Anyone major in economics

Study Guide

Economics 1 By

A. J. Cataldo II, Ph.D., CPA, CMA

About the Author

A. J. Cataldo is currently a professor of accounting at West Chester University, in West Chester, Pennsylvania. He holds a B.S. degree in accounting/finance and a master of accounting degree from the University of Arizona. He earned a Ph.D. from the Virginia Polytechnic Institute and State University. He is a certified public accountant and a certified management accountant. He has worked in public accounting, as a government auditor, controller, and provided expert testimony in business litigation engagements. His publications include three Elsevier Science monographs, and his articles have appeared in Journal of Accountancy, National Tax Journal, Research in Accounting Regulation, Journal of Forensic Accounting, Accounting Historians Journal, and many others. He has also published in and served on editorial review boards for Institute of Management Accounting association journals, including Management Accounting, Strategic Finance, and Management Accounting Quarterly, since January 1990.

Copyright © 2015 by Penn Foster, Inc.

All rights reserved. No part of the material protected by this copyright may be reproduced or utilized in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without permission in writing from the copyright owner.

Requests for permission to make copies of any part of the work should be mailed to Copyright Permissions, Penn Foster, 925 Oak Street, Scranton, Pennsylvania 18515.

Printed in the United States of America

06/02/2015

All terms mentioned in this text that are known to be trademarks or service marks have been appropriately capitalized. Use of a term in this text should not be regarded as affecting the validity of any trademark or service mark.

INSTRUCTIONS TO STUDENTS 1

LESSON ASSIGNMENTS 5

LESSON 1: INTRODUCTION TO ECONOMICS AND THE ECONOMY 7

LESSON 2: GDP, GROWTH, AND INSTABILITY 29

LESSON 3: MACROECONOMIC MODELS AND FISCAL POLICY 47

LESSON 4: MONEY, BANKING, AND MONETARY POLICY 67

LESSON 5: EXTENSIONS AND ISSUES, AND INTERNATIONAL ECONOMICS 87

GRADED PROJECT 111

SELF-CHECK ANSWERS 119

iii

C o

n t

e n

t s

C o

n t

e n

t s

INTRODUCTION Welcome to Economics 1! This course will cover the topic of macroeconomics, which is the study of the economy as a whole. It analyzes economy-wide phenomena including inflation, unemployment, and trade deficits.

Macroeconomics information shows up daily in our news- papers and on the television news, because its implications are important to the quality of our lives. For instance, why is income high in some countries and very low in others? Why do production and employment expand in some years and contract in others? These questions can be addressed by macroeconomic analysis to help us better understand how the condition of the overall economy affects us all.

You often hear about such things as the rate at which aver- age prices are rising (inflation) and the imbalance of trade between the United States and the rest of the world (the trade deficit). These statistics are compiled and monitored by the economists who study the macroeconomy.

OBJECTIVES When you complete this course, you’ll be able to

n Identify the basic function of economics in our society

n Examine various economic tradeoffs that people face

n Explain the laws of supply and demand

n Use the concept of elasticity to explain changes in a market

n Discuss the pros and cons of trade restrictions

n Calculate and interpret the unemployment rate and the labor-force participation rate

n Describe the notion of deadweight loss and its relevance to taxes

n Draw and interpret short-run and long-run Phillips curves

1

In s

t r

u c

t io

n s

In s

t r

u c

t io

n s

n Explain why economists focus on GDP, inflation, and unemployment when assessing economic health

n Describe how comparative advantage and specialization affect international trade

n Describe how differences between world prices and domestic prices prompt exports and imports

n Describe how changes in income affect consumption and saving

YOUR TEXTBOOK Your textbook, Macroeconomics, Eighteenth Edition, by Campbell R. McConnell, Stanley L. Brue, and Sean M. Flynn, is the heart of this course. It contains the study material on which your examinations will be based. We’ve divided the textbook material into five lessons.

It’s very important that you read the material in the textbook and study it until you’re completely familiar with it. It’s a good idea to begin by skimming the contents at the front of the book. This will give you an overview of the entire textbook.

Each chapter opens with a brief overview of the goal for that section. Use these descriptions and the objectives listed above to judge your understanding of the text material before you take your examinations. Your textbook is filled with use- ful illustrations and tables to further your understanding of the reading. There’s a summary and a list of important terms at the end of each chapter. There’s also a glossary and an index at the back of the book.

COURSE MATERIALS You should have received the following learning materials for this course:

1. Your textbook, Macroeconomics, which contains the assigned readings and study questions

Instructions to Students2

2. This study guide, which will help you to understand the major ideas presented in the textbook in addition to providing background information about specific topics

The study guide also includes

n Self-checks for each lesson

n Answers to the self-checks

A STUDY PLAN In studying your assignments, be sure to read all of the instructional material in both the textbook and the study guide. Here’s a good plan to follow:

1. Note carefully the page where the assignment begins and the page where it ends. These pages are indicated in the Lesson Assignments section.

2. Read the introduction to the assignment in the study guide.

3. Read the designated pages for that assignment in the textbook to get a general idea of their contents. Then study the assignment, paying careful attention to all details, including the figures referenced in the text.

4. When you’re comfortable with the material for each assignment, complete the self-check at the end of the assignment in your study guide, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. To get to the quiz at that website, find the dropdown menu on the left side of the screen, then click the chapter you’ve just read (e.g., Chapter 1), and then click Quiz once the new win- dow opens to see the multiple-choice questions. Neither the self-checks nor the online quizzes are graded, so do not send the self-check answers to the school. They’re designed to reveal weak points that you need to review and for you to evaluate your understanding of the mate- rial.

Instructions to Students 3

5. When you’ve finished the self-check and the online quiz, check your answers. The answers for the self-checks can be found at the end of this study guide, while the answers to the online quizzes are given once you take the quiz and click Submit Answers. If you’ve missed any questions, go back and review the related topic. This review will reinforce your understanding of the material.

6. Complete each assignment in this way.

7. When you feel that you understand all of the material presented in the lesson assignments, you may complete the examination for that lesson.

8. Follow this procedure for all five lessons.

9. Complete the research project after completing all five lessons.

Remember, at any time, you can e-mail your instructor for information regarding the materials. The instructor can pro- vide you with answers to any questions you may have about the course or your study materials.

Now you’re ready to begin Lesson 1.

Good luck!

Instructions to Students4

Remember to check your student portal regularly. Your instructor may

post additional resources that you can access to enhance your learn-

ing experience.

Lesson 1: Introduction to Economics and the Economy For: Read in the Read in study guide: the text:

Assignment 1 Pages 8–10 Chapter 1, Pages 3–19 and 22–26

Assignment 2 Pages 11–14 Chapter 2, Pages 29–42

Assignment 3 Pages 15–18 Chapter 3, Pages 45–63 and 66–70

Assignment 4 Pages 19–23 Chapter 4, Pages 72–89

Assignment 5 Pages 24–27 Chapter 5, Pages 91–109

Examination 050472 Material in Lesson 1

Lesson 2: GDP, Growth, and Instability For: Read in the Read in study guide: the text:

Assignment 6 Pages 30–34 Chapter 6, Pages 113–123

Assignment 7 Pages 36–38 Chapter 7, Pages 126–142

Assignment 8 Pages 39–42 Chapter 8, Pages 145–165

Assignment 9 Pages 43–45 Chapter 9, Pages 167–185

Examination 050473 Material in Lesson 2

Lesson 3: Macroeconomic Models and Fiscal Policy For: Read in the Read in study guide: the text:

Assignment 10 Pages 48–50 Chapter 10, Pages 188–205

Assignment 11 Pages 51–55 Chapter 11, Pages 208–227

Assignment 12 Pages 57–60 Chapter 12, Pages 230–248 and 251–253

Assignment 13 Pages 61–65 Chapter 13, Pages 254–272

Examination 050474 Material in Lesson 3

5

A s

s ig

n m

e n

t s

A s

s ig

n m

e n

t s

Lesson 4: Money, Banking, and Monetary Policy For: Read in the Read in study guide: the text:

Assignment 14 Pages 69–72 Chapter 14, Pages 276–290

Assignment 15 Pages 74–75 Chapter 15, Pages 292–304

Assignment 16 Pages 77–80 Chapter 16, Pages 307–331

Assignment 17 Pages 81–84 Chapter 17, Pages 334–350

Examination 050475 Material in Lesson 4

Lesson 5: Extensions and Issues, and International Economics For: Read in the Read in study guide: the text:

Assignment 18 Pages 89–93 Chapter 18, Pages 354–371

Assignment 19 Pages 94–96 Chapter 19, Pages 373–386

Assignment 20 Pages 97–99 Chapter 20, Pages 390–408

Assignment 21 Pages 100–104 Chapter 21, Pages 411–429

Assignment 22 Pages 106–108 Chapter 22, Page 433

**Note that Chapter 22, “The Economics of Developing Countries,” is found on the Web site, www.mcconnell18e.com.

Examination 050476 Material in Lesson 4

Graded Project 05047700

Lesson Assignments6

Note: To access and complete any of the examinations for this study

guide, click on the appropriate Take Exam icon on your student portal.

You should not have to enter the examination numbers. These numbers

are for reference only if you have reason to contact Student CARE.

7

L e

s s

o n

1

L e

s s

o n

1

Introduction to Economics and the Economy

INTRODUCTION This first lesson is an introduction to the economic concepts you’ll be learning about in the textbook, and it contains four reading assignments.

Assignment 1 starts with a discussion of the meaning and importance of economics. You’ll learn the difference between macroeconomics and microeconomics, and review the methods that economists use to study economic behavior.

Assignment 2 reviews the differences between a command system and a market system, and explains the important characteristics of the market system that’s used in the United States economy.

Assignment 3 introduces the topics of demand and supply, and illustrates and explains their determinants.

Assignment 4 discusses the private sector and the public sector in our market economy, and uses the circular flow diagram to show how the public sector interacts with the private sector.

Assignment 5 introduces the basic principles of international trade, the global economy, and the United States’ role in each.

OBJECTIVES When you complete this lesson, you’ll be able to

n Define economics, and describe the features of the economic perspective

n Describe the distinction between microeconomics and macroeconomics

n Use a budget line to illustrate opportunity costs

n List the four types of economic resources for society

Economics 18

n Construct a production possibilities curve with given data

n Compare and contrast the command system and the market system

n Define the concepts of demand and supply

n Describe how changes in supply and demand affect equilibrium prices and quantities

n Explain how government-set prices can cause product surpluses and shortages

n List the five economic functions of government in the United States

n Describe the government’s main categories of spending and sources of revenue

n Explain the importance of international trade to the U.S. economy

n Describe how comparative advantage and specialization affect international trade

n Explain how exchange rates are determined in currency markets

n Describe how and why governments sometimes interfere with free international trade

ASSIGNMENT 1 Read this introduction to Assignment 1. Then, read Chapter 1, “Limits, Alternatives, and Choices,” on pages 3–19 and 22–26 in your textbook Macroeconomics.

The Economic Perspective Chapter 1 starts with a discussion of the meaning and importance of economics. You’ll learn how economists think about problems, and review the methods economists use to study economic behavior.

Lesson 1 9

Economics is the social science that studies how individuals, institutions, and society make optimal choices under condi- tions of scarcity. Human wants are unlimited, but the means to satisfy these wants are limited. Resources can be used for only one purpose at a time, and scarcity requires that choices be made. The opportunity cost of any good, service, or activity is the value of what must be given up to obtain it.

Rational self-interest involves making decisions to achieve maximum utility, which is the pleasure or satisfaction obtained from consuming a good or service. Each person’s unique preferences and circumstances (including errors) lead to different choices. Note that rational self-interest isn’t the same as selfishness.

Most decisions concern a change in current conditions; therefore, the economic perspective is largely focused on marginal analysis. In marginal analysis, the marginal benefit of each option is weighed against the marginal cost. Whether the decision is personal or made by business or government, the principle is the same—the marginal cost of an action shouldn’t exceed its marginal benefits. The opportunity cost is the value of the next best thing forgone, and opportunity costs are always present whenever a decision is made.

Economists use the scientific method to establish theories, laws, and principles relating to their field of study.

Microeconomics and Macroeconomics In this section, the difference between macroeconomics and microeconomics is explained. Microeconomics looks at individual economic units, such as a person, household, company, or industry. Macroeconomics examines the econ- omy as a whole, at the level of a nation or government.

Next, you’ll look at the economizing problem from both the individual’s and society’s perspective, and you’ll be introduced to the budget line and the production possibilities model. In the discussion of production possibilities, the concepts of opportunity costs, increasing opportunity costs, unemployment, growth, and present versus future possibili- ties are all demonstrated. Finally, the highlighted section titled “Last Word” reviews some of the problems, limitations, and pitfalls that hinder sound economic reasoning.

Economics 110

The Appendix to Chapter 1 provides an important review of graphs and their meaning. You may already be familiar with this material, but it won’t hurt to review the section before proceeding. Graphs will be used throughout the textbook to illustrate important economic concepts.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 1, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide.

Self-Check 1 At the end of each section of Economics 1, you’ll be asked to pause and check

your understanding of what you’ve just read by completing a “Self-Check” exercise.

Answering these questions will help you review what you’ve studied so far. Please

complete Self-Check 1 now.

Indicate whether each of the following statements is True or False.

______ 1. An economy will always operate at some point on its production possibilities curve.

______ 2. Microeconomics is concerned with the economy as a whole, while macroeconomics

explains the behavior of individual households and businesses.

______ 3. An economy can’t produce at a point outside of its production possibilities curve

because human economic wants are insatiable.

______ 4. In marginal analysis, decision makers compare the extra benefits with the extra costs

of a specific choice.

______ 5. The lower the consumer’s income, the higher his or her budget line will be.

______ 6. The entrepreneur’s sole function is to combine other resources (land, labor, and capital)

in the production of some good or service.

(Continued)

Lesson 1 11

ASSIGNMENT 2 Read this introduction to Assignment 2. Then, read Chapter 2, “The Market System and the Circular Flow,” on pages 29–42 in your textbook Macroeconomics.

Economic Systems Chapter 2 begins with a comparison of the command and market systems, and a discussion of the institutional frame- work of the American market system. The characteristics of the market system are explained, including private property, freedom of enterprise and choice, the role of self-interest, competition, markets and prices, the reliance on technology and capital goods, specialization, use of money, and the role of government.

Self-Check 1 ______ 7. The process by which capital goods are accumulated is known as investment.

______ 8. Positive statements are expressions of value judgments, and normative statements

are expressions of facts.

______ 9. In drawing a particular budget line, money income and the prices of the two products

are fixed.

______ 10. The production possibilities curve shows various combinations of two products that

an economy can produce when achieving full employment.

Check your answers with those on page 119.

Economics 112

Every nation and society has an economic system. These economic systems can differ in two important ways:

1. Who owns the factors of production

2. What method is used to coordinate the economic activity

In a command economy (also known as socialism or communism), economic resources are owned and controlled by the state, and economic activity is coordinated by central planning. In contrast, in a market system (also known as capitalism), resources are owned privately, and markets and prices coordinate and direct the economic activity. Each participant acts in his or her own self-interest. In pure capitalism, the government plays a very limited role. In the version of capitalism seen in the United States, the govern- ment plays a substantial role.

The following are some important characteristics of the market system:

n Private individuals and firms own most of the private property (land and capital).

n Freedom of enterprise and choice exist.

n Self-interest is the motivator.

n Competition among buyers and sellers is a controlling mechanism.

n Markets and prices drive the economic activity.

n There’s a strong reliance on technology and capital goods.

n Specialization is an important factor.

n Money is used as a medium of exchange.

n Government influence is active, but limited.

Lesson 1 13

Five Fundamental Questions In this section, the authors address the five fundamental questions faced by every economy, and explain how a market economy answers each one. The following are the five funda- mental questions that must be answered by all economic systems:

1. What goods and services will be produced?

2. How will the goods and services be produced?

3. Who will get the output?

4. How will the system accommodate change?

5. How will the system promote progress?

The “Invisible Hand” In this section, a discussion of Adam Smith’s “invisible hand” leads into an explanation of why command systems have failed.

Competition is the mechanism of control for the market system. It not only guarantees that industry responds to consumer wants, but it also forces firms to adopt the most efficient production techniques. The famous economist Adam Smith spoke of the “invisible hand” that promotes public interest through a market system in which the primary motivation is self-interest. By attempting to maximize profits, firms will also be producing the goods and services that are most wanted by society.

Of the many merits of the market system, the following three stand out:

1. Market systems promote efficiency in the allocation of resources.

2. Market systems provide incentives for people to be productive through work effort and acquiring skills.

3. Market systems provide a lot of personal freedom in making economic decisions.

Economics 114

Command systems in the Soviet Union, Eastern Europe, and China have eventually given way to market systems. The failure of command systems can be attributed to the coordination problem and the incentive problem.

The Circular Flow Model The final part of the chapter introduces the circular flow model as an overview of how resources and goods move through a market system. There are two main groups of decision makers in the private economy: households and businesses. The textbook provides a graph that illustrates how resources flow from households to businesses through the resource martket, and from businesses to households through the product market. Be sure to review the graph carefully.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 2, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide.

Self-Check 2 Indicate whether each of the following statements is True or False.

______ 1. In the Soviet Union and pre-reform China, central planning emphasized the expansion

of the production of consumer goods to raise the domestic standard of living.

