Page 122 (4,11,12,13) Page 144 (2, 4, 6, 9, 10,11) 6-4 What is the difference between gross private domestic investment and net private domestic investment? If you were to determine net domestic product (NDP) through the expenditures approach, which of these two measures of investment spending would be appropriate? Explain. Gross private domestic investment less depreciation is net private domestic investment. Depreciation is the value of all the physical capital—machines, equipment, buildings—used up in producing the year’s output. Since net domestic product is gross domestic product less depreciation, in determining net domestic product through the expenditures approach it would be appropriate to use the net investment measure that excludes depreciation, that is, net private domestic investment. 6-11 (Key Question) Suppose that in 1984 the total output in a single-good economy was 7,000 buckets of chicken. Also suppose that in 1984 each bucket of chicken was priced at $10. Finally, assume that in 1996 the price per bucket of chicken was $16 and that 22,000 buckets were purchased. Determine the GDP price index for 1984, using 1996 as the base year. By what percentage did the price level, as measured by this index, rise between 1984 and 1996? Use the two methods listed in Table 7-6 to determine real GDP for 1984 and 1996. X/100 = $10/$16 = .625 or 62.5 when put in percentage or index form (.625 x 100) 100 62.5 16 10 6 .60 or 60% (Easily calculated .6 60% ) 62.5 10 10 Method 1: 1996 = (22,000 x $16) ÷ 1.0 = $352,000 1984 = (7,000 x $10) ÷ .625 = $112,000 Method 2: 1996 = 22,000 x $16 = $352,000 1984 = 7,000 x $16 = $112,000 6-12 (Key Question) The following table shows nominal GDP and an appropriate price index for a group of selected years. Compute real GDP. Indicate in each calculation whether you are inflating or deflating the nominal GDP data. Nominal GDP, Price index Real GDP, Year Billions (1996 = 100) Billions 1960 $527.4 22.19 $ ______ 1968 911.5 26.29 $ ______ 1978 2295.9 48.22 $ ______ 1988 4742.5 80.22 $ ______ 1998 8790.2 103.22 $ ______ Values for real GDP, top to bottom of the column: $2,376.7 (inflating); $3,467.1 (inflating); $4,761.3 (inflating); $5,911.9 (inflating); $8,516 (deflating). 6-13 Which of the following are actually included in this year’s GDP? Explain your answer in each case. a. Interest on an AT&T bond. b. Social security payments received by a retired factory worker. c. The services of a family member in painting the family home. d. The income of a dentist. e. The money received by Smith when she sells her economics textbook to a book buyer. f. The monthly allowance a college student receives from home. g. Rent received on a two-bedroom apartment. h. The money received by Josh when he resells his current-year-model Honda automobile to Kim. i. Interest received on corporate bonds. j. A 2-hour decrease in the length of the workweek. k. The purchase of an AT&T corporate bond. l. A $2 billion increase in business inventories. m. The purchase of 100 shares of GM common stock. n. The purchase of an insurance policy. (a) Included. Income received by the bondholder for the services derived by the corporation for the loan of money. (b) Excluded. A transfer payment from taxpayers for which no service is rendered (in this year). (c) Excluded. Not a market transaction. If any payment is made, it will be within the family. (d) Included. Payment for a final service. You cannot pass on a tooth extraction! (e) Excluded. Secondhand sales are not counted; the textbook is counted only when sold for the first time. (f) Excluded. A private transfer payment; simply a transfer of income from one private individual to another for which no transaction in the market occurs. (g) Included. Payment for the final service of housing. (h) Excluded. The production of the car had already been counted at the time of the initial sale. (i) Included. The income received by the bondholders is paid by the corporations for the current use of the “money capital” (the loan). (j) Excluded. The effect of the decline will be counted, but the change in the workweek itself is not the production of a final good or service or a payment for work done. (k) Excluded. A noninvestment transaction; it is merely the transfer of ownership of financial assets. (If AT&T uses the money from the sale of a new bond to carry out an investment in real physical assets that will be counted.) (l) Included. The increase in inventories could only occur as a result of increased production. (m) Excluded. Merely the transfer of ownership of existing financial assets. (n) Included. Insurance is a final service. If bought by a household, it will be shown as consumption; if bought by a business, as investment—as a cost added to its real investment in physical capital. Page 144 (2, 4, 6, 9, 10,11) 7-2 (Key Question) Suppose an economy’s real GDP is $30,000 in year 1 and $31,200 in year 2. What is the growth rate of its real GDP? Assume that population was 100 in year 1 and 102 in year 2. What is the growth rate of GDP per capita? Growth rate of real GDP = 4 percent (= $31,200 - $30,000)/$30,000). GDP per capita in year 1 = $300 (= $30,000/100). GDP per capita in year 2 = $305.88 (= $31,200/102). Growth rate of GDP per capita is 1.96 percent = ($305.88 - $300)/300). 