evident? What corrective policies would you recommend and why?
Increase in Increase in Average
Price labor industrial Unemp. hourly
Year index productivity production rate wage
1 167 4% 4% 4.5% $6.00
2 174 3 2 5.2 6.50
3 181 2.5 1.5 5.8 7.10
This economy seems to be in a period of stagflation-inflation is rising at the same time that unemployment is increasing. There appear to be two reasons for this: labor productivity and industrial production growth are falling, and at the same time the hourly wage rate is rising. This indicates an increase in unit labor costs that must be covered by rising prices or firms will cut back still further on output plans due to declining profits, which would be caused by the increase in labor cost, and decline in production. Cost-push inflation is present. [text: E pp. 299-300; MA pp. 299-300]
21. What contributed to stagflation's demise between 1982 and 1989? How did these events affect aggregate supply and the Phillips Curve?
There was a deep recession from 1981 to 1982 that reduced the pressure for workers to increase wages and for firms to increase prices. Increased foreign competition also restrained domestic wage and price increases in the United States. The U.S. economy also underwent deregulation in many basic industries
that stimulated more competition and further restrained price and wage increases. In addition, the monopoly and pricing power over oil by the OPEC cartel was weakened, thus reducing energy prices for consumers and businesses. These factors worked to reduce the per-unit cost of production and shift the economy's short-run aggregate supply curve to the right and shift the Phillips Curve back to the left. [text E p. 300; MA p. 300]
22. Compare and contrast the short-run Phillips Curve and the long-run Phillips Curve.
In the short-run, an expansion of aggregate demand may temporarily increase profits and therefore output and employment. Nominal wages, however, will soon rise as workers demand that their nominal wages keep pace with inflation, which reduces profits and negates the short-run stimulus to production and employment. Consequently, in the long run there is no tradeoff between the rates of inflation and the unemployment rate because the unemployment rate tends back to its natural rate after resource markets adapt to changes in policy. The long-run Phillips Curve is thus vertical with the unemployment rate equal to the natural rate and constant at all levels of inflation. [text: E pp. 300-302; MA pp. 300-302]
23. Answer the questions based on the following diagram.
(a) Assume the economy is initially at point B1 and there is an increase in aggregate demand which results in a 4% increase in prices. Describe the short-run and long-run outcomes that would result in this economy.
(b) Assume the economy is initially at point B2, and there is an increase in aggregate demand. What will happen in the economy? Explain, using the graph.
(c) Based on this diagram, what would the prediction be for the natural (full-employment) rate of unemployment?
(a) In the short run, the unemployment rate will fall to C1, or 5% from its original level of 7% as firms increase prices, obtain more revenues, and thus can afford to hire more workers at the fixed nominal wage. In the long run, as workers and firms adapt to the higher price level, the unemployment rate will return to 7% as indicated by point B2 at the annual rate of inflation.
(b) Essentially the same answer as in (a). In the short run, the unemployment rate will fall to C2, or 5% from its original level of 7%. In the long run, as workers and firms adapt to the new higher price level, the unemployment rate will return to 7%, as indicated by point B3.
(c) According to the diagram 7% is the natural rate. [text: E pp. 301-302; MA pp. 301-302]
24. Why is the difference between the actual and expected rates of inflation important for explaining inflation?
When the actual rate of inflation is higher than the expected rate of inflation, profits temporarily rise because prices that firms charge for their products are rising faster than wage rates. (The nominal wage rates were based on a lower expected rate of inflation than actually exists.) With more revenues, firms can afford to employ more workers so the unemployment rate temporarily falls. In the long run, firms and workers adjust their expectations to the new higher rate of inflation. This means that there will be an increase in the nominal wages rate, so the profits decrease. The firm cannot afford to hire as many workers so some workers get laid off. The unemployment rate rises and returns to its natural rate. [text: E pp. 301-302; MA pp. 301-302]
25. What is disinflation? Give examples of it.
Disinflation is a reduction in the inflation rate from year to year. If the inflation rate was 10 percent the first year, the rate might be only 8 percent the next year, and 6 percent the year after. In each year, there is inflation in the economy, but the rate of inflation is lower from one year to the next. [text: E p. 302; MA p. 302]
