Econ: Checkunderstanding**

Front 1

1.1 Explain how each of the following situations illustrates one of the four principles of individual choice.
a. You are on your third trip to a restaurant’s all-you-can-eat dessert buffet and are feeling very full. Although it would cost you no additional money, you forgo a slice of coconut cream pie but have a slice of chocolate cake. MORE...

Back 1

This illustrates the concept of opportunity cost. Given that a person can only eat so much at one sitting, having a slice of chocolate cake requires that you forgo eating something else, such as a slice of coconut cream pie.

Front 2

1.2 Explain how each of the following situations illustrates one of the five principles of interaction.
a. Using the college website, any student who wants to sell a used textbook for at least $30 is able to sell it to someone who is willing to pay $30. MORE

Back 2

This illustrates the concept that markets usually lead to efficiency. Any seller who wants to sell a book for at least $30 does indeed sell to someone who is willing to buy a book for $30. As a result, there is no way to change how used textbooks are distributed among buyers and sellers in a way that would make one person better off without making someone else worse off.

Front 3

1.2 Which of the following describes an equilibrium situation? Which does not? Explain your answer.
a. The restaurants across the street from the university dining hall serve better-tasting and cheaper meals than those served at the university dining hall. The vast majority of students continue to eat at the dining hall.

Back 3

This does not describe an equilibrium situation. Many students should want to change their behavior and switch to eating at the restaurants. Therefore, the situation described is not an equilibrium. An equilibrium will be established when students are equally as well off eating at the restaurants as eating at the dining hall—which would happen if, say, prices at the restaurants were higher than at the dining hall.

Front 4

1.2 Which of the following describes an equilibrium situation? Which does not? Explain your answer.
b. You currently take the subway to work. Although taking the bus is cheaper, the ride takes longer. So you are willing to pay the higher subway fare in order to save time.

Back 4

This does describe an equilibrium situation. By changing your behavior and riding the bus, you would not be made better off. Therefore, you have no incentive to change your behavior.

Front 5

1.3 Explain how each of the following examples illustrates one of the three principles of economy-wide interactions.
a. The White House urged Congress to pass a package of temporary spending increases and tax cuts in early 2009, a time when employment was plunging and unemployment soaring. MORE...

Back 5

This illustrates the principle that government policies can change spending. The tax cut would increase people’s after-tax incomes, leading to higher consumer spending.

Front 6

2.1 The production possibility frontier is useful because it illustrates how much of one good an economy must give up to get more of another good regardless of whether resources are being used efficiently.

Back 6

False. The production possibility frontier illustrates how much of one good an economy must give up to get more of another good only when resources are used efficiently in production. If an economy is producing inefficiently—that is, inside the frontier—then it does not have to give up a unit of one good in order to get another unit of the other good. Instead, by becoming more efficient in production, this economy can have more of both goods.

Front 7

2.1 In Italy, an automobile can be produced by 8 workers in one day and a washing machine by 3 workers in one day. In the United States, an automobile can be produced by 6 workers in one day and a washing machine by 2 workers in one day.
a. Which country has an absolute advantage in the production of automobiles? In washing machines?

Back 7

The United States has an absolute advantage in automobile production because it takes fewer Americans (6) to produce a car in one day than Italians (8). The United States also has an absolute advantage in washing machine production because it takes fewer Americans (2) to produce a washing machine in one day than Italians (3).

Front 8

2.1 Use the circular-flow diagram to explain how an increase in the amount of money spent by households results in an increase in the number of jobs in the economy. Describe in words what the circular-flow diagram predicts.

Back 8

So, there is an increase in the amount of money spent by households results in an increase in the flow of goods to households. This, in turn, generates an increase in demand for factors of production by firms. Therefore, there is an increase in the number of jobs in the economy.

Front 9

3.1 Explain whether each of the following events represents (i) a shift of the demand curve or (ii) a movement along the demand curve.
a. A store owner finds that customers are willing to pay more for umbrellas on rainy days.