7-4 (Key Question) What are the four phases of the business cycle? How long do business cycles last? How do seasonal variations and secular trends complicate measurement of the business cycle? Why does the business cycle affect output and employment in capital goods and consumer durable goods industries more severely than in industries producing nondurables? The four phases of a typical business cycle, starting at the bottom, are trough, recovery, peak, and recession. As seen in Table 8-2, the length of a complete cycle varies from about 2 to 3 years to as long as 15 years. There is a pre-Christmas spurt in production and sales and a January slackening. This normal seasonal variation does not signal boom or recession. From decade to decade, the long-term trend (the secular trend) of the U.S. economy has been upward. A period of no GDP growth thus does not mean all is normal, but that the economy is operating below its trend growth of output. 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 nondurable output. Also, capital and durable goods expenditures tend to be “lumpy.” Usually, a large expenditure is needed to purchase them, and this shrinks to zero after purchase is made. 7-6 (Key Question) Use the following data to calculate (a) the size of the labor force and (b) the official unemployment rate: total population, 500; population under 16 years of age or institutionalized, 120; not in labor force, 150; unemployed, 23; part-time workers looking for full-time jobs, 10. Labor force 230 500 - 120 150 ; official unemployme nt rate 10% 23 / 230 100 7-9 Explain how an increase in your nominal income and a decrease in your real income might occur simultaneously. Who loses from inflation? Who loses 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 choose? 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 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. In the worst recession since the Great Depression (1981-82), 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. The choice between (a) and (b) illustrates why economists are unpopular. Option (a) spreads the pain by not having a small percentage of the population bear the burden of employment. There is the risk, however, that inflationary expectations will give rise to creeping inflation and ultimately hyperinflation; or that the central bank will raise interest rates to reduce inflation, stalling economic growth. If one chooses (b) 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. However, the weakness in spending resulting from an 8% unemployment rate might push the economy into deflation, which would ultimately exacerbate the weak economic conditions. 7-10 What is the Consumer Price Index (CPI) and how is it determined each month? How does the Bureau of Labor Statistics (BLS) 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 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 5, the BLS subtracts the CPI of year 4 from the CPI of year 5, and then divides by the CPI of year 4 (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). Inflation in modest amounts (<3%) is tolerable, although there is not universal agreement on this point. 7-11 (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] x 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). p163-164 (3-10) 8-3 Explain how each of the following will affect the consumption and saving schedules or the investment schedule: a. A large increase in the value of real estate, including private houses. b. A decline in the real interest rate. c. A sharp, sustained decline in stock prices. d. An increase in the rate of population growth. e. The development of a cheaper method of manufacturing computer chips. f. A sizable increase in the retirement age for collecting Social Security benefits. g. The expectation that mild inflation will persist in the next decade. (a) If this simply means households have become more wealthy, then consumption will increase at each income level. The consumption schedule should shift upward and the saving schedule shift downward. The investment schedule may shift rightward if owners of existing homes sell them and invest in construction of new homes more than previously. (b) The decline in the real interest rate will increase interest-sensitive consumer spending; the consumption schedule will shift up and the saving schedule down. Investors will increase investment as they move down the investment-demand curve; the investment schedule will shift upward. (c) A sharp decline in stock prices can be expected to decrease consumer