26. Why is the difference between the actual and expected rates of inflation important for explaining disinflation?
When the actual rate of inflation is lower than the expected rate of inflation, profits temporarily fall because the prices that firms charge for their products are falling faster than wage rates. (The nominal wage rates were based on a higher expected rate of inflation than actually exists.) With less revenue, firms cannot afford to employ more workers so the unemployment rate temporarily rises. In the long run, firms and workers adjust their expectations to the new lower rate of inflation. This means that the increase in nominal wages falls and the profits of firms rise. Firms can afford to hire more workers, so the unemployment rate falls and returns to its natural rate. [text: E p. 302; MA p. 302]
27. Explain the basic arguments for supply-side economics.
The basic tenet of supply-side economics is that macroeconomic policies have focused on aggregate demand while ignoring the impact of those policies on aggregate supply. Supply-siders contend that changes in aggregate supply are just as active a force in determining employment and price levels as are changes in aggregate demand. In particular, they argue that high marginal tax rates, public transfer programs, and overregulation have caused the aggregate-supply curve to shift leftward while the aggregate-demand curve is being shifted rightward. [text: E pp. 302-303; MA pp. 302-303]
New28. Contrast �supply-side� economics with �demand-side� fiscal policy.
�Supply-side� economics advocates the use of government tax or spending policies to alter the supply schedule, that is, the production side of the economy. Tax reductions may have an expansionary effect on aggregate
supply as well as aggregate demand. Some economists argue that as taxes are cut, savings and investment will increase. Also tax cuts could be aimed specifically at encouraging business investment such as investment tax credits. �Supply-side� economists also argue that tax increases can reduce tax revenues rather than increasing them due to a leftward shift in the aggregate supply curve which causes a decrease in domestic output. [text: E pp. 302-303; MA pp. 302-303]
New29. (Consider This) How did Arthur Laffer use Robin Hood and Sherwood Forest to explain the advantage of supply-side economics?
Laffer considered people passing through Sherwood Forest as taxpayers from which Robin Hood collected taxes. The tax rate in this case was almost 100 percent because travelers had all their money confiscated when they passed through the forest. The reaction to this situation would be to avoid the forest. In this case, there would be less revenue for Robin Hood. Laffer suggested that people, when confronted with high taxes, would change their behavior by working less, saving less, retiring early, and doing other things to avoid taxes. The tax collection policy would result in less revenue for government rather than more. [text: E p. 304; MA p. 304]
30. What is the Laffer Curve? Explain the relationship that is shown in the curve.
The Laffer Curve indicates that the relationship between tax rates and tax revenues is not a clear one. At the extreme, both a zero rate and 100% tax rate will produce zero revenue. In between the two extremes there is an optimal tax rate in terms of maximizing revenue. If tax rates are above the optimal level, then tax revenues will rise as tax rates are cut. If tax rates are below the optimal level then tax revenues will fall as tax rates are cut. Laffer argued that tax rates were above the optimal level and that by lowering tax rates, the government could increase tax revenue and increase economic output at the same time. [text: E p. 303; MA p. 303]
31. Use the following diagram to answer the next three questions.
(a) What is this diagram called and what does it say about the relationship between tax rates and tax revenues?
(b) If tax rates are at level c, should the government raise or lower tax rates to increase revenues? Explain.
(c) What does tax level b represent? Could policy makers find the actual rate that b represents? Discuss this point.
(a) This diagram is called the Laffer Curve, named after the economist who first used the diagram to illustrate the hypothesized relationship between tax rates and tax revenues shown. It illustrates that there is an optimal rate of taxes in terms of maximizing tax revenues and that rates above or below that level will cause revenue to decline. At the extreme, a zero rate and a 100% rate of tax have the same zero revenue.
(b) If rates are at level c, the government could increase revenue by lowering the tax rate to any rate between levels c and b. Tax revenues rise according to the diagram as rates fall from c to b, but below level b, revenues fall again.
(c) Tax level b represents the maximum revenue-producing rate. It is difficult for policy-makers to find this point because of the different types of taxes levied and their differing impact on both supply and demand. If a cut in taxes can be shown to increase revenue, then we know that the rate was above b. The problem is that this is often not known until the tax cut is enacted and if policy makers were wrong, the tax cut could end up reducing revenues. Then it is very difficult to raise taxes again to bring revenues back to their former level. [text: E p. 303; MA p. 303]
32. Draw a Laffer Curve and explain the relationship it purports to portray. Why might this curve be important for macroeconomic policy?
