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ECO102 Principles of Macroeconomics Problem Session-1 by Research Assistant Serkan Değirmenci 02.03.2012.

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Presentation on theme: "ECO102 Principles of Macroeconomics Problem Session-1 by Research Assistant Serkan Değirmenci 02.03.2012."— Presentation transcript:

1 ECO102 Principles of Macroeconomics Problem Session-1 by Research Assistant Serkan Değirmenci

2 Today Mankiw (2008), Principles of Economics: - Chapter 23: Measuring A Nation’s Income:  Questions for Review (QfR): 1-8 (page: 525)  Problems and Applications (P&A): 1-11 (page: ) - Chapter 24: Measuring the Cost of Living:  Questions for Review (QfR): 1-5 (page: 543)  Problems and Applications (P&A): 1-10 (page: ) - Chapter 25: Production and Growth:  Questions for Review (QfR): 1-8 (page: 573)  Problems and Applications (P&A): 1-10 (page: 574) - Chapter 26: Saving, Investment, and the Financial System:  Questions for Review (QfR): 1-6 (page: 594)  Problems and Applications (P&A): 1-11 (page: )

3 CHAPTER 23 MEASURING A NATION’S INCOME

4 Chapter 23: QfR-1 (page: 525) Explain why an economy’s income must equal its expenditure. income = expenditure (why?) ANSWER: (page: 508) => please see Figure 1 (page: 509) An economy's income must equal its expenditure, because every transaction has a buyer and a seller. Thus, expenditure by buyers must equal income by sellers.

5 Chapter 23: QfR-2 (page: 525) Which contributes more to GDP—the production of an economy car or the production of a luxury car? Why? GDP: the market value of all officially recognized final goods and services produced within a country in a given period. ANSWER: (page: ) The production of a luxury car contributes more to GDP than the production of an economy car because the luxury car has a higher market value. because market prices measure the amount people are willing to pay for different goods, they reflect the value of those goods. (page 510)

6 Chapter 23: QfR-3 (page: 525) A farmer sells wheat to a baker for $2. The baker uses the wheat to make bread, which is sold for $3. What is the total contribution of these transactions to GDP? ANSWER: (page: 511) The contribution to GDP is $3, the market value of the bread, which is the final good that is sold.

7 Chapter 23: QfR-4 (page: 525) Many years ago, Peggy paid $500 to put together a record collection. Today, she sold her albums at a garage sale for $100. How does this sale affect current GDP? ANSWER: (page: 511) The sale of used records does not affect GDP at all because it involves no current production.

8 Chapter 23: QfR-5 (page: 525) List the four components of GDP. Give an example of each. ANSWER: (page: ) The four components of GDP are consumption, such as the purchase of a music CD; investment, such as the purchase of a computer by a business; government purchases, such as an order for military aircraft; and net exports, such as the sale of American wheat to Russia. (Many other examples are possible.)

9 Chapter 23: QfR-6 (page: 525) Why do economists use real GDP rather than nominal GDP to gauge economic well-being? ANSWER: (page: ) Economists use real GDP rather than nominal GDP to gauge economic well-being because real GDP is not affected by changes in prices, so it reflects only changes in the amounts being produced. You cannot determine if a rise in nominal GDP has been caused by increased production or higher prices.

10 Chapter 23: QfR-7 (page: 525) In the year 2010, the economy produces 100 loaves of bread that sell for $2 each. In the year 2011, the economy produces 200 loaves of bread that sell for $3 each. Calculate nominal GDP, real GDP, and the GDP deflator for each year. (Use 2010 as the base year.) By what percentage does each of these three statistics rise from one year to the next? ANSWER: (page: ) YearNominal GDPReal GDPGDP Deflator X $2 = $200 ($200/$200) X 100 = X $3 = $ X $2 = $400($600/$400) X 100 = 150 The percentage change in nominal GDP is (600 − 200)/200 x 100 = 200%. The percentage change in real GDP is (400 − 200)/200 x 100 = 100%. The percentage change in the deflator is (150 − 100)/100 x 100 = 50%.

11 Chapter 23: QfR-8 (page: 525) Why is it desirable for a country to have a large GDP? Give an example of something that would raise GDP and yet be undesirable. ANSWER: (page: ) It is desirable for a country to have a large GDP because people could enjoy more goods and services. But GDP is not the only important measure of well-being. For example, laws that restrict pollution cause GDP to be lower. If laws against pollution were eliminated, GDP would be higher but the pollution might make us worse off. Or, for example, an earthquake would raise GDP, as expenditures on cleanup, repair, and rebuilding increase. But an earthquake is an undesirable event that lowers our welfare.

12 Chapter 23: P&A-1 (page: 525) The “government purchases” component of GDP does not include spending on transfer payments such as Social Security. Thinking about the definition of GDP, explain why transfer payments are excluded. ANSWER: (page: 514) With transfer payments, nothing is produced, so there is no contribution to GDP.