Back 9

The quantity of umbrellas demanded is higher at any given price on a rainy day than on a dry day. This is a rightward shift of the demand curve, since at any given price the quantity demanded rises. This implies that any specific quantity can now be sold at a higher price.

Front 10

3.1 A sharp rise in the price of gasoline leads many commuters to join carpools in order to reduce their gasoline purchases.(i) a shift of the demand curve or (ii) a movement along the demand curve.

Back 10

The quantity of gasoline demanded falls in response to a rise in price. This is a movement along the demand curve.

Front 11

3.2 Explain whether each of the following events represents (i) a shift of the supply curve or (ii) a movement along the supply curve.
a. More homeowners put their houses up for sale during a real estate boom that causes house prices to rise.

Back 11

The quantity of houses supplied rises as a result of an increase in prices. This is a movement along the supply curve.

Front 12

3.2 Many construction workers temporarily move to areas that have suffered hurricane damage, lured by higher wages.(i) a shift of the supply curve or (ii) a movement along the supply curve.

Back 12

The quantity of labor supplied rises in response to a rise in wages. This is a movement along the supply curve.

Front 13

3.2 Since new technologies have made it possible to build larger cruise ships (which are cheaper to run per passenger), Caribbean cruise lines offer more cabins, at lower prices, than before.

Back 13

The quantity of cabins supplied is higher at any given price. This is a rightward shift of the supply curve.

Front 14

3.3 In the following three situations, the market is initially in equilibrium. Explain the changes in either supply or demand that result from each event. After each event described below, does a surplus or shortage exist at the original equilibrium price? What will happen to the equilibrium price as a result?
a. 2009 was a very good year for California wine-grape growers, who produced a bumper crop.

Back 14

The supply curve shifts rightward. At the original equilibrium price of the year before, the quantity of grapes supplied exceeds the quantity demanded. This is a case of surplus. The price of grapes will fall.

Front 15

3.3 After a hurricane, Florida hoteliers often find that many people cancel their upcoming vacations, leaving them with empty hotel rooms.

Back 15

The demand curve shifts leftward. At the original equilibrium price, the quantity of hotel rooms supplied exceeds the quantity demanded. This is a case of surplus. The rates for hotel rooms will fall.

Front 16

3.4 In each of the following examples, determine (i) the market in question; (ii) whether a shift in demand or supply occurred, the direction of the shift, and what induced the shift; and (iii) the effect of the shift on the equilibrium price and the equilibrium quantity.
a. As the price of gasoline fell in the United States during the 1990s, more people bought large cars.

Back 16

The market for large cars: this is a rightward shift in demand caused by a decrease in the price of a complement, gasoline. As a result of the shift, the equilibrium price of large cars will rise and the equilibrium quantity of large cars bought and sold will also rise.

Front 17

3.4 b. As technological innovation has lowered the cost of recycling used paper, fresh paper made from recycled stock is used more frequently.

Back 17

The market for fresh paper made from recycled stock: this is a rightward shift in supply due to a technological innovation. As a result of this shift, the equilibrium price of fresh paper made from recycled stock will fall and the equilibrium quantity bought and sold will rise.

Front 18

3.4 c. When a local cable company offers cheaper on-demand films, local movie theaters have more unfilled seats.

Back 18

The market for movies at a local movie theater: this is a leftward shift in demand caused by a fall in the price of a substitute, pay-per-view movies. As a result of this shift, the equilibrium price of movie tickets will fall and the equilibrium number of people who go to the movies will also fall.

Front 19

6.1 Which of the following questions involve microeconomics, and which involve macroeconomics? In each case, explain your answer.
a. Why did consumers switch to smaller cars in 2008?

Back 19

This is a microeconomic question because it addresses decisions made by consumers about a particular product.

Front 20

6.1 Microeconomics vs. Macroeconomics?
b. Why did overall consumer spending slow down in 2008?

Back 20

This is a macroeconomic question because it addresses consumer spending in the overall economy.