Draw a curve similar to Figure 16.10 from the text. The following curve suggests that up to point b higher tax rates will result in larger tax revenues, but beyond that any increase in rates will have adverse effects on incentives, result in tax avoidance or tax evasion, and generally reduce overall tax revenues. The
curve is important for macroeconomic policy because it correctly suggests that there is an upper limit to tax rates in terms of their potential to increase revenue. Beyond the limit, higher rates will not raise revenues, but will lower them. Laffer was suggesting that the government had already reached the limit and that by lowering rates the government could increase revenue. That is the point of debate. There is little evidence to suggest what the upper limit on tax rates might be in terms of their revenue-raising potential. See graph below. [text: E p. 303; MA p. 303]
New33. What is supply-side economics? What is the rationale for it? Is it effective?
Some economists argue that a reduction in taxes will expand aggregate supply. From this perspective, fiscal policy can be used to increase real GDP with little or no rise in the price level, as would be the case if tax cuts expanded aggregate demand.
There are three possible reasons for the supply-side effect of tax cuts. First, lower taxes increase disposable income that may increase household saving. They
may also stimulate businesses� investments because they increase the after-tax profitability of businesses. Second, lower taxes also give people more incentive to work because they keep more of their income. Third, lower taxes will encourage more risk-taking and entrepreneurship in society because the after-tax reward has been increased.
Many economists are skeptical about the supply-side effect of tax cuts based on the experience with them during the 1980s. The positive effects on incentives to save, invest, or work may not be very large, and therefore the stimulus to the supply-side may be minor. In other words, the demand-side effects of tax cuts appear to be far greater, and more immediate than any of the supply-side effects. [text: E pp. 302-305; MA pp. 302-305]
34. What are the major criticisms of the Laffer curve and supply-side economics?
First, a fundamental criticism relates to the question of economic incentives and whether they are affected much by existing tax rate changes. The skeptics contend that tax cuts have minimal effects on short-run incentives to work, save, and invest. These tax cuts do not appear to increase productivity. Second, most economists believe that the demand-side effects of tax-transfer policies outweigh any offsetting supply-side effects. If the tax cuts increase aggregate demand more than aggregate supply, inflation is likely to result. Third, it is difficult to determine the optimal level of taxation. If the tax rate for the economy is below the optimal tax rate, a tax cut can reduce tax revenues rather than raise them. [text: E p. 304; MA p. 304]
35. (Last Word) Has the effect of oil prices increases on the economy been diminished? Cite evidence to support the case for a diminished effect.
An increase in oil prices has been thought to contribute to stagflation. Oil prices are a major input into the cost of producing many products. If this price increases, then the AS curve would decrease, driving up the price level and reducing real output.
Several reasons are cited as to why the oil price increase in the late 1990s has been less severe than would be expected. First, some firms that used oil-related products for production may have thought that any oil price increases would be temporary, and thus did not change their production plans or prices. Second, and perhaps most important, other factors affecting aggregate supply may have offset the negative effects of the oil price increase. One such factor would be an increase in productivity due to investments in new technology. Third, the nation is less sensitive to changes in oil prices than in past decades because it uses less energy to produce GDP. The Federal Reserve has also become more adept using monetary policy to respond to short-term changes in energy prices so that they have less of an effect on the core inflation rate. [text: E p. 305; MA p. 305]
CHAPTER 12
1. Give a brief definition of fiscal policy? What are its economic goals?
Fiscal policy is the use of the federal budget to achieve full employment, control inflation, and stimulate economic growth. The changes to the federal budget can be made through increases or decreases in government spending or through increases or decreases in tax revenues. [text: E p. 214; MA p. 214].
2. What is the Council of Economic Advisers?
The Council of Economic Advisors is responsible for assisting and advising the president on economic affairs. One of its principal responsibilities is to prepare an annual report for the president that is submitted to Congress that describes the state of the economy and recommends economic policies to achieve full employment, control inflation, and encourage economic growth. [text: E pp. 214-215; MA pp. 214-215].
3. �The Employment Act of 1946 is no more than a vague and ill-defined commitment by the Federal government to assist in the achievement of full employment.� Do you agree? Explain.