13 Chapter 23: P&A-2 (page: 525) As the chapter states, GDP does not include the value of used goods that are resold. Why would including such transactions make GDP a less informative measure of economic well-being? ANSWER: (page: 511) If GDP included goods that are resold, it would be counting output of that particular year, plus sales of goods produced in a previous year. It would double- count goods that were sold more than once and would count goods in GDP for several years if they were produced in one year and resold in another.

14 Chapter 23: P&A-3 (page: 525) What components of GDP (if any) would each of the following transactions affect? Explain. a. A family buys a new refrigerator. b. Aunt Jane buys a new house. c. Ford sells a Thunderbird from its inventory. d. You buy a pizza. e. California repaves Highway 101. f. Your parents buy a bottle of French wine. g. Honda expands its factory in Marysville, Ohio. ANSWER: (page: ) a. Consumption increases because a refrigerator is a good purchased by a household. b. Investment increases because a house is an investment good. c. Consumption increases because a car is a good purchased by a household, but investment decreases because the car in Ford’s inventory had been counted as an investment good until it was sold. d. Consumption increases because pizza is a good purchased by a household. e. Government purchases increase because the government spent money to provide a good to the public. f. Consumption increases because the bottle is a good purchased by a household, but net exports decrease because the bottle was imported. g. Investment increases because new structures and equipment were built.

15 Chapter 23: P&A-5 (page: 526) a. Compute nominal GDP, real GDP, and the GDP deflator for each year, using 2008 as the base year. b. Compute the percentage change in nominal GDP, real GDP, and the GDP deflator in 2009 and 2010 from the preceding year. For each year, identify the variable that does not change. Explain in words why your answer makes sense. c. Did economic well-being rise more in 2009 or 2010? Explain. Below are some data from the land of milk and honey

16 Chapter 23: P&A-5 (page: 526)-cont. ANSWER: a.Calculating nominal GDP: 2008: ($1 per qt. of milk  100 qts. milk) + ($2 per qt. of honey  50 qts. honey) = $ : ($1 per qt. of milk  200 qts. milk) + ($2 per qt. of honey  100 qts. honey) = $ : ($2 per qt. of milk  200 qts. milk) + ($4 per qt. of honey  100 qts. honey) = $800 Calculating real GDP (base year 2008): 2008: ($1 per qt. of milk  100 qts. milk) + ($2 per qt. of honey  50 qts. honey) = $ : ($1 per qt. of milk  200 qts. milk) + ($2 per qt. of honey  100 qts. honey) = $ : ($1 per qt. of milk  200 qts. milk) + ($2 per qt. of honey  100 qts. honey) = $400 Calculating the GDP deflator: 2008: ($200/$200)  100 = : ($400/$400)  100 = : ($800/$400)  100 = 200 b.Calculating the percentage change in nominal GDP: Percentage change in nominal GDP in 2009 = [($400 − $200)/$200]  100 = 100%. Percentage change in nominal GDP in 2010 = [($800 − $400)/$400]  100 = 100%. Calculating the percentage change in real GDP: Percentage change in real GDP in 2009 = [($400 − $200)/$200]  100 = 100%. Percentage change in real GDP in 2010 = [($400 − $400)/$400]  100 = 0%. Calculating the percentage change in GDP deflator: Percentage change in the GDP deflator in 2009 = [(100 − 100)/100]  100 = 0%. Percentage change in the GDP deflator in 2010 = [(200 − 100)/100]  100 = 100%. Prices did not change from 2008 to Thus, the percentage change in the GDP deflator is zero. Likewise, output levels did not change from 2009 to This means that the percentage change in real GDP is zero. c.Economic well-being rose more in 2009 than in 2010, since real GDP rose in 2009 but not in In 2009, real GDP rose but prices did not. In 2010, real GDP did not rise but prices did. 100% 0% 100%

17 Chapter 23: P&A-6 (page: 526) a. What was the growth rate of nominal GDP between 1999 and 2000? (Note: The growth rate is the percentage change from one period to the next.) b. What was the growth rate of the GDP deflator between 1999 and 2000? c. What was real GDP in 1999 measured in 1996 prices? d. What was real GDP in 2000 measured in 1996 prices? e. What was the growth rate of real GDP between 1999 and 2000? f. Was the growth rate of nominal GDP higher or lower than the growth rate of real GDP? Explain. Consider the following data on U.S. GDP:

18 Chapter 23: P&A-6 (page: 526)-cont. ANSWER: a.The growth rate of nominal GDP is ($9,873 − $9,269)/$9,269  100% = 6.5%. b.The growth rate of the deflator is (118 − 113)/113  100% = 4.4%. c.Real GDP in 1999 (in 1996 dollars) is $9,269/(113/100) = $8,203. d.Real GDP in 2000 (in 1996 dollars) is $9,873/(118/100) = $8,367. e.The growth rate of real GDP is ($8,367 − $8,203)/$8,203  100% = 2.0%. f.The growth rate of nominal GDP is higher than the growth rate of real GDP because of inflation.

