Chapter 23 - An Introduction to Macroeconomics

Chapter 23 An Introduction to Macroeconomics

QUESTIONS

1. Draw a graph with “Level of real output” on the vertical axis and “Time” on the horizontal
axis. If the long-run trend line of economic growth for the United States were to appear on your
graph as a straight upsloping line, how would you pencil in economic fluctuations in relationship
to that straight line? Referring to your graph, very briefly explain why economic fluctuations and
economic growth are compatible concepts. Check your drawing against Figure 26.1, page 527.
LO1

Answer:

Level of Real
Output

Trend Line

Time

The upsloping trend line captures long-run economic growth over time. However there
are deviations from this trend line. We call these deviations economic fluctuations, or
sometimes expansions and recessions. These deviations will look something like the
graph below.

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Level of Real
Output
Expansion

Trend Line

Deviation
line

Recession

Time

These concepts are compatible because economic growth captures the 'average ' rate of
growth over time the economic fluctuations capture the deviations from this long-run
average.

2. Why do you think macroeconomists focus on just a few key statistics when trying to
understand the health and trajectory of an economy? Would it be better to try to make examine all
possible data? LO2

Answer: Macroeconomists focus on a few key statistics, real GDP, unemployment, and
inflation because it is too difficult to process all of the information in each market or for
every good or service in the economy. By using these three ‘summary’ measures
economists can gain some insight into the health of the economy as a whole.

3. Consider a nation in which the volume of goods and services is growing by 5 percent per year.
What is the likely impact of this high rate of growth on the power and influence of its government
relative to other countries experiencing slower rates of growth? What about the effect of this 5
percent growth on the nation’s living standards? Will these also necessarily grow by 5 percent per
year, given population growth? Why or why not? LO2

Answer: If a country’s economic size is growing faster than the rest of the world then
this country will gain influence in the international sector. China is a classic example of
this phenomenon in the last decade. This is because a greater share of the world’s goods
and services are produced in this country. If a country’s living standards are increasing at
5%, this implies that output is increasing at a rate of 5% above population growth. If this
rate of growth is greater than that in other countries, political influence will increase as
well.

4. Did economic output start growing faster than population from the beginning of the human
inhabitation of the earth? When did modern economic growth begin? Have all of the world’s
nations experienced the same extent of modern economic growth? LO3

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Answer: No, rapid and sustained economic growth is a modern phenomenon. Before the
Industrial Revolution began in the late 1700s in England, standards of living showed
virtually no growth over hundreds or even thousands of years. For instance, the standard
of living of the average Roman peasant was virtually the same at the start of the Roman
Empire around the year 500 B.C. as it was at the end of the Roman Empire 1000 years
later. Similarly, historians and archeologists have estimated that the standard of living
enjoyed by the average Chinese peasant was essentially the same in the year A.D. 1800
as it was in the year A.D. 100.

No, the vast differences in living standards seen today between rich and poor countries
are almost entirely the result of the fact that only some countries have experienced
modern economic growth.

5. Why is there a trade-off between the amount of consumption that people can enjoy today and
the amount of consumption that they can enjoy in the future? Why can’t people enjoy more of
both? How does saving relate to investment and thus to economic growth? What role do banks
and other financial institutions play in aiding the growth process? LO4

Answer: To increase consumption in the future households must save so that firms can
undertake investment projects that will produce the goods and services of the future. In
other words, without savings and investment the resources will not be in place to produce
the goods and services in the future (thus we cannot have both). Typically a higher
savings rate, the fraction of GDP not consumed today, results in higher investment rates.
Thus, the more a society invests (and saves) results in more production opportunities in
the future, implying a higher rate of growth.
Financial Intermediaries (banks and other institutions) help allocate resources to the most
productive investments. These institutions accomplish this by identifying the most
productive investment opportunities, pooling risks associated with long-term investment
projects and (potential) short-term savings, and monitoring the investment projects. This
will increase the return on investments or stimulate savings, which will promote growth.

6. How does investment as defined by economists differ from investment as defined by the
general public? What would happen to the amount of economic investment made today if firms
expected the future returns to such investment to be very low? What if firms expected future
returns to be very high? LO4

Answer: Economic Investment refers to the purchase of machinery, tools, etc… that can
be used to produce goods and services in the future. This investment is undertaken by
firms and the way economists think about investment. Financial Investment captures
what ordinary people mean when they say investment, namely the purchase of assets like
stocks, bonds, or real estate in the hope of reaping a financial gain. If firms expect low
returns on their investments they will typically invest less. If firms expect high returns on
their investment they will typically invest more. However these results depend on how
households respond to interest rates and the availability of savings for investment
purposes.

