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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. 2 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 4 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. 5 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: 6 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)) 8 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%. 10 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