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Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
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Chapter 26 Inflation and Monetary Policy
Review Questions
2.
If the Fed increases the interest rate target, the price of bonds drops. Bonds become more
attractive, so people sell stocks to acquire bonds, and stock prices drop as well. Conversely, if the
Fed lowers the interest rate target, the price of bonds and stocks increases. An expected change in
the Fed’s interest-rate target will also cause movements in stock and bond prices. For example, if
people expect the Fed to raise its interest rate target in the near future, they also expect stock and
bond prices to fall in the near future. People will want to sell their bonds and stocks now, before
the target is raised, so the prices of bonds and stocks will drop in the present.
4.
A negative supply shock sends prices up and unemployment up as well. The Fed faces a tradeoff
because shifting the AD curve rightward would lessen the rise in unemployment, but increase
prices further. Shifting the AD curve leftward would lessen the rise in prices, but increase
unemployment further. A hawk policy moves the AD curve leftward because it is tougher on
inflation, while a dove policy moves the AD curve to the right, in order to lessen the rise in
unemployment.
6.
The Phillips curve describes the relationship between inflation and unemployment in the short
run. By adjusting the rate at which the AD curve shifts, the Fed moves along the Phillips curve in
the short run. The long-run Phillips curve is vertical since in the long run the unemployment rate
returns to its natural rate; monetary policy only determines the price level.
8.
The uncertain and changing time lags before monetary policy affects the economy, and lack of
knowledge of the economy’s potential output are two of the most important information problems
faced by the Fed.
10.
First, it made announcements designed to reassure the public by pointing out that a modest
deflation rate was unlikely to create a downward spiral for the economy, and that if the deflation
was perceived to be temporary, it would not affect the economy significantly.
Second, it announced that it was prepared to change the way it conducts monetary policy
should the need arise. By buying long term government bonds, the Fed could still reduce other
interest rates in the economy.
Finally, the Fed could lower the real interest rate by raising expected inflation, if the need
arose. (It could do this by announcing believable policies designed to raise the inflation to a
modest, positive level.)
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Problems and Exercises
2.
The tax hike is a negative spending shock, which would shift the AD curve to the left. With
passive monetary policy, the Fed would leave the money supply unchanged. The economy would
slide down the AS curve to point F. Both output and the price level would fall (and the money
demand curve would shift to the left, moving money market equilibrium to point B). If the Fed
decides to use active policy to neutralize the spending shock, it must increase the money supply.
This action would lead to a lower interest rate (at point C), which would stimulate consumption
and investment spending by enough to offset the initial spending shock. The economy would
return to point E.
4.
Possibly, the announcement itself would be enough to change the behavior of workers and firms.
Understanding that the new Chair would fight unemployment even at the cost of inflation, they
would expect higher inflation in the future. People would build higher inflation into their
contracts and the Phillips curve would shift upwards. At each level of unemployment, there
would be a higher inflation rate. If the announcement were not enough to change expectations,
but the Chair did, in fact, turn out to be more concerned with unemployment than inflation, the
aggregate demand curve would begin shifting rightward more rapidly. The economy would ride
up the Phillips curve in the short run, and once a higher inflation rate were built in to contracts,
the Phillips curve would shift upward.
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6.
The Fed would have to increase the money supply increasingly more rapidly in each successive
year. This year, for example, it could increase the money supply by enough to choose the
unemployment rate-inflation rate combination of U2 and 9%. But, as the short run Phillips curve
shifts rightward to PCbuilt-in inflation = 9%, the Fed would have to increase the money supply even more
next year, in order to move the economy to point K. But this, in turn, would make the short run
Phillips curve shift rightward again. The inflation rate would rise continuously.
8.
The problem is that ongoing, expected deflation creates difficulties for monetary policy. The Fed
can lower its Federal Funds rate target all the way to 0%--but it can't use open market operations
or any of its other tools to make the Federal Funds rate fall below 0%.
Think about what would happen if the Federal Funds rate fell to 0%. If this happened, the Fed
would not be able to use open market operations to reduce interest rates further. This could limit
the Fed’s ability to raise aggregate expenditure and output with monetary policy.
Challenge Questions
2.