19 Chapter 23: P&A-11 (page: 527) One day Barry the Barber, Inc., collects $400 for haircuts. Over this day, his equipment depreciates in value by $50. Of the remaining $350, Barry sends $30 to the government in sales taxes, takes home $220 in wages, and retains $100 in his business to add new equipment in the future. From the $220 that Barry takes home, he pays $70 in income taxes. Based on this information, compute Barry’s contribution to the following measures of income: a. gross domestic product b. net national product c. national income d. personal income e. disposable personal income

20 Chapter 23: P&A-11 (page: 526)-cont. ANSWER: a. GDP equals the dollar amount Barry collects, which is $400. b. NNP = GDP – depreciation = $400 − $50 = $350. c. National income = NNP − sales taxes = $350 − $30 = $320. d. Personal income = national income − retained earnings = $320 − $100 = $220. e. Disposable personal income = personal income − personal income tax = $220 − $70 = $150.

21 CHAPTER 24 MEASURING THE COST OF LIVING

22 Chapter 24: QfR-1 (page: 543) Which do you think has a greater effect on the consumer price index: a 10 percent increase in the price of chicken or a 10 percent increase in the price of caviar? Why? ANSWER: A 10% increase in the price of chicken has a greater effect on the consumer price index than a 10% increase in the price of caviar because chicken is a bigger part of the average consumer's market basket.

23 Chapter 24: QfR-2 (page: 543) Describe the three problems that make the consumer price index an imperfect measure of the cost of living. ANSWER: The three problems in the consumer price index as a measure of the cost of living are: (1) substitution bias, which arises because people substitute toward goods that have become relatively less expensive; (2) the introduction of new goods, which are not reflected quickly in the CPI; and (3) unmeasured quality change.

24 Chapter 24: QfR-3 (page: 543) If the price of a Navy submarine rises, is the consumer price index or the GDP deflator affected more? Why? ANSWER: If the price of a Navy submarine rises, there is no effect on the consumer price index, because Navy submarines are not consumer goods. But the GDP price index is affected, because Navy submarines are included in GDP as a part of government purchases.

25 Chapter 24: QfR-4 (page: 543) Over a long period of time, the price of a candy bar rose from $0.10 to $0.60. Over the same period, the consumer price index rose from 150 to 300. Adjusted for overall inflation, how much did the price of the candy bar change? ANSWER: Because the overall price level doubled, but the price of the candy bar rose sixfold, the real price (the price adjusted for inflation) of the candy bar tripled.

26 Chapter 24: QfR-5 (page: 543) Explain the meaning of nominal interest rate and real interest rate. How are they related? ANSWER: The nominal interest rate is the rate of interest paid on a loan in dollar terms. The real interest rate is the rate of interest corrected for inflation. The real interest rate is the nominal interest rate minus the rate of inflation. r = i - ∏

27 Chapter 24: P&A-2 (page: ) Suppose that people consume only three goods, as shown in this table: 2009 price 2009 quantity 2010 price 2010 quantity Golf Balls a.What is the percentage change in the price of each of three goods? b.Using the method similar to the consumer price index, compute the percentage change in the overall price level. c.If you were to learn that a bottle of Gatorade increased in size from 2009 to 2010, should that information affect your calculation of the inflation rate? If so, how? d.If you were to learn that Gatorade introduced new flavors in 2010, should that information affect your calculation of the inflation rate? If so, how? $4 100 $6 100

28 Chapter 24: P&A-2 (page: )-cont. ANSWER: a. The percentage change in the price of tennis balls is (2 – 2)/2 × 100% = 0%. The percentage change in the price of golf balls is (6 – 4)/4 × 100% = 50%. The percentage change in the price of Gatorade is (2 – 1)/1 × 100% = 100%. b. The cost of the market basket in 2009 is ($2 × 100) + ($4 × 100) + ($1 × 200) = $200 + $400 + $200 = $800. The cost of the market basket in 2010 is ($2 × 100) + ($6 × 100) + ($2 × 200) = $200 + $600 + $400 = $1,200. The percentage change in the cost of the market basket from 2009 to 2010 is (1,200 – 800)/800 × 100% = 50%. c. This would lower my estimation of the inflation rate because the value of a bottle of Gatorade is now greater than before. The comparison should be made on a per-ounce basis. d. More flavors enhance consumers’ well-being. Thus, this would be considered a change in quality and would also lower my estimate of the inflation rate.