spending because of the decrease in wealth; the consumption schedule shifts down and the saving schedule upward. Because of the depressed share prices and the number of speculators forced out of the market, it will be harder to float new issues on the stock market. Therefore, the investment schedule will shift downward. (d) The increase in the rate of population growth will, over time, increase the rate of income growth. In itself this will not shift any of the schedules but will lead to movement upward to the right along the upward sloping investment schedule. (e) This innovation will in itself shift the investment schedule upward. Also, as the innovation starts to lower the costs of producing everything using these chips, prices will decrease leading to increased quantities demanded. This, again, could shift the investment schedule upward. (f) The postponement of benefits may cause households to save more if they planned to retire before they qualify for benefits; the saving schedule will shift upward, the consumption schedule downward. This impact is uncertain, however, if people continue to work and earn productive incomes. (g) If this is a new expectation, the consumption schedule will shift upwards and the saving schedule downwards until people have stocked up enough. After about a year, if the mild inflation is not increasing, the household schedules will revert to where they were before. 8-4 Explain why an upward shift in the consumption schedule typically involves an equal downshift in the saving schedule. What is the exception to this relationship? If, by definition, all that you can do with your income is use it for consumption or saving, then if you consume more out of any given income, you will necessarily save less. And if you consume less, you will save more. This being so, when your consumption schedule shifts upward (meaning you are consuming more out of any given income), your saving schedule shifts downward (meaning you are consuming less out of the same given income). The exception is a change in personal taxes. When these change, your disposable income changes, and, therefore, your consumption and saving both change in the same direction and opposite to the change in taxes. If your MPC, say, is 0.9, then your MPS is 0.1. Now, if your taxes increase by $100, your consumption will decrease by $90 and your saving will decrease by $10. 8-5 (Key Question) Complete the accompanying table. Level of Output and income (GDP = DI) Consumption Saving APC APS MPC MPS $240 $ _____ $-4 _____ _____ _____ _____ 260 $ _____ 0 _____ _____ _____ _____ 280 $ _____ 4 _____ _____ _____ _____ 300 $ _____ 8 _____ _____ _____ _____ 320 $ _____ 12 _____ _____ _____ _____ 340 $ _____ 16 _____ _____ _____ _____ 360 $ _____ 20 _____ _____ _____ _____ 380 $ _____ 24 _____ _____ _____ _____ 400 $ _____ 28 _____ _____ _____ _____ Data for completing the table (top to bottom). Consumption: $244; $260; $276; $292; $308; $324; $340; $356; $372. APC: 1.02; 1.00; .99; .97; .96; .95; .94; .94; .93. APS: -.02; .00; .01; .03; .04; .05; .06; .06; .07. MPC: .80 throughout. MPS: .20 throughout. a. Show the consumption and saving schedules graphically. b. Find the break-even level of income. How is it possible for households to dissave at very low-income levels? c. If the proportion of total income consumed (APC) decreases and the proportion saved (APS) increases as income rises, explain both verbally and graphically how the MPC and MPS can be constant at various levels of income. (a) See the graphs. Question 9-5a 420 400 380 C 360 Consumption 340 Question 9-5a 320 300 Break-Even Income 30 S 280 25 260 240 20 45 220 15 220 240 260 280 300 320 340 360 380 400 420 Savings 10 Real GDP 5 0 220 240 260 280 300 320 340 360 380 400 420 -5 -10 Real GDP (b) Break-even income = $260. Households dissave borrowing or using past savings. (c) Technically, the APC diminishes and the APS increases because the consumption and saving schedules have positive and negative vertical intercepts, respectively. (Appendix to Chapter 1). MPC and MPS measure changes in consumption and saving as income changes; they are the slopes of the consumption and saving schedules. For straight-line consumption and saving schedules, these slopes do not change as the level of income changes; the slopes and thus the MPC and MPS remain constant. 