______ 2. Money functions as a medium of exchange by eliminating the need for a coincidence

of wants.

______ 3. Continued losses in an industry will cause some firms to reduce output or eventually

leave the industry.

(Continued)

Lesson 1 15

ASSIGNMENT 3 Read this introduction to Assignment 3. Then, read Chapter 3, “Demand, Supply, and Market Equilibrium,” on pages 45–63 and 66–70 in your textbook Macroeconomics.

Demand and Supply Chapter 3 introduces demand and supply concepts. Both demand and supply are defined and illustrated; determinants of demand and supply are listed and explained.

A market is an institution or mechanism that brings together buyers (demanders) and sellers (suppliers) of particular goods and services. Demand is a curve that shows the various amounts of a product that consumers are willing and able to buy at each possible price during a specified time period.

Self-Check 2 ______ 4. Market economies use capital goods because they improve productive efficiency.

______ 5. Consumers’ wants are expressed in the marketplace with “dollar votes.”

______ 6. Central planning is plagued with a coordination problem and an incentive problem.

______ 7. The “invisible hand” refers to the many indirect controls that the federal government

imposes in a market system.

______ 8. A state government program keeps milk prices higher than market-determined prices

in order to protect family dairy farms from bankruptcy. This type of program promotes

the efficient allocation of resources.

Check your answers with those on page 119.

Economics 116

The law of demand is a fundamental characteristic of demand behavior. According to the law of demand, as the price of an item falls, the quantity demanded rises; and as the price of an item rises, the quantity demanded falls.

There are several other determinants besides price that can affect demand. The following are the determinants of demand discussed in your textbook:

n Tastes

n Number of buyers

n Income

n Prices of related goods

n Substitutes

n Complements

n Unrelated goods

n Consumer expectations

Be sure to review these determinants carefully, and note how each one affects demand. Also, note the distinction between a change in quantity demanded that’s caused by a price change, and a change in quantity demand that’s caused by a change in determinants.

Supply is a curve that shows the amounts of a product that a producer is willing and able to produce and sell at each possible price during a specified time period. According to the law of supply, as the price of an item falls, the quantity supplied falls; and as the price of an item rises, the quantity supplied rises.

In addition to price, there are several other determinants of supply. The following are the determinants of supply discussed in your textbook:

n Resource prices

n Technology

n Taxes and subsidies

n Prices of other goods

Lesson 1 17

n Producer expectations

n Number of sellers

Note how each determinant affects supply. Then, review the distinction between a change in quantity supplied that’s caused by a price change, and a change in quantity supplied that’s caused by a change in determinants.

Market Equilibrium In this section of your textbook, the concept of equilibrium and the effects of changes in demand and supply on equilibrium price and quantity are explained and illustrated. Note that another name for the equilibrium price is market- clearing price.

If demand is changed while supply is held constant, the following will occur:

n An increase in demand will increase equilibrium price and quantity.

n A decrease in demand will decrease equilibrium price and quantity.

If supply is changed while demand is held constant, the following will occur:

n An increase in supply will decrease equilibrium price and increase quantity.

n A decrease in supply will increase equilibrium price and decrease quantity.

In some complex cases, both supply and demand shift, and the following will occur:

n If supply increases and demand decreases, price declines, but the new equilibrium quantity depends on the relative sizes of shifts in demand and supply.

n If supply decreases and demand increases, price rises, but the new equilibrium quantity again depends on the relative sizes of shifts in demand and supply.

Economics 118

n If supply and demand both change in the same direction (both increase or both decrease), the change in equilib- rium quantity will be in the direction of the shift, but the change in equilibrium price will depend on the relative shifts in demand and supply.

Application: Government-Set Prices This section includes a discussion of productive and alloca- tive efficiency, and a review of price controls. A price ceiling is the maximum legal price a seller may charge for a product or service. A price floor is a minimum price for an item that’s fixed by the government. You’ll learn how government-set price controls prevent the market from reaching the equilib- rium price and quantity.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 3, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide.

Self-Check 3 Indicate whether each of the following statements is True or False.

______ 1. Consumers buy fewer normal goods as their incomes rise.

______ 2. A government tax per unit of output reduces supply.

______ 3. Shortages drive market prices down, while surpluses drive them up.

______ 4. In a competitive market, a price floor will result in persistent shortages of a product.

______ 5. Allocative efficiency is the process of producing a good in the least costly way.

(Continued)

Lesson 1 19

ASSIGNMENT 4 Read this introduction to Assignment 4. Then, read Chapter 4, “The U.S. Economy: Private and Public Services,” on pages 72–89 in your textbook Macroeconomics.

Households as Income Receivers and Spenders Chapter 4 provides details about the private sector (house- holds and businesses) and the public sector (government) in our market economy. The goal is to understand households,

Self-Check 3 ______ 6. If supply decreases and demand simultaneously increases, the equilibrium price

will rise.

______ 7. A government subsidy per unit of output increases supply.

______ 8. A market that’s producing the quantity of goods most desired by society is achieving

productive efficiency.

______ 9. An increase in quantity supplied might be caused by an increase in production costs.

______ 10. A market that’s achieving allocative efficiency must also be achieving productive

efficiency.

______ 11. In a competitive market, every consumer willing to pay the market price can buy

a product, and every producer willing to sell the product at that price can sell it.

______ 12. The rationing function of prices refers to the fact that government must distribute

any surplus goods that may be left in a competitive market.

Check your answers with those on page 119.

Economics 120

businesses, and governmental units as the primary decision makers in our economy. The circular flow diagram has been expanded to show how the public sector interacts with two parts of the private sector.

Households are a key element in the circular flow diagram, and are the major spender in our economy. The measure- ment called the functional distribution of income shows how the nation’s income is distributed among wages, rents, interest, and profits. The personal distribution of income measurement shows how the nation’s income is divided among households. Your textbook describes how households in the United States dispose of their income in relation to these measurements.

The Business Population Businesses are the second major part of the private sector. While you’re reading about businesses, keep the following important definitions in mind:

n A plant is a physical establishment where production or distribution takes place (such as a factory, farm, or store).

n A firm is a business organization that owns and operates one or more plants, and produces goods and services for profit.

n An industry is a group of related firms, producing the same or similar products (such as the automobile industry or the tobacco industry).

A multiplant firm is a business with several physical plants. The organizational structure of a multiplant firm can be complex and varied. A horizontally integrated business is a multiplant firm with several plants performing the same function, like a retail chain store (such as J.C. Penney or Safeway). A vertically integrated business has several plants that perform functions at different production stages (such as a steel company that owns ore mines and manufacturing plants). A conglomerate is a firm that owns plants in different industries or markets.

Lesson 1 21

There are three major legal forms of businesses:

1. A sole proprietorship is a business owned by a single individual.

2. A partnership is a business owned and operated by two or more individuals in a partnership agreement.

3. A corporation is a legal entity that can produce and sell products, and conduct other business activities. The corporation is distinct and separate from the individual stockholders who own it.

The corporate structure has both advantages and disadvan- tages. Advantages include the following:

n An improved ability to raise financial capital by issuing stocks and bonds

n Limited liability (owners risk only what they pay for the stock)

n Permanence that’s conducive to long-run planning and growth

Some disadvantages of the corporate structure include the following:

n Red tape and expense in obtaining a corporate charter

n Unscrupulous business owners that sometimes avoid responsibility for questionable business activities

n Double taxation of corporate income

n Possible inconsistency between owner objectives and manager objectives (principal-agent problem)

The Public Sector: Government’s Role The public sector, which includes the federal, state, and local governments, is extensive and has many economic functions in our society. The most important economic activities of the public sector include the following:

n Providing the legal structure

n Maintaining competition

Economics 122

n Redistributing income

n Reallocating resources

n Promoting stability

Your textbook shows a revised diagram of the circular flow model with the addition of the government sector. There are several modifications to the Chapter 2 model. Flows (5) through (8) illustrate that the government makes purchases and expenditures in both the product and resource markets. Flows (9) and (10) illustrate that the government provides public goods and services to households and businesses. Flows (11) and (12) illustrate that government receives taxes from and distributes subsidies to households and businesses.

You can see the size of the government’s economic role by looking at government purchases of goods and services, and at government transfer payments. Government purchases of goods and services have declined as a percentage of U.S. output since 1961. However, expenditures on transfer payments have increased greatly since that time. Thus, the major source of growth in government spending since the 1960s has been in the transfer payment area.

Federal government expenditures are mainly in the following four areas:

1. Income security (pensions and disability payments)

2. National defense

3. Health

4. Interest on the public debt

Federal government revenue (income) comes from the follow- ing main sources:

n Personal income tax

n Payroll taxes (such as Social Security contributions)

n Corporate income taxes on corporation profits

n Excise taxes

Lesson 1 23

State and local expenditures and receipts differ in composi- tion from those of the federal government. For example, the largest source of revenue for state governments is sales and excise taxes. Be sure to review these various sources of income and expenditure.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 4, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide.

Self-Check 4 Indicate whether each of the following statements is True or False.

______ 1. If the average tax rate rises as income increases, a tax is progressive.

______ 2. A group of plants, each operating at different stages of production, is known

as a vertically integrated firm.

______ 3. If a good’s production creates substantial negative externalities, then too little

of it will be produced unless firms are subsidized.

______ 4. Unemployment compensation payments are considered to be a type of transfer

payment.

______ 5. Salaries and wages make up the largest source of household income.

______ 6. Increasing taxes and reducing government expenditures might be helpful in

constraining inflation.

______ 7. The sales tax is the largest source of a local government’s revenue.

______ 8. Only the bondholders of a corporation have the right to vote for a corporation’s

directors.

(Continued)

Economics 124

ASSIGNMENT 5 Read this introduction to Assignment 5. Then, read Chapter 5, “The United State in the Global Economy,” on pages 91–109 in your textbook Macroeconomics.

International Linkages Chapter 5 introduces the basic principles underlying the global economy. First, you’ll learn about the growth of world trade, and the United States’ role in it.

Self-Check 4 ______ 9. If a market is competitive, the resulting equilibrium output will always be the socially

efficient output.

______ 10. The “free-rider problem” refers to the possibility that someone may benefit from

a good without paying for it.

______ 11. As it relates to public goods, nonexcludability means that nonpayers can be barred

from obtaining the benefits.

______ 12. The marginal tax rate is the tax rate that applies to additional income.

______ 13. It would be appropriate for the government to cut tax rates if there’s substantial

unemployment in the economy.

______ 14. Households spend a larger proportion of their incomes for services than for either

nondurable goods or durable goods.

______ 15. The property tax is the basic source of a state government’s revenue.

______ 16. Limited liability means all members of a partnership are liable for the debts incurred

by one another.

Check your answers with those on page 120.

Lesson 1 25

Several economic flows link the U.S. economy with the econ- omies of other nations. These links include the following:

n Goods and services flows

n Capital and labor (resource) flows

n Information and technology flows

n Financial flows

International trade implies complex financial linkages among nations. Trade deficits must be financed by borrowing or earning foreign exchange. This can be accomplished by sell- ing American assets through foreign investment. The United States borrows money from citizens of other nations, and the United States is, in fact, the world’s largest debtor nation.

Specialization and Comparative Advantage This section of your textbook introduces the concept of com- parative advantage as the basis for world trade. Given the presence of an open economy, the United States produces more of certain goods (exports) and fewer of other goods (imports) than it would otherwise. Why? Well, economist Adam Smith observed in 1776 that specialization and trade increase the productivity of a nation’s resources. His observa- tion related to the principle of absolute advantage, whereby Country A should buy a good from other countries if they can supply it more cheaply than Country A can itself.

The principle of comparative advantage was first observed and explained in the early 1800s by David Ricardo. This principle explains that it pays for a person or a country to specialize in and exchange goods, even if that person or nation is more productive than the potential trading partners in all economic activities. Specialization in the production of goods is economically desirable because it results in more efficient production.

The “Consider This...” feature on page 97 explains the prin- ciple of comparative advantage by comparing the labor costs of a certified public accountant and a house painter. Would

Economics 126

the CPA save money by painting her own house? The CPA earns $50 per hour as accountant, and can hire a painter for $15 per hour. On economic grounds, the opportunity cost is greater for the accountant to paint her house, so she should focus on her accounting job and hire the painter to paint her house. This example shows that even if a person (the accountant) has an absolute advantage in production of two products (painting and accounting), it’s still advanta- geous to specialize and trade. The same concept is true for nations.

The principle of comparative advantage for two countries, the United States and Mexico, is also illustrated with a simplified example on page 97. Both countries can produce soybeans and avocados. In Mexico, the opportunity cost of producing 1 ton of soybeans is giving up 4 tons of avocados. In the United States, the opportunity cost of 1 ton of soybeans is giving up 3 tons of avocados. This means that the compara- tive cost of producing soybeans is less in the United States than in Mexico, when the alternative is producing avocados. Thus, the United States should specialize in growing soy- beans, and Mexico should specialize in growing avocados.

Foreign Exchange Markets This section of your textbook discusses foreign currencies and international exchange rates. In a foreign exchange market, various national currencies are exchanged for one another so that international trade can take place. The equi- librium prices in the currency market is called the exchange rate. Exchange rates link one country’s domestic prices with all foreign prices, and enable you to translate the price of foreign products into U.S. dollars.

Government and Trade Restrictive trade practices are examined in this part of your textbook, leading to a discussion of multilateral trade agree- ments and free-trade regions of the globe.

Lesson 1 27

Trade impediments are sometimes enacted by governments, including protective tariffs and import quotas. Trade barriers can harm American consumers, who must pay higher prices for products than people in other areas of the world. Interference with international trade through protective tariffs and quotas is shown to cost society more than the benefits that are received by the protected firms and workers.

The imposition of trade barriers can also cause “trade wars,” in which all nations retaliate by enacting trade barriers of their own. The Smoot-Hawley Tariff Act of 1930 was a classic example of this. It prompted other nations to increase tariffs on their goods, and both global trade and U.S. output fell as a result. Be sure to review the terms of modern trade agreements, including the General Agreement of Tariffs and Trade (GATT) and the North American Free Trade Agreement (NAFTA).

Trade-Related Issues, Off-Shoring, and Global Competition The chapter concludes with a discussion of how well U.S. firms are competing in an increasingly competitive global economy. Although imports of many products have decreased the share of American firms in the U.S. market, hundreds of U.S. firms have prospered in the global market. Although some domestic producers are harmed and their workers will have to find employment elsewhere, freer trade tends to benefit the consumer and society overall.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 5, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide. When you’re sure you understand the material covered in this les- son, take your Lesson 1 examination.

Economics 128

Self-Check 5 Indicate whether each of the following statements is True or False.

______ 1. The European Union (EU) is a free-trade zone comprising all the nations of eastern

and western Europe.

______ 2. When the dollar price of yen rises, the dollar appreciates in value relative to the yen.

______ 3. NAFTA is an international accord that will eliminate all tariffs and quotas worldwide

by the year 2025.

______ 4. One example of a goods and services flow is the immigration of workers.

______ 5. Barriers to free trade impair efficiency in the international allocation of resources.

______ 6. When a nation can produce a product at a lower domestic opportunity cost than a

potential trading partner can, the first nation is said to have a comparative advantage.

______ 7. The WTO is comprised of 27 European nations.

______ 8. Taxes or duties on imported products are called import quotas.

______ 9. In reciprocal trade agreements, the most-favored-nation clause means that any tariff

reductions the United States negotiates with a specific nation will automatically apply

to many other nations.

______ 10. Specialized production and international trade increase a nation’s productivity and

increase the availability of goods and services.

Check your answers with those on page 120.

GDP, Growth, and Instability

INTRODUCTION Lesson 2 examines the gross domestic product (GDP), mod- ern economic growth, and economic instability. The lesson contains four reading assignments.

Assignment 6 begins with a discussion about the business cycle, which concerns short-run fluctuations in output and employment. You’ll also learn about three important statistics that macroeconomists use to assess the health and develop- ment of the economy: real GDP, unemployment, and inflation.

Assignment 7 reviews the concept of national income accounting, which involves estimating output or income for the nation as a whole.

Assignment 8 looks at the impact of economic growth in general. You’ll learn how economic growth is measured, and review some basic facts about economic growth rates in the United States.

Assignment 9 reviews how business cycles affect employment and inflation, and how these factors are measured and evalu- ated in the macroeconomy.

OBJECTIVES When you complete this lesson, you’ll be able to

n Distinguish between real GDP and nominal GDP

n Explain why economists focus on GDP, inflation, and unemployment when assessing economic health

n Discuss why unemployment is a loss to the economy

n Define savings and investment, and explain why these are key factors in raising living standards

29

L e

s s

o n

2

L e

s s

o n

2

Economics 130

n Explain the effects of demand shocks, supply shocks, and sticky prices on output and employment

n Describe how GDP is defined and measured

n Discuss the relationships between GDP, net domestic product, national income, personal income, and dispos- able income

n List seven shortcomings of GDP as a measure of total output and economic well-being

n Explain how modern economic growth changed work, living standards, and societies

n List the institutional structures and supply factors that affect economic growth

n Discuss why productivity in the United States acceler- ated beginning in the 1990s

n Review some of the differing perspectives on whether eco- nomic growth is desirable and sustainable

n Explain what is meant by the “business cycle”

n Describe how unemployment and inflation are measured

n Distinguish between different types of unemployment and inflation, and describe their impacts

ASSIGNMENT 6 Read this introduction to Assignment 6. Then, read Chapter 6, “An Introduction to Macroeconomics,” on pages 113–123 in your textbook Macroeconomics.