29 Chapter 24: P&A-3 (page: 544) Suppose that the residents of Vegopia spend all of their income on cauliflower, broccoli, and carrots. In 2008, they buy 100 heads of cauliflower for $200, 50 bunches of broccoli for $75, and 500 carrots for $50. In 2009, they buy 75 heads of cauliflower for $225, 80 bunches of broccoli for $120, and 500 carrots for $100. a.Calculate the price of each vegetable in each year. b.Using 2008 as the base year, calculate the CPI for each year. c.What is the inflation rate in 2009? ANSWER: a. Find the price of each good in each year: YearCauliflowerBroccoliCarrots 2008$2$1.50$ $3$1.50$0.20 b. If 2008 is the base year, the market basket used to compute the CPI is 100 heads of cauliflower, 50 bunches of broccoli, and 500 carrots. We must now calculate the cost of the market basket in each year: 2008: (100 x $2) + (50 x $1.50) + (500 x $.10) = $ : (100 x $3) + (50 x $1.50) + (500 x $.20) = $475 Then, using 2008 as the base year, we can compute the CPI in each year: 2008: $325/$325 x 100 = : $475/$325 x 100 = 146 c. We can use the CPI to compute the inflation rate for 2009: (146 − 100)/100 x 100% = 46%

30 Chapter 24: P&A-7 (page: 544) The New York Times cost $0.15 in 1970 and $0.75 in The average wage in manufacturing was $3.23 per hour in 1970 and $14.32 in a. By what percentage did the price of a newspaper rise? b. By what percentage did the wage rise? c. In each year, how many minutes does a worker have to work to earn enough to buy a newspaper? d. Did workers’ purchasing power in terms of newspapers rise or fall? ANSWER: a. ($0.75 − $0.15)/$0.15 x 100% = 400%. b. ($14.32 − $3.23)/$3.23 x 100% = 343%. c. In 1970: $0.15/($3.23/60) = 2.8 minutes. In 2000: $0.75/($14.32/60) = 3.1 minutes. d. Workers' purchasing power fell in terms of newspapers.

31 CHAPTER 25 PRODUCTION AND GROWTH

32 Chapter 25: QfR-1 (page: 573) What does the level of a nation’s GDP measure? What does the growth rate of GDP measure? Would you rather live in a nation with a high level of GDP and a low growth rate, or in a nation with a low level and a high growth rate? ANSWER: The level of a nation’s GDP measures both the total income earned in the economy and the total expenditure on the economy’s output of goods and services. The level of real GDP is a good gauge of economic prosperity, and the growth of real GDP is a good gauge of economic progress. You would rather live in a nation with a high level of GDP, even though it had a low growth rate, than in a nation with a low level of GDP and a high growth rate, because the level of GDP is a measure of prosperity.

33 Chapter 25: QfR-2 (page: 573) List and describe four determinants of productivity. ANSWER: The four determinants of productivity are: (1) physical capital, which is the stock of equipment and structures that are used to produce goods and services; (2) human capital, which consists of the knowledge and skills that workers acquire through education, training, and experience; (3) natural resources, which are inputs into production that are provided by nature; and (4) technological knowledge, which is society’s understanding of the best ways to produce goods and services.

34 Chapter 25: QfR-3 (page: 573) In what way is a college degree a form of capital? ANSWER: A college degree is a form of human capital. The skills learned in earning a college degree increase a worker's productivity.

35 Chapter 25: QfR-4 (page: 573) Explain how higher saving leads to a higher standard of living. What might deter a policymaker from trying to raise the rate of saving? ANSWER: Higher saving means fewer resources are devoted to consumption and more to producing capital goods. The rise in the capital stock leads to rising productivity and more rapid growth in GDP for a while. In the long run, the higher saving rate leads to a higher standard of living. A policymaker might be deterred from trying to raise the rate of saving because doing so requires that people reduce their consumption today and it can take a long time to get to a higher standard of living.

36 Chapter 25: QfR-5 (page: 573) Does a higher rate of saving lead to higher growth temporarily or indefinitely? ANSWER: A higher rate of saving leads to a higher growth rate temporarily, not permanently. In the short run, increased saving leads to a larger capital stock and faster growth. But as growth continues, diminishing returns to capital mean growth slows down and eventually settles down to its initial rate, though this may take several decades.

37 Chapter 25: QfR-6 (page: 573) Why would removing a trade restriction, such as a tariff, lead to more rapid economic growth? ANSWER: Removing a trade restriction, such as a tariff, would lead to more rapid economic growth because the removal of the trade restriction acts like an improvement in technology. Free trade allows all countries to consume more goods and services.

38 Chapter 25: QfR-7 (page: 573) How does the rate of population growth influence the level of GDP per person? ANSWER: The higher the rate of population growth, the lower is the level of GDP per person because there's less capital per person, hence lower productivity.

