Download ANSWERS TO END-OF-CHAPTER QUESTIONS

Introduction to Economic Growth and Instability
ANSWERS TO END-OF-CHAPTER QUESTIONS
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Explain how an increase in your nominal income and a decrease in your real income might occur
simultaneously. Who loses from inflation? From unemployment? If you had to choose between
(a) full employment with a 6 percent annual rate of inflation or (b) price stability with an 8
percent unemployment rate, which would you select? Why?
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 from 100 to 95.65 (= 110/1.15). Alternatively
expressed, her real income has decreased by 4.35 percent (= 100 - 95.65). Generally, whenever
the cost of living increases faster than my 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. In the worst recession since the Great
Depression, those who lost the most from unemployment were, in descending order, blacks (who
also suffer the most in good times), teenagers, and blue-collar workers generally. In addition to
the specific groups who lose the most, the economy as a whole loses in terms of the living
standards of its members because of the lost production.
Choosing between (a) and (b) is truly a Hobson’s choice! But if one must choose, it would
probably be (b) because with inflation at zero, the central bank will have no cause to raise interest
rates and cut off the economic expansion needed to get unemployment down from the
unforgivable 8 percent. If one chose (a), we would not stay at full employment because the
central bank would be raising interest rates to choke off demand to get inflation down from 6
percent. And we might soon have stagflation—increasing unemployment in the presence of high
inflation.
(Key Question) If the price index was 110 last year and is 121 this year, what is this year’s rate of
inflation? What is the “rule of 70”? How long would it take for the price level to double if
inflation persisted at (a) 2, (b) 5, and (c) 10 percent per year?
This year' s rate of inflation is 10% or [(121 − 110) / 110]× 100.
Dividing 70 by the annual percentage rate of increase of any variable (for instance, the rate of
inflation or population growth) will give the approximate number of years for doubling of the
variable.
(a) 35 years ( = 70/2); (b) 14 years ( = 70/5); (c) 7 years ( = 70/10).
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Describe the relationship between total spending and the level of output and employment.
Explain what happens to the price level as increases in total spending move the economy from
substantial unemployment to moderate unemployment, to full employment, and, finally, to fullcapacity output.
As total spending rises and falls, so does output and employment. Cyclical unemployment is
caused by a deficiency in total spending in the economy. If this deficiency begins to disappear—
as total spending increases—output increases and unemployment decreases.
With substantial unemployment, an increase in total spending can occur without any increase in
the price level. After a while (range 2 in Figure 8-7), if total spending continues to increase and
unemployment to decrease, the price level will start to rise, because some sectors will begin to
experience full employment and a demand for resources rising faster than their supply in that
sector. This price-level increase will become more and more pronounced as full employment is
approached. The economy may reach the formal definition of full employment and still be able
to produce more by working overtime, for example. Finally, at absolute capacity, when, by
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definition, no more can be produced, any further increase in total spending will be entirely
inflationary (range 3 in Figure 8-7).
Explain how “hyperinflation” might lead to a depression.
With inflation running into the double, triple, quadruple, or even greater number of digits per
year, it makes little sense to save. The only sensible thing to do with money is to spend it before
its value is cut in half within a month, a week, or a day. This very fact of everyone trying to
spend as fast as possible will speed the inflationary spiral and cause people to spend more and
more time trying to figure out what goods are most likely to go up fastest in price. More and
more people will turn away from productive activity, because wages and salaries are not keeping
up with inflation. Instead, they will spend their time speculating, transferring goods already in
existence and producing nothing.
Eventually, money may become worthless. No one will work for money. Barter and living by
one’s wits become the only means of survival. Production falls for this reason and also because
investment in productive capital practically ceases. Unemployment soars. A massive depression
is at hand.
Evaluate as accurately as you can how each of the following individuals would be affected by
unanticipated inflation of 10 percent per year:
a. A pensioned railroad worker
b. A department-store clerk
c. A unionized automobile assembly-line worker
d. A heavily indebted farmer
e. A retired business executive whose current income comes entirely from interest on
government bonds
f. The owner of an independent small-town department store
(a) Assuming the pensioned railway worker has no other income and that the pension is not
indexed against inflation, the retired worker’s real income would decrease by approximately
10 percent of its former value.
(b) Assuming the clerk was unionized and the contract had over a year to run, the clerk’s real
income would decrease in the same manner as the pensioner. However, the clerk could
expect to recoup at least part of the loss at contract renewal time. In the more likely event of
the clerk not being unionized, the clerk’s real income would decrease, possibly by as much as
the pensioned railroad worker.
(c) Since the UAW worker is unionized, the loss in the first year would be the same as in (b) but
we can be sure—barring a deep recession—that the loss will be made up at contract renewal
time plus the usual real increase that may or may not be related to increased productivity. If
the contract had a cost-of-living allowance clause in it, the wage would automatically be
raised at the end of the year to cover the loss in purchasing power. Next year’s wage would
rise by 10 percent.
(d) If the inflation is also in the price the farmer gets for his products, he could gain. But more
likely the price increases are mostly in what he buys, since farm machinery, fertilizer, etc.,
tend to be sold by less competitive sellers with more power to raise their prices. The farmer
faces a lot of competition and has to rely on the market price to go up—the farmer has little
control over prices on an individual basis. Moreover, if interest rates on the farmer’s new
debts have gone up with the prices, the farmer could be even worse off. The other side of the
coin is that if no new borrowing is necessary, the inflation will reduce the real burden of the
farmer’s debt, because the purchasing power declines on the fixed payments he contracted to
make before inflation.
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(e) The retired executive is in the same boat as the pensioned railroad worker, except that the
executive’s income from the bonds or other interest bearing assets is probably greater than
that of the worker from the pension. The increase in inflation has most probably been
accompanied by rising interest rates, with a proportional drop in the price of bonds.
Therefore, the retired executive would suffer a capital loss if he or she decided to cash in
some of the bonds at this time and the fixed interest received on these existing bonds is worth
less in terms of purchasing power. In other words, the executive, although wealthier than the
retired worker, may be affected just as much or more from inflation.
(f) Assuming the store owner’s prices and revenues have been keeping pace with inflation, his or
her real income will not change unless the costs have risen more than the product prices.
A noted television comedian once defined inflation as follows: “Inflation? That means your
money today won’t buy as much as it would have during the depression when you didn’t have
any.” Was his definition accurate?
Humorous, but largely correct!
(Last Word) Suppose that stock prices fall by 10 percent in the stock market. All else being
equal, are these lower stock prices likely to cause a decrease in real GDP? How might they
predict a decline in real GDP?
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.
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