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Answer Key, Principles of Macroeconomics, 8e – Chapter 12
CHAPTER TWELVE
Answers to Test Your Understanding 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:
2011
2012
2013
2014
2015
Inflation %
2.0
3.0
6.0
10.0
16.0
From this data, the following graph can be drawn:
1
Unemployment %
12.0
8.0
6
4.5
3.0
Answer Key, Principles of Macroeconomics, 8e – 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.
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Answer Key, Principles of Macroeconomics, 8e – Chapter 12
Answers to Connect Study Problems
1. 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
b) See the following figure:
Figure 12.7 (Completed)
3
Tax Revenue
0
25
50
75
100
125
150
175
184
189
190
187
180
169
154
Answer Key, Principles of Macroeconomics, 8e – Chapter 12
c) % tax rate: 50%;
tax revenue: $190
2. $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.
3. a) $680 billion. ($600 + (4 x 20)
b) See the following figure:
Figure 12.8A (Completed)
8
MS
7
Interest rate (%)
6
MD2
5
MD1
4
3
2
1
0
0
30
60
90
120
150
180
210
240
Quantity of money
c) 6%
(The intersection of MS with the new curve MD2)
d) $10 billion.
at 6%)
(Read off Figure 12.11B, investment falls from $60 at 5% to $50
e) $640 billion. (with a multiplier of 4, GDP falls by $40 billion from $680 –
answer to part a) – to $640.)
4. 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)
unemploymentrate:12%(The GDP gap is $60 and if each $10 equals 1%
cyclical unemployment, there must be cyclical unemployment of 6%. If the
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Answer Key, Principles of Macroeconomics, 8e – Chapter 12
natural rate is 6%, then adding on cyclical unemployment of 6% gives us the
actual unemployment of 12%);
b) See the following table:
TABLE 12.3 (Completed)
Price Index
Aggregate Quantity
Demanded
Aggregate Quantity
Demanded 2
Aggregate Quantity
Supplied
110
860
900
740
115
840
880
760
120
820
860
780
125
800
840
800
130
780
820
820
135
760
800
840
140
740
780
860
c) 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).
d) See the following figure:
Figure 12.9 (Completed)
5. 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 12.10shows that an increase of $10 billion in the money
demand will increase the interest rate from 4% to 6%. Figure 12.11 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.
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Answer Key, Principles of Macroeconomics, 8e – Chapter 12
c) $424 billion. Since investment drops by $8 billion, GDP will drop by 3 x $8
billion = $24 billion from $448 to $424.
6 a) See the following figure:
Figure 12.12 (Completed)
140
130
AS
Price Index
120
110
AD2
100
90
AD1
80
200
240
280
320
360
400
440
480
520
560
600
Real GDP
b) $480
(Intersection of AS with new curve, AD2)
c) 120
(Intersection of AS with new curve, AD2)
d) $40
(If the price level had not changed, then GDP would have increased to 520
instead of $480).
7. a) $40.
(GDP increase from old equilibrium of $800 to new equilibrium of $840)
b) See the following figure:
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Answer Key, Principles of Macroeconomics, 8e – Chapter 12
Figure 12.13B (Completed)
9
MS
8
Interest rate (%)
7
6
5
4
3
MD2
2
MD1
1
0
74
78
82
86
90
94
98
102
106
Quantity of money
Since GDP increases by $40, the transactions demand increases by 10% x $40 = $4.
c) 5%
(Intersection of MS with MD2)
d) $140 billion
(Reading from Figure 12.13C, the amount of investment at 5%)
8. a) GDP: $600
price index: 90. (The supply-side economist feels that her
policy will result in the AS shifting right till it intersects the AD at the potential GDP
(LAS) of 600 – a shift of 4 squares or $200.)
b) GDP: $600
price index: 110. (The Keynesian economist feels that his
policy will result in the AD shifting right till it intersects the AD at the potential GDP
(LAS) of 600 – a shift of 4 squares or $200.)
9.a) See the following table:
TABLE 12.4 (Completed)
Year
Price Index
2010
2011
2012
2013
2014
2015
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
7
Unemployment
Rate (%)
10.0
8.0
6.0
5.0
4.0
Answer Key, Principles of Macroeconomics, 8e – Chapter 12
b) See the following figure:
Figure 12.15 (Completed)
14
12
Inflation rate (%)
10
8
6
4
2
0
0
2
4
6
8
10
12
Unemployment rate (%)
10. a)See the following table:
Table 12.5A (Completed)
Interest
rate
Asset
Demand
Transactions
6
50
80
130
5
60
80
140
4
70
80
150
3
80
80
160
2
90
80
170
1
100
80
180
Demand
Total
Money
demand
b) interest rate = 3% (Where the money supply of 160 equals the total money demand
of 160.)
exchange rate = 0.97 (read from Table 12.5B at 3% interest.)
investment spending = 80(read from Table 12.5B at 3% interest.)
net exports = +2 (read from Table 12.5C at an exchange rate of 0.97)
c) Total injections = $220(Government spending of 140 + investment of 80 and net
exports of +2 (both from answer b))
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Answer Key, Principles of Macroeconomics, 8e – Chapter 12
d) Total injections = $236 (The new interest rate is 2% and the exchange rate 0.96.At
these values, investment is $90 and net exports is +6. Adding this to the government
spending of 140 gives a total of 236.)
Answer to Comprehensive Problem
a) See the following figure:
Figure 12.16 (Completed)
124
Potential
GDP =LAS
122
120
AS
118
116
114
Price Index
112
110
AD4
108
106
104
102
100
AD3
98
96
94
AD 1
92
AD2
90
0
200
400
600
800
1000
Real GDP
9
1200
1400
1600
1800
2000
Answer Key, Principles of Macroeconomics, 8e – Chapter 12
b) See the following table;
Table 12.6A (Completed)
Year
2014
Price Index
Annual
Inflationrate (%)
Recessionary
Gap ($)
Unemployment
rate (%)
102
2%
$600
12%
The price index is where AD2 intersects AS. Inflation = (102-100/100) x 100 = 2%.
Cyclical unemployment = 600/100 = 6%. Total unemployment = natural rate + cyclical
unemployment = 6% + 6% = 12%.
c) See Figure 12.16 (Completed)
d)) See the following table;
Table 12.6B (Completed)
Year
2015
Price Index
Annual
Inflationrate (%)
Recessionary
Gap ($)
Unemployment
rate (%)
106
3.9%
$300
9%
The price index is where AD3 intersects AS. Inflation = (106-102/100) x 100 = 3.9%.
Cyclical unemployment = 300/100 = 3%. Total unemployment = natural rate + cyclical
unemployment = 6% + 3% = 9%.
e) See Figure 12.16 (Completed)
f)) See the following table;
Table 12.6C (Completed)
Year
2016
Price Index
Annual
Inflationrate (%)
Recessionary
Gap ($)
Unemployment
rate (%)
114
7.5%
$100
1%
The price index is where AD4 intersects AS. Inflation = (114-106/100) x 100 = 7.5%.
Cyclical unemployment = 100/100 = 1%. Total unemployment = natural rate + cyclical
unemployment = 6% + 1% = 7%.
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Answer Key, Principles of Macroeconomics, 8e – Chapter 12
g) See the following figure:
Figure 12.17 (Completed)
10
9
Inflation rate (%)
8
7
6
5
4
3
2
1
0
0
2
4
6
8
Unemployment rate (%)
11
10
12
14