To agree with this statement does not diminish the importance of the Employment Act of 1946. The Constitution has also been called vague and ill-defined, but that does not diminish its importance. This act committed the Federal government to following policies which would attempt to stabilize prices and promote full employment and established the CEA and JEC to assist in this task. While specific policies were not outlined, the intention of the act is clear it is a responsibility of the Federal government to assist in this effort. That had not been an explicit on-going policy before 1946. [text: E p. 214; MA p. 214]
4. Explain the effect of a discretionary cut in taxes of $40 billion on the economy when the economy�s marginal propensity to consume is .75. By how much is output likely to expand if the economy is operating in the horizontal range of its aggregate supply curve and there are no complications to this fiscal policy? How does this discretionary fiscal policy differ from a discretionary increase in government spending of $40 billion?
If MPC is .75, the multiplier is 4. A tax cut of $40 billion will result in initial increase in consumption of $30 billion (.75 × $40 billion). This initial increase in spending will ultimately result in an increase in consumption spending of $120 billion because of the multiplier process. In contrast, an initial increase in government spending of $40 billion will ultimately increase consumer spending by $160 billion (4 × $40) because none of the initial increase is siphoned off as savings as would be the case with a $40 billion tax cut. [text: E pp. 215-216; MA pp. 215-216]
5. Explain the effect of a discretionary increase in government spending of $50 billion on the economy when the economy�s marginal propensity to consume is .75. By how much is output likely to expand if the economy is operating in the horizontal range of its aggregate supply curve and there are no complications to this fiscal policy?
If MPC is .75, the multiplier is 4. An initial increase of $50 billion government spending will result in a total increase in output of $200 billion. [text: E pp. 215-216; MA pp. 215-216]
6. Explain the aspects of expansionary and contractionary fiscal policy. During which phases of the business cycle would each be appropriate?
Expansionary fiscal policy refers to increases in government spending or decreases in taxes or both, so that the net effect on aggregate demand is an increase in net government spending. Contractionary fiscal policy is the opposite: an increase in taxes or decrease in government spending or both, so that the net effect on aggregate demand is a decrease in net government spending.
Expansionary policy would most likely be used during a recession (or trough) phase. A contractionary policy would most likely be employed near the peak of the business cycle as the economy reaches full-employment GDP and the potential for inflation accelerates. [text: E pp. 215-217; MA pp. 215-217]
7. Differentiate between discretionary fiscal policy and nondiscretionary or built-in stabilization policy.
Discretionary fiscal policy is the deliberate manipulation of taxes and government spending by the Congress to alter real domestic output and employment, to control inflation, and to stimulate economic growth during a particular period of time. Nondiscretionary fiscal policy, on the other hand, is the change in government expenditures or taxes which occurs automatically as a result of existing laws. In particular, personal income taxes have progressive rates and will slow spending and inflation as GDP expands; when GDP declines, taxes will decrease by a more than proportionate amount allowing incomes and spending to decline at a slower rate than GDP. There are also many transfer payment programs which become effective when incomes decline or unemployment occurs to reduce the decline in disposable income. Conversely, these programs automatically are reduced when the economy expands and unemployment declines and spending increases. [text: E pp. 215, 219-220; MA pp. 215, 219-220]
8. Describe two ways the Federal government can finance a deficit and explain which would have the more expansionary effect.
The government can borrow money from the private sector in which case it will be competing with private business borrowers for funds. If planned investment spending is �crowded out,� the impact of expansionary deficits will be offset by the decline in investment spending.
The government can also finance a deficit by issuing new money which essentially means that the Federal Reserve has financed the deficit. This type of financing would be more expansionary than borrowing from the private sector. [text: E pp. 217-218; MA pp. 217-218]
9. Describe two ways the Federal government could retire debt in the event of a budget surplus and explain which would have the most contractionary impact.
The government could use a budget surplus to pay off existing debt which would �recycle� funds back into the economy and potentially offset the decline in government spending. Alternatively, the government could impound the surplus funds, or allow them to stand idle, which means these funds are not injected into the economy and would have a more contractionary effect than the first alternative. [text: E p. 218; MA p. 218]
10. What is the anti-inflationary or contractionary effect of a budget surplus?
The anti-inflation effect of a budget surplus depends on what the government does with the surplus. The budget surpluses may be used for debt reduction. In this case, bonds are bought back by the government and money is pumped back into the economy. Interest rate will tend to fall, and this may increase consumer and investment spending, thus offsetting some of the contractionary effect of the budget surplus. The government may also impound funds (not spend them). This action will be more contractionary because it actually removes spending from the economy that would have been spent otherwise. [text: E p. 218; MA p. 218]