39 Chapter 25: QfR-8 (page: 573) Describe two ways in which the U.S. government tries to encourage advances in technological knowledge. ANSWER: The U.S. government tries to encourage advances in technological knowledge by providing research grants through the National Science Foundation and the National Institute of Health, with tax breaks for firms engaging in research and development, and through the patent system.

40 Chapter 25: P&A-1 (page: 574) Suppose that society decided to reduce consumption and increase investment. a. How would this change affect economic growth? b. What groups in society would benefit from this change? What groups might be hurt? ANSWER: a. More investment would lead to faster economic growth in the short run. b. The change would benefit many people in society who would have higher incomes as the result of faster economic growth. However, there might be a transition period in which workers and owners in consumption-good industries would get lower incomes, and workers and owners in investment-good industries would get higher incomes. In addition, some group would have to reduce their spending for some time so that investment could rise.

41 Chapter 25: P&A-2 (page: 574) Societies choose what share of their resources to devote to consumption and what share to devote to investment. Some of these decisions involve private spending; others involve government spending. a. Describe some forms of private spending that represent consumption, and some forms that represent investment. b. Describe some forms of government spending that represent consumption, and some forms that represent investment. ANSWER: a. Private consumption spending includes buying food and buying clothes; private investment spending includes people buying houses and firms buying computers. Many other examples are possible. Education can be considered as both consumption and investment. b. Government consumption spending includes paying workers to administer government programs; government investment spending includes buying military equipment and building roads. Many other examples are possible. Government spending on health programs is an investment in human capital. This is truer for spending on health programs for the young rather than those for the elderly.

42 Chapter 25: P&A-3 (page: 574) Most countries, including the United States, import substantial amounts of goods and services from other countries. Yet the chapter says that a nation can enjoy a high standard of living only if it can produce a large quantity of goods and services itself. Can you reconcile these two facts? ANSWER: The facts that countries import many goods and services yet must produce a large quantity of goods and services themselves to enjoy a high standard of living are reconciled by noting that there are substantial gains from trade. In order to be able to afford to purchase goods from other countries, an economy must generate income. By producing many goods and services, then trading them for goods and services produced in other countries, a nation maximizes its standard of living.

43 Chapter 25: P&A-4 (page: 574) What is the opportunity cost of investing in capital? Do you think a country can “over-invest” in capital? What is the opportunity cost of investing in human capital? Do you think a country can “over-invest” in human capital? Explain. ANSWER: The opportunity cost of investing in capital is the loss of consumption that results from redirecting resources toward investment. Over-investment in capital is possible because of diminishing marginal returns. A country can "over-invest" in capital if people would prefer to have higher consumption spending and less future growth. The opportunity cost of investing in human capital is also the loss of consumption that is needed to provide the resources for investment. A country could "over-invest" in human capital if people were too highly educated for the jobs they could get  for example, if the best job a Ph.D. in philosophy could find is managing a restaurant.

44 Chapter 25: P&A-5 (page: 574) Suppose that an auto company owned entirely by German citizens opens a new factory in South Carolina. a. What sort of foreign investment would this represent? b. What would be the effect of this investment on U.S. GDP? Would the effect on U.S. GNP be larger or smaller? ANSWER: a. When a German firm opens a factory in South Carolina, it represents foreign direct investment. b. The investment increases U.S. GDP because it increases production in the United States. The effect on U.S. GNP would be smaller because the owners would get paid a return on their investment that would be part of German GNP rather than U.S. GNP.

45 Chapter 25: P&A-6 (page: 574) In the 1990s and the first decade of the 2000s, investors from the Asian economies of Japan and China made significant direct and portfolio investments in the United States. At the time, many Americans were unhappy that this investment was occurring. a. In what way was it better for the United States to receive this Japanese investment than not to receive it? b. In what way would it have been better still for Americans to have done this investment? ANSWER: a. The United States benefited from the Chinese and Japanese investment because it made our capital stock larger, increasing our economic growth. b. It would have been better for the United States to make the investments itself because then it would have received the returns on the investment itself, instead of the returns going to China and Japan.

46 Chapter 25: P&A-7 (page: 574) In many developing nations, young women have lower enrollment rates in secondary school than do young men. Describe several ways in which greater educational opportunities for young women could lead to faster economic growth in these countries. ANSWER: Greater educational opportunities for women could lead to faster economic growth in these developing countries because increased human capital would increase productivity and there would be external effects from greater knowledge in the country. Second, increased educational opportunities for young women may lower the population growth rate because such opportunities raise the opportunity cost of having a child.

47 Chapter 25: P&A-8 (page: 574) International data show a positive correlation between income per person and the health of the population. a.Explain how higher income might cause better health outcomes. b.Explain how better health outcomes might cause higher income. c.How might the relative importance of your two hypotheses be relevant for public policy? ANSWER: a.Individuals with higher incomes have better access to clean water, medical care, and good nutrition. b. Healthier individuals are likely to be more productive. c. Understanding the direction of causation will help policymakers place proper emphasis on the programs that will achieve both greater health and higher incomes.