7. Why, in general, do shocks force people to make changes? Give at least two examples from
your own experience. LO5

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Answer: Shocks to the economy force people to make changes in expectations and actual
behavior. For example, you believe your annual income once you graduate will be
$50,000 and you spend accordingly (perhaps making purchases using high interest credit
cards). But once you graduate you find out that your income is only $40,000. The first
thing you do is reduce your current demand because your income expectations about
future income are adjusted downward (you were previously overly optimistic about your
income prospects). You also adjust your demand downward because your income is in
fact lower today (that is, lower than expected).
The answer to the last part of the question will vary across students.

8. Catalogue companies are committed to selling at the prices printed in their catalogues. If a
catalogue company finds its inventory of sweaters rising, what does that tell you about the
demand for sweaters? Was it unexpectedly high, unexpectedly low, or as expected? If the
company could change the price of sweaters, would it raise the price, lower the price, or keep the
price the same? Given that the company cannot change the price of sweaters, consider the number
of sweaters it orders each month from the company that makes its sweaters. If inventories become
very high, will the catalogue company increase, decrease, or keep orders the same? Given what
the catalogue company does with its orders, what is likely to happen to employment and output at
the sweater manufacturer? LO5

Answer: If the inventories are rising for sweaters then we know that demand for sweaters
must be falling. This is because prices are fixed, so this implies that people are buying
less of the good due to a decrease in demand (see Figure 23.1b). In most circumstances,
this accumulation of inventories suggests that the demand for sweaters was unexpectedly
low since companies try to smooth out production to minimize costs.
If inventories start to accumulate then this company will reduce its orders from the
production company. Given this reduction in the purchase of sweaters by the catalogue
company, the firm producing the sweaters will reduce output and in most cases reduce
employment. Thus, output and employment is likely to decline for the sweater
manufacturer.

9. LAST WORD Why do some economists believe that better inventory control software and
systems may help to reduce the frequency and severity of recessions caused by mild demand
shocks? How could those same inventory systems quickly transmit large demand shocks directly
to sudden, deep recessions?

Answer: The basic logic is as follows. Prior to the time of computers inventories were
counted a few times each year. This was because the firm had to employ workers to count
everything held in stock. This activity was costly so it wasn’t done frequently. If demand
decreased right after the inventory was counted this meant that it would be a long time
before the firm figured out demand had decreased, thus inventories were accumulating.
The more time that passed, the greater this accumulation. This meant that once a firm
figured out demand had decreased, it had a large excess inventory on hand. They would
then have to make major cuts in production until excess inventories were worked off.

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With the advent of the computer most inventories can be tracked in real time. Everything
sold and purchased by the firm is recorded. This meant a firm could make minor
adjustments in production as demand changed. This ‘smoother’ adjustment process
would reduce fluctuations in output and employment. The potential problem is that when
there is a sudden (large) and continuing decline in demand this shock will generate an
immediate and sustained reduction in production. The outcome, or at least a contributing
factor, is the worst recession in the United States since 1982.

PROBLEMS

1. Suppose that the annual rates of growth of real GDP of Econoland over a five-year period were
sequentially as follows: 3 percent, 1 percent, -2 percent, 4 percent, and 5 percent. What was the
average of these growth rates in Econoland over these 5 years? What term would economists use
to describe what happened in year 3? If the growth rate in year 3 had been a positive 2 percent
rather than a negative 2 percent, what would have been the average growth rate? LO1

Answers: 2.2 percent; recession; 3 percent.

Feedback: Consider the following example. Suppose that the annual rates of growth of
real GDP of Econoland over a five-year period were sequentially as follows: 3 percent, 1
percent, -2 percent, 4 percent, and 5 percent. What was the average of these growth rates
in Econoland over these 5 years? What term would economists use to describe what
happened in year 3? If the growth rate in year 3 had been a positive 2 percent rather than
a negative 2 percent, what would have been the average growth rate?

To calculate the average annual rate of growth for this economy add each year's rate of
growth then divide by the number of years.

The average annual growth rate is 2.2% (= (3 + 2 + (-2) + 4 + 5) / 5).

The negative rate of growth in year 3 would be considered a recession.

If growth had been a positive 2% in year 3 the average growth rate would have been 3%
(= (3 + 1 + 2 + 4 + 5) / 5).

2. Suppose that Glitter Gulch, a gold mining firm, increased its sales revenues on newly mined
gold from $100 million to $200 million between one year and the next. Assuming that the price of
gold increased by 100 percent over the same period, by what numerical amount did Glitter
Gulch’s real output change? If the price of gold had not changed, what would have been the
change in Glitter Gulch’s real output? LO2

Answers: 0; $100 million.

Feedback: Consider the following example. Suppose that Glitter Gulch, a gold mining
firm, increased its sales revenues on newly mined gold from $100 million to $200 million
between one year and the next. Assuming that the price of gold increased by 100 percent
over the same period, by what numerical amount did Glitter Gulch’s real output change?
If the price of gold had not changed, what would have been the change in Glitter Gulch’s
real output?

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Since the price doubled and the sales revenue doubled between one year and the next, this
implies that the company sold and mined the same amount of gold over the period. The
change in real output is zero.