Performance and Policy The main purpose of Chapter 6 is to introduce you to the con- cept of macroeconomics. As you’ve learned, macroeconomics studies the behavior of the economy as a whole. It’s primarily concerned with two topics: long-run economic growth, and the short-run fluctuations in output and employment that are often referred to as the business cycle. These phenomena

Lesson 2 31

are closely related because they happen simultaneously. This chapter provides an overview of the data that macro- economists use to measure the status and growth of an entire economy, as well as a preview of the models they use to help explain both long-run growth and short-run fluctuations.

Macroeconomists follow a few important statistics when trying to assess the health and development of an economy. These statistics include real GDP, unemployment, and inflation.

n Real gross domestic product (or real GDP ) measures the value of goods and services produced within the borders of a given country during a given period of time (typically one year). In contrast, nominal gross domestic product (or nominal GDP ) measures the dollar value of all goods and services produced within the borders of a given country, using their current prices during the year that they were produced. Real GDP is the appropriate meas- ure one should use to determine changes in economic activity across time. This is because nominal GDP captures both changes in output and changes in prices over time. Thus, nominal GDP may increase without any change (or even a decrease) in real economic activity.

n Unemployment is the state a person is in if he or she can’t get a job, despite being willing to work and actively seeking work. High rates of unemployment are undesir- able, because they indicate that the nation isn’t using a large fraction of its most important resource, the talents and skills of its people.

n Inflation is an increase in the overall level of prices.

Macroeconomic models also clarify many important questions about the powers and limits of government and economic pol- icy. These include the following questions:

1. Can governments promote long-run economic growth?

2. Can governments reduce the severity of recessions by smoothing out short-run fluctuations?

3. Are certain government policy tools more effective at mitigating short-run fluctuations than others?

Economics 132

Economies show a distinct growth trend that leads to higher output and higher standards of living in the long run, but in the short run, there’s a great deal of variability. Sometimes growth occurs rapidly, and sometimes it occurs more slowly. It may even turn negative for a while, with the result that output and living standards actually decline; this situation is referred to as a recession.

The Miracle of Modern Economic Growth Rapid and sustained economic growth is a modern phenome- non. Before the Industrial Revolution began in the late 1700s in England, human standards of living showed virtu- ally no growth over hundreds (or even thousands) of years. The Industrial Revolution ushered in factory production and automation, along with massive increases in research and development so that new and better technologies could continuously be invented. This resulted in modern economic growth, or sustained increases in output per person.

Today, the vast differences in living standards that we see between rich and poor countries are almost entirely due to the fact that only some countries have experienced modern economic growth.

To make international comparisons of living standards, the following three steps must be taken:

1. Convert each country’s GDP from its own currency into U.S. dollars

2. Divide each country’s GDP (measured in dollars) by the size of its population

3. Adjust per capita GDP using the purchasing power parity method

The last step is necessary because some goods (nontraded goods) are typically cheaper in poorer countries.

At the heart of economic growth is the principle that in order to raise living standards over time, an economy must devote at least some fraction of its current output to increasing future output. This process requires both savings and

Lesson 2 33

investment. Savings are generated when the current con- sumption is less than the current output, and investment happens when resources are devoted to increasing future output.

Financial investment involves the purchase of assets, such as stocks, bonds, or real estate in the hope of reaping a financial gain. In contrast, economic investment includes any money that’s spent purchasing capital goods, such as machinery, tools, factories, and warehouses.

When economists refer to investment, they are talking about economic investment. In the United States, households are the principal source of savings, and businesses are the main economic investors. Financial institutions collect savings from households, and lend these funds to businesses. Thus, savings and investment are fundamentally linked.

Uncertainty, Expectations, and Shocks Decisions about savings and investment are complicated by the fact that the future is uncertain. Investment projects sometimes produce disappointing results, or even fail totally. This means that macroeconomics must take expectations about the future into account.

Expectations are important for the following two reasons:

1. Changing expectations can have an effect on current behavior. For example, if businesses become pessimistic about the future of the economy, they may reduce investment today.

2. Firms are often forced to cope with shocks to the econ- omy. A shock is a situation in which businesses were expecting one thing to happen in the economy, but something very different happened instead.

The economy is exposed to both demand shocks and supply shocks. Economists believe that most short-run fluctuations are the result of demand shocks. The way in which these demand shocks affect the economy will depend on how prices adjust.

Economics 134

Price Stickiness Inflexible prices (or sticky prices, as economists say), help explain how unexpected changes in demand lead to fluctua- tions in GDP and employment. These fluctuations are referred to as the business cycle.

Price stickiness can play a large role in the short-run eco- nomic fluctuations we observe in modern economies. Price stickiness moderates over time. This is true because firms that choose to use a fixed-price policy in the short run don’t have to remain with that policy permanently. This realization is very useful in categorizing and understanding the differ- ences between various macroeconomic models.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 6, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide.

Self-Check 6 Indicate whether each of the following statements is True or False.

______ 1. Gasoline prices tend to be stickier than milk prices.

______ 2. Nominal GDP measures a nation’s output in current-year prices.

______ 3. In the short run, firms are more likely to respond to demand shocks by altering

inventory levels than by changing how much they produce.

______ 4. The term “economic investment” refers only to money spent purchasing newly

created capital goods such as factories, tools, and warehouses.

______ 5. Higher unemployment rates are linked with higher crime rates and higher rates

of physical and mental illness.

(Continued)

Lesson 2 35

Self-Check 6 ______ 6. In order to achieve modern economic growth, a nation’s output must grow faster

than its population.

______ 7. Any person who doesn’t have a job is considered to be unemployed.

______ 8. “Supply shocks” occur any time there’s a change in the supply of goods and services.

______ 9. A nation that wants to invest in more newly created capital in the present must be

willing to forgo consumption in the present.

______ 10. When there are only two or three rival firms in the marketplace (rather than a large

number of sellers), prices tend to be more flexible.

______ 11. The amount of investment in an economy is ultimately limited by the amount of

savings in that economy.

______ 12. A recession is defined as an extended period of increasing output and living standards.

______ 13. When large numbers of consumers unexpectedly reduce their purchases of goods

and services, a demand shock occurs.

______ 14. Inflation increases the purchasing power of a person’s income and savings.

______ 15. The business cycle is primarily concerned with changes in the level of overall prices

over time.

______ 16. Shocks occur when actual events don’t match expectations.

Check your answers with those on page 121.

Economics 136

ASSIGNMENT 7 Read this introduction to Assignment 7. Then, read Chapter 7, “Measuring Domestic Output and National Income,” on pages 126–142 in your textbook Macroeconomics.

Assessing the Economy’s Performance News headlines frequently report the status of the nation’s economic conditions, but to many citizens, the information is confusing or incomprehensible. Chapter 7 will acquaint you with the basic language of macroeconomics and national income accounting. National income accounting involves estimating output or income for the nation as a whole.

The first topic covered is the gross domestic product (GDP). The GDP is an important economic statistic that provides the best estimate of the total market value of all final goods and services produced by the economy in one year. Note that the GDP is a monetary measure that excludes nonproductive transactions, such as secondhand sales.

There are two equally acceptable methods for determining GDP: the expenditures approach, in which the GDP is viewed as the sum of all the money spent in buying it; and the income approach, in which the GDP is seen in terms of the income created from producing it.

In the expenditure approach, the GDP is composed of the following four categories:

1. Personal consumption expenditures

2. Gross private domestic investment

3. Government purchases

4. Net exports

These expenditures become income when they’re paid out in the form of employee compensation, rent, interest, corporate profits, and taxes on production and imports. In national income accounting, the amount spent to purchase this year’s total output is equal to money income from production of this year’s output.

Lesson 2 37

The chapter also relates the GDP to the following four national income accounts:

1. Net domestic product (NDP), which is equal to GDP minus depreciation allowance (consumption of fixed capital)

2. National income (NI) as derived from NDP, which is income earned by American-owned resources here or abroad

3. Personal income (PI), which is income received by households

4. Disposable income (DI), which is personal income minus personal taxes

Your textbook has a table that shows the relationship between these accounts on page 135.

Nominal GDP and Real GDP This part of the chapter shows you how to calculate real GDP from nominal GDP. Nominal GDP is the market value of all final goods and services produced in a year. Valid compar- isons can’t be made with the nominal GDP alone, since both prices and quantities are subject to change. Because nominal GDP is measured in monetary units, these measures must be adjusted over time to account for changes in the price level. Your textbook explains why the calculation of real GDP is needed and how it’s used.

Shortcomings of GDP The last section of the chapter looks at the shortcomings of GDP measurement techniques, as measures of total output and well-being. Certain economic factors are excluded from the measurement of GDP, including illegal transactions, unpaid services (such as parental child care, volunteer efforts, and home improvement projects), changes in leisure and product quality, differences in the composition and dis- tribution of output, and the environmental effects of GDP production. These exclusions can lead to an understatement

Economics 138

or overstatement of economic well-being. Global comparisons are made with respect to the size of the national GDP and the size of the underground economy.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 7, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide.

Self-Check 7 Indicate whether each of the following statements is True or False.

______ 1. If real GDP is 50 and nominal GDP is 100, the GDP price index is 200.

______ 2. The simplest way to calculate GDP is to add the total sales of all business firms.

______ 3. Disposable income measures the before-tax income received by resource suppliers.

______ 4. All expenditures on new construction are included as investment in calculating GDP.

______ 5. NDP can be determined by adding taxes on production and imports to GDP.

______ 6. Interest on the public debt is included as a part of government purchases in

determining GDP by the expenditures method.

______ 7. If nominal GDP is 150 and the GDP price index is 200, real GDP is 75.

______ 8. Disposable income usually exceeds personal income.

______ 9. Welfare payments to low-income families are included in national income.

______ 10. Exports are subtracted from imports in calculating U.S. GDP because exports aren’t

available for domestic consumption.

Check your answers with those on page 122.

Lesson 2 39

ASSIGNMENT 8 Read this introduction to Assignment 8. Then, read Chapter 8, “Economic Growth,” on pages 145–165 in your textbook Macroeconomics.

Economic Growth Chapter 8 looks at the impact of economic growth in general. The economic health of a nation relies on economic growth because it means more material abundance and reduces the burden of scarcity. The chapter describes how economic growth is measured, and discusses some basic facts about U.S. growth rates.

There are two basic definitions of economic growth:

1. The increase in real GDP, which occurs over a period of time

2. The increase in real GDP per capita, which occurs over time

The arithmetic of growth is an interesting topic. Using the “rule of 70,” a growth rate of 2 percent annually would cause a nation’s GDP to double within 35 years; however, a growth rate of 4 percent annually would cause the GDP to double in only about 18 years.

The main sources of growth in the economy are increasing inputs, or increasing productivity of existing inputs. About one-third of U.S. growth comes from increased inputs, and two-thirds comes from increased productivity.

Although punctuated by periods of cyclical instability, eco- nomic growth in the United States has been impressive. For example, during the last half century, real output increased more than 800 percent in absolute terms, and more than 200 percent on a per capita basis. Real GDP has grown about 3.4 percent per year since 1950, and real GDP per capita has grown about 2.1 percent per year. The chapter examines whether the United States is achieving a “new economy” that might deliver a stronger future rate of growth, and the positive and negative aspects of growth are explored.

Economics 140

Modern Economic Growth It’s important to note that continuous and sustained increases in economic growth, and the resulting improve- ments in living standards, are a relatively new development from a historical perspective. The era of modern economic growth began in 1776 with the invention of the steam engine, and the Industrial Revolution that followed. Modern economic growth is characterized by sustained, ongoing increases in living standards that can cause dramatic improvements in the standard of living within a generation. Not all nations experienced modern growth, however, and this is why some nations have a higher standard of living than others.

Ingredients of Growth The chapter next explains the factors that contribute to economic growth. The following four supply factors relate to the ability to grow:

1. The quantity and quality of natural resources

2. The quantity and quality of human resources

3. The supply or stock of capital goods

4. Technology

The following two demand and efficiency factors are also related to growth:

1. Aggregate demand must increase for production to expand.

2. Full employment of resources and both productive and allocative efficiency are necessary to get the maximum amount of production possible.

Lesson 2 41

Accounting for Growth In this section, growth accounting is discussed. Economic growth in the United States depends on the increase in size of the labor force and on the increase in labor productivity. The productivity increase is particularly important in recent years, and is largely attributed to the following factors:

n Technological advances

n The expansion of stock of capital goods

n The improved training and education of the labor force

n Economies of scale

n Reallocation of resources

Technological advances, the most important factor in pro-duc- tivity growth, account for 40 percent of productivity growth. Increases in quantity of capital are estimated to explain about 30 percent of productivity growth. Education and training improve the quality of labor, and account for about 15 percent of productivity growth. Improved resource allocation and economies of scale also contribute to growth and explain about 15 percent of total productivity growth. Economies of scale occur as the size of markets and firms that serve them have grown. Improved resource allocation has occurred as discrimi- nation disappears and labor moves where it’s most productive, and as tariffs and other trade barriers are lowered.

The Recent Productivity Acceleration A major development in recent years has been the almost dou- bling of the rate of labor productivity from 1995–2007, as compared to the period between 1973–1995. Much of the recent improvement in productivity is due to advances in tech- nology (particularly the microchip), more entrepreneurship, increasing returns from resource inputs, and greater global competition. New firms characterize the new economy, and some of today’s most successful firms didn’t exist 25 years ago: Dell, Compaq, Microsoft, Oracle, Cisco Systems, AOL (America Online), Yahoo, and Amazon are just a few examples. Economies of scale and increasing returns in these new firms encourage rapid growth.

Economics 142

Even if average growth rates in productivity and real output remain higher over time, business cycle fluctuations can still occur. Skepticism about long-term continued growth remains, and only time will tell whether this higher rate of growth is a permanent trend.

Is Growth Desirable and Sustainable? The last section of the chapter examines the following very important question: Is more economic growth desirable and sustainable? Growth leads to an improved standard of living, helps to reduce poverty in poor countries, improves working conditions, and allows more leisure time and less alienation from work. However, growth also causes pollution, global warming, ozone depletion, and other problems, including a higher level of stress in workers. There are arguments in favor of both sides of this controversial topic.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 8, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide.

Self-Check 8 Indicate whether each of the following statements is True or False.

______ 1. Strong patent laws discourage innovation and prevent economic growth.

______ 2. To achieve its full production potential, an economy must reach full employment.

______ 3. Since the 1820s, modern economic growth has widened wealth and income disparities

between richer and poorer nations.

(Continued)

Lesson 2 43

ASSIGNMENT 9 Read this introduction to Assignment 9. Then, read Chapter 9, “Business Cycles, Unemployment, and Inflation,” on pages 167–185 in your textbook Macroeconomics.

The Business Cycle Chapter 9 begins with an explanation of business cycles, which are the fluctuations that occur in the real output of the economy over the years. Over the history of the United

Self-Check 8 ______ 4. Improvements in technology are considered a demand factor in economic growth.

______ 5. An economy with an average growth rate of 10 percent can expect to see its real

GDP double in approximately 7 years.

______ 6. Proponents of economic growth claim that rising living standards can lead to environ-

mental improvements, since people can afford to care more about the environment.

______ 7. Growth is a widely held economic goal primarily because it creates a more equal

distribution of wealth and income.

______ 8. Leader countries tend to have higher growth rates than follower countries.

______ 9. In the United States, real GDP per capita has increased more rapidly than real GDP.

______ 10. Strong property rights inhibit economic growth by strictly regulating economic behavior.

______ 11. Improvements in education and training explain about 80 percent of the historical

growth of U.S. labor productivity.

______ 12. Real GDP per capita is found by dividing real GDP by the size of the labor force.

Check your answers with those on page 122.

Economics 144

States, periods of prosperity have alternated with hard times, in a cycle of “booms and busts.” However, the overall trends in employment, output, and the standard of living have been upward.

The business cycle is introduced in historical perspective, and is presented in stylized form. While discussing various business cycle theories, the authors stress the general belief that changes in aggregate spending (especially durable goods and investment spending) are the immediate cause of eco- nomic instability. Noncyclical fluctuations are also reviewed briefly.

Two basic problems result from instability in the economy: unemployment and inflation.

Unemployment In this section of the chapter, several types of unemployment, including frictional, structural, and cyclical, are described. The problems involved in measuring unemployment and in defining the unemployment rate are considered, and the economic and noneconomic costs of unemployment are presented. Finally, you’ll review an international comparison of unemployment rates.

Inflation Inflation is a rising general level of prices in the economy. However, not all prices rise at the same rate during periods of inflation, and some may fall. The main index used to measure inflation is the Consumer Price Index (CPI). To measure inflation, subtract last year’s price from this year’s price and divide by last year’s index; then multiply by 100 to express the value as a percentage.

Regardless of its cause, inflation may impose a real hardship on various groups in our society (particularly those who are on fixed incomes, because their nominal income doesn’t rise with prices). Inflation tends to arbitrarily redistribute real income and wealth. Cost-push inflation and demand-pull inflation have different effects on output and employment that vary with the severity of the inflation.