48 Chapter 25: P&A-9 (page: 574) International data show a positive correlation between political stability and economic growth. a. Through what mechanism could political stability lead to strong economic growth? b. Through what mechanism could strong economic growth lead to political stability? ANSWER: a. Political stability could lead to strong economic growth by making the country attractive to investors. The increased investment would raise economic growth. b. Strong economic growth could lead to political stability because when people have high incomes they tend to be satisfied with the political system and are less likely to overthrow or change the government.

49 Chapter 25: P&A-10 (page: 574) From 1950 to 2000, manufacturing employment as a percentage of total employment in the U.S. economy fell from 28 percent to 13 percent. At the same time, manufacturing output experienced slightly more rapid growth than the overall economy. a.What do these facts say about growth in labor productivity (defined as output per worker) in manufacturing? b.In your opinion, should policymakers be concerned about the decline in the share of manufacturing employment? Explain. ANSWER: a. If output is rising and the number of workers is declining, then output per worker must be rising. b. Policymakers should not be concerned as long as output in the manufacturing sector is not declining. The reduction in manufacturing jobs will allow labor resources to move to other industries, increasing total output in the economy. An increase in productivity of workers (as measured by output per worker) is beneficial to the economy.

50 CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

51 Chapter 26: QfR-1 (page: 594) What is the role of the financial system? Name and describe two markets that are part of the financial system in our economy. Name and describe two financial intermediaries. ANSWER: The financial system's role is to help match one person's saving with another person's investment. Two markets that are part of the financial system are the bond market, through which large corporations, the federal government, or state and local governments borrow, and the stock market, through which corporations sell ownership shares. Two financial intermediaries are banks, which take in deposits and use the deposits to make loans, and mutual funds, which sell shares to the public and use the proceeds to buy a portfolio of financial assets.

52 Chapter 26: QfR-2 (page: 594) Why is it important for people who own stocks and bonds to diversify their holdings? What type of financial institution makes diversification easier? ANSWER: It is important for people who own stocks and bonds to diversify their holdings because then they will have only a small stake in each asset, which reduces risk. Mutual funds make such diversification easy by allowing a small investor to purchase parts of hundreds of different stocks and bonds.

53 Chapter 26: QfR-3 (page: 594) What is national saving? What is private saving? What is public saving? How are these three variables related? ANSWER: National saving is the amount of a nation's income that is not spent on consumption or government purchases. Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Public saving is the amount of tax revenue that the government has left after paying for its spending. The three variables are related because national saving equals private saving plus public saving. S = (Y-T-C) + (T-G) => National Saving = Private Saving + Public Saving

54 Chapter 26: QfR-4 (page: 594) What is investment? How is it related to national saving? ANSWER: Investment refers to the purchase of new capital, such as equipment or buildings. It is equal to national saving. S = I

55 Chapter 26: QfR-5 (page: 594) Describe a change in the tax code that might increase private saving. If this policy were implemented, how would it affect the market for loanable funds? ANSWER: A change in the tax code that might increase private saving is the expansion of eligibility for special accounts that allow people to shelter some of their saving from taxation. This would increase the supply of loanable funds, lower interest rates, and increase investment.

56 Chapter 26: QfR-6 (page: 594) What is a government budget deficit? How does it affect interest rates, investment, and economic growth? ANSWER: A government budget deficit arises when the government spends more than it receives in tax revenue. Because a government budget deficit reduces national saving, it raises interest rates, reduces private investment, and thus reduces economic growth.

57 Chapter 26: P&A-1 (page: 595) Theodore Roosevelt once said, “There is no moral difference between gambling at cards or in lotteries or on the race track and gambling in the stock market.” What social purpose do you think is served by the existence of the stock market? ANSWER: The stock market does have a social purpose. Firms obtain funds for investment by issuing new stock. People are more likely to buy that stock because there are organized stock markets, so people know that they can sell their stock if they want to.

58 Chapter 26: P&A-2 (page: 595) When the Russian government defaulted on its debt to foreigners in 1998, interest rates rose on bonds issued by many other developing countries. Why do you suppose this happened? ANSWER: When the Russian government defaulted on its debt, investors perceived a higher chance of default (than they had before) on similar bonds sold by other developing countries. Thus, the supply of loanable funds shifted to the left, as shown in Figure 1. The result was an increase in the interest rate. Figure 1

59 Chapter 26: P&A-3 (page: 595) For each of the following pairs, which bond would you expect to pay a higher interest rate? Explain. a. a bond of the U.S. government or a bond of an eastern European government b. a bond that repays the principal in 2013 or a bond that repays the principal in 2030 c. a bond from Coca-Cola or a bond from a software company you run in your garage d. a bond issued by the federal government or a bond issued by New York State ANSWER: a. The bond of an eastern European government would pay a higher interest rate than the bond of the U.S. government because there would be a greater risk of default. b. A bond that repays the principal in 2030 would pay a higher interest rate than a bond that repays the principal in 2013 because it has a longer term to maturity, so there is more risk to the principal. c. A bond from a software company you run in your garage would pay a higher interest rate than a bond from Coca-Cola because your software company has more credit risk. d. A bond issued by the federal government would pay a higher interest rate than a bond issued by New York State because an investor does not have to pay federal income tax on the bond from New York State.