Assume the economy is initially in equilibrium at point E. If the Fed wrongly believes that the
natural rate of unemployment is higher and acts to bring the economy back to its supposed
potential, it will decrease the money supply. This will cause the interest rate to rise from r1 to r2,
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
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causing the AD curve to shift leftward from AD1 to AD2. The economy will experience a lower
price level and higher unemployment (at point F). With no more intervention, wage rates will
eventually fall, causing the AS curve to shift rightward from AS1 to AS2, returning the economy to
full employment (at point G). If the Fed, however, continues to decrease the money supply in an
effort to maintain output below potential, the public will come to expect deflation in the future,
and the economy will experience ongoing deflation.
4.
No. As people see the Fed increasing the money supply more rapidly in each successive year,
their expectations of future inflation rates would change and the short run Phillips curve would
shift rightward by increasingly larger amounts in successive years. This would make it even
harder for the Fed to keep the unemployment rate below the natural rate.
Economic Applications Exercises
2.
a. These diagrams confirm Fed’s implementation of expansionary monetary policy during
recessions and contractionary monetary policy to fight inflation.
b. Bernanke does not argue for strict rules, but for what he calls constrained discretion.
Constrained discretion is defined by two principles. First, through its words and (especially)
its actions, the central bank must establish a strong commitment to keeping inflation low and
stable. Second, subject to the condition that inflation be kept low and stable, and to the extent
possible given our uncertainties about the structure of the economy and the effects of policy,
monetary policy should strive to limit cyclical swings in resource utilization. In short, under
constrained discretion, the central bank is free to do its best to stabilize output and
employment in the face of short-run disturbances, with the appropriate caution born of our
imperfect knowledge of the economy and of the effects of policy. However, a critical proviso
is that, in conducting stabilization policy, the central bank must also maintain a strong
commitment to keeping inflation—and, hence, public expectations of inflation—firmly under
control. Because monetary policy influences inflation with a lag, keeping inflation under
control may sometimes require the central bank to anticipate and move in advance of
inflationary developments--that is, to engage in “preemptive strikes” on inflation. In
Bernanke’s view, constrained discretion characterizes the current monetary policy framework
of the United States.
Chapter 27 Fiscal Policy: Taxes, Spending, and the Federal Budget
Review Questions
2.
The three broad categories of government outlays are government purchases, transfer payments,
and interest on the debt. Transfer payments are the largest category. Government purchases have
been stable as a percentage of GDP, interest relative to GDP has fallen, and transfers relative to
GDP have grown.
4.
The federal government receives most of its revenue from personal income, corporate profits,
and Social Security taxes. Recently, there has been a steady increase in social security tax
revenues as a fraction of GDP. This is mainly a result of demographics, especially the large
number of people born in the 1950s who are now peak-earners, and the higher tax rates imposed
on current earnings to pay benefits to retiring baby boomers in the future. All other sources of
revenue have trended slightly downward, due to the slow recovery from the 2001 recession and
the significant long-term reductions in tax rates.
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6.
The cyclical deficit is the part of the deficit that changes as the economy changes, rising during
recessions and falling during booms. The cyclical deficit acts as an automatic stabilizer and so is
a good thing for the economy. The structural deficit is the rest of the deficit—the part that does
not depend on macroeconomic conditions.
8.
False. If GDP rises while government receipts and expenditures remain constant, then the
national debt as a fraction of GDP will fall.
10.
According to the OMB numbers, the Bush administration is temporarily violating the guideline
for responsible government by allowing debt to rise faster than GDP through 2006. This policy
will cause both interest payments relative to GDP and the tax burden to rise, although after 2006
the debt-to-GDP ratio will fall a little. The Democratic Caucus numbers show a long run violation
of the guideline for responsible government (the debt-to-GDP ratio rises continually). Part of the
difference in outcomes arises because the OMB projects only five years into the future, rather
than 10, but the rest arises from differing assumptions. The OMB leaves out estimates of
government outlays for military operations in Iraq or Afghanistan beyond 2003, does not add the
expenses of a proposal to start a Medicare prescription drug benefit in 2006, and assumes that the
tax cuts set to expire between 2004 and 2008 will, indeed, expire. The Democratic Caucus makes
none of these assumptions.
Problems and Exercises
2. If other things remain constant, it is impossible to keep all of your promises in the short run. If
you cut taxes and increase transfers and government purchases then the budget deficit will rise.