Lesson 2 45

Unanticipated inflation also harms those who save money and lend money. Savers will be hurt by unanticipated infla- tion because interest rate returns may not cover the cost of inflation, and their savings lose purchasing power. Lenders are hurt by unanticipated inflation because the interest payments on borrowed money may be less than the inflation rate. Thus, borrowers receive “expensive” money and are pay- ing back “cheap” dollars that have less purchasing power for the lender. Many families are simultaneously helped and hurt by inflation, because they’re both borrowers and savers.

In demand-pull inflation, spending increases faster than production. It’s often described as “too much spending chasing too few goods.” In cost-push inflation, prices rise because of a rise in per-unit production costs. Output and employment decline while the price level is rising. Historically, supply shocks have been a major source of cost-push inflation. These typically occur with dramatic increases in the price of raw materials or energy. It’s difficult to distinguish between demand-pull and cost-push causes of inflation, although cost-push will die out in a recession if spending doesn’t also rise.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 9, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide. When you’re sure you understand the material covered in this les- son, take your Lesson 2 examination.

Economics 146

Self-Check 9 Indicate whether each of the following statements is True or False.

______ 1. Unanticipated inflation doesn’t benefit any group in the economy.

______ 2. During recent years, the U.S. unemployment rate has been substantially higher

than the rate in most of the other major industrial nations.

______ 3. The natural rate of unemployment in the United States is about 4 to 5 percent.

______ 4. In the business cycle, upswings and downswings in business activity are equal

in terms of duration and intensity.

______ 5. An annual rate of inflation of 7 percent will double the price level in about 15 years.

______ 6. The production of durable goods is more stable than the production of nondurables

over the business cycle.

______ 7. Unanticipated inflation benefits creditors at the expense of debtors.

______ 8. People who work part time, but desire to work full time, are considered to be officially

unemployed.

Check your answers with those on page 123.

Macroeconomic Models and Fiscal Policy

INTRODUCTION In Lesson 3, you’ll begin to build economic models that explain how the business cycle, unemployment, and inflation combine to form economic trends. The lesson contains four reading assignments.

Assignment 10 introduces the basic relationships between three pairs of economic factors: income and consumption, interest rates and investment, and spending and output.

Assignment 11 introduces the aggregate expenditures model, which is a more detailed explanation for these relationships.

Assignment 12 introduces a model of the economy that’s based on aggregate demand and aggregate supply. This is a variable-price model in which it’s possible to simultaneously analyze changes in real GDP and the price level.

Assignment 13 examines fluctuations in the business cycle, the factors that determine the equilibrium level of output and prices in the economy, and the role of the government in controlling recession and inflation.

OBJECTIVES When you complete this lesson, you’ll be able to

n Describe how changes in income affect consumption and saving

n Explain how changes in real interest rates affect investment

n Discuss why changes in investment increase or decrease real GDP by a multiple amount

n Define the aggregate expenditures model for a private closed economy

47

L e

s s

o n

3

L e

s s

o n

3

Economics 148

n Explain how changes in equilibrium real GDP can occur and how those changes relate to the multiplier

n Describe how economists integrate government expendi- tures, taxes, exports, and imports into the aggregate expenditures model

n Contrast the causes of recessionary expenditure gaps and inflationary expenditure gaps

n Define aggregate demand (AD) and aggregate supply (AS), and list the factors that cause them to change

n Describe how AD and AS determine an economy’s equilibrium price level and the level of real GDP

n Explain how the AD-AS model explains periods of demand-pull inflation, cost-push inflation, and recession

n List the purposes, tools, and limitations of fiscal policy

n Describe the role of built-in stabilizers in moderating business cycles

n Review how the standardized budget reveals the status of U.S. fiscal policy

n Discuss the size, composition, and consequences of the U.S. public debt

ASSIGNMENT 10 Read this introduction to Assignment 10. Then, read Chapter 10, “Basic Macroeconomic Relationships,” on pages 188–205 in your textbook Macroeconomics.

The Income-Consumption and Income-Saving Relationships The purpose of this chapter is to introduce three basic macroeconomic relationships that can help us to organize our thinking about macroeconomic theories and controver- sies. First, you’ll learn about income-consumption and

Lesson 3 49

income-saving relationships. Second, you’ll examine the relationship between the interest rate and investment. Finally, the multiplier concept is explained, with changes in spending related to changes in output.

Consumption is the largest aggregate in the U.S. economy. Disposable income is the most important determinant of consumer spending; the amount that’s not spent is called saving. This section of your textbook describes the main characteristics of the consumption and saving schedules.

Nonincome determinants of consumption and saving can cause people to spend or save more or less at various income levels, although the level of income is the basic determinant. Wealth, expections, real interest rates, and household sav- ings impacts are reviewed in your text.

The Interest Rate–Investment Relationship The purchase of capital goods depends on the rate of return that business firms expect to earn from an investment and on the real rate of interest they have to pay for use of the money. The expected rate of return is found by comparing the expected economic profit (total revenue minus total cost) to the cost of investment. There’s an inverse relationship between the real interest rate and the level of investment spending; the lower the interest rate, the higher the invest- ment spending. The example in the textbook describes $100 expected profit on a $1,000 investment, which works out to a 10 percent expected rate of return. Thus, this business wouldn’t want to pay more than a 10 percent rate of interest on the investment. Remember that the expected rate of return isn’t a guaranteed rate of return; investment always carries risk.

Investment is a very unstable type of spending; it’s more volatile than GDP. This is because capital goods are durable, innovation occurs irregularly, profits vary, and expectations change quickly.

Economics 150

The Multiplier Effect Changes in spending ripple through the economy to generate even larger changes in real GDP. This is called the multiplier effect. The multiplier is based on the following two facts:

1. The economy has continuous flows of expenditures and income.

2. 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 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.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 10, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide.

Self-Check 10 Indicate whether each of the following statements is True or False.

______ 1. The estimate for the value of the real-world multiplier is 2.

______ 2. If the MPC is constant at various levels of income, then the APC must also be constant

at all of those income levels.

______ 3. Investment is highly stable; it rarely changes.

______ 4. The average propensity to consume is defined as income divided by consumption.

______ 5. The greater the MPC, the greater the multiplier.

(Continued)

Lesson 3 51

ASSIGNMENT 11 Read this introduction to Assignment 11. Then, read Chapter 11, “The Aggregate Expenditure Model,” on pages 208–227 in your textbook Macroeconomics.

In the previous chapter, you saw three basic relationships: how income relates to consumption and saving, how the interest rate affects investment spending, and how changes in spending work through the system to create larger changes in output. In this chapter, we’ll build the more detailed explanation for these relationships: the aggregate expenditures model.

This chapter discusses the aggregate expenditures model of the economy in detail. You’ll learn what determines the demand for real domestic output (real GDP) and how an economy achieves an equilibrium level of output.

Assumptions and Simplifications The chapter begins with the simple version of the aggregate expenditures model, which occurs in a closed, private econ- omy. Equilibrium GDP is determined, and multiplier effects are briefly reviewed. The “closed economy” is discussed

Self-Check 10 ______ 6. A decline in the real interest rate will shift the investment demand curve to the right.

______ 7. The slope of the consumption schedule is measured by the MPC.

______ 8. If DI is $275 billion and the APC is 0.8, we can conclude that saving is $55 billion.

Check your answers with those on page 123.

Economics 152

without the effects of any international trade, and the govern- ment component of the economy is also ignored. Although both households and businesses save, assume here that all saving is personal. Depreciation and net foreign income are assumed to be zero for simplicity.

Note that government spending and foreign trade are left out of the initial discussion because they’re largely affected by influences outside the domestic market system, and with no government or foreign trade, the factors of GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.

Consumption and Investment Schedules The level of output and employment depend directly on the level of aggregate expenditures. Changes in output reflect changes in aggregate spending. In a closed private economy, the two components of aggregate expenditures are consumption and gross investment. Economists also define an investment schedule that shows the amounts business firms collectively intend to invest at each possible level of GDP or DI. The chapter explains how the investment decisions of individual firms can be used to construct an investment schedule.

Equilibrium GDP Equilibrium GDP is the level of output whose production will create total spending just sufficient to purchase that output. Otherwise, there will be a disequilibrium situation. Two features of equilibrium GDP are

1. Savings and planned investment are equal.

2. In equilibrium, there are no unplanned changes in inventory.

In summary, equilibrium GDP is where aggregate expendi- tures equal real domestic output. A difference between saving and planned investment causes a difference between the production and spending plans of the economy as a whole.

Lesson 3 53

This difference between production and spending plans leads to unintended inventory investment or unintended decline in inventories. As long as unplanned changes in inventories occur, businesses will revise their production plans upward or downward until the investment in inventory is equal to what they planned. This will occur at the point that house- hold saving is equal to planned investment. Only where planned investment and saving are equal will there be no unintended investment or disinvestment in inventories to drive the GDP down or up.

Adding International Trade In this section of your textbook, the simplified closed economy is “opened” to show how it would be affected by exports and imports. Net exports (exports minus imports) affect aggregate expenditures in an open economy. Exports expand and imports contract aggregate spending on domestic output. Exports create domestic production, income, and employment due to foreign spending on U.S.-produced goods and services. Imports reduce the sum of consumption and investment expenditures by the amount expended on imported goods, so this figure must be subtracted so as not to overstate aggregate expenditures on U.S.-produced goods and services.

Positive net exports increase aggregate expenditures beyond what they would be in a closed economy, and thus have an expansionary effect. Negative net exports decrease aggregate expenditures beyond what they would be in a closed econ- omy, and thus have a contractionary effect. The multiplier effect also is at work in both situations.

International Economic Linkages Prosperity abroad generally raises U.S. exports, and transfers some of their prosperity to us. (Conversely, recession abroad has the reverse effect.) Tariffs on U.S. products may reduce our exports and depress our economy, causing us to retaliate and worsen the situation. Your textbook reviews how trade barriers in the 1930s contributed to the Great Depression.

Economics 154

Depreciation of the dollar lowers the cost of American goods to foreigners and encourages exports from the United States, while discouraging the purchase of imports in the United States. This could lead to higher real GDP or to inflation, depending on the domestic employment situation. Appreciation of the dollar could have the opposite impact.

Adding the Public Sector In this section, government spending and taxes are brought into the model to include the public aspects of the system. Government purchases of goods and services add to aggre- gate expenditures, and taxation reduces the disposable income of consumers, thereby reducing both the amount of consumption and the amount of saving that will take place at any level of real GDP.

Equilibrium vs. Full-Employment GDP It’s important to be aware that the equilibrium real GDP isn’t necessarily the real GDP at which full employment is achieved. Aggregate expenditures may be greater or less than the full-employment real GDP. When aggregate expenditures are less than full-employment GDP, there’s a recessionary expenditure gap. When aggregate expenditures exceed full- employment GDP, there’s an inflationary expenditure gap. The chapter explains how to measure the size of each expenditure gap: the amount by which the aggregate expenditures sched- ule must change to bring the economy to its full-employment real GDP.

Equilibrium Revisited As demonstrated earlier, in a closed private economy, equilibrium occurs when saving (a leakage) equals planned investment (an injection). With the introduction of a foreign sector (net exports) and a public sector (government), new leakages and injections are introduced. Imports and taxes are added leakages; exports and government purchases are

Lesson 3 55

added injections. Equilibrium is found when the leakages equal the injections. When leakages equal injections, there are no unplanned changes in inventories.

Simplifying assumptions are helpful for clarity when we include the government sector in our analysis. Simplified investment and net export schedules are used; assume that they’re independent of the level of current GDP. Assume gov- ernment purchases don’t impact private spending schedules, and that net tax revenues are derived entirely from personal taxes so that GDP, NI, and PI remain equal. Assume that tax collections are independent of GDP level (a lump-sum tax). The price level is assumed to be constant unless otherwise indicated.

Historical Applications Your textbook provides several historical examples that will help you see the application of recessionary and inflationary expenditure gaps. The U.S. recession of 2001 provides a good illustration of a recessionary expenditure gap. In 2007, the United States experienced both full employment (no recessionary or inflationary expenditure gap) and large negative net exports.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 11, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide.

Economics 156

Self-Check 11 Indicate whether each of the following statements is True or False.

______ 1. A lump-sum tax causes the after-tax consumption schedule to be flatter than

the before-tax consumption schedule.

______ 2. In moving from a closed to an open economy, exports are added to, and imports

are subtracted from, aggregate expenditures.

______ 3. Graphically, the height of the investment schedule depends on the real interest

rate, together with the location of the investment demand curve.

______ 4. Equal increases in government expenditures and tax collections will leave the

equilibrium GDP unchanged.

______ 5. Actual investment consists of planned investment plus unplanned changes in

inventories (plus or minus).

______ 6. The aggregate expenditures model allows for cost-push inflation.

______ 7. The recessionary expenditure gap is the amount by which the equilibrium GDP

and the full-employment GDP differ.

______ 8. In the aggregate expenditure model presented in the textbook, investment is

assumed to rise with increases in real GDP and fall with decreases in real GDP.

Check your answers with those on page 123.

Lesson 3 57

ASSIGNMENT 12 Read this introduction to Assignment 12. Then, read Chapter 12, “Aggregate Demand and Aggregate Supply,” on pages 230–248 and 251–253 in your textbook Macroeconomics.

The aggregate expenditures model of the economy that you learned about in Chapter 11 is a fixed-price model that focuses on changes in real GDP, not on changes in the price level. In contrast, this chapter introduces a macro model of the economy that’s based on aggregate demand and aggregate supply. This is a variable-price model in which it’s possible to simultaneously analyze changes in real GDP and the price level. This model can be used to explain real domestic output and the level of prices at any point in time. It can also be used to understand what causes output and the price level to change.

Aggregate Demand Aggregate demand is a schedule or curve that shows the various amounts of real domestic output that domestic and foreign buyers will desire to purchase at each possible price level. The aggregate demand curve shows an inverse relationship between price level and real domestic output. The explanation of the inverse relationship isn’t the same as for demand for a single product, which centered on substitution and income effects.

The substitution effect doesn’t apply within the scope of domestically produced goods, since there’s no substitute for everything. The income effect also doesn’t apply in the aggregate case, since income now varies with aggregate output. The explanation of the inverse relationship between the price level and the real output in aggregate demand includes real balances effects, interest-rate effects, and foreign purchases effects.

Economics 158

Changes in Aggregate Demand The aggregate demand curve can increase or decrease due to a change in one of the determinants of aggregate demand, which are the other things (besides price level) that can cause a shift or change in demand. Effects of the following determi- nants are discussed in more detail in the textbook:

n Changes in consumer spending, which can be caused by changes in consumer wealth, consumer expectations, household debt, and taxes

n Changes in investment spending, which can be caused by changes in interest rates and expected returns

n Changes in government spending

n Changes in net export spending unrelated to price level

You’ll learn that there are factors that can cause each determinant to change. The size of the change involves two components. For example, if one of these spending determi- nants increases, then aggregate demand will increase. The change in aggregate demand involves an increase in initial spending plus a multiplier effect that results in a greater change in aggregate demand than the initial change.

Aggregate Supply Aggregate supply is a schedule or curve that shows the level of real domestic output available at each possible price level. In the long run, the aggregate supply curve is vertical at the economy’s full-employment output. The curve is vertical, because in the long run, resources prices adjust to changes in the price level. This leaves no incentive for firms to change their output.

The short-run aggregate supply curve is upward-sloping. The lag between product prices and resource prices makes it profitable for firms to increase output when the price level rises. To the left of full-employment output, the curve is rela- tively flat. The relative abundance of idle inputs means that firms can increase output without substantial increases in production costs. To the right of full-employment output, the

Lesson 3 59

curve is relatively steep. Shortages of inputs and production bottlenecks will require substantially higher prices to induce firms to produce.

The aggregate supply curve is horizontal at a given price level due to the rigidity of prices. The determinants of aggregate supply are the things besides price level that cause changes or shifts in aggregate supply. The following determinants of aggregate supply are discussed in more detail in the textbook:

n Changes in input prices, which can be caused by changes in domestic resource prices, prices of imported resources, and market power in certain industries

n Changes in productivity, which can cause changes in per-unit production cost

n Changes in the legal or institutional environment, which can be caused by changes in business taxes, subsidies, and government regulation

Changes in Equilibrium Equilibrium real output and the equilibrium price level are found where the aggregate demand and aggregate supply curves intersect. If we assume that the determinants of aggregate supply and aggregate demand don’t change, then there are pressures that will tend to keep the economy at equilibrium. If a determinant changes, then aggregate supply, aggregate demand, or both, may shift.

Increases in aggregate demand will lead to changes in equilibrium real output and the price level. If the economy is operating at or above full employment, the increase in aggregate demand will cause demand-pull inflation. The multiplier effect weakens the farther to the right that the aggregate demand curve moves along the aggregate supply curve. More of the increase in spending is absorbed into price increases instead of generating greater real output. In contrast, if aggregate demand decreases, recession and cyclical unemployment may result.

Economics 160

Aggregate supply may also increase or decrease. An increase in aggregate supply causes prices to fall, and output and employment increase. In contrast, a decrease in aggregate supply causes the price level to increase, and output and employment fall. This is referred to as cost-push inflation.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 12, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide.

Self-Check 12 Indicate whether each of the following statements is True or False.

______ 1. An increase in imports (independent of a change in the U.S. price level) will increase

both U.S. aggregate supply and U.S. aggregate demand.