60 Chapter 26: P&A-4 (page: 595) Many workers hold large amounts of stock issued by the firms at which they work. Why do you suppose companies encourage this behavior? Why might a person not want to hold stock in the company where he works? ANSWER: Companies encourage their employees to hold stock in the company because it gives the employees the incentive to care about the firm’s profits, not just their own salary. Then, if employees see waste or see areas in which the firm can improve, they will take actions that benefit the company because they know the value of their stock will rise as a result. It also gives employees an additional incentive to work hard, knowing that if the firm does well, they will profit. But from an employee’s point of view, owning stock in the company for which she or he works can be risky. The employee’s wages or salary is already tied to how well the firm performs. If the firm has trouble, the employee could be laid off or have her or his salary reduced. If the employee owns stock in the firm, then there is a double whammy  the employee is unemployed or gets a lower salary and the value of the stock falls as well. So owning stock in your own company is a very risky proposition. Most employees would be better off diversifying  owning stock or bonds in other companies  so their fortunes would not depend so much on the firm for which they work.

61 Chapter 26: P&A-5 (page: 595) Explain the difference between saving and investment as defined by a macroeconomist. Which of the following situations represent investment? Saving? Explain. a. Your family takes out a mortgage and buys a new house. b. You use your $200 paycheck to buy stock in AT&T. c. Your roommate earns $100 and deposits it in her account at a bank. d. You borrow $1,000 from a bank to buy a car to use in your pizza delivery business. ANSWER: To a macroeconomist, saving occurs when a person’s income exceeds his consumption, while investment occurs when a person or firm purchases new capital, such as a house or business equipment. a. When your family takes out a mortgage and buys a new house, that is investment because it is a purchase of new capital. b. When you use your $200 paycheck to buy stock in AT&T, that is saving because your income of $200 is not being spent on consumption goods. c. When your roommate earns $100 and deposits it in her account at a bank, that is saving because the money is not spent on consumption goods. d. When you borrow $1,000 from a bank to buy a car to use in your pizza-delivery business, that is investment because the car is a capital good.

62 Chapter 26: P&A-6 (page: 595) Suppose GDP is $8 trillion, taxes are $1.5 trillion, private saving is $0.5 trillion, and public saving is $0.2 trillion. Assuming this economy is closed, calculate consumption, government purchases, national saving, and investment. ANSWER: Given that Y = 8, T = 1.5, S private = 0.5 = Y −T − C, S public = 0.2 = T − G. Because S private = Y − T − C, then rearranging gives C = Y − T − S private = 8 − 1.5 − 0.5 = 6. Because S public = T − G, then rearranging gives G = T − S public = 1.5 − 0.2 = 1.3. Because S = national saving = S private + S public = = 0.7. Finally, because I = investment = S, I = 0.7.

63 Chapter 26: P&A-7 (page: 595) Economists i n Funlandia, a closed economy, have collected the following information about the economy for a particular year: Y = 10,000 C = 6,000 T = 1,500 G = 1,700 The economist also estimate that the investment function is: I = 3,300 – 100r Where r is the country’s real interest rate, expressed as a percentage. Calculete private saving, public saving, national saving, investment, and the equilibrium real interest rate. ANSWER: Private saving is equal to (Y – C – T) = 10,000 – 6,000 – 1,500 = 2,500. Public saving is equal to (T – G) = 1,500 – 1,700 = National saving is equal to (Y – C – G) = 10,000 – 6,000 – 1,700 = 2,300. Investment is equal to saving = 2,300. The equilibrium interest rate is found by setting investment equal to 2,300 and solving for r: 3,300 – 100r = 2, r = 1,000. r = 10 percent.

64 Chapter 26: P&A-8 (page: 595) Suppose that Intel is considering building a new chipmaking factory. a. Assuming that Intel needs to borrow money in the bond market, why would an increase in interest rates affect Intel’s decision about whether to build the factory? b. If Intel has enough of its own funds to finance the new factory without borrowing, would an increase in interest rates still affect Intel’s decision about whether to build the factory? Explain. ANSWER: a. If interest rates increase, the costs of borrowing money to build the factory become higher, so the returns from building the new plant may not be sufficient to cover the costs. Thus, higher interest rates make it less likely that Intel will build the new factory. b. Even if Intel uses its own funds to finance the factory, the rise in interest rates still matters. There is an opportunity cost on the use of the funds. Instead of investing in the factory, Intel could invest the money in the bond market to earn the higher interest rate available there. Intel will compare its potential returns from building the factory to the potential returns from the bond market. If interest rates rise, so that bond market returns rise, Intel is again less likely to invest in the factory.