This will increase the national debt, and may, at least in the short run, increase national debt as a
fraction of GDP.
In the long run, however, if the tax cuts raise labor force participation rates by more than the
extra transfers reduce them, the tax base may rise by enough to bring in enough revenues to offset
government outlays. The lower tax rates may also lead to more investment spending in the
economy, which will cause GDP to rise and therefore reduce national debt as a fraction of GDP.
So it is possible to keep all of your campaign promises in the long run.
4.
a. Revenue from Type A households =10  250,000  0.15 = 375,000 zips
Revenue from Type B households = 10  50,000  0.15 = 75,000 zips
Revenue from Type C households = 10  20,000  0.15 = 30,000 zips
Total tax revenue = 375,000 + 75,000 + 30,000 = 480,000 zips
b. Revenue from Type A households =10  150,000  0.15 = 225,000 zips
Revenue from Type B households = 10  30,000  0.15 = 45,000 zips
No tax revenue collected from Type C households.
Total tax revenue = 225,000 + 45,000 = 270,000 zips
If the government continues to spend 480,000 zips, the budget deficit will be 480,000 –
270,000 = 210,000 zips. The recession causes a budget deficit.
c. Revenue from Type A households =10  400,000  0.15 = 600,000 zips
Revenue from Type B households = 10  70,000  0.15 = 105,000 zips
Revenue from Type C households = 10  30,000  0.15 = 45,000 zips
Total tax revenue = 600,000 + 105,000 + 45,000 = 750,000 zips
If the government continues to spend 480,000 zips, the budget will be in surplus, and the
surplus will be equal to 750,000 – 480,000 = 270,000 zips. (Alternatively, the deficit is –
270,000 zips.)
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During recessions the government deficit increases, and during booms it falls. These are changes
in the cyclical deficit. Since the government collects fewer taxes during recessions, household
disposable income decreases by less than it otherwise would, so consumption spending decreases
by less and the recession is milder. In booms, the government collects more tax, so household
disposable income increases by less than it otherwise would, consumption spending increases by
less and the boom is milder.
6.
Country A is in trouble. Between 1999 and 2000, the debt grew by 100% but GDP only grew by
10%; from 2000 to 2001, the debt grew again by 50%, but GDP grew only by 36%. In country B,
between 1999 and 2000, the debt grew by about 9% while GDP grew by about 11%; from 2000
to 2001, the debt grew by about 4.5% and GDP grew by about 10%. Country B meets the
minimal guideline for responsible government.
8.
a. Economica’s budget deficit = ($10 + $5) - $12 = -$2, which means that it has a surplus of $2
million.
b. The budget deficit equals the sum of the cyclical deficit and the structural deficit. Assuming
that the current unemployment rate of 6% is higher than the unemployment rate at full
employment, output would be below potential GDP, and there would be a cyclical deficit.
Since the cyclical deficit is positive and the actual budget deficit is negative, we can see from
the following equation that the structural deficit would also be negative, i.e., there is a
structural surplus:
Budget deficit = cyclical deficit + structural deficit
or
-$2 million = (some positive number) + structural deficit.
The only way this equation can be true is if the structural deficit is some negative number,
which is a structural surplus.
Economic Applications Exercises
2.
a. The diagrams and data confirm that in the short-run, the increase in real per-capita disposable
personal income is inversely related to personal tax rates or directly related to personal
consumption.
Chapter 28 Exchange Rates and Macroeconomic Policy
Review Questions
2.
Foreigners supply foreign currency (say, in the market where their currency is exchanged for U.S.
dollars) because they want to buy U.S. goods and services or U.S. assets. In general economists
believe that the supply curve for foreign currency is upward sloping. As the price of foreign
currency increases, U.S. goods and services become cheaper. Foreigners buy more U.S. goods
and services, and supply more foreign currency to get the dollars with which to buy the goods.
The following shift the supply of foreign currency schedule to the right: an increase in foreign
GDP, an increase in the relative interest rate in the United States, a change in tastes that makes
U.S. goods more desirable to foreigners, a relative decrease in prices in the United States, and an
expectation that the foreign currency will depreciate. The following shift the supply of foreign
currency curve to the left: a decrease in foreign GDP, a decrease in the relative interest rate in the
United States, a change in tastes that makes U.S. goods less desirable to foreigners, a relative
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increase in prices in the United States, and an expectation that the foreign currency will
appreciate.