______ 2. An increase in business excise taxes will shift the aggregate supply curve to the left.

______ 3. The price level in the United States is more flexible upward than downward.

______ 4. In the immediate short run, both input and output prices are fixed.

______ 5. The equilibrium price level and equilibrium level of real GDP occur at the intersection

of the aggregate demand curve and the aggregate supply curve.

______ 6. The real-balances effect indicates that inflation makes people feel wealthier, and

therefore they spend more out of their current incomes.

______ 7. Other things equal, an increase in productivity will shift the short-run aggregate

supply curve to the right.

(Continued)

Lesson 3 61

ASSIGNMENT 13 Read this introduction to Assignment 13. Then, read Chapter 13, “Fiscal Policy, Deficits, and Debt,” on pages 254–272 in your textbook Macroeconomics.

In the past, many serious macroeconomic problems have been caused by fluctuations in the business cycle. Examining these fluctuations, and learning what determines the equilib- rium level of real output and prices in the economy, can help us find policies that control recession and inflation.

One major function of the government is to stabilize the economy (prevent unemployment or inflation). Stabilization can be achieved in part by manipulating the public budget— government spending and tax collections—to increase output and employment or to reduce inflation. This chapter explores government stabilization policy in terms of the aggregate demand-aggregate supply (AD-AS) model.

Self-Check 12 ______ 8. An increase in wealth from a substantial increase in stock prices will move the

economy along a fixed aggregate demand curve.

______ 9. The interest-rate effect is one of the determinants of aggregate demand.

______ 10. A negative GDP gap can be caused by either a decrease in aggregate demand

or a decrease in aggregate supply.

Check your answers with those on page 124.

Economics 162

Fiscal Policy and the AD/AS Model Discretionary fiscal policy refers to the deliberate manipula- tion of taxes and government spending by Congress in order to alter real domestic output and employment, control infla- tion, and stimulate economic growth. The term discretionary means that the changes are at the option of the federal government. Discretionary fiscal policy changes are often initiated by the President, on the advice of the Council of Economic Advisers (CEA). Changes that don’t directly result from congressional action are referred to as nondiscretionary or passive fiscal policy.

Note that expansionary fiscal policy is used to stimulate the economy and combat a recession, by increasing government spending and decreasing taxes. When demand-pull inflation occurs, however, then contractionary fiscal policy is the remedy; it counters inflationary pressure in the economy by cutting government spending and raising taxes. Economists tend to favor higher G during recessions, and higher taxes during inflationary times if they’re concerned about unmet social needs or infrastructure. Others tend to favor lower T for recessions, and lower G during inflationary periods when they think government is too large and inefficient.

Built-In Stability Discretionary fiscal policy requires that Congress take action to change tax rates, transfer payment programs, or purchase goods and services. Nondiscretionary fiscal policy doesn’t require Congress to take any action and is a built-in stabi- lizer for the economy. The progressive tax system provides built-in stability.

Built-in stability arises because net taxes change with GDP (recall that taxes reduce incomes and therefore, spending). It’s desirable for spending to rise when the economy is slumping, and vice versa when the economy is becoming inflationary.

Taxes automatically rise with GDP because incomes rise and tax revenues fall when GDP falls. Transfers and subsidies rise when GDP falls, and when government payments

Lesson 3 63

(welfare, unemployment, and so on) rise, net tax revenues fall along with GDP. The size of automatic stability depends on the responsiveness of changes in the tax rates to changes in GDP. The more progressive the tax system is, the greater the economy’s built-in stability will be. The U.S. tax system reduces business fluctuations by as much as 8 to 10 percent of the change in GDP that would otherwise occur.

Evaluating Fiscal Policy To evaluate the direction of fiscal policy requires an under- standing of the standardized budget and the distinction between a cyclical deficit and a standardized deficit. The budget analysis allows economists to determine whether the federal fiscal policy is expansionary, contractionary, or neutral, and to determine what policies should be adopted to improve economic performance. Fiscal policy measures automatically adjust government expenditures and tax revenues when the economy moves through phases of the business cycle. The recent use of fiscal policy as a tool is discussed, as are problems, criticisms, and complications of fiscal policy.

Problems, Criticisms and Complications There are a number of problems involved in enacting and applying fiscal policy. The following are three timing problems:

n Recognition lag is the elapsed time between the beginning of recession or inflation and awareness of this occurrence.

n Administrative lag is the difficulty in changing policy once the problem has been recognized.

n Operational lag is the time elapsed between change in policy and its impact on the economy.

There are also political considerations that interfere with fiscal policy. Government has other goals besides economic stability, and these may conflict with a stabilization policy.

Economics 164

A political business cycle may destabilize the economy; elec- tion years have been characterized by more expansionary policies regardless of economic conditions. State and local finance policies may also offset federal stabilization policies. They’re often procyclical, because balanced-budget require- ments cause states and local governments to raise taxes in a recession or cut spending (possibly making a recession worse). In an inflationary period, they may increase spending or cut taxes as their budgets head for surplus. The crowding- out effect may be caused by fiscal policy.

Some economists oppose the use of fiscal policy, believing that monetary policy is more effective or that the economy is sufficiently self-correcting. Most economists, however, support using fiscal policy to help “push” the economy in a desired direction, and using monetary policy more for fine- tuning. Economists agree that the potential impacts (positive and negative) of fiscal policy on long-term productivity growth should be evaluated and considered in the decision-making process, along with the short-run cyclical effects.

The Public Debt The national or public debt is the accumulation of the federal government’s total deficits and surpluses that have occurred through time. Deficits (and by extension the debt) are the result of war financing, recessions, and lack of political will to reduce or avoid them. The public debt was $9.01 trillion in 2007. Although the United States has the highest public debt in absolute terms, a number of countries owe more, relative to their ability to support it (through income or GDP). Interest charges are the main burden imposed by the debt. Interest on the debt was $237 billion in 2007, and was the fourth-largest item in the federal budget. Interest payments were 1.7 percent of GDP in 2007. The percentage is impor- tant because it represents the average tax rate necessary just to cover annual interest on the debt. Low interest rates brought the percentage down from the 1990s.

Lesson 3 65

False Concerns The discussion on the public debt will explain two popular mis- conceptions as to the character and problems associated with a large public debt:

1. The debt will force the United States into bankruptcy.

2. The debt imposes a burden on future generations.

Your textbook reviews some important reasons why these eco- nomic concerns are misplaced. However, the real poten-tial problems of a large public debt include greater income inequal- ity, reduced economic incentives, and crowding out of private investment.

Repayment of the public debt affects income distribution. If working taxpayers will be paying interest to the mainly wealthier groups who hold the bonds, this probably increases income inequality. Since the interest must be paid out of government revenues, a large debt and high interest rate can increase the tax burden and may decrease taxpayers’ incentives to work, save, and invest. A higher proportion of the debt is owed to foreigners (about 25 percent) than in the past, and this can increase the burden since payments leave the country. However, Americans also own foreign bonds, and this offsets the concern.

Some economists believe that public borrowing crowds out pri- vate investment, but the extent of this effect isn’t clear. The following are some positive aspects of borrowing, even with crowding out:

If borrowing is for public investment that causes the economy to grow more in the future, the burden on future generations will be less than if the government hadn’t borrowed for this purpose.

Public investment makes private investment more attractive. For example, new federal buildings generate private business; good highways help private shipping; and so on.

After you’ve carefully read the assigned pages in your textbook and before moving on to the next assignment, complete Self- Check 13, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide. When you’re sure you understand the material covered in this lesson, take your Lesson 3 examination.

Economics 166

Self-Check 13 Indicate whether each of the following statements is True or False.

______ 1. The public debt is the accumulation of all deficits and surpluses that have occurred

through time.

______ 2. The standardized budget may be in surplus while the actual budget is in deficit.

______ 3. Economically, the best way to measure the public debt is to measure it relative

to the GDP, rather than in absolute terms.

______ 4. Fiscal policy is mainly undertaken by the Federal Reserve.

______ 5. A nation can defer a part of the economic cost of war by financing wartime

expenditures through the increase of internally-held public debt permits.

______ 6. The term built-in stability is the same as discretionary fiscal policy.

______ 7. The reason why a tax cut was passed by Congress and the Bush administration

in 2001 was to stop a recession.

______ 8. Expansionary fiscal policy involves an expansion of the nation’s money supply.

______ 9. The United States experienced both budget surpluses and deficits during the 1990s–

2000s.

______ 10. As measured by the standardized budget, the U.S. government engaged in a

contractionary fiscal policy in 2002 and 2003.

______ 11. Demand-pull inflation can be restrained by increasing government spending and

reducing taxes.

______ 12. Political considerations have no effect on fiscal policy.

______ 13. A contractionary fiscal policy shifts the aggregate demand curve to the right.

______ 14. The per capita public debt doubled between 1990 and 2000.

______ 15. The operational lag of fiscal policy refers to the time that elapses between the begin-

ning of a recession or inflationary period and the certainty that it’s actually happening.

______ 16. Tax revenues automatically increase during economic expansions and decrease during

recessions.

Check your answers with those on page 124.

67

L e

s s

o n

4

L e

s s

o n

4

Money, Banking, and Monetary Policy

INTRODUCTION Lesson 4 discusses the role of money and the monetary system in the economy. A monetary system that’s operating well can help the economy achieve full employment and the most efficient use of resources. When the monetary system isn’t working well, however, it can create serious fluctuations in employment, output, and prices. The lesson contains four reading assignments.

Assignment 14 explains the nature and functions of money, and how the monetary system affects the operation of the economy. Then, you’ll learn about the money supply and the U.S. financial system, with a focus on the functions of the Federal Reserve System.

Assignment 15 reviews the fractional reserve banking system, and explains how commercial banks can create checkable deposits by issuing loans. You’ll also learn about the factors that limit the money-creating ability of commercial banks.

Assignment 16 explains how the Federal Reserve affects output, employment, and the price level of the economy. The Fed can changes the nation’s money supply by manipulating the size of excess reserves held by banks, and their monetary policies have a powerful impact on the economy as a whole.

Assignment 17 introduces you to financial economics, and reviews the differences between economic investment and financial investment.

Economics 168

OBJECTIVES When you complete this lesson, you’ll be able to

n List the functions of money, and the primary compo- nents of the U.S. money supply

n Explain what “backs” the money supply, allowing us to be willing to accept it as payment

n Describe the composition of the Federal Reserve and the U.S. banking system

n List the main functions and responsibilities of the Federal Reserve

n Explain why the U.S. banking system is called a fractional reserve system

n Describe the differences between a bank’s actual reserves and its required reserves

n Explain how a bank can create money through the granting of loans

n Describe how the equilibrium interest rate is determined in the market for money

n Review the major goals and tools of monetary policy

n Explain the federal funds rate, and describe how the Fed controls it

n List the mechanisms by which monetary policy affects GDP and the price level

n Explain the idea of present value and why it’s critical in making financial decisions

n Discuss the differences between the most popular investments: stocks, bonds, and mutual funds

n Describe portfolio diversification, and explain why higher levels of nondiversifiable risk are associated with higher rates of return

n Explain why it’s so hard to “beat the market,” even for professional investors

Lesson 4 69

ASSIGNMENT 14 Read this introduction to Assignment 14. Then, read Chapter 14, “Money and Banking,” on pages 276–290 in your textbook Macroeconomics.

Functions of Money This chapter explains how the financial system affects the operation of the economy. First, you’ll learn about the nature and functions of money. Money has the following three important functions:

1. Money acts as a medium of exchange, which means that money can be used for buying and selling goods and services.

2. Money is also a unit of account, which is the unit of measure for prices (in dollars and cents).

3. Money is a store of value, which allows us to transfer purchasing power from present to future. It’s the most liquid (spendable) of all assets, and a convenient way to store wealth.

Components of the Money Supply This section of the chapter discusses the Federal Reserve System’s definition of the money supply. In the narrowest definition, called M1, money includes currency and checkable deposits.

Currency is all coins and paper money held by public. The currency of the United States is actually token money, which means that the intrinsic value of the coins and paper money are less than their actual value. All paper currency consists of Federal Reserve Notes that are issued by the Federal Reserve.

Checkable deposits are included in M1, since they can be spent almost as readily as currency and can easily be changed into currency. Commercial banks are a main source of checkable deposits for households and businesses. Thrift institutions (savings and loans, credit unions, mutual savings banks) also have checkable deposits.

Economics 170

The currency and checkable deposits that are held by the federal government, Federal Reserve, or other financial institutions, aren’t included in M1.

A second and broader definition of the money supply is M2, which includes the following near-monies:

n Savings deposits and money market deposit accounts

n Small time deposits (certificates of deposit) less than $100,000

n Money market mutual funds held by individuals

Next, the chapter addresses the question of what “backs” money by looking at the value of money, money and prices, and the management of the money supply.

The Federal Reserve and the Banking System This section of the chapter includes a comprehensive descrip- tion of the U.S. financial system, focusing on the features and functions of the Federal Reserve System. The Federal Reserve System (the “Fed”) was established by Congress in 1913 and holds power over the money and banking system. The central controlling authority for the system is the Board of Governors, which has seven members who are appointed by the President for staggered 14-year terms. Its power means the system operates like a central bank.

The Federal Open Market Committee (FOMC) includes the seven governors, plus five regional Federal Reserve Bank presidents whose terms alternate. They set policy on the buying and selling of government bonds, the most important type of monetary policy, and meet several times each year.

The system has 12 districts, each with its own district bank and two or three branch banks. The 12 Federal Reserve banks collectively serve as the nation’s central bank. They help implement Fed policy and are advisory. Each is quasi- public; it’s owned by member banks, but controlled by the government’s Federal Reserve Board, and any profits go to the U.S. Treasury. They act as bankers’ banks by accepting

Lesson 4 71

reserve deposits and making loans to banks and other finan- cial institutions. In making loans, the Federal Reserve is the “lender of last resort,” meaning that the Fed is available to lend money should other avenues (such as other commercial banks) not be available.

The Fed performs the following functions:

n The Fed issues Federal Reserve Notes, the paper currency used in the U.S. monetary system.

n The Fed sets reserve requirements, and holds the reserves of banks and thrifts not held as vault cash.

n The Fed may lend money to banks and thrifts, charging them an interest rate called the discount rate.

n The Fed provides a check-collection service for banks (checks are also cleared locally or by private clearing firms).

n The Federal Reserve System acts as the fiscal agent for the federal government.

n The Federal Reserve System supervises member banks.

n The Fed has the ultimate responsibility for monetary policy and control of the money supply.

The independence of the Federal Reserve is important, but is also controversial from time to time. Advocates of inde- pendence fear that more political ties would cause the Fed to follow expansionary policies and create too much inflation, leading to an unstable currency that’s sometimes seen in other countries.

Commercial Banks and Thrifts About 7,600 commercial banks existed in 2006. They’re pri- vately owned and consist of state banks and large national banks.

Thrift institutions consist of savings and loan associations, credit unions, and mutual savings banks. They’re regulated by the Treasury Department Office of Thrift Supervision, but

Economics 172

they may use the services of the Fed and keep reserves on deposit at the Fed. Of the approximately 11,400 thrift institu- tions in the United States, most are credit unions.

Recent Developments in Money and Banking The final section of this chapter discusses some recent developments in the world of banking. These developments include the following:

n There has been a significant shift in financial assets from banks and thrifts to other financial services institutions.

n There has been a lot of consolidation among banks and thrifts. Because of failures and mergers, there are fewer banks and thrifts today than in the past.

n There has been a convergence in the services provided by different types of financial institutions.

n Financial markets are now global and more integrated than in the past. Recent advances in computer and communications technology suggest the trend is likely to accelerate.

n Technological advancements have introduced new types of electronic payments and changed the character of money. Internet buying and selling (including PayPal), Fedwire transfers, and smart cards are examples of these newer technologies. In the future, nearly all payments could be made wirelessly, through personal computers, or with smart cards.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 14, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide.

Lesson 4 73

Self-Check 14 Indicate whether each of the following statements is True or False.

______ 1. Currency and coins held by banks are part of the M1 definition of money supply.

______ 2. Thrifts are known as “banker’s banks” because they lend money to commercial banks.

______ 3. The M1 money supply is larger than the M2 money supply.

______ 4. Less than $10 billion of U.S. currency is circulating in foreign countries.

______ 5. The percentage share of total U.S. financial assets held by commercial banks and

thrifts has increased since 1980.

______ 6. The 12 Federal Reserve Banks are privately controlled, but governmentally owned.

______ 7. The United States Treasury is the only source of money in the U.S. economy.

______ 8. Credit cards are treated as money because they facilitate transactions.

______ 9. Depository institutions are a major source of money in the U.S. economy.

______ 10. Checkable deposits held in saving and loan institutions, mutual savings banks,

and credit unions are part of the M1 definition of the money supply.

Check your answers with those on page 125.

Economics 174

ASSIGNMENT 15 Read this introduction to Assignment 15. Then, read Chapter 15, “Money Creation,” on pages 292–304 in your textbook Macroeconomics.

The Fractional Reserve System The United States has a fractional reserve banking system, in which only a part of checkable deposits is backed up by cash in bank vaults. This chapter will discuss this system and explain how commercial banks can create checkable deposits by issuing loans. You’ll also learn about the factors that determine and limit the money-creating ability of com- mercial banks.