8-6 What are the basic determinants of investment? Explain the relationship between the real interest rate and the level of investment. Why is investment spending unstable? How is it possible for investment spending to increase even in a period in which the real interest rate rises? The basic determinants of investment are the expected rate of return (net profit) that businesses hope to realize from investment spending, and the real rate of interest. When the real interest rate rises, investment decreases; and when the real interest rate drops, investment increases—other things equal in both cases. The reason for this relationship is that it makes sense to borrow money at, say, 10 percent, if the expected rate of net profit is higher than 10 percent, for then one makes a profit on the borrowed money. But if the expected rate of net profit is less than 10 percent, borrowing the money would be expected to result in a negative rate of return on the borrowed money. Even if the firm has money of its own to invest, the principle still holds: The firm would not be maximizing profit if it used its own money to carry out an investment returning, say, 9 percent when it could lend the money at an interest rate of 10 percent. Investment is unstable because, unlike most consumption, it can be put off. In good times, with demand strong and rising, businesses will bring in more machines and replace old ones. In times of economic downturn, no new machines will be ordered. A firm can continue for years with, say, a tenth of the investment it was carrying out in the boom. Very few families could cut their consumption so drastically. New business ideas and the innovations that spring from them do not come at a constant rate. This is another reason for the irregularity of investment. Profits and the expectations of profits also vary. Since profits, in the absence of easy access to borrowed money, are essential for investment and since, moreover, the object of investment is to make a profit, investment, too, must vary. As long as expected rates of return rise faster than real interest rates, investment spending may increase. This is most likely to occur during periods of economic expansion. 8-7 (Key Question) Suppose a handbill publisher can buy a new duplicating machine for $500 and that the duplicator has a 1-year life. The machine is expected to contribute $550 to the year’s net revenue. What is the expected rate of return? If the real interest rate at which funds can be borrowed to purchase the machine is 8 percent, will the publisher choose to invest in the machine? Explain. The expected rate of return is 10% ($50 expected profit/$500 cost of machine). The $50 expected profit comes from the net revenue of $550 less the $500 cost of the machine. If the real interest rate is 8%, the publisher will invest in the machine as the expected profit (marginal benefit) from the investment exceeds the cost of borrowing the funds (marginal cost). 8-8 (Key Question) Assume there are no investment projects in the economy that yield an expected rate of return of 25 percent or more. But suppose there are $10 billion of investment projects yielding an expected rate of return of between 20 and 25 percent; another $10 billion yielding between 15 and 20 percent; another $10 billion between 10 and 15 percent; and so forth. Cumulate these data and present them graphically, putting the expected rate of net return on the vertical axis and the amount of investment on the horizontal axis. What will be the equilibrium level of aggregate investment if the real interest rate is (a) 15 percent, (b) 10 percent, and (c) 5 percent? Explain why this curve is the investment-demand curve. See the graph below. Aggregate investment: (a) $20 billion; (b) $30 billion; (c) $40 billion. This is the investment-demand curve because we have applied the rule of undertaking all investment up to the point where the expected rate of return, r, equals the interest rate, i. 8-9 (Key Question) What is the multiplier effect? What relationship does the MPC bear to the size of the multiplier? The MPS? What will the multiplier be when the MPS is 0, .4, .6, and 1? What will it be when the MPC is 1, .9, .67, .5, and 0? How much of a change in GDP will result if firms increase their level of investment by $8 billion and the MPC is .80? If the MPC is .67? The multiplier effect describes how an initial change in spending ripples through the economy to generate a larger change in real GDP. It occurs because of the interconnectedness of the economy, where a change in Haslett’s spending will generate more income for Davidic, who will in turn spend more, generating additional income for Grimes. The MPC is directly (positively) related to the size of the multiplier. The MPS is inversely (negatively) related to the size of the multiplier. The multiplier values for the MPS values: undefined, 2.5, 1.67, and 0. The multiplier values for the MPC values: undefined, 10, 3 (approx. actually 3.03), 2, 0. If MPC is .80, change in GDP is $40 billion (5 x $8 = $40) If MPC is .67, change in GDP is $24 billion (approximately) (3 x $8 = $24) 8-10 Why is the actual multiplier for the U.S. economy less than the multiplier in this chapter’s simple examples? The actual multiplier (estimated to be about 2) is smaller because it includes other leakages from the spending and income cycle besides just saving. Imports and taxes reduce the flow of money back into spending on domestically produced output, reducing the multiplier effect.