11. Explain how a small budget surplus could actually be somewhat expansionary rather than contractionary.
This could be the unlikely result of what the government decides to do with the surplus. If it is used to retire existing debt, then the surplus is pumped right back into the economy and with the multiplier effect this additional liquid wealth in the hands of individuals could lead to an increase in aggregate demand and GDP. [text: E p. 218; MA p. 218]
New12. Comment on the statement: �Increasing government spending is preferred to a cut in taxes when the U.S. government seeks to fight a recession.�
The statement is a normative one. Either action, increased government spending or taxation, can be use to fight a recession. The policy choice will depend on the preferences of the individual. Those individuals who want to fight a recession with an increase in government spending may want to preserve the size of government in the economy and have specific government programs they would like to see funded. Those individuals who prefer a tax cut may want to reduce the size of government and give people more money and the freedom to spend it as they chose. [text: E p. 218; MA p. 218]
13. Explain what is meant by a built-in stabilizer and give two examples.
Built-in stabilizers are changes in tax revenues or government spending which occur automatically during different phases of the business cycle. For example, the progressive income tax will dampen any expansion of aggregate demand in the recovery peak phases; and will dampen any decline in income and aggregate demand during a recession as taxes are automatically reduced by a greater proportion than the decline in personal income. There are also government spending programs which increase during recessionary periods automatically as incomes decline or are lost. The so-called �safety net� programs include unemployment compensation, welfare programs, and food stamp spending. These spending programs are automatically reduced during a recovery peak phase which would dampen aggregate demand and inflationary pressures automatically. [text: E pp. 218-219; MA pp. 218-219]
14. �The more progressive a tax system, the greater is the economy�s built-in stability.� Explain this statement for both recessionary and peak phases of the business cycle.
A progressive tax would take a progressively greater proportion of rising incomes during the peak phase of the business cycle which means it would dampen spending increases and aggregate demand which, in turn, reduces inflationary pressures. On the other hand, a progressive tax would take proportionately less away from declining incomes during a recessionary phase allowing disposable income to fall less rapidly than real GDP. Therefore, aggregate demand would decline less rapidly than GDP and the magnitude of the spending decline that might occur in the absence of the tax would be reduced. [text: E pp. 219-220; MA pp. 219-220]
15. Explain how the below graph illustrates the built-in stability of a progressive tax
structure.
The graph illustrates how net taxes are negative as GDP declines which will add to aggregate demand. When GDP expands, tax revenues increase which dampens aggregate demand. [text: E pp. 219-220; MA pp. 219-220]
16. In Year 1, the full-employment budget showed a deficit of about $100 billion and the actual budget showed a deficit of $150 billion one year. In Year 2, the full employment budget showed a deficit of about $125 billion and the actual budget showed a deficit of $150 billion. Based on these data, what can be concluded about the direction of fiscal policy?
Fiscal policy was expansionary because the full-employment budget deficit increased from one year to the next. The actual deficit is composed of the full-employment portion and the cyclical portion. The full-employment portion of the actual budget deficit rose from $100 to $150 billion. The cyclical portion is determined by taking the actual deficit and subtracting the cyclical portion from it. The cyclical portion of the actual deficit fell from $50 billion to $25 billion. The actual budget deficit did not change, but it does not provide a good indication of the direction of fiscal policy. Only the full-employment budget tells the direction of fiscal policy. [text: E pp. 220-221; MA pp. 220-221]
17. What is the difference between the actual deficit, the full-employment deficit, and the cyclical deficit?
The actual budget deficit for any year consists of the full-employment and the cyclical deficit. The full-employment deficit is the difference between government expenditures and tax collections which would occur if there were full employment output. The cyclical deficit is the portion of the actual deficit that arises because the economy is in recession and is produced by this downturn in the business cycle. During a recession, a cyclical deficit often occurs because tax revenues fall as incomes fall and government expenditures increase as more is spent for government transfer payments and other programs. The cyclical deficit occurs because of the operation of these automatic stabilizers. [text: E pp. 221-222; MA pp. 221-222]
18. What does the �full-employment budget� measure and of what significance is this concept?
The full-employment budget refers to the budget deficit or surplus that would result with existing tax and spending programs if the economy were operating at full-employment. In other words, tax revenues and government spending are estimated at the level that would result if full employment existed.