If the price of gold did not change and sales revenue doubled, the amount of gold sold
and mined must have doubled. The change in real output is $100 million (= $200 million
(new revenue) - $100 million (old revenue)).

3. A mathematical approximation called the rule of 70 tells us that the number of years that it will
take something that is growing to double in size is approximately equal to the number 70 divided
by its percentage rate of growth. Thus, if Mexico’s real GDP per person is growing at 7 percent
per year, it will take about 10 years (= 70/ 7) to double. Apply the rule of 70 to solve the
following problem. Real GDP per person in Mexico in 2005 was about $11,000 per person, while
it was about $44,000 per person in the United States. If real GDP per person in Mexico grows at
the rate of 5 percent per year, about how long will it take Mexico’s real GDP per person to reach
the level that the United States was at in 2005? (Hint: How many times would Mexico’s 2005 real
GDP per person have to double to reach the United States’ 2005 real GDP per person?) LO3

Answer: 28 years

Feedback: Consider the following example. Apply the rule of 70 to solve the following
problem. Real GDP per person in Mexico in 2005 was about $11,000 per person, while it
was about $44,000 per person in the United States. If real GDP per person in Mexico
grows at the rate of 5 percent per year, about how long will it take Mexico’s real GDP per
person to reach the level that the United States was at in 2005? (Hint: How many times
would Mexico’s 2005 real GDP per person have to double to reach the United States’
2005 real GDP per person?)

Using the rule of 70 Mexico's Real GDP per person will double every 14 years (= 70 / 5
or 70 divided by the rate of growth in Mexico).

This implies that in 14 years Mexico's Real GDP per person will be $22,000. This is still
only half of the $44,000 Real GDP per person in the United States.

If we move ahead another 14 years Mexico's Real GDP per person will double again to
$44,000 (from $22,000). Thus, after 28 years Mexico's Real GDP per person will reach
the level of the United States in 2005.

Mexico's Real GDP per person will need to double twice.

4. Assume that a national restaurant firm called BBQ builds 10 new restaurants at a cost of $1
million per restaurant. It outfits each restaurant with an additional $200,000 of equipment and
furnishings. To help partially defray the cost of this expansion, BBQ issues and sells 200,000
shares of stock at $30 per share. What is the amount of economic investment that has resulted
from BBQ’s actions? How much purely financial investment took place? LO4

Answer: $12 million; $6 million.

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Feedback: Consider the following example. Assume that a national restaurant firm called
BBQ builds 10 new restaurants at a cost of $1 million per restaurant. It outfits each
restaurant with an additional $200,000 of equipment and furnishings. To help partially
defray the cost of this expansion, BBQ issues and sells 200,000 shares of stock at $30 per
share. What is the amount of economic investment that has resulted from BBQ’s actions?
How much purely financial investment took place?

Economic Investment is the purchase of buildings and machinery that can be used to
produce goods and services in the future. The restaurant firm builds 10 new restaurants at
a cost of $1 million each, which results in $10 million ($1 million x 10 restaurants built)
worth of economic investment. In addition to each structure it cost $200,000 in
equipment and furnishings for each restaurant. This results in an additional $2 million
($200,000 x 10 restaurants) worth of economic investment. Combining the two we have
$12 million worth of economic investment.

The purely financial investments is the value of the shares the company sold to help
finance the economic investment. Since the company sold 200,000 shares at $30 a piece,
the financial investment is $6 million (200,000 x $30).

5. Refer to Figure 23.1b and assume that price is fixed at $37,000 and that Buzzer Auto needs 5
workers for every 1 automobile produced. If demand is DM and Buzzer wants to perfectly match
its output and sales, how many cars will Buzzer produce and how many workers will it hire? If
instead, demand unexpectedly falls from DM to DL, how many fewer cars will Buzzer sell? How
many fewer workers will it need if it decides to match production to these lower sales? LO5

Answers: 900; 4500; 200; 1000.

Feedback: Consider the following example. Refer to Figure 23.1b and assume that price
is fixed at $37,000 and that Buzzer Auto needs 5 workers for every 1 automobile
produced. If demand is DM and Buzzer wants to perfectly match its output and sales,
how many cars will Buzzer produce and how many workers will it hire? If instead,
demand unexpectedly falls from DM to DL, how many fewer cars will Buzzer sell? How
many fewer workers will it need if it decides to match production to these lower sales?

If demand is DM and Buzzer Auto wants to perfectly match its output and sales it will
produce 900 cars. Buzzer Auto will want to employ 4,500 workers since it takes 5
workers to produce 1 automobile (= 5 x 900).

If instead, demand unexpectedly falls from DM to DL, Buzzer Auto will want to produce
700 cars and employ 3,500 workers (= 5 x 700). This implies that Buzzer Auto will
produce 200 (= 900 (DM) - 700 (DL)) fewer cars and employ 1000 (= 4,500 (DM) - 3,500
(DL)) fewer workers.

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