Front 21

6.1 Microeconomics vs. Macroeconomics?
c. Why did the standard of living rise more rapidly in the first generation after World War II than in the second?
MORE.....

Back 21

This is a macroeconomic question because it addresses changes in the overall economy.

Front 22

6.1 In 2008, problems in the financial sector led to a drying up of credit around the country: home-buyers were unable to get mortgages, students were unable to get student loans, car buyers were unable to get car loans, and so on.
a. Explain how the drying up of credit can lead to compounding effects throughout the economy and result in an economic slump.

Back 22

When people can’t get credit to finance their purchases, they will be unable to spend money. This will weaken the economy, and as others see the economy weaken, they will also cut back on their spending in order to save for future bad times. As a result, the credit shortfall will spark a compounding effect through the economy as people cut back their spending, making the economy worse, leading to more cutbacks in spending, and so on.

Front 23

6.1 b. If you believe the economy is self-regulating, what would you advocate that policy makers do?
c. If you believe in Keynesian economics, what would you advocate that policy makers do?

Back 23

If you believe the economy is self-regulating, then you would advocate doing nothing in response to the slump.
C. If you believe in Keynesian economics, you would advocate that policy makers undertake monetary and fiscal policies to stimulate spending in the economy.

Front 24

6.2 Why do we talk about business cycles for the economy as a whole, rather than just talking about the ups and downs of particular industries?

Back 24

We talk about business cycles for the economy as a whole because recessions and expansions are not confined to a few industries—they reflect downturns and upturns for the economy as a whole. In downturns, almost every sector of the economy reduces output and the number of people employed. Moreover, business cycles are an international phenomenon, sometimes moving in rough synchrony across countries.

Front 25

6.2 Describe who gets hurt in a recession, and how.

Back 25

Recessions cause a great deal of pain across the entire society. They cause large numbers of workers to lose their jobs and make it hard to find new jobs. Recessions hurt the standard of living of many families and are usually associated with a rise in the number of people living below the poverty line, an increase in the number of people who lose their houses because they can’t afford their mortgage payments, and a fall in the percentage of Americans with health insurance. Recessions also hurt the profits of firms.

Front 26

6.3 Many poor countries have high rates of population growth. What does this imply about the long-run growth rates of overall output that they must achieve in order to generate a higher standard of living per person?

Back 26

Countries with high rates of population growth will have to maintain higher growth rates of overall output than countries with low rates of population growth in order to achieve an increased standard of living per person because aggregate output will have to be divided among a larger number of people.

Front 27

6.3 Argentina used to be as rich as Canada; now it’s much poorer. Does this mean that Argentina is poorer than it was in the past? Explain.

Back 27

No, Argentina is not poorer than it was in the past. Both Argentina and Canada have experienced long-run growth. However, after World War II, Argentina did not make as much progress as Canada, perhaps because of political instability and bad macroeconomic policies. Canada’s economy grew much faster than Argentina’s. Although Canada is now about three times as rich as Argentina, Argentina still had long-run growth of its economy.

Front 28

6.4 Which of these sound like inflation, which sound like deflation, and which are ambiguous?
a. Gasoline prices are up 10%, food prices are down 20%, and the prices of most services are up 1-2%.

Back 28

As some prices have risen but other prices have fallen, there may be overall inflation or deflation. The answer is ambiguous.

Front 29

6.4 b.Gas prices have doubled, food prices are up 50%, and most services seem to be up 5% or 10%.
c. Gas prices haven’t changed, food prices are way down, and services have gotten cheaper, too.

Back 29

As all prices have risen significantly, this sounds like inflation. C. As most prices have fallen and others have not changed, this sounds like deflation.

Front 30

6.5 Which of the following reflect comparative advantage, and which reflect macroeconomic forces?
a. Thanks to the development of huge oil sands in the province of Alberta, Canada has become an exporter of oil and an importer of manufactured goods. MORE...

Back 30

This situation reflects comparative advantage. Canada’s comparative advantage results from the development of oil—Canada now has an abundance of oil.