Some economists believe that the full-employment budgetary deficit or surplus is what should determine the expansionary or contractionary nature of fiscal
policy rather than the actual budgetary deficit or surplus. If the full-employment budget is not in deficit, then expansionary fiscal policy is not being followed according to this view even if the actual budget is in deficit. [text: E pp. 221-222; MA pp. 221-222]
19. Complete the table below by stating whether the direction of discretionary fiscal policy was contractionary (C), expansionary (E), or neither (N), given the hypothetical budget data for an economy.
(1) (2) (3) (4)
Actual budget
deficit (�) or Full-employment budget Direction of
Year surplus (+) deficit (�) or surplus (+) fiscal policy
1 � 3.9% � 2.1%
2 � 4.5 � 2.6 E
3 � 4.7 � 3.0 E
4 � 3.9 � 2.6 C
5 � 2.9 � 2.0 C
6 � 2.2 � 1.9 C
[text: E pp. 221-222; MA pp. 221-222]
20. In what fundamental way do the spending-taxation decisions of government differ from the consumption-saving plans of households? Why is this difference significant?
The spending-taxation decisions of government are made in a political environment in which the majority must be satisfied, or satisfied enough to continue to vote for its elected representatives. Furthermore, since the
government does not have a limited lifespan and always has the ability to tax, deficit-spending and debt do not have the same significance to governments that they do to individual households. Households face a much more uncertain future with regard to their power to raise revenue (income) and therefore must plan their spending and saving to coincide with their lifetime earnings expectations.
The difference is significant because so many people try to draw an analogy between government spending policies and household spending plans when it is usually not appropriate to do so. [text: E pp. 223-224; MA pp. 223-224]
New21. Comment on the statement: �Discretionary fiscal policy offers an ideal approach to dealing with the nation�s economic problems. It is without problems, criticisms, or complications.�
Discretionary fiscal policy does offer government policymakers potential tools (changing taxes or government spending) to use for stimulating the economy during a recession or for contracting the economy during a period of high inflation. Fiscal policy, however, is not without its problems, criticisms, or complications. First, there are timing problems in getting it implemented at the right time so it will be effective. Second, there are political problems in getting it accepted because it takes time to get the actions passed through Congress and signed by the President. Third, there are expectations problems because policies may be reversed in the future. Fourth, the taxing and spending decisions of the Federal government may be partially offset by the taxing and spending decisions of state and local governments. Fifth, some economists are concerned that expansionary fiscal policy that requires the Federal government to borrow money will raise interest rates and crowd out investment spending, thus reducing the expansionary effect of the fiscal policy. Sixth, there are complications arising from the connection of the domestic economy to the world economy. Aggregate demand shocks from abroad or a net export effect may increase or decrease the effectiveness of a given fiscal policy. [text: E pp. 223-225; MA pp. 223-225]
New22. Explain the six problems, criticisms, or complications that arise in the implementation of fiscal policy.
First there is a timing problem. Three lags are identified under the �timing problem� category. There is a lag in recognizing the phase of the business cycle; there is an administrative lag in deciding which policies to follow; there is an operational lag in terms of the impact of the policy once it is implemented.
Second, there are political considerations in the adoption of fiscal policy. There is some evidence of a political business cycle where particular expansionary policies are followed in election years whether or not economic conditions merit them.
Third, there is an expectations complication. If businesses and households expect that the fiscal policy will be reversed in the future, they may not change their behavior in the way that would be expected if the fiscal policy was permanent.
Fourth, the taxing and spending decisions of state and local governments may counteract or reduce the effectiveness of fiscal policy decisions at the federal level. The U.S. government may enact an expansionary fiscal policy by increasing its budget deficit, but state and local governments often have to balance a budget and economic conditions may force them to adopt a contractionary policy that partially offset what the federal government is seeking to achieve.
Fifth, there is concern about possible offsetting effects of government borrowing crowding out private spending that would occur in the absence of the government deficit; and an offsetting net export effect which partly counteracts expansionary policy or contractionary policy.
Sixth, there are complications to domestic fiscal policy from the national economy�s connection to the world economy. Economic shock from abroad can have an effect on the nation�s imports and exports. The net export effect can reduce the intended effects of fiscal policy. [text: E pp. 223-226; MA pp. 223-226]
New23. Explain the problems giving rise to this statement: �You would think the government would want to do something to improve economic conditions when the economy is in trouble, but the government is slow to act.�
Fiscal policy is subject to timing problems. There are three timing lags that limit the speed with which fiscal policy can be enacted and effective. First, there is a lag in recognizing the phase of the business cycle to determine when the government might want to provide help. Second, there is an administrative lag in decision-making that involves deciding which specific policies should be adopted. Third, there is an operational lag because the adoption of policies takes time to have an effect on output and employment. [text: E p. 223; MA p. 223]
New24. How do expectations about the future by households and businesses affect the effectiveness of fiscal policy? Cite examples.