Banks in the United States and most other countries are only required to keep a percentage (fraction) of checkable deposits in cash or with the central bank. Your textbook explains the history behind this system through the example of goldsmiths. In the sixteenth century, goldsmiths had safes for gold and precious metals, which they often kept for consumers and merchants. They issued receipts for these deposits. Receipts came to be used as money in place of gold because of their convenience, and goldsmiths became aware that much of the stored gold was never redeemed. The goldsmiths then realized they could “loan” the gold by issuing receipts to borrowers, who agreed to pay back gold plus interest. These loans began the system of fractional reserve banking, because the amount of actual gold in the vaults was eventually only a fraction of the receipts held by borrowers and owners of gold.

The following are two important characteristics of fractional reserve banking:

1. Banks can “create” money by lending more than the original reserves on hand.

2. Lending policies must be prudent to prevent bank panics or runs by depositors who become worried about the security of their funds. (Note: The U.S. deposit insurance system is designed to prevent panics.)

Lesson 4 75

A Single Commercial Bank Most transaction accounts are “created” as a result of loans from banks or thrifts. This section of the chapter demon- strates the money-creating abilities of a single commercial bank, and then looks at that of the system as a whole.

The simple device that’s used to explain the operations of a commercial bank is the balance sheet. A balance sheet states the assets and claims of a bank at some point in time. All banking transactions affect the balance sheet. All balance sheets must balance, that is, the value of assets must equal the value of claims.

As you read the chapter, pay attention to the effect of each transaction discussed on the balance sheet. The checkable deposits and reserves are important because checkable deposits are money. The ability of a bank to create new checkable deposits is determined by the amount of reserves the bank has. Expansion of the money supply depends on the possession of excess reserves. Remember that excess reserves are the difference between the actual reserve and the required reserve of a commercial bank.

Required reserves don’t exist to protect against runs, because banks must keep their required reserves. Required reserves are to give the Federal Reserve control over the amount of lending or deposits that banks can create. In other words, required reserves help the Fed control credit and money creation. Banks can’t loan beyond their excess reserves.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 15, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide.

Economics 176

Self-Check 15 Indicate whether each of the following statements is True or False.

______ 1. If the reserve requirement is 10 percent, the monetary multiplier will be 20.

______ 2. When commercial banks retire outstanding loans, the supply of money is increased.

______ 3. Federal deposit insurance discourages, but doesn’t prevent, bank runs.

______ 4. Commercial banks decrease the supply of money when they purchase personal

IOUs or government bonds from businesses and households.

______ 5. The amount by which required reserves exceed actual reserves is called excess

reserves.

______ 6. On a bank’s balance sheet, checkable deposits are considered to be an asset.

______ 7. The supply of money increases when the public buys government securities from

commercial banks.

______ 8. Loans made to customers are a liability on a bank’s balance sheet.

______ 9. Required reserves plus excess reserves equals actual reserves.

______ 10. Commercial bank reserves are an asset to commercial banks, but a liability to

the Federal Reserve Bank holding them.

Check your answers with those on page 125.

Lesson 4 77

ASSIGNMENT 16 Read this introduction to Assignment 16. Then, read Chapter 16, “Interest Rates and Monetary Policy,” on pages 307–331 in your textbook Macroeconomics.

Interest Rates This chapter explains how the Federal Reserve affects out- put, employment, and the price level of the economy. The Fed’s Board of Governors formulates policy, and 12 Federal Reserve Banks implement policy. The fundamental objective of monetary policy is to aid the economy in achieving full- employment output with stable prices. To do this, the Fed changes the nation’s money supply by manipulating the size of excess reserves held by banks.

Monetary policy has a very powerful impact on the economy, and the Chairman of the Fed’s Board of Governors is some- times called the “second most powerful person in the United States” (after the President).

The work of the Fed focuses on the interest rate, and on the supply and demand in the market for money. The total demand for money is made up of a transaction demand and an asset demand. Transaction demand is money kept for purchases, and will vary directly with GDP. Asset demand is money kept as a store of value for later use. Asset demand varies inversely with the interest rate, since that’s the price of holding idle money. The total demand will equal the quanti- ties of money demanded for assets plus that for transactions.

The money market combines the demand for money and the supply of money. If the quantity demanded exceeds the quantity supplied, people will sell assets like bonds to get money. This causes the bond supply to rise, bond prices to fall, and a higher market rate of interest. In contrast, if the quantity supplied exceeds the quantity demanded, people will reduce their money holdings by buying other assets like bonds. Bond prices will rise, and lower market rates of interest will result.

Economics 178

The Consolidated Balance Sheet of the Federal Reserve Banks The assets column on the Fed’s balance sheet contains the following two major items:

1. Securities, which are federal government bonds that are purchased by Fed

2. Loans to commercial banks

The liability side of the balance sheet contains the following three major items:

1. Reserves of banks held as deposits at Federal Reserve Banks

2. U.S. Treasury deposits of tax receipts and borrowed funds

3. Federal Reserve Notes outstanding (our paper currency)

“Tools” of Monetary Policy As we examine the Federal Reserve Banks’ consolidated bal- ance sheet, we can consider how the Fed can influence the money-creating abilities of the commercial banking system. The Fed has the following four tools of monetary control:

1. Open-market operations, which refers to the Fed’s buying and selling of government bonds

2. The reserve ratio, which is the fraction of reserves required relative to their customer deposits

3. The discount rate, which is the interest rate that the Fed charges to commercial banks that borrow from the Fed

4. The term auction facility, which was introduced in December 2007 in response to the mortgage debt crisis. Under the term auction facility, the Fed holds two auctions each month, and banks bid for the right to borrow reserves for 28 days.

Lesson 4 79

Targeting the Federal Funds Rate The Federal Reserve focuses monetary policy on the interest rate that it can best control: the federal funds rate, which is the interest rate that banks charge each other for overnight loans. Banks lend to each other from their excess reserves, but because the Fed is the only supplier of federal funds (the currency used as reserves), it can set the federal funds rate and then use open-market operations to make sure that rate is achieved. The Fed will increase the availability of reserves if it wants the federal funds rate to fall (or keep it from rising). Reserves will be withdrawn if the Fed wants to raise the federal funds rate (or keep it from falling).

The Fed may use an expansionary monetary policy if the economy is experiencing a recession and rising rates of unemployment. The Fed will initially announce a lower target for the federal funds rate, then use open-market operations to buy bonds from banks and the public. The Fed may also lower the reserve ratio or the discount rate. Increasing reserves will generate two results:

1. The supply of federal funds will increase, lowering the federal funds rate

2. Through the money multiplier process, a greater expan- sion of the money supply will occur

Expansionary monetary policy will put downward pressure on interest rates, including the prime interest rate, which is the benchmark interest rate used by banks to set many other interest rates.

Restrictive monetary policy is used to combat rising inflation. The initial step is for the Fed to announce a higher target for the federal funds rate, followed by the selling of bonds to soak up reserves. Raising the reserve ratio and/or discount rate is also an option. The reduced supply of federal funds will raise the federal funds rate to the new target. Restrictive monetary policy results in higher interest rates, including the prime rate.

Economics 180

Monetary Policy: Evaluation and Issues The major strengths of monetary policy are its speed and flexibility, and its isolation from political pressures. The Federal Reserve has been successful many times since the 1990s in countering recession by lowering the interest rate, and in controlling inflation by raising the interest rate.

However, monetary policy does have problems and compli- cations. Recognition and operational lags impair the Fed’s ability to quickly recognize the need for policy change and to affect that change in a timely fashion. Although policy changes can be implemented rapidly, there’s a lag of at least three to six months before the changes will have their full impact.

Cyclical asymmetry may exist. A restrictive monetary policy may work effectively to brake inflation, but an expansionary monetary policy isn’t always as effective in stimulating the economy out of recession.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 16, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide.

Self-Check 16 Indicate whether each of the following statements is True or False.

______ 1. The Fed decreases interest rates by selling government securities.

______ 2. The federal funds rate and the prime interest rate typically change in opposite

directions.

______ 3. In the last half of the 1990s, monetary policy was highly ineffective in Japan,

but highly effective in the United States.

(Continued)

Lesson 4 81

Self-Check 16 ______ 4. An expansionary monetary policy is one that reduces the supply of money.

______ 5. The term auction facility is the most frequently used monetary policy tool.

______ 6. According to the Taylor rule, if real GDP falls by 1 percent below potential GDP,

the Fed should lower the federal funds rate by one-half a percentage point.

______ 7. When the Fed auctions reserves through the term auction facility, the interest

rate is set by the rate offered by the highest bidder.

______ 8. Bond prices and interest rates are directly or positively related.

______ 9. The higher the interest rate, the larger the amount of money that will be demanded

for transaction purposes.

______ 10. Changes in the interest rate are more likely to affect consumer spending than

investment spending.

______ 11. A change in the reserve ratio will have no effect on the amount of the banking

system’s excess reserves.

______ 12. The asset demand for money varies inversely with the nominal GDP.

Check your answers with those on page 125.

Economics 182

ASSIGNMENT 17 Read this introduction to Assignment 17. Then, read Chapter 17, “Financial Economics,” on pages 334–350 in your textbook Macroeconomics.

Financial Investment This chapter will introduce you to financial economics. It begins by identifying the differences between economic investment and financial investment. Economic investment involves spending for the production and accumulation of capital goods, whether public (new roads and bridges) or private (new factories, homes, and equipment). Financial investment involves buying assets in the expectation of earning a financial gain (such as stocks, bonds, and mutual funds). Economic investments are often also financial invest- ments, but financial investment is broader in that it includes transfers of ownership (such as buying stock) that don’t directly affect the nation’s capital stock. In everyday conver- sation, financial investment is typically referred to as just “investment.”

Present Value This section of the chapter reviews the calculation and use of present value in decision-making. Present value measures the present-day value, or current worth, of returns or costs expected to arrive in the future. This concept is important because it allows investors to calculate the appropriate price to pay for now for an asset that will generate expected returns in the future.

The concept of present value is explained through the use of the compound interest formula, which shows how an amount of money will grow over time if interest is paid on both the initial investment and on any interest payments.

Lesson 4 83

Some Popular Investments A wide array of financial instruments are available for invest- ment. This part of the chapter includes an explanation of why investors choose different assets, and why those assets produce different returns. Portfolio diversification and the relationship between risk and return are explained.

Though the range of choices is vast and complex, all invest- ments share these three features:

1. Stocks are ownership shares in a corporation.

2. Bonds are debt contracts issued by corporations and governments.

3. Mutual funds are a collection (portfolio) of stocks and/or bonds, purchased by pooling the money of many investors.

Bonds are generally more predictable than stocks in making payments. However, stocks historically generate higher rates of return.

Arbitrage Arbitrage occurs when investors try to profit from differ- ences in rates of return between identical or nearly identical assets. Investors will simultaneously sell the asset with the lower rate of return and buy the asset with the higher rate of return. As investors sell the asset with the lower rate of return, the asset’s price will fall, increasing the rate of return. Likewise, as investors move to buy the asset with the higher rate of return, its price will be driven up, and its rate of return will fall. The arbitrage process will continue until rates of return on identical assets equalize, and it generally happens quickly. This process illustrates why it’s hard even for professional investors to “beat the market.”

Economics 184

Risk Risk is a major factor affecting financial assets. Risk refers to the uncertainty of the size of future payments. Some risk can be diversified by purchasing different types of assets with different returns that offset each other. Owning many different investments is a means to reduce the overall risk to the portfolio. Risk that can be reduced by diversification is known as diversifiable risk. Events that are bad for one part of the portfolio are offset by good effects for other invest- ments. Risk that can’t be reduced by diversification is known as nondiversifiable risk, or systemic risk.

Security Market Line The Security Market Line (SML) graphically portrays, across all assets, the relationship between risk levels and average rates of return. The model is based on the premise that an investment’s average expected rate of return is based on two parts: compensation for time preference, and compensation for risk.

An Increase in the Risk-Free Rate The Federal Reserve can increase the risk-free interest rate by selling government bonds in the open market (restrictive monetary policy). An increase in the risk-free rate will raise the intercept and cause a parallel shift of the security market line. As the risk-free interest rate rises, so do the average expected rates of return of all other assets. By shifting the security market line, the Federal Reserve can affect all asset prices, which explains why investors closely watch the deci- sions of the Fed.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 17, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide. When you’re sure you understand the material covered in this les- son, take your Lesson 4 examination.

Lesson 4 85

Self-Check 17 Indicate whether each of the following statements is True or False.

______ 1. When a company declares bankruptcy, stockholders are the first to be paid when

company assets are sold.

______ 2. A 10 percent rate of interest will increase the value of an asset more quickly

if the interest is compounded.

______ 3. The term economic investment refers to the buying or selling of any asset in

expectation of a financial gain.

______ 4. Dividends are payments to holders of corporate bonds.

______ 5. The Federal Reserve can use monetary policy to shift the Securities Market Line.

______ 6. The term compound interest refers to the multiple interest rates an investor will

be paid in a diversified portfolio.

______ 7. A portfolio of many different stocks and bonds protects against nondiversifiable risk.

______ 8. Index funds consistently beat actively managed funds because the latter incur greater

management costs.

______ 9. Average expected rates of return and levels of risk are positively related.

______ 10. Short-term U.S. government bonds are considered to be risk-free.

Check your answers with those on page 126.

Economics 186

NOTES

Extensions and Issues, and International Economics

INTRODUCTION In Lesson 5, the analysis of aggregate supply is extended, the relationship between inflation and unemployment is discussed, and the effect of taxes on aggregate supply is studied. The lesson contains five reading assignments.

Assignment 18 reviews the short-run and long-run relation- ships between unemployment and inflation, and discusses the occurrence of demand-pull and cost-push inflation. You’ll learn how expectations can affect the economy, and assess the effect of taxes on aggregate supply.

Assignment 19 examines some popular theories on how the economy works and some current issues in macroeconomic theory and policy.

Assignment 20 provides an analysis of international trade and protectionism, and continues the discussion of compar- ative advantage by examining the economic effects of imports, exports, tariffs, and quotas.

Assignment 21 reviews how nations can trade goods and services using different currencies.

Assignment 22 looks at the problem of raising the standards of living in developing countries. You’ll identify some develop- ing countries and discuss their characteristics. Then, you’ll examine the obstacles to economic growth that these coun- tries experience.

87

L e

s s

o n

5

L e

s s

o n

5

Economics 188

OBJECTIVES When you complete this lesson, you’ll be able to

n Describe the relationship between short-run aggregate supply and long-run aggregate supply

n Explain how to apply the extended AD-AS model to inflation, recessions, and economic growth

n Describe the short-run trade off between inflation and unemployment by using the Phillips Curve

n Discuss the relationship between tax rates, tax revenues, and aggregate supply

n Explain the equation of exchange, and how it relates to monetarism

n Discuss why new classical economists believe that the economy will “self-correct” from supply shocks

n Explain the debate over “rules versus discretion” in the development of stabilization policies

n Explain the graphical model of comparative advantage, specialization, and the gains from trade

n Describe how differences between world prices and domestic prices prompt exports and imports

n Describe how economists analyze the economic effects of tariffs and quotas

n Discuss the pros and cons of trade protectionism

n Explain how different currencies are exchanged when international transactions take place

n Describe how exchange rates are determined in currency markets

n Explain the difference between flexible exchange rates and fixed exchange rates

n Describe how the World Bank defines an industrially- advanced country and a developing country

Lesson 5 89

n List some of the obstacles to economic development in developing nations

n Describe the vicious cycle of poverty that afflicts low- income nations

n Explain the role of government in promoting economic development within low-income nations

n Describe some of the ways in which industrial nations attempt to aid low-income nations

ASSIGNMENT 18 Read this introduction to Assignment 18. Then, read Chapter 18, “Extending the Analysis of Aggregate Supply,” on pages 354–371 in your textbook Macroeconomics.

This chapter continues the discussion of the aggregate demand-aggregate supply model, and will help you to improve your understanding of the short-run and long-run relationships between unemployment and inflation. Recent focus on long-run adjustments and economic outcomes has renewed debates about stabilization policy and the causes of instability. This chapter reviews the distinction between short-run and long-run aggregate supply, and the extended model is used to glean new insights on demand-pull and cost-push inflation. You’ll learn how expectations can affect the economy, and assess the effect of taxes on aggregate supply.

Short-Run and Long-Run Aggregate Supply In macroeconomics, the short run is a period in which wages (and other input prices) don’t respond to price level changes. Workers may not be fully aware of the change in their real wages due to inflation (or deflation), and thus haven’t adjusted their labor supply decisions and wage demands accordingly. Employees hired under fixed-wage contracts must wait to renegotiate, regardless of changes in the price level.

Economics 190

In the long run, nominal wages are fully responsive to price level changes. The long-run aggregate supply curve is a vertical line at the full employment level of real GDP.

If the price level rises, higher product prices with constant wages will bring higher profits and increased output. If the price level falls, lower product price with constant wages will bring lower profits and decreased output.

The extended AD-AS model makes the distinction between the short-run and long-run aggregate supply curves. Equilibrium occurs at a point where aggregate demand intersects both the vertical long-run supply curve and the short-run supply curve at full employment output.

Applying the Extended AD-AS Model In the short run, demand-pull inflation drives up the price level and increases real output; in the long run, only the price level rises. Cost-push inflation arises from factors that increase the cost of production at each price level (the increase in the price of a key resource, for example). This shifts the short-run supply to the left, not as a response to a price level increase, but as its initiating cause.