Front 31

7.1 Explain why the three methods of calculating GDP produce the same estimate of GDP.

Back 31

Let’s start by considering the relationship between the total value added of all domestically produced final goods and services and aggregate spending on domestically produced final goods and services. These two quantities are equal because every final good and service produced in the economy is either purchased by someone or added to inventories. And additions to inventories are counted as spending by firms. Next, consider the relationship between aggregate spending on domestically produced final goods and services and total factor income. These two quantities are equal because all spending that is channeled to firms to pay for purchases of domestically produced final goods and services is revenue for firms. Those revenues must be paid out by firms to their factors of production in the form of wages, profit, interest, and rent. Taken together, this means that all three methods of calculating GDP are equivalent.

Front 32

7.1 What are the various sectors to which firms make sales? What are the various ways in which households are linked with other sectors of the economy?

Back 32

Firms make sales to other firms, households, the government, and the rest of the world. Households are linked to firms through the sale of factors of production to firms, through purchases from firms of final goods and services, and through lending funds to firms in the financial markets. Households are linked to the government through their payment of taxes, their receipt of transfers, and their lending of funds to the government via the financial markets. Finally, households are linked to the rest of the world through their purchases of imports and transactions with foreigners in financial markets.

Front 33

7.2 Assume there are only two goods in the economy, french fries and onion rings. In 2011, 1,000,000 servings of french fries were sold at $0.40 each and 800,000 servings of onion rings at $0.60 each. From 2011 to 2012, the price of french fries rose by 25% and the servings sold fell by 10%; the price of onion rings fell by 15% and the servings sold rose by 5%.
a. Calculate nominal GDP in 2011 and 2012. Calculate real GDP in 2012 using 2011 prices.

Back 33

In 2011 nominal GDP was (1,000,000 × $0.40) + (800,000 × $0.60) = $400,000 + $480,000 = $880,000. A 25% rise in the price of french fries from 2011 to 2012 means that the 2012 price of french fries was 1.25 × $0.40 = $0.50. A 10% fall in servings means that 1,000,000 × 0.9 = 900,000 servings were sold in 2012. As a result, the total value of sales of french fries in 2012 was 900,000 × $0.50 = $450,000. A 15% fall in the price of onion rings from 2011 to 2012 means that the 2012 price of onion rings was 0.85 × $0.60 = $0.51. A 5% rise in servings sold means that 800,000 × 1.05 = 840,000 servings were sold in 2012. As a result, the total value of sales of onion rings in 2012 was 840,000 × $0.51 = $428,400. Nominal GDP in 2012 was $450,000 + $428,400 = $878,400. To find real GDP in 2012, we must calculate the value of sales in 2012 using 2011 prices: (900,000 french fries × $0.40) + (840,000 onion rings × $0.60) = $360,000 + $504,000 = $864,000.

Front 34

2. From 2005 to 2010, the price of electronic equipment fell dramatically and the price of housing rose dramatically. What are the implications of this in deciding whether to use 2005 or 2010 as the base year in calculating 2012 real GDP?

Back 34

A price index based on 2005 prices will contain a relatively high price of electronics and a relatively low price of housing compared to a price index based on 2010 prices. This means that a 2005 price index used to calculate real GDP in 2012 will magnify the value of electronics production in the economy, but a 2010 price index will magnify the value of housing production in the economy.

Front 35

7.3 For each of the following events, how would an economist using a 10-year-old market basket create a bias in measuring the change in the cost of living today?
a. A typical family owns more cars than it would have a decade ago. Over that time, the average price of a car has increased more than the average prices of other goods.

Back 35

A market basket determined 10 years ago will contain fewer cars than at present. Given that the average price of a car has grown faster than the average prices of other goods, this basket will underestimate the true increase in the cost of living because it contains relatively too few cars.

Front 36

7.3 The consumer price index in the United States (base period 1982-1984) was 214.537 in 2009 and 218.056 in 2010. Calculate the inflation rate from 2009 to 2010.

