Download Table 12.2 (completed)

AK Macroeconomics – Chapter 12
CHAPTER TWELVE
Answers to Self-Test Questions
1. a) $900 billion. GDP will increase by the amount of increased government
spending times the multiplier, i.e. $25 billion x 4 = $100. So GDP will increase from
$800 billion to $900 billion.
b) $10 billion. The MD curve will shift right by two squares (($40) which will
increase the interest rate from 6% to 8%. If the interest rate increases from 6% to 8%,
then investment spending will drop from $60 billion to $50 billion i.e. a fall of $10
billion.
c) $860 billion. With a multiplier of 4, GDP will decrease by $40 billion (4 x $10)
to new lower level of $860 billion.
2. $40 billion. In order to avoid crowding out, the central bank must increase the money
supply by the same amount as the increase in the money demand. This will keep the
interest rate at its original value of 6%.
3. It’s good idea to do a little table of inflation and unemployment rates as follows:
2002
2003
2004
2005
2006
Inflation %
2.0
3.0
6.0
10.0
16.0
From this data, the following graph can be drawn:
101
Unemployment %
12.0
8.0
6
4.5
3.0
AK Macroeconomics – Chapter 12
4. Completing the table gives:
ATR
GDP
Tax
Revenue
0.30
0.35
0.40
0.45
0.50
0.55
$2000
1900
1700
1500
1300
1100
$600
665
680
675
650
605
Tax revenue is maximized at a tax rate of 0.40. At rates higher or lower, tax revenue
would be less.
5.
Supply-side economists say that a decrease in taxes will lead to more work and
more investment so that production and incomes will rise. Keynesians say that the
major impact of a cut in taxes will be increased expenditures, which will increase
production and incomes.
6. Among the major benefits of fixed exchange rates:



they add a degree of certainty to international trade
they prevent instability in the export and import industries
it enhances the power of fiscal policy because there is no crowding out of
investment or exports
7. Stagflation is a combination of inflation and recession (stagnation). Deflation means
a fall in the general level of prices (the opposite of inflation). Since deflation is also
generally associated with a recession, this what the two have in common.
Answers to Study Guide Questions
1. True
2. True
3. True
4. False: stagflation can only be cured by changes in aggregate supply
5. False: it is based on the relationship between unemployment and inflation rates.
6. True.
7. False: it relates tax rates with tax revenues.
8. True.
9. False: it went as low as 64 cents during the 20 year period.
10. False: it means that the average price level is falling.
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AK Macroeconomics – Chapter 12
11. a
12. b
13. b
14. a
15. a
16. b
17. b
18. e
19. b
20. d
21. c
22. a
23. c
24. c
25. b
26. c
27. a
28. b
29. b
30. d
31. b
32. a
33. b
34. d
35. e
36A. Key Problem
a) See the following figure:
Figure 12.9 (completed)
b) The AD curve shifts to the right by 6 squares in Figure 13.12 (completed) .
(Since aggregate demand changes by $20 billion for every 1% change in taxes, a
6% decrease in taxes will cause a $120 billion increase in aggregate demand.)
c) Real GDP has increased by $40, and the price level has increased by 16 points.
Reading the graph in Figure 13.12 (completed) shows that the new equilibrium is
at a real GDP level of $640 and a price level of 116.
d) The AS and the Potential GDP curves shift to the right by 1.5 squares as
shown in Figure 13.12 (completed). Since aggregate supply changes by $5 billion
for every 1% change in taxes, a 6% decrease in taxes will cause a $30 billion
increase in both the aggregate supply and Potential GDP curves.
e) Real GDP has increased by $20, and the price level has decreased by 4 points.
Ignoring the new AD2 curve, Figure 13.12 (completed) shows that the increase in
the aggregate supply curve to AS2 which would bring about a new equilibrium at
a real GDP level of $620 and a price level of 96.
f) The total increase is the sum of the aggregate demand increase of $40 and the
aggregate supply increase of $20. The two together would therefore increase
real GDP by $60. The increase in aggregate demand pushes up the price level by
16 points whereas the increase in the aggregate supply pushes the price level
down by 4 points. Overall, therefore, the price level has increased by 12 points.
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AK Macroeconomics – Chapter 12
g) Inflationary gap of $20.
The Potential GDP initially was at the $610 level of real GDP. (Equilibrium was
at $600, and the introduction to the question said there was a $10 recessionary
gap.) The decrease in taxation shifted both the AS and the Potential GDP curves
since it increased the productivity of Copland. The new Potential GDP curve
therefore increases by $30 and is located at the $640 level of GDP. Since
equilibrium (the intersection of AD2 and AS2) is at $660, there is an inflationary
gap.
37A.