4.
In the very short run, exchange rates move mainly due to changes in interest rates and
expectations of future exchanges rates since these forces drive hot money. In the short run,
business cycles account for most of the change in exchange rates. Countries with higher relative
GDPs demand more foreign currency, causing their own currencies to depreciate.
6.
Purchasing power parity says that the exchange rate between two countries should adjust until
the average price of goods is approximately the same in the two countries. Exchange rates might
deviate from purchasing power parity because of high transportation costs, barriers to trade, and
the inherent difficulty in trading some goods.
8.
A managed float is when the central bank intervenes in the foreign currency market to prevent an
appreciation or depreciation of its currency. Governments use a managed float to help their
export-oriented industries, to keep costs down for firms that import inputs, or to decrease the risks
of international trade that arise from exchange rate changes.
10.
During the 1980s interest rates rose due to the rising budget deficit, a burst of investment
spending, and a drop in the private saving rate. All of these contributed to a higher U.S. interest
rate, and a capital inflow, as foreigners purchased more U.S. assets than Americans purchased of
foreign assets. The dollar appreciated making American goods more expensive to foreigners, and
foreign goods cheaper to Americans, and a trade deficit resulted. The trade deficit persisted in the
1990s because of the continuing budget deficit, strong investment spending, and relatively low
private savings.
12.
Managed floats are controversial because countries often intervene when the forces behind an
appreciation or depreciation are strong, which only serves to delay inevitable changes in the
exchange rate—sometimes at great cost to a country’s currency reserves.
Problems and Exercises
2.
a. Setting the quantity of pounds demanded equal to the quantity supplied, we have
10 – 2e = 4 + 3e  6 = 5e  e = 6/5, or 1.2 dollars per pound.
b. After the U.S. government intervenes, the demand for pounds equation becomes
12 – 2e. Resolving for equilibrium, the exchange rate climbs to 1.6 dollars per pound, a
depreciation of the dollar. The U.S. government might intervene in this way if it wanted to
help its export-oriented industries.
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4.
Dollars
per
Peso
S1
pesos
pesos
S2
e1
D1
e2
D2
pesos
pesos
Quantity
of pesos
a. As the money supply decreases, the interest rate rises, causing a and I to fall, and, therefore,
decreasing GDP. As the interest rate rises, U.S. assets are more attractive to Americans and
Mexicans. This, combined with the fall in U.S. GDP, causes the demand curve for Mexican
pesos to shift leftward and the supply curve to shift rightward. The U.S. dollar appreciates.
b. The U.S. dollar appreciation causes net exports to fall, further shrinking equilibrium GDP in
the U.S.
c. If the Mexican central bank raised its interest rates just as much as the United States, then the
dollar would not appreciate as much. (It might still appreciate somewhat, depending on the
relative decline in U.S. and Mexican GDP, and the impact of these declines on U.S. net
exports). While U.S. output would still fall, it would not fall as much as in the initial analysis.
6.
a.
b. A fixed rate of 1.41 dinars per dollar is the equivalent of $0.71 per dinar. Since this is higher
than the market equilibrium price of $0.50 per dinar, Jordan’s central bank must buy dinars to
keep the dinar from depreciating.
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c. Jordan would eventually run out of foreign reserves, and so could not buy dinars forever.
d.
An expected fall in the dinar causes the supply curve for dinars to shift rightward from S 1 to
S2and the demand curve to shift leftward D1 to D2.
e. The end result is that Jordan’s central bank must buy even more dinars to maintain the fixed
rate
8.
Since Country B has the higher inflation rate, its relative price level is rising. As its basket of
goods becomes relatively more expensive, only a depreciation of its currency can restore
purchasing power parity. Traders would buy Country A’s currency in order to buy its goods for
resale in Country B. Country A’s currency will appreciate relative to Country B’s (alternately
stated: Country B’s currency will depreciate relative to Country A’s).
10.