Back 36

Using Equation 7-3, the inflation rate from 2009 to 2010 is ((218.056 − 214.537)/214.537) × 100 = 1.6%.

Front 37

8.1 Suppose that the advent of employment websites enables job-seekers to find suitable jobs more quickly. What effect will this have on the unemployment rate over time? Also suppose that these websites encourage job-seekers who had given up their searches to begin looking again. What effect will this have on the unemployment rate?

Back 37

The advent of websites that enable job-seekers to find jobs more quickly will reduce the unemployment rate over time. However, websites that induce discouraged workers to begin actively looking for work again will lead to an increase in the unemployment rate over time.

Front 38

8.1 In which of the following cases is a worker counted as unemployed? Explain.
a. Rosa, an older worker who has been laid off and who gave up looking for work months ago. MORE....

Back 38

Rosa is not counted as unemployed because she is not actively looking for work, but she is counted in broader measures of labor underutilization as a discouraged worker.

Front 39

8.1 Which of the following are consistent with the observed relationship between growth in real GDP and changes in the unemployment rate? Which are not?
A. A rise in the unemployment rate accompanies a fall in real GDP.
B. An exceptionally strong business recovery is associated with a greater percentage of the labor force being employed.
C. Negative real GDP growth is associated with a fall in the unemployment rate.

Back 39

Both parts a and b are consistent with the relationship, illustrated in Figure 8-5, between above-average or below-average growth in real GDP and changes in the unemployment rate: during years of above-average growth, the unemployment rate falls, and during years of below-average growth, the unemployment rate rises. However, part c is not consistent: it implies that a recession is associated with a fall in the unemployment rate, which is correct.

Front 40

8.2 Explain the following.
a. Frictional unemployment is higher when the pace of technological advance quickens.

Back 40

When the pace of technological advance quickens, there will be higher rates of job creation and destruction as old industries disappear and new ones emerge. As a result, frictional unemployment will be higher as workers leave jobs in declining industries in search of jobs in expanding industries.

Front 41

8.2 b. Structural unemployment is higher when the pace of technological advance quickens.

Back 41

When the pace of technological advance quickens, there will be greater mismatch between the skills employees have and the skills employers are looking for, leading to higher structural unemployment.

Front 42

8.2 Frictional unemployment accounts for a larger share of total unemployment when the unemployment rate is low.

Back 42

When the unemployment rate is low, frictional unemployment will account for a larger share of total unemployment because other sources of unemployment will be diminished. So the share of total unemployment composed of the frictionally unemployed will rise.

Front 43

8.2 Suppose that at the peak of the business cycle the United States dramatically increases benefits for unemployed workers. Explain what will happen to the natural rate of unemployment.

Back 43

An increase in unemployment benefits at the peak of the business cycle reduces the cost to individuals of being unemployed, causing them to spend more time searching for new jobs. So the natural rate of unemployment would increase.

Front 44

8.3 The widespread use of technology has revolutionized the banking industry, making it much easier for customers to access and manage their assets. Does this mean that the shoe-leather costs of inflation are higher or lower than they used to be?

Back 44

Shoe-leather costs as a result of inflation will be lower because it is now less costly for individuals to manage their assets in order to economize on their money holdings. This reduction in the costs associated with converting other assets into money translates into lower shoe-leather costs.

Front 45

8.3 Most people in the United States have grown accustomed to a modest inflation rate of around 2% to 3%. Who would gain and who would lose if inflation unexpectedly came to a complete stop over the next 15 or 20 years?

Back 45

If inflation came to an unexpected and complete stop over the next 15 or 20 years, the inflation rate would be zero, which of course is less than the expected inflation rate of 2% to 3%. Because the real interest rate is the nominal interest rate minus the inflation rate, the real interest rate on a loan would be higher than expected, and lenders would gain at the expense of borrowers. Borrowers would have to repay their loans with funds that have a higher real value than had been expected.