If households or businesses expect that the fiscal policy changes are only temporary, they may not change their behavior in the expected way. For example, if tax cuts are enacted to stimulate consumer spending, some consumers may not change their spending habits if they think the tax change is only temporary. In the future, they will have to pay more in taxes, so they might increase their saving. Similarly, businesses may not invest in new plants and equipment if they get a tax cut, if they expect taxes in the future to rise or the fiscal policy to be ineffective. [text: E pp. 223-224; MA pp. 223-224]
25. �If economic forecasting was a more exact science, the business cycle could be entirely corrected by fiscal measures.� Do you agree?
Exact forecasting, if possible, would still not solve all of the problems encountered in trying to correct the business cycle. There is also the problem of timing the enactment and application of fiscal policy, not to mention the coordination of monetary policy and international economic policies, or
reduced private spending (�crowding out�). [text: E pp. 223-225; MA pp. 223-225]
26. Explain the crowding-out effect.
The crowding-out effect is the notion that government borrowing to finance a deficit may crowd out or reduce private borrowing. To the extent that this occurs, the expansionary impact of fiscal policy is reduced because increased demand by the government is partially offset by reduced demand in private investment. [text: E pp. 224-225; MA pp. 224-225]
27. Using the below graph, illustrate the possible impact of a crowding-out effect of a fiscal policy by drawing in the relevant aggregate demand shifts. Label and
explain any shifts in the demand curve shown.
Expansionary fiscal policy increases demand from AD1 to AD2, but this crowds out some private investment spending that offsets the increase to some extent
causing AD2 to decrease to AD3. See graph below. [text: E pp. 224-225; MA pp. 224-225]
28. Explain how the net-export effect would reduce the effectiveness of fiscal policy.
If an expansionary fiscal policy brings with it higher interest rates, this could increase the demand for American dollars by foreign investors seeking to earn the higher U.S. returns. This appreciation of the dollar makes U.S. goods and services more expensive to foreigners and foreign imports less expensive to Americans. The net export category of aggregate demand will be reduced which would reduce the impact of expansionary fiscal policy. A contractionary fiscal policy could have the opposite effect causing net exports to increase that again reduces the desired effect of the contractionary fiscal policy. [text: E pp. 225-226; MA pp. 225-226]
New29. What fiscal policy is most likely to be invoked during a period of recession and high unemployment? A period of rapid inflation? What political, investment, and international problems might the U.S. Congress encounter in enacting these policies and putting them into effect?
During recession and high unemployment, the government would most likely initiate an expansionary fiscal policy. A contractionary fiscal policy would most likely be called for during a period of rapid inflation, especially if it seems to be demand-pull inflation.
Several problems are likely to arise in enacting either of these policies. Timing lags in recognition, implementation, and impact are one concern. Another has to do with political realities. A contractionary policy has many unpopular aspects to it because it calls for raising taxes and for cutting government spending. There are also unique problems associated with expansionary policy: crowding out is one potential result that would reduce the expansionary effect of the policy. In both cases, the net-export part of aggregate demand is likely to move in a direction that would tend to offset the policy. [text: E pp. 223-226; MA pp. 223-226]
30. (Last Word) What is the purpose of the Conference Board�s index of leading economic indicators? The index of leading indicators is a monthly index of economic statistics that are used to forecast the
direction of real GDP. Changes in the index provide an indication of the future direction of the economy and are useful to policy makers in developing responses to deteriorating conditions in the economy. The rule of thumb is that three successive decreases or increases in the index indicate a change of direction in the economy. [text: E p. 227; MA p. 227]
31. (Last Word) Why is the index of leading economic indicators a composite index of ten economic statistics
and not just one? Each of the economic statistics used to prepare the index may increase or decrease in any month and thus
give false or contradictory signals about the direction of the economy. It is less likely that all these economic indicators, taken together, will give as many false signals about the direction of the economy as one indicator will. Thus the composite index is more reliable than any one indicator. The composite index, however, is not infallible and can also give false indications about the direction of the economy because of changes in the structure of the economy or developments that are not covered by the indicators that make up the index. [text: E p. 227; MA p. 227]
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