Download answers to end-of-chapter questions 26-1

ANSWERS TO END-OF-CHAPTER QUESTIONS
26-1 (Key Question) What are the four phases of the business cycle? How long do business cycles
last? Why does the business cycle affect output and employment in capital goods industries and
consumer durable goods industries more severely than in industries producing consumer
nondurables?
The four phases of a business cycle are trough, expansion, peak, and recession. As seen in Table
26.1, the length of a complete cycle varies from about 2 or 3 years to as long as 11 years.
Because capital goods and durable goods last, purchases can be postponed. This may happen
when a recession is forecast. Capital and durable goods industries, therefore, suffer large output
declines during recessions. In contrast, consumers cannot long postpone the buying of
nondurables such as food; therefore, recessions only slightly reduce non-durable product output.
26-2 How, in general, can a financial crisis lead to a recession? How, in general, can a major new
invention lead to an expansion?
A financial crisis can have an adverse wealth effect; if assets lose value and people have poor
expectations for the economy, spending and investment decrease, leading to recession. A major
new invention can lead to expansion as firms adopt new technology and consumers purchase new
products resulting from the invention.
26-3 How is the labor force defined and who measures it? How is the unemployment rate calculated?
Does an increase in the unemployment rate necessarily mean a decline in the size of the labor
force? Why is a positive unemployment rate—one more than zero percent—fully compatible
with full employment?
The labor force is the number of people who are willing and able to work. It includes those who
are employed, as well as those who are not working but are actively seeking work. The labor
force is measured by the Bureau of Labor Statistics. The unemployment rate is the number of
unemployed divided by the labor force. An increase in the unemployment rate does not
necessarily mean a decline in the labor force; a higher unemployment rate can occur if the
number of people entering the labor force as unemployed is larger than the number of people
entering the labor force as employed. A positive unemployment rate occurs during a period of
full employment, because the full-employment unemployment rate is the sum of frictional
unemployment and structural unemployment.
26-4 How, in general, do unemployment rates vary by race and ethnicity, gender, occupation, and
education? Why does the average length of time people are unemployed rise during a recession?
Unemployment rates tend to be higher for African Americans and Hispanics, men (during
recessions), those with lower-skill jobs, and those with less education. The average length of
time people are unemployed rises during recessions because the reduced demand for products
reduces the demand for labor, so fewer jobs are available at the same time more people are
looking for work.
26-5 Why is it difficult to distinguish between frictional, structural, and cyclical unemployment? Why
is unemployment an economic problem? What are the consequences of a negative GDP gap?
What are the noneconomic effects of unemployment?
It is not easy to distinguish between these three types of unemployment because they can
interact. For example, a person who quits a job in search of a better one would normally be
considered frictionally unemployed. But suppose the former job then disappears completely
because the firm is in a declining industry and can no longer make money. Our still jobless
worker could now be considered structurally unemployed. And then suppose the economy slips
into a severe recession so that our worker cannot find any job and has become cyclically
unemployed. The unavoidable minimums of frictional and structural unemployment fluctuate as
the labor force structure changes. In other words, there is no automatic label on the type of
unemployment when someone is counted as unemployed.
Unemployment is an economic problem because of the opportunity cost. Unemployment is
economic waste; a labor resource that could be engaged in production is sitting idle.
The “GDP gap” is the difference between the economy’s potential GDP and its actual GDP. The
consequence of a negative GDP gap is that what is not produced—the amount represented by the
gap—is lost forever. Moreover, to the extent that this lost production represents capital goods,
the potential production for the future is impaired. Future economic growth will be reduced.
The noneconomic effects of unemployment include a loss of skills, low morale, family
disintegration, sociopolitical unrest, increased poverty, depression, and mental illness.
26-6 Because the U.S. has an unemployment compensation program that provides income for those
out of work, why should we worry about unemployment?
The unemployment compensation program merely gives the unemployed enough funds for basic
needs, not their full former salaries. Furthermore, many of the unemployed do not qualify for
unemployment benefits. The programs apply only to those workers who were covered by the
insurance, and this may be as few as one-third of those without jobs. Most of the unemployed
get no sense of self-worth or accomplishment out of drawing this compensation. Moreover, from
the economic point of view, unemployment is a waste of resources; when the unemployed go
back to work, nothing is forgone except undesired leisure. Finally, unemployment could be
inflationary and costly to taxpayers; the unemployed are producing nothing, but the
compensation helps keep demand in the economy high.