Front 46

9.1 Why do economists use real GDP per capita to measure economic progress rather than some other measure, such as nominal GDP per capita or real GDP? MORE... require calculator

Back 46

Economic progress raises the living standards of the average resident of a country. An increase in overall real GDP does not accurately reflect an increase in an average resident’s living standard because it does not account for growth in the number of residents. If, for example, real GDP rises by 10% but population grows by 20%, the living standard of the average resident falls: after the change, the average resident has only (110/120) × 100 = 91.6% as much real income as before the change. Similarly, an increase in nominal GDP per capita does not accurately reflect an increase in living standards because it does not account for any change in prices. For example, a 5% increase in nominal GDP per capita generated by a 5% increase in prices implies that there has been no change in living standards. Real GDP per capita is the only measure that accounts for both changes in the population and changes in prices.

Front 47

9.2 Predict the effect of each of the following events on the growth rate of productivity.
a. The amounts of physical and human capital per worker are unchanged, but there is significant technological progress.

Back 47

Significant technological progress will result in a positive growth rate of productivity even though physical capital per worker and human capital per worker are unchanged.

Front 48

9.2 Predict the effect of each of the following events on the growth rate of productivity.
b. The amount of physical capital per worker grows at a steady pace, but the level of human capital per worker and technology are unchanged.

Back 48

The growth rate of productivity will fall but remain positive due to diminishing returns to physical capital.

Front 49

9.2 Output in the economy of Erewhon has grown 3% per year over the past 30 years. The labor force has grown at 1% per year, and the quantity of physical capital has grown at 4% per year. The average education level hasn’t changed. Estimates by economists say that each 1% increase in physical capital per worker, other things equal, raises productivity by 0.3%. (Hint: % change in (X/Y) = % change in X − % change in Y.)
a. How fast has productivity in Erewhon grown?

Back 49

If output has grown 3% per year and the labor force has grown 1% per year, then productivity—output per person—has grown at approximately 3% − 1% = 2% per year.

Front 50

9.2 b. How fast has physical capital per worker grown?

Back 50

If physical capital has grown 4% per year and the labor force has grown 1% per year, then physical capital per worker has grown at approximately 4% − 1% = 3% per year.

Front 51

9.3 Explain the link between a country’s growth rate, its investment spending as a percent of GDP, and its domestic savings.

Back 51

A country that has high domestic savings is able to achieve a high rate of investment spending as a percent of GDP. This, in turn, allows the country to achieve a high growth rate.

Front 52

9.4 Some economists think the high rates of growth of productivity achieved by many Asian economies cannot be sustained. Why might they be right? What would have to happen for them to be wrong?

Back 52

The conditional version of the convergence hypothesis says that countries grow faster, other things equal, when they start from relatively low GDP per capita. From this we can infer that they grow more slowly, other things equal, when their real GDP per capita is relatively higher. This points to lower future Asian growth. However, other things might not be equal: if Asian economies continue investing in human capital, if savings rates continue to be high, if governments invest in infrastructure, and so on, growth might continue at an accelerated pace.

Front 53

9.4 Some economists think the best way to help African countries is for wealthier countries to provide more funds for basic infrastructure. Others think this policy will have no long-run effect unless African countries have the financial and political means to maintain this infrastructure. What policies would you suggest?

Back 53

The evidence suggests that both sets of factors matter: better infrastructure is important for growth, but so is political and financial stability. Policies should try to address both areas.

Front 54

9.5 Are economists typically more concerned about the limits to growth imposed by environmental degradation or those imposed by resource scarcity? Explain, noting the role of negative externalities in your answer.

Back 54

Economists are typically more concerned about environmental degradation than resource scarcity. The reason is that in modern economies the price response tends to alleviate the limits imposed by resource scarcity through conservation and the development of alternatives. However, because environmental degradation involves a negative externality—a cost imposed by individuals or firms on others without the requirement to pay compensation—effective government intervention is required to address it. As a result, economists are more concerned about the limits to growth imposed by environmental degradation because a market response would be inadequate.

Front 55

10.1 Suppose that expected inflation rises from 3% to 6%. A. How will the real interest rate be affected by this change?

Back 55

The real interest rate will not change. According to the Fisher effect, an increase in expected inflation drives up the nominal interest rate, leaving the real interest rate unchanged.