(a)
(b)
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(c)
The initial increase in the money supply causes the interest rate to fall (panel (a)), which increases
investment and consumption spending, which shifts the AD curve rightward from AD1 to AD2 in
panel (b). The lower interest rate also shifts the supply of pounds curve leftward, and the demand
for pounds curve rightward in panel (c). The price per pound measured in U.S. dollars rises, and
this dollar depreciation causes net exports to rise. This shifts the AD curve rightward from AD2 to
AD3 in panel (b). Monetary policy is more effective when the effects on exchange rates are
included.
Challenge Questions
2.
More spending by the U.S. government causes U.S. interest rates to rise. This makes U.S. assets
more attractive, increasing the supply and decreasing the demand for foreign currency. The dollar
appreciates, causing net exports to fall, thus reducing real GDP. This makes fiscal policy less
effective in changing equilibrium GDP than it would be if the effects on exchange rates were
excluded.
Economic Applications Exercises
2.
a. Virtually all economists argue that free international trade increases the total consumption
possibilities for all trading partners. Adam Smith noted in The Wealth of Nations, total output
increases in an economy as a result of specialization and division of labor. It is argued that
countries gain in a similar manner as a result of international specialization and division of
labor. David Ricardo elaborated on this argument by noting that gains from international trade
will always occur when each country specializes in the production of those goods and services
in which it possesses a comparative advantage. A comparative advantage exists when the
opportunity cost of producing a good is lower in the domestic economy than in foreign
economies. The gains from trade occur because each country is able to import goods at a lower
opportunity cost than it would face if it produced these goods domestically. If each good is
produced in the country in which the opportunity cost is lowest, the total output of the world
economy is greater.
b. Following Smith and Ricardo, most economists support free international trade and recognize
only a few possible rationales for trade barriers:
 to protect “infant industries” that cannot compete effectively during their formative
period but will acquire a comparative advantage in the future once a trained labor
force and the necessary infrastructure has been developed,
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
to protect industries that are important for national security reasons (to prevent
political pressure from countries or cartels - such as OPEC - that might be able to
exert control over a critical commodity or resource),
 as a mechanism for correcting for differences in environmental and labor laws that
result in lower production costs in countries with fewer environmental and safety
regulations, and
 as a temporary measure to reduce the adjustment costs associated with job losses due
to the loss of comparative advantage in a particular industry.
The political reasons for trade barriers include:
 While consumers always gain from the reduction of trade barriers, firms and workers
in specific industries are better off when substantial trade barriers exist. The owners
of firms and workers in these industries receive very large losses if trade barriers are
eliminated; each individual consumer tends to receive relatively small gains from the
elimination of these barriers. If trade barriers are eliminated, the dollar value of the
gains to consumers will always outweigh the dollar value of the losses to producers
and workers. Each individual consumer, though, has little incentive to lobby for a
reduction in specific trade barriers (nor is even aware of most such trade barriers).
Each individual worker and owner, however, has a substantial incentive to lobby for
such trade restrictions. This “special-interest” effect often results in the passage of
laws resulting in trade barriers.
 There is also a concern that free trade with low-wage economies will reduce the wage
of high-wage U.S. workers. In specific industries, such an effect is likely. This
argument was at the heart of much of the opposition to NAFTA (since wage rates are
generally lower in Mexico).
4.
a. When the value of the dollar falls relative to the yen (the number of yen per dollar decreases),
Japanese goods become relatively more expensive for the U.S. to import, while U.S. goods
become relatively less expensive for Japanese to import. Thus when exchange rates drive the
current account, the U.S. current account balance should rise when the value of the dollar
decreases relative to the yen. As one can see in the diagram and the data table below,
throughout the 1980’s and into the early 1990’s there tended to be an inverse relationship
between changes in the U.S. current account balance and changes in the value of the dollar.
Interestingly, since the mid-1990’s there has been a direct rather than an inverse relationship
between current account and the value of the dollar in terms of yen.
b. One can see in the diagram on the Web site that rising real disposable personal income in the
U.S. has helped fuel our consumption of imports. Specifically, the current account tended to
be in deficit (imports exceeding exports) during times of growing real personal income as
Americans used their rising affluence to finance the purchase of imports. Note that in each of
the four recessions since 1980 (1981, 1982, 1990-91, and 2001, as well as the near-recession
in 1995), the current account balance tended to increase, or at least decline more slowly,
indicating that imports tend to decline during recessions. It is interesting to note that real
personal disposable income has continued to grow even through our most recent recession,
spurring greater consumption of imported goods.