65 Chapter 26: P&A-9 (page: 595) Suppose the government borrows $20 billion more next year than this year. a. Use a supply-and-demand diagram to analyze this policy. Does the interest rate rise or fall? b. What happens to investment? To private saving? To public saving? To national saving? Compare the size of the changes to the $20 billion of extra government borrowing. c. How does the elasticity of supply of loanable funds affect the size of these changes? (Hint: See Chapter 5 to review the definition of elasticity.) d. How does the elasticity of demand for loanable funds affect the size of these changes? e. Suppose households believe that greater government borrowing today implies higher taxes to pay off the government debt in the future. What does this belief do to private saving and the supply of loanable funds today? Does it increase or decrease the effects you discussed in parts (a) and (b)?

66 Chapter 26: P&A-9 (page: 595) -continued Figure 2

67 Chapter 26: P&A-9 (page: 595) ANSWER: a. Figure 2 illustrates the effect of the $20 billion increase in government borrowing. Initially, the supply of loanable funds is curve S 1, the equilibrium real interest rate is i 1, and the quantity of loanable funds is L 1. The increase in government borrowing by $20 billion reduces the supply of loanable funds at each interest rate by $20 billion, so the new supply curve, S 2, is shown by a shift to the left of S 1 by exactly $20 billion. As a result of the shift, the new equilibrium real interest rate is i 2. The interest rate has increased as a result of the increase in government borrowing. b. Because the interest rate has increased, investment and national saving decline and private saving increases. The increase in government borrowing reduces public saving. From the figure you can see that total loanable funds (and thus both investment and national saving) decline by less than $20 billion, while public saving declines by $20 billion and private saving rises by less than $20 billion. c. The more elastic is the supply of loanable funds, the flatter the supply curve would be, so the interest rate would rise by less and thus national saving would fall by less, as Figure 3 shows.

68 Chapter 26: P&A-9 (page: 595) -continued Figure 3 Figure 4

69 Chapter 26: P&A-9 (page: 595) ANSWER: d. The more elastic the demand for loanable funds, the flatter the demand curve would be, so the interest rate would rise by less and thus national saving would fall by more, as Figure 4 shows. e. If households believe that greater government borrowing today implies higher taxes to pay off the government debt in the future, then people will save more so they can pay the higher future taxes. Thus, private saving will increase, as will the supply of loanable funds. This will offset the reduction in public saving, thus reducing the amount by which the equilibrium quantity of investment and national saving decline, and reducing the amount that the interest rate rises. If the rise in private saving was exactly equal to the increase in government borrowing, there would be no shift in the national saving curve, so investment, national saving, and the interest rate would all be unchanged. This is the case of Ricardian equivalence.

70 Chapter 26: P&A-10 (page: 595) “Some economists worry that the aging populations of industrial countries are going to start running down their savings just when the investment appetite of emerging economies is growing” (Economist, May 6, 1995). Illustrate the effect of these phenomena on the world market for loanable funds. ANSWER: If world savings declines at the same time world investment rises, the supply curve of loanable funds shifts to the left and the demand curve shifts to the right. Figure 6 illustrates the result. The world interest rate will rise, while the overall effect on the equilibrium quantity of loanable funds is ambiguous  it depends on the relative sizes of the shifts of the two curves and on their elasticities.

71 Chapter 26: P&A-11 (page: 595) This chapter explains that investment can be increased both by reducing taxes on private saving and by reducing the government budget deficit. a. Why is it difficult to implement both of these policies at the same time? b. What would you need to know about private saving in order to judge which of these two policies would be a more effective way to raise investment? ANSWER: a. Investment can be increased by reducing taxes on private saving or by reducing the government budget deficit. But reducing taxes on private saving has the effect of increasing the government budget deficit, unless some other taxes are increased or government spending is reduced. So it is difficult to engage in both policies at the same time. b. To know which of these policies would be a more effective way to raise investment, you would need to know: (1) what the elasticity of private saving is with respect to the after-tax real interest rate, because that would determine how much private saving would increase if you reduced taxes on saving; (2) how private saving responds to changes in the government budget deficit, because, for example, if Ricardian equivalence holds, the decline in the government budget deficit would be matched by an equal decline in private saving, so national saving would not increase at all; and (3) how elastic investment is with respect to the interest rate, because if investment is quite inelastic, neither policy will have much of an impact on investment.

72 to be continued…


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