Cost-push inflation creates a dilemma for policymakers. If the government attempts to maintain full employment when there’s cost-push inflation, an inflationary spiral may occur. However, if the government takes a hands-off approach to cost-push inflation, a recession will occur. The recession may eventually undo the initial rise in per-unit production costs, but in the meantime, unemployment and loss of real output will occur.

When aggregate demand shifts leftward, a recession occurs. If prices and wages are downwardly flexible, the price level falls. The decline in the price level reduces nominal wages, which then eventually shifts the aggregate supply curve to the right. The price level declines, and output returns to the full employment level. This is the most controversial applica- tion of the extended AD-AS model. The key point of dispute is how long it would take in the real world for the necessary price and wage adjustments to take place to achieve the indi- cated outcome.

Lesson 5 91

The aggregate demand-aggregate supply framework can also be used to illustrate growth. As the aggregate supply sched- ule shifts outward, this results in economic growth. However, in recent decades, aggregate demand has shifted outward by an even greater amount. Nominal GDP rises faster than real GDP. This also results in inflation.

The Inflation-Unemployment Relationship Both low inflation and low unemployment are major eco- nomic goals. However, are they compatible? The relation- ship between inflation and unemployment has been studied for many years. One important observation was embodied in the Phillips Curve (named after A. W. Phillips, who devel- oped his theory in Great Britain in the 1960s by observing the British relationship between unemployment and wage inflation). Phillips observed that there was a stable and predictable trade-off between the rate of inflation and the unemployment rate. However, this tradeoff between output and inflation doesn’t occur over long time periods.

The stability of the Phillips Curve was called into question in 1970s and 1980s, because the economy was experiencing both higher rates of inflation and unemployment, called stagflation. The obvious inverse relationship of the 1960s had become obscure and highly questionable.

The conclusion to be drawn from studies of the Phillips Curve is that there’s no long-term tradeoff between inflation and unemployment. The original idea of a stable tradeoff between inflation and unemployment has given way to other views that focus more on long-run effects. Most economists accept the idea of a short-run tradeoff—where the short run may last several years—while recognizing that in the long run, such a tradeoff is much less likely.

Economics 192

Taxation and Aggregate Supply Economic disturbances can be generated on the supply side, as well as on the demand side of the economy. Certain government policies may reduce the growth of aggregate sup- ply. Supply-side economists advocate policies that promote output growth. They argue the following points:

1. The U.S. tax transfer system has negatively affected incentives to work, invest, innovate, and assume entrepreneurial risks.

2. To induce more work, government should reduce marginal tax rates on earned income.

3. Unemployment compensation and welfare programs have made job loss less of an economic crisis for some people. Many transfer programs are structured to actu- ally discourage the seeking of work.

The rewards for saving and investing have also been reduced by high marginal tax rates. One critical determinant of investment spending is the expected after-tax return. Lower marginal tax rates may encourage more people to enter the labor force and to work longer. The lower rates should reduce periods of unemployment and raise capital investment, which increases worker productivity. Aggregate supply will expand and keep inflation low.

The relationship between marginal tax rates and tax revenues is expressed in the Laffer Curve, named after economist Arthur Laffer, who originated the theory. The Laffer Curve suggests that cuts in tax rates can increase tax revenues if tax rates are too high for the economy. Thus, Laffer argued that tax rates were above the optimal level, and that by low- ering tax rates, government could increase the tax revenue collected. The lower tax rates would trigger an expansion of real output and income, enlarging the tax base. The main impact would be on supply rather than aggregate demand.

Critics of the Laffer Curve contend that the incentive effects are small and potentially inflationary. Tax cuts also increase demand, which can fuel inflation. Demand impacts may exceed supply impacts. The Laffer Curve is based on a logical premise, but where the economy is actually located on the

Lesson 5 93

curve is an empirical question and difficult to determine. It may be hard to know in advance the impact of a tax cut on supply.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 18, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide.

Self-Check 18 Indicate whether each of the following statements is True or False.

______ 1. The Laffer Curve shows the tradeoff between the price level and tax rates.

______ 2. A shift in the Phillips Curve to the left will improve the inflation-unemployment

choices available to society.

______ 3. There’s no tradeoff between unemployment and inflation in the long run.

______ 4. Demand-pull inflation and cost-push inflation are identical concepts, because

both involve lower unemployment rates and rising prices.

______ 5. The short-run aggregate supply curve shifts to the left when nominal wages

rise in response to price level increases.

______ 6. The Phillips Curve suggests an inverse relationship between increases in the

price level and the level of employment.

______ 7. A rightward and upward shift of the Phillips Curve is consistent with the occurrence

of stagflation.

______ 8. The short-run aggregate supply curve is vertical, and the long-run aggregate supply

curve is horizontal.

Check your answers with those on page 126.

Economics 194

ASSIGNMENT 19 Read this introduction to Assignment 19. Then, read Chapter 19, “Current Issues in Macro Theory and Policy,” on pages 373–386 in your textbook Macroeconomics.

This chapter looks at some of the different perspectives on how the economy works and some current issues in macro- economic theory and policy. Contemporary disagreements on the following three interrelated questions are considered:

1. What causes instability in the economy?

2. Is the economy self-correcting?

3. Should government adhere to rules or use discretion in setting economic policy?

Let’s take a brief look at these questions.

What Causes Macro Instability? From the mainstream view, which is the prevailing perspec- tive of most economists, macro instability arises mainly from price stickiness that makes it difficult for the economy to adjust and achieve its potential output when there are aggre- gate demand or aggregate supply shocks to the economy.

Monetarists focus on the money supply. Monetarism argues that the price and wage flexibility provided by competitive markets cause fluctuations in product and resource prices, rather than output and employment. Therefore, a competitive market system would provide substantial macroeconomic stability if there were no government interference in the economy.

A third perspective on macroeconomic stability called the real business cycle view focuses on aggregate supply. The view is that business cycles are caused by real factors affect- ing aggregate supply, such as a decline in productivity, which causes a decline in AS.

A fourth view relates to so-called coordination failures, in which people are prevented from acting jointly to determine the optimal level of output. There’s no mechanism for firms and households to agree on actions that would make them

Lesson 5 95

all better off if a failure occurs. The initial problem may be due to expectations that aren’t justified, but if everyone believes that a recession may come, they reduce spending, firms reduce output, and the recession occurs. The economy can be stuck in a recession because of a failure of house- holds and businesses to coordinate positive expectations.

Does the Economy “Self-Correct”? The view of new classical economics is that internal mecha- nisms of the economy allow it to self-correct. The adjustment process retains full employment output, according to this view. The disagreement among new classical economists is over the speed of the adjustment process.

The two variants in the new classical perspective are based on monetarism and the rational expectations theory (RET). Monetarists think that the economy will self-correct to its long-run level of output. The rational expectations theory suggests that the self-correction process is quick and doesn’t change the price level or real output.

In contrast, mainstream economists believe that there’s ample evidence that many prices and wages are inflexible downward for long periods of time. The adjustment process moves along a horizontal aggregate supply curve. Downward wage inflexibility may occur because firms are unable to cut wages due to contracts and the legal minimum wage. Firms may not want to reduce wages if they fear problems with morale and efficiency.

Rules or Discretion? Monetarists and other new classical economists believe that policy rules would reduce instability in the economy. A mone- tary rule would direct the Fed to expand the money supply each year at the same annual rate as the typical growth of GDP. The rule would tie increases in the money supply to the typical rightward shift of long-run aggregate supply, and ensure that aggregate demand shifts rightward along with it. A monetary rule, then, would promote steady growth of real output along with price stability.

Economics 196

Mainstream economists defend discretionary monetary policy, arguing that the velocity of money is variable and unpredictable, and in the short run, monetary policy can help offset more changes in AD than monetarists contend. Mainstream economists oppose requirements to balance the budget annually, because it would require actions that would intensify the business cycle, such as raising taxes and cutting spending during recessions (and the opposite during booms). They support discretionary fiscal policy to combat recession or inflation, even if it causes a deficit or surplus budget.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 19, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide.

Self-Check 19 Indicate whether each of the following statements is True or False.

______ 1. Mainstream economists say that recessions are unlikely to occur today because

prices and wages are highly flexible downward.

______ 2. Efficiency wage theory says that an above-market wage can reduce labor costs

per unit of output by eliciting greater work effort, lowering supervision costs, and

reducing job turnover.

______ 3. Mainstream macroeconomics has incorporated some aspects of monetarism and

rational expectations theory.

______ 4. The idea that the economy will “self-correct” when confronted with changes in

aggregate demand is associated with new classical economics.

(Continued)

Lesson 5 97

ASSIGNMENT 20 Read this introduction to Assignment 20. Then, read Chapter 20, “International Trade,” on pages 390–408 in your textbook Macroeconomics.

This chapter provides an analysis of international trade and protectionism, and continues the discussion of comparative advantage by examining the economic effects of imports, exports, tariffs, and quotas.

International trade and finance link economies, and economic change in one part of the world will have repercussions for other countries in other areas of the globe. International trade and finance is often at the center of U.S. economic policy.

Self-Check 19 ______ 5. In the theory of coordination failures, shifts of the nation’s long-run aggregate

supply curve are the main cause of business cycles.

______ 6. Monetarists say that fiscal policy, such as a tax cut, will affect the level of real

GDP only if it entails a change in the supply of money.

______ 7. In the insider-outsider theory, insiders are agents, and outsiders are principals.

______ 8. Monetarists say the velocity of money is highly variable and there’s no close link

between the money supply and the level of economic activity.

______ 9. Mainstream macroeconomists see two main sources of macroeconomic instability:

changes in investment spending and, occasionally, adverse aggregate supply shocks.

______ 10. According to monetarists, discretionary monetary policy has been a major source

of economic instability.

Check your answers with those on page 127.

Economics 198

Some Key Facts The first part of the chapter reviews some important facts about world trade.

The principal exports of the United States include computers, chemicals, semiconductors, consumer durables, and agricul- tural products. Its main imports are petroleum, automobiles, computers, and metals. The United States exports many of the same goods it imports, through intra-industry trade. The United States leads the world in the volume of exports and imports.

Although the United States, Japan, and western European nations dominate world trade, some emerging nations around the world collectively generate substantial international trade, including South Korea, Taiwan, Singapore, and China. China exported an estimated $1.2 trillion in goods in 2007, making it a major player in international trade.

The Economic Basis for Trade International specialization based on comparative advantage can mutually benefit participating nations. International trade enables nations to specialize their production, increase the productivity of their resources, acquire more goods and services, and realize a larger total output than they otherwise would be able to do alone.

The following are three points that amplify the rationale for international trade:

1. The distribution of economic resources among nations is uneven.

2. The efficient production of goods requires different tech- nologies or combinations of resources.

3. Products are differentiated among nations, and some people prefer imported goods over domestic goods.

The basic principle of comparative advantage rests on differing opportunity costs of producing various goods and services. Through free trade, based on the principle of com- parative advantage, the world economy can achieve a more efficient allocation of resources and a higher level of material well-being.

Lesson 5 99

Trade Barriers No matter how compelling the case for free trade, barries to free trade exist. The chapter reviews several trade barriers, including the following:

1. Tariffs, which are excise taxes on imported goods

2. Import quotas, which specify the maximum amount of a commodity that can be imported

3. Nontariff barriers, which restrict licenses needed to import foreign goods

4. Voluntary export restrictions, in which foreign companies voluntarily restrict the amount of their exports

This part of the chapter examines the economic impact of trade barriers, and includes some arguments for protection- ism. Finally, the chapter discusses the costs of protectionism and some continuing international trade controversies.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 20, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide.

Self-Check 20 Indicate whether each of the following statements is True or False.

______ 1. The percentage of the United States’ domestic output that’s derived from international

trade is higher than that for any other industrially advanced nation.

______ 2. During the Great Depression, most nations lowered tariffs and abolished import

quotas to encourage the flow of trade.

______ 3. International trade that’s based on the principle of comparative advantage creates

a more efficient allocation of world economic resources.

(Continued)

Economics 1100

ASSIGNMENT 21 Read this introduction to Assignment 21. Then, read Chapter 21, “Previous International Exchange-Rate Systems,” on pages 411–429 in your textbook Macroeconomics.

In the previous chapter, you learned why nations engage in international trade and why trade barriers are put in place. Now, in this chapter, you’ll learn how nations can trade goods and services using different currencies.

Self-Check 20 ______ 4. The World Trade Organization (WTO) is comprised of 25 European nations that

are dedicated to abolishing trade barriers and integrating their economies.

______ 5. The nation that has a comparative advantage in a particular product will be the

only world exporter of that product.

______ 6. The law of increasing opportunity costs limits international specialization.

______ 7. It’s impossible for a nation to have a comparative advantage in producing everything.

______ 8. Barriers to free trade impair efficiency in the international allocation of resources.

______ 9. A side benefit of international trade is that it links national interests and increases

the opportunity costs of war.

______ 10. Tariffs create larger gains to domestic producers than losses to domestic consumers.

______ 11. The World Trade Organization (WTO) is an international organization that’s designed

to provide short-term advances of foreign monies to those nations faced with trade

deficits.

______ 12. Economists prefer free trade to tariffs, and prefer tariffs to import quotas.

Check your answers with those on page 127.

Lesson 5 101

International Financial Transactions The chapter begins by addressing several important aspects of international trade. The vast majority of international financial transactions fall into these two categories:

1. International trade, which involves selling or purchasing goods across an international border

2. International asset transactions, which involve the transfer of property rights between citizens of different countries

Foreign exchange markets (or currency markets ) provide markets for the exchange of national currencies, enabling international transactions to take place.

The Balance of Payments A nation’s balance of payments is the sum of all transactions that take place between its residents and the residents of all foreign nations. These transactions include merchandise exports and imports, tourist expenditures, and interest plus dividends from the sale and purchases of financial assets abroad. The balance of payments account is subdivided into two components: the current account, which includes inter- national trade, and the capital and financial account, which includes international asset exchanges.

Flexible Exchange Rates Freely floating exchange rates are determined by the forces of demand and supply. Depreciation means that the value of a currency has fallen; it takes more units of one country’s currency to buy another country’s currency. Appreciation means that the value of a currency or its purchasing power has risen; it takes less of that currency to buy another coun- try’s currency.

The forces that cause a nation’s currency to depreciate or appreciate are called the determinants of exchange rates. Theoretically, flexible exchange rates have the virtue of automatically correcting any imbalance in the balance of

Economics 1102

payments. If there’s a deficit in the balance of payments, this means that there will be a surplus of that currency and its value will depreciate. As depreciation occurs, prices for goods and services from that country become more attractive, and the demand for them will rise. At the same time, imports become more costly as it takes more currency to buy foreign goods and services. With rising exports and falling imports, the deficit is eventually corrected.

The following are some disadvantages to flexible exchange rates:

1. Uncertainty and diminished trade may result if traders can’t count on future prices of exchange rates, which affect the value of their planned transactions.

2. Terms of trade may be worsened by a decline in the value of a nation’s currency.

3. Unstable exchange rates can destabilize a nation’s econ- omy. This is especially true for nations whose exports and imports are a substantial part of their GDPs.

Fixed Exchange Rates Fixed exchange rates are those that are pegged to some set value, such as the value of gold or the U.S. dollar. Official reserves are used to correct an imbalance in the balance of payments, since exchange rates can’t fluctuate to bring about automatic balance. This is called currency intervention. Trade policies that directly control the amount of trade and finance might be used to avoid imbalance in trade and payments.

Domestic macroeconomic adjustments may be more difficult to make under fixed rates. For example, a persistent deficit of trade may call for tight monetary and fiscal policies to reduce prices, which raises exports and reduces imports. Such contractionary policies can also cause recessions and unemployment, however.

Lesson 5 103

The Current Exchange Rate System: The Managed Float The current international exchange-rate system is called managed floating exchange rates, in which governments attempt to prevent rates from changing too rapidly in the short term. The G8 nations—the United States, Germany, Japan, Britain, France, Italy, Canada, and Russia—meet regularly to assess economic conditions and coordinate economic policy.

The following are two arguments in support of the managed float system:

1. Trade has expanded and not diminished under this system as some predicted it might.

2. Flexible rates have allowed international adjustments to take place without domestic upheaval when there has been economic turbulence in some areas of the world.

However, there are also concerns with the managed float system, including the following:

1. Much volatility occurs without the balance of payments adjustments predicted.

2. There’s no real “system” in the current system, and it’s too unpredictable.

Speculation in Currency Markets The “Last Word” section at the end of the chapter examines currency speculation. Do speculators in the international currency market provide a positive or a negative influence? Speculators sometimes contribute to exchange rate volatility. The expectation of currency appreciation or depreciation can be self-fulfilling.

For example, if speculators expect the Japanese yen to appreciate, they sell other currencies to buy yen. The increase in demand for yen and in supply of other currencies will boost its value, which may attract still other speculators to buy yen. The rise in yen value is partly a result of expecta- tions. Eventually, the yen’s value may soar too high relative

Economics 1104

to economic realities, the speculative bubble bursts, and the value of the yen can plummet for the same self-fulfilling reasons, as speculators sell yen to buy other currencies.

However, speculation can also have positive effects in foreign exchange markets. Speculators may be useful in smoothing out temporary fluctuations. If there’s a temporary decline in demand, speculators take advantage of the dip in value by buying the currency; this props up demand, strengthening the value again. If there’s a temporarily strong demand that artificially raises the value of a currency, speculators will sell to take advantage of the price hike, and this will reduce the inflated value.