1
2
3
4
5
B
D
E
A
C
38A. a) See the following table:
TABLE 12.2 (completed)
% Tax Rate
0
5
10
15
20
25
30
35
40
45
50
55
60
65
70
GDP
$500
500
500
500
500
500
500
500
460
420
380
340
300
260
220
104
Tax Revenue
0
25
50
75
100
125
150
175
184
189
190
187
180
169
154
AK Macroeconomics – Chapter 12
b) See the following figure:
Figure 12.10 (completed)
c) % tax rate: 50%;
tax revenue: $190
39A. $3.6 billion. The economy is expected to grow by 2.4% x $1500 billion = $36
billion. Therefore the transactions demand will increase by 10% x $36 billion = $3.6
billion. To keep the interest rate the same, the money supply must increase by the
same amount of $3.6 billion.
40A.
Interest rate ↓;
investment ↑;
exchange rate ↓;
net exports ↑.
41A. a) Price index = 125; equilibrium GDP = $800;
potential GDP = $860
(there is a recessionary gap of 60 so potential GDP must be 60 higher than
equilibrium GDP)
unemployment rate: 12% (The GDP gap is $60 and if each $10 equals 1%
cyclical unemployment, there must be cyclical unemployment of 6%. If the
natural rate is 6%, then adding on cyclical unemployment of 6% gives us the
actual unemployment of 12%);
b) Unemployment = 10%. (The increase of 40 in AD creates a new equilibrium
of P =130 and GDP = 820. The recessionary gap is now 40, so cyclical
unemployment is 4% + natural rate of 6% = 10%).
inflation rate= 4% (price increases from 125 to 130. Inflation = +5/125 x 100).
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AK Macroeconomics – Chapter 12
c) See the following figure:
Figure 12.11 (Completed)
42A. a) $448 billion. An increase of government spending of $16 billion will increase
GDP by $16 billion x 3 = $48 billion.
b) $8 billion. Figure 12.12 shows that an increase of $10 billion in the money
demand will increase the interest rate from 4% to 6%. Figure 12.13 shows that the
increase in the interest rate from 4% to 6% will cause investment demand to drop
from $40 billion to $32 billion, a drop of $8 billion.
c) $424 billion. Since investment drops by $8 billion, GDP will drop by 3 x $8
billion = $24 billion from $448 to $424.
43A. Originally at full-employment, when the bubble burst in Japan in the 1990s it
caused a drop in spending, shown graphically as a fall (left shift) in the AD from
AD1 to AD2. The result was a lower price level (deflation) as well as a drop in real
GDP (a recession).
44A. See the figure below:
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AK Macroeconomics – Chapter 12
45A. The Phillips curve is the observed relationship in most economies between the
unemployment and inflation rates. The curve shows that there is a “trade-off”
between the two: the lower the unemployment rate, the higher the inflation rate and
the lower the inflation rate, the higher the unemployment rate. In addition it is not a
constant trade-off in that the lower is one rate, the increasingly higher is the other.
46A. If people believe that deflation will persist so that prices in general will be lower
next year than this, they may well hold up buying large ticket items, like houses, cars and
electronics in the hope that they can be bought cheaper in the future. The same is true for
firms who may hold off on capital investment not only because they believe that the price
of capital goods are likely to fall and also because it may be difficult to borrow funds
since credit may not be easily available.
47A. a) See the following table:
TABLE 12.4 (Completed)
Year
Price Index
2006
2007
2008
2009
2010
2011
100
102
105.1
110.4
119.2
133.5
Inflation
Rate (%)
Unemployment
(in millions)
2.0
3.0
5.0
8.0
12.0
12
9.6
7.2
6.0
4.8
b) See the following figure:
107
Unemployment
Rate (%)
10.0
8.0
6.0
5.0
4.0
AK Macroeconomics – Chapter 12
48A. Stagflation means the simultaneous occurrence of both unemployment (a stagnant
economy) and inflation. Higher prices and lower real GDP can only be caused by a
lower aggregate supply and this in turn must be the result of either higher resource
prices or lower productivity. The cure for stagflation, some economists believe, is
through policies designed to increase competition – thus lowering prices – and though
tax-incentive programs to boost incentives and productivity.
49A. a) The quantity of work (and possibly the quality too) because with lower marginal
tax rates, employees will be encouraged to work longer hours since the after-tax
rewards are higher. Many retired and unemployed people will also be tempted to take
a job now that the after-tax rewards are higher.
b) Savings will increase because the disposable income of people will be higher so
that they will not only increase spending but also savings too.
c) Investment will be higher with lower tax rates on corporations because they will
now have higher after-tax profits much of which they will retain in the companies so
that they can invest the funds in new capital projects.
50A Many products that are easily transportable between counties, such as cars, prices
tend to be very similar. But for services like restaurant meals, haircuts, hotel rooms
and so on which cannot be transported prices are usually very different from country
to country and usually reflect local labour costs.
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