Front 56

10.2 Rank the following assets in terms of (i) level of transaction costs, (ii) level of risk, (iii) level of liquidity.
A) A bank deposit with a guaranteed interest rate
B) A share of a highly diversified mutual fund, which can be quickly sold
C) A share of the family business, which can be sold only if you find a buyer and all other family members agree to the sale

Back 56

The transaction costs for (a) a bank deposit and (b) a share of a mutual fund are approximately equal because each can typically be accomplished by making a phone call, going online, or visiting a branch office. Transaction costs are highest for (c) a share of a family business, since finding a buyer for the share consumes time and resources. The level of risk is lowest for (a) a bank deposit, since these deposits are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000; somewhat higher for (b) a share of a mutual fund, since despite diversification, there is still risk associated with holding mutual funds; and highest for (c) a share of a family business, since this investment is not diversified. The level of liquidity is highest for (a) a bank deposit, since withdrawals can usually be made immediately; somewhat lower for (b) a share of a mutual fund, since it may take a few days between selling your shares and the payment being processed; and lowest for (c) a share of a family business, since it can only be sold with the unanimous agreement of other members and it will take some time to find a buyer.

Front 57

10.2 What relationship would you expect to find between the level of development of a country’s financial system and its level of economic development? Explain in terms of the country’s level of savings and level of investment spending.

Back 57

Economic development and growth are the result of, among other factors, investment spending on physical capital. Since investment spending is equal to savings, the greater the amount saved, the higher investment spending will be, and so the higher growth and economic development will be. So the existence of institutions that facilitate savings will help a country’s growth and economic development. As a result, a country with a financial system that provides low transaction costs, opportunities for diversification of risk, and high liquidity to its savers will experience faster growth and economic development than a country that doesn’t.

Front 58

10.3 What is the likely effect of each of the following events on the stock price of a company? Explain your answers.
a. The company announces that although profits are low this year, it has discovered a new line of business that will generate high profits next year.

Back 58

Today’s stock prices reflect the market’s expectation of future stock prices, and according to the efficient markets hypothesis, stock prices always take account of all available information. The fact that this year’s profits are low is not new information, so it is already built into the share price. However, when it becomes known that the company’s profits will be high next year, the price of a share of its stock will rise today, reflecting this new information.

Front 59

10.3 b. The company announces that although it had high profits this year, those profits will be less than had been previously announced. MORE...

Back 59

The expectations of investors about high profits were already built into the stock price. Since profits will be lower than expected, the market’s expectations about the company’s future stock price will be revised downward. This new information will lower the stock price.

Front 60

10.3 Assess the following statement: “Although many investors may be irrational, it is unlikely that over time they will behave irrationally in exactly the same way—such as always buying stocks the day after the Dow has risen by 1%.”

Back 60

The efficient markets hypothesis states that all available information is immediately taken into account in stock prices. So if investors consistently bought stocks the day after the Dow rose by 1%, a smart investor would sell on that day because demand—and so stock prices—would be high. If a profit can be made that way, eventually many investors would be selling, and it would no longer be true that investors always bought stocks the day after the Dow rose by 1%.

Front 61

11.1 Explain why a decline in investment spending caused by a change in business expectations leads to a fall in consumer spending.

Back 61

A decline in investment spending, like a rise in investment spending, has a multiplier effect on real GDP—the only difference in this case is that real GDP falls instead of rises. The fall in I leads to an initial fall in real GDP, which leads to a fall in disposable income, which leads to lower consumer spending, which leads to another fall in real GDP, and so on. So consumer spending falls as an indirect result of the fall in investment spending.

Front 62

11.1 What is the multiplier if the marginal propensity to consume is 0.5? What is it if MPC is 0.8?

Back 62

When the MPC is 0.5, the multiplier is equal to 1/(1 − 0.5) = 1/0.5 = 2. When the MPC is 0.8, the multiplier is equal to 1/(1 − 0.8) = 1/0.2 = 5.