Speculators also absorb risks that others don’t want to bear. International transactions in goods and services can be risky if exchange rates change. Buyers and sellers in international trade can reduce the risk of exchange rate changes in foreign transactions by hedging or buying the needed currency with forward contracts. This is where a buyer or seller protects against a change in future exchange rates in the futures market. Foreign exchange is bought or sold at contract prices fixed now, for delivery at a specified future date.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 21, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide.

Lesson 5 105

Self-Check 21 Indicate whether each of the following statements is True or False.

______ 1. If the United States and France are both on the international gold standard

and U.S. exports to France exceed U.S. imports from France, gold

will flow from the United States to France.

______ 2. Under freely flexible (floating) exchange rates, a U.S. trade deficit with Japan

will eventually cause the dollar price of yen to rise.

______ 3. U.S. exports increase and U.S. imports decrease the supplies of foreign monies

owned by U.S. banks.

______ 4. If the dollar depreciates, U.S. exports will eventually rise and U.S. imports will

eventually fall.

______ 5. If the price of British pounds, measured in terms of U.S. dollars, is rising, then

the price of U.S. dollars, measured in terms of British pounds, is also rising.

______ 6. A current account deficit will reduce U.S. foreign indebtedness.

______ 7. A system of fixed exchange rates is more likely to result in exchange controls

than is a system of flexible (floating) exchange rates.

______ 8. A nation that imports more goods and services than it exports is necessarily

realizing an international balance of payments deficit.

______ 9. Under the international gold standard, exchange rates fluctuate without restraint

to correct any international disequilibrium by affecting the relative attractiveness

of domestic and foreign goods.

______ 10. Under freely flexible (floating) exchange rates, if the dollar price of pounds rises,

the pound price of dollars will fall.

Check your answers with those on page 128.

Economics 1106

ASSIGNMENT 22 Read this introduction to Assignment 22. Then, read Chapter 22, “The Economics of Developing Countries,” on page 433 in the textbook Macroeconomics and on the Web site, www.mcconnell18e.com.

Introduction Go to the Web site, www.mcconnell18e.com, and click on the picture of the Macroeconomics textbook. A new window will open. On the left-hand side of the page, in the box labeled “Online Learning Center,” click on Student Edition. Another window will open; on the left-hand side of the page, under “Course-wide Content,” click on Web Chapters and Supplements. Finally, click on the link for Chapter 22W: The Economics of Developing Countries. The textbook chapter will open, and you can simply read the content as you would in your regular textbook. If you don’t intend to read the chapter all at once, you can click on Save a Copy at the top left of the page, and save a copy of the chapter’s .pdf file to your computer’s hard drive.

The Rich and the Poor This chapter looks at the problem of raising the standards of living in developing countries (DVCs). These countries have significant problems, including extreme or widespread poverty, low literacy rates, high dependence on agriculture, low levels of industrialization, and rapid population growth.

It’s sometimes difficult for the citizens of affluent countries to realize that poverty, hunger, and disease are commonplace for most of the world’s population. This chapter begins by identify- ing the developing countries and discussing their characteristics. Then, you’ll examine why these countries have such low stan- dards of living, emphasizing the obstacles to economic growth.

Industrially advanced countries (IACs), including the United States, Canada, Australia, New Zealand, Japan, and the nations of Western Europe, have developed market economies based on large stocks of capital goods, advanced technologies, and well-

Lesson 5 107

educated labor forces. They have a high per capita output. In contrast, developing countries have far less industrialization and are heavily committed to agriculture, and their exports are largely agricultural or raw materials. Capital equipment is scarce, production technologies are primitive, and productivity is low. More than 60 percent of the world’s population lives in these nations.

Obstacles to Economic Development The path to economic development requires that the DVCs use their natural resources more efficiently, and expand their avail- able supplies. Resource distribution is often very uneven in these countries, and ownership of natural resources is an issue.

While the populations of many DVCs are large, the following are some common difficulties with the available human resources:

1. Overpopulation is the rule.

2. Unemployment and underemployment are widespread.

3. Labor productivity is low.

Poverty makes it incredibly difficult for these nations to grow and develop. The obstacles to development listed in this chapter seem to arise from poverty. How can a country break the cycle of poverty? Increasing the rate of capital accumulation may help, but only if the rate of population growth is somehow slowed at the same time.

The Role of Government Economists generally agree that the governments of the DVCs should be doing something to promote growth, but they dis- agree on the appropriate role of government. The following are some positive functions of the government:

1. The government can provide law and order.

2. The government can spearhead investment, in the absence of entrepreneurship.

3. The government can improve infrastructure (sanitation, highways, and medical care).

4. The government may institute forced saving and investment programs.

Economics 1108

The Role of the Advanced Nations How can the IACs help developing countries in their pursuit of economic growth? Expanding trade may be the simplest way to benefit DVCs, and IACs can lower trade barriers against DVC products. However, many countries need basic capital and assistance to produce exports.

Foreign aid, through public or private loans and grants, represents one possible solution. However, a large portion of foreign aid money is distributed on the basis of political and military concerns, rather than purely economic consider- ations. The last part of the chapter examines private money flows from the IACs to the developing countries, and assesses the debt problem the developing countries face.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 22, as well as the chapter’s online quiz at http://tinyurl.com/o5xxw9o. Compare your answers for the self-check with those at the end of this study guide. When you’re sure you understand the material covered in this les- son, take your Lesson 5 examination.

Self-Check 22 Indicate whether each of the following statements is True or False.

______ 1. Most nations of the world are now IACs, not middle- and low-income DVCs.

______ 2. The differences in the per capita incomes of the IACs and the DVCs has diminished

sharply since the Second World War because of U.S. aid programs.

(Continued)

Lesson 5 109

Self-Check 22 ______ 3. DVCs might increase their rates of economic growth through privatization of state

industries, encouraging direct foreign investment, controlling population growth,

and opening economies to international trade.

______ 4. If the real outputs per capita of a rich nation and a poor nation grow at the same

percentage rate, the absolute income gap between the two nations will shrink.

______ 5. One advantage of direct foreign investment (as compared to foreign loans) is that

management skill and technological knowledge often accompany such capital flows.

______ 6. Saving is low in many DVCs primarily because income is very equally distributed.

______ 7. Reduction of tariff barriers against DVC imports would benefit both the DVCs and

the IACs.

______ 8. Capital flight refers to the fact that many DVCs must use their export earnings

to pay interest on their outstanding external debts.

______ 9. DVCs tend to have permanent shortages of farm labor.

______ 10. The most important growth obstacle common to all DVCs is the lack of desire to

increase their standards of living.

______ 11. The “capricious universe view” is the idea that the IACs are exploiting the DVCs.

______ 12. The vast majority of the labor forces of the low-income DVCs are engaged in

agriculture.

______ 13. Because families can afford to have more children, population growth is greater

in the IACs than in the DVCs.

______ 14. Most of the DVCs of the world are located in Western Europe.

Check your answers with those on page 128.

Economics 1110

NOTES

INTRODUCTION Over the past decade, many media articles have discussed the topics of “outsourcing” and “emerging markets,” voicing concerns about U.S. deficits and debt and the impact on the U.S. dollar. Gold prices have increased, commodity prices have soared, and there has been an explosion of exchange traded funds (ETFs), many that allow individual investors to “invest” in foreign currencies. As recently as mid-September 2010, the Japanese yen, for example, reached a 15-year high in value against the U.S. dollar.

Emerging Markets Emerging markets (EMs) are countries where the cost of labor (both direct and indirect) is very low compared to those costs in other countries. Companies in wealthier nations have therefore identified opportunities to reduce their costs by outsourcing (transferring) many lower-skilled production activities to these emerging markets. A list of EMs as com- piled by The Economist magazine is provided below:

One component of outsourcing is known as business process outsourcing, or BPO. This type of outsourcing to emerging markets was a prominent issue during the 2008 U.S. presi- dential campaign. During this period, the United States and other world economies (including emerging market economies) appeared to be entering a contraction period.

111

G ra

d e

d P

ro je

c t

G ra

d e

d P

ro je

c t

1 Argentina 10 Indonesia 19 Poland

2 Brazil 11 Israel 20 Russia

3 Chile 12 Malaysia 21 South Africa

4 China 13 Mexico 22 South Korea

5 Columbia 14 Morocco 23 Taiwan

6 Czech Republic 15 Pakistan 24 Thailand

7 Egypt 16 Peru 25 Turkey

8 Hungary 17 Philippines 26 Tunisia

9 India 18 Russia 27 Vietnam

Graded Project112

Outsourcing isn’t a new idea, but the 1990s and early 2000s saw dramatic increases in the outsourcing of manufacturing jobs to emerging markets, particularly India, China, and Mexico. During this period, big emerging markets (BEMs) and economies were defined as Brazil, China, Egypt, India, Mexico, Poland, Russia, South Africa, South Korea, and Turkey.

Exchange-Traded Funds (ETFs) An exchange-traded fund (ETF) is an investment fund that holds assets such as stocks, commodities, or bonds, and is traded on stock exchanges. ETFs can be attractive invest- ments because of their low costs and tax efficiency, and are a very popular type of exchange-traded product.

ETFs have grown in recent years. Some examples of ETFs include EWZ for Brazil, ECH for Chile, EPI for India, EWM for Malaysia, EWW for Mexico, RSX for Russia, EWS and SGT for Singapore, EZA and SZR for South Africa, EWY for South Korea, EWT for Taiwan, THD for Thailand, and TUR for Turkey.

Your Assignment Your final project will require you to examine any foreign currency of your choice (preferably one from an emerging market), and provide an analysis of that currency against the U.S. dollar over the 5-year period ending with 2010. To complete this assignment, examine an exchange-traded fund (ETF) for that currency, perform any additional research you need to do in order to understand the topic, and then write a 750-word paper that summarizes the results of your macro- economic analysis.

To find an ETF fund for a country that you’re interested in, go to an Internet search engine such as Google, and enter the keywords “exchange-traded fund for X,” and replace the “X” with the name of the country of your choice. You can see the history of your chosen ETF, in terms of U.S. dollars, by checking or entering the ETF call letters or ticker symbol in a financial search engine such as Yahoo! Finance (the web address for this site is http://finance.yahoo.com/).

GRADED PROJECT SUBMISSION INSTRUCTIONS

Project Objective The goal of this project is to demonstrate the knowledge that you’ve obtained in your Economics 1 course. To complete the project, you’ll need to research a foreign currency and an ETF for an emerging market that you find interesting, per- form a macroeconomic analysis of the currency, and write a paper that summarizes your analysis.

Instructions

Step 1: Select a foreign currency as described above.

Step 2: Perform your research. The content of your text- book can be one of your sources. However, your paper should also include at least four independent and reliable sources. Use general Internet search engines and financial search engines to perform your research.

Step 3: Perform your macroeconomic analysis on the material. Remember that you need to provide an analysis of your chosen currency against the U.S. dollar over the 5-year period ending with 2010.

Step 4: Write a first draft of your paper. Your paper should be written using a word-processing program, such as Microsoft Word or a Word-compatible program. Your essay should include a separate title page, and between three and five pages on your topic. The essay should include a brief introduction, several paragraphs that cover the required infor- mation, and a conclusion. The last page after the main body of the essay should provide a list of your reference sources.

Graded Project 113

Step 5: Complete your final draft. Carefully review your written essay, correct any errors, and submit your final draft to your instructor. Use the following Writing Guidelines to complete and submit your essay.

Writing Guidelines 1. Type your submission, double-spaced, in a standard

print font, size 12. Use a standard document format with 1-inch margins. (Do not use any fancy or cursive fonts.)

2. Read the assignment carefully, and follow the instructions.

3. Include the following information at the top of your paper:

n Name and complete mailing address

n Student number

n Course title and number (Economics 1, BUS 121)

n Graded project number (05047700)

4. Be specific. Limit your submission to the issues covered by your chosen topic.

5. Include a reference page in either APA or MLA style. On this page, list Web sites, books, journals, and all other references used in preparing the submission.

6. Proofread your work carefully. Check for correct spelling, grammar, punctuation, and capitalization.

Graded Project114

Grading Criteria Your project will be based on the following criteria:

Content 80%

Written communication 10%

Format 10%

Here’s a brief explanation of each of these points.

Content

The student must

n Provide a clear discussion of the chosen topic

n Address the topic in complete sentences

n Support his or her opinion by citing specific information from the textbook, Web sites, and any other references and by using correct APA or MLA guidelines for citations and references

n Stay focused on the chosen topic

n Write in his or her own words and use quotation marks to indicate direct quotations

Written Communication

The student must

n Discuss the topic in complete paragraphs that include an introductory sentence, at least four sentences of explana- tion, and a concluding sentence

n Use correct grammar, spelling, punctuation, and sen- tence structure

n Provide clear organization (for example, uses words like first, however, on the other hand, and so on, conse- quently, since, next, and when)

n Make sure the paper contains no typographical errors

Graded Project 115

Graded Project116

Format

The paper should be double-spaced and typed in font size 12. It must include the student’s

n Name and complete mailing address

n Student number

n Course title and number (Economics 1, BUS 121)

n Research project number (05047700)

Submitting Your Work You can submit your project online or by regular mail.

Online Method

Follow this procedure to submit your assignment online:

1. On your computer, save a revised and corrected version of your assignment. Be sure it includes all of the infor- mation listed in “Writing Guidelines.”

2. Go to http://www.pennfoster.edu and log onto the site.

3. At your student portal, click on Take an Exam.

4. In the box provided, enter the examination number. The number for this research assignment is 05047700.

5. Click on Submit.

6. On the next screen, enter your e-mail address. (Note: This information is required for online submission.)

Important

After you submit the assignment for evaluation, you should receive a

confirmation e-mail with a tracking number. If you don’t receive this

number within 24 hours, you must resubmit the assignment.

7. If you wish to tell your instructor anything specific regarding this assignment, enter it in the Comments box.

8. Attach your file or files as follows:

a. Click on the first Browse box.

b. Locate the file you wish to attach.

c. Double-click on the file.

d. If you have more than one file to attach, click on the next Browse box and repeat steps b and c for each file.

9. Click on Submit.

Graded Project 117

NOTES

Graded Project118

Self-Check 1 1. False

2. False

3. False

4. True

5. False

6. False

7. True

8. False

9. True

10. True

Self-Check 2 1. False

2. True

3. True

4. True

5. True

6. True

7. False

8. False

Self-Check 3 1. False

2. True

3. False

4. False

5. False

6. True

119

A n

s w

e r

s A

n s

w e

r s

7. True

8. False

9. False

10. True

11. True

12. False

Self-Check 4 1. True

2. True

3. False

4. True

5. True

6. True

7. False

8. False

9. False

10. True

11. False

12. True

13. True

14. True

15. False

16. False

Self-Check 5 1. False

2. False

3. False

4. False

Self-Check Answers120

5. True

6. True

7. False

8. False

9. True

10. True

Self-Check 6 1. False

2. True

3. True

4. True

5. True

6. True

7. False

8. False

9. True

10. False

11. True

12. False

13. True

14. False

15. False

16. True

Self-Check Answers 121

Self-Check Answers122

Self-Check 7 1. True

2. False

3. False

4. True

5. False

6. False

7. True

8. False

9. False

10. False

Self-Check 8 1. False

2. True

3. True

4. False

5. True

6. True

7. False

8. False

9. False

10. False

11. False

12. False

Self-Check 9 1. False

2. False

3. True

4. False

5. False

6. False

7. False

8. False

Self-Check 10 1. True

2. False

3. False

4. False

5. True

6. False

7. True

8. True

Self-Check 11 1. False

2. True

3. True

4. False

5. True

6. False

7. False

8. False

Self-Check Answers 123

Self-Check 12 1. False

2. True

3. True

4. True

5. True

6. False

7. True

8. False

9. False

10. True

Self-Check 13 1. True

2. True

3. True

4. False

5. False

6. False

7. False

8. False

9. True

10. False

11. False

12. False

13. False

14. False

15. False

16. True

Self-Check Answers124

Self-Check 14 1. False

2. False

3. False

4. False

5. False

6. False

7. False

8. False

9. True

10. True

Self-Check 15 1. False

2. False

3. True

4. False

5. False

6. False

7. False

8. False

9. True

10. True

Self-Check 16 1. False

2. False

3. True

4. False

Self-Check Answers 125

Self-Check Answers126

5. False

6. True

7. False

8. False

9. False

10. False

11. False

12. False

Self-Check 17 1. False

2. True

3. False

4. False

5. True

6. False

7. False

8. True

9. True

10. True

Self-Check 18 1. False

2. True

3. True

4. False

5. True

6. False

7. True

8. False

Self-Check Answers 127

Self-Check 19 1. False

2. True

3. True

4. True

5. False

6. True

7. False

8. False

9. True

10. True

Self-Check 20 1. False

2. False

3. True

4. False

5. False

6. True

7. True

8. True

9. True

10. False

11. False

12. True

Self-Check 21 1. False

2. True

3. True

4. True

5. False

6. False

7. True

8. False

9. False

10. True

Self-Check 22 1. False

2. False

3. True

4. False

5. True

6. False

7. True

8. False

9. False

10. False

11. False

12. True

13. False

14. False

Self-Check Answers128