26-7 What is the Consumer Price Index (CPI) and how is it determined each month? How does the
Bureau of Labor Statistics calculate the rate of inflation from one year to the next? What effect
does inflation have on the purchasing power of a dollar? How does it explain differences
between nominal and real interest rates? How does deflation differ from inflation?
The CPI is constructed from a “market basket” sampling of goods that urban consumers typically
purchase. Prices for goods in the market basket are collected each month, weighted by the
importance of the good in the basket (cars are more expensive than bread, but we buy a lot more
bread), and averaged to form the price level.
To calculate the rate of inflation for year 2, the BLS subtracts the CPI of year 1 from the CPI of
year 2, and then divides by the CPI of year 1 (percentage change in the price level).
Inflation reduces the purchasing power of the dollar. Facing higher prices with a given number
of dollars means that each dollar buys less than it did before.
The rate of inflation in the CPI approximates the difference between the nominal and real interest
rates. A nominal interest rate of 10% with a 6% inflation rate will mean that real interest rates
are approximately 4%.
Deflation means that the price level is falling, whereas with inflation overall prices are rising.
Deflation is undesirable because the falling prices mean that incomes are also falling, which
reduces spending, output, employment, and, in turn, the price level (a downward spiral).
26-8 Distinguish between demand-pull inflation and cost-push inflation. Which of the two types is
most likely to be associated with a negative GDP gap? Which with a positive GDP gap, in which
actual GDP exceeds potential GDP? What is core inflation? Why is it calculated?
Demand-pull inflation occurs when an increase in aggregate spending is not fully matched by an
increase in aggregate output. Cost-push inflation describes prices rising because of increases in
per-unit costs of production.
Cost-push inflation is most likely to be associated with a negative GDP gap, as the rising
production costs reduce spending and output. Demand-pull inflation is more likely to occur with
a positive GDP gap, because actual GDP will exceed its potential only when aggregate spending
is strong and rising. As the economy produces above its potential, bottlenecks and more severe
resource scarcity occur, driving up prices.
Core inflation measures the prices of market basket goods that are more stable in price
(excluding food and energy). It is calculated because the more volatile food and energy prices
can lead to misinterpretations of economic performance, so policymakers prefer to examine core
inflation to make economic policy decisions.
26-9 Explain how an increase in your nominal income and a decrease in your real income might occur
simultaneously. Who loses from inflation? Who gains?
If a person’s nominal income increases by 10 percent while the cost of living increases by 15
percent, then her real income has decreased because it has not kept up with inflation. Generally,
whenever the cost of living increases faster than nominal income, real income decreases.
The losers from inflation are those on incomes fixed in nominal terms or, at least, those with
incomes that do not increase as fast as the rate of inflation. Creditors and savers also lose. The
winners are borrowers who must repay borrowed funds with dollars that are worth less than the
value of the dollars borrowed.
26-10 Explain how “hyperinflation” might lead to a severe decline in total output.
With extremely high inflation, it makes little sense to save. The only sensible thing to do with
money is to spend it before its value significantly falls. This act of trying to spend as fast as
possible speeds the inflationary spiral and causes people to spend more time trying to figure out
what goods are most likely to go up fastest in price. People turn away from productive activity,
because wages and salaries are not keeping up with inflation. Instead, they spend their time
speculating, transferring goods already in existence and producing nothing. Production and
investment in productive capital decrease and unemployment soars.
26-11 (LAST WORD) Suppose that stock prices were to fall by 10 percent in the stock market. All else
equal, would the lower stock prices be likely to cause a recession? How might lower stock prices
help predict a recession?
GDP could be reduced if stock owners feel significantly poorer and reduce their spending on
goods and services, including investment in real capital goods. However, research indicates that
downturns in the stock market have not had major impacts on GDP.
A fall in stock prices might signal a change in expectations. Evidence does suggest that there is a
link between falling stock prices and future recessions. However, this is only one factor related
to predicting recessions and, by itself, a fall in stock prices is not a reliable predictor of
recession.