Front 63

11.1 As a percentage of GDP, savings accounts for a larger share of the economy in the country of Scania compared to the country of Amerigo. Which country is likely to have the larger multiplier? Explain.

Back 63

The greater the share of GDP that is saved rather than spent, the lower the MPC. Disposable income that goes to savings is like a “leak” in the system, reducing the amount of spending that fuels a further expansion. So it is likely that Amerigo will have the larger multiplier.

Front 64

11.2 Suppose that problems in the capital markets make consumers unable either to borrow or to put money aside for future use. What implication does this have for the effects of expected future disposable income on consumer spending?

Back 64

If you expect your future disposable income to fall, you would like to save some of today’s disposable income to tide you over in the future. But you cannot do this if you cannot save. If you expect your future disposable income to rise, you would like to spend some of tomorrow’s higher income today. But you cannot do this if you cannot borrow. If you cannot save or borrow, your expected future disposable income will have no effect on your consumer spending today. In fact, your MPC must always equal 1: you must consume all your current disposable income today, and you will be unable to smooth your consumption over time.

Front 65

11.3 For each event, explain whether planned investment spending or unplanned inventory investment will change and in what direction.
a. An unexpected increase in consumer spending

Back 65

An unexpected increase in consumer spending will result in a reduction in inventories as producers sell items from their inventories to satisfy this short-term increase in demand. This is negative unplanned inventory investment: it reduces the value of producers’ inventories.

Front 66

11.3 B) a sharp rise in the cost of business borrowing.
C) a sharp increase in the economy’s growth rate of real GDP.

Back 66

B) A rise in the cost of borrowing is equivalent to a rise in the interest rate: fewer investment spending projects are now profitable to producers, whether they are financed through borrowing or retained earnings. As a result, producers will reduce the amount of planned investment spending. C) A sharp increase in the rate of real GDP growth leads to a higher level of planned investment spending by producers, according to the accelerator principle, as they increase production capacity to meet higher demand.

Front 67

11.3 Historically, investment spending has experienced more extreme upward and downward swings than consumer spending. Why do you think this is so? (Hint: Consider the marginal propensity to consume and the accelerator principle.)

Back 67

Since the marginal propensity to consume is less than 1—because consumers normally spend part but not all of an additional dollar of disposable income—consumer spending does not fully respond to fluctuations in current disposable income. This behavior diminishes the effect of fluctuations in the economy on consumer spending. In contrast, by the accelerator principle, investment spending is directly related to the expected future growth rate of GDP. As a result, investment spending will magnify fluctuations in the economy: a higher expected future growth rate of real GDP leads to higher planned investment spending; a lower expected future growth rate of real GDP leads to lower planned investment spending.

Front 68

11.3 Consumer spending was sluggish in late 2007, and economists worried that an inventory overhang—a high level of unplanned inventory investment throughout the economy—would make it difficult for the economy to recover anytime soon. Explain why an inventory overhang might, like the existence of too much production capacity, depress current economic activity.

Back 68

When consumer spending is sluggish, firms with excess production capacity will cut back on planned investment spending because they think their existing capacities are sufficient for expected future sales. Similarly, when consumer spending is sluggish and firms have a large amount of unplanned inventory investment, they are likely to cut back their production of output because they think their existing inventories are sufficient for expected future sales. So an inventory overhang is likely to depress current economic activity as firms cut back on their planned investment spending and on their output.

Front 69

11.4 Although economists believe that recessions typically begin as slumps in investment spending, they also believe that consumer spending eventually slumps during a recession. Explain why.

Back 69

A slump in planned investment spending will lead to a fall in real GDP in response to an unanticipated increase in inventories. The fall in real GDP will translate into a fall in households’ disposable income, and households will respond by reducing consumer spending. The decrease in consumer spending leads producers to further decrease output, further lowering disposable income and leading to further reductions in consumer spending. So although the slump originated in investment spending, it will cause a reduction in consumer spending