Differences Between Recession and Depression and Examples of Each

Chapter 1
57.
What is the difference between recession and depression in an
economy? Provide an example of depression from the real world
that has hit the global economy.
Use the following to answer question 58:
Answer: When there is a mild fall in the gross domestic product
(GDP) of an economy over a period of time it leads to recession
in the economy. If the intensity of the fall in GDP is severe over
a period of time, then it turns into a depression. Recession is
cyclic in nature; that is, it repeats itself over a period of time in
an economy. A famous example of depression is that of the
Great Depression of the 1930s that occurred in the United States
and affected the global economy. Even the financial crisis of
2008-2009 in the United States was very much reminiscent of
the Great Depression.
58.
Refer to the following graph and identify the years for which
Country A and Country B experienced recession.
Country A experienced its recession during 2003 and its early
recovery during 2004. Country B experienced its first recession
during 2002 and its early recovery in 2003. Country B
experienced a second recession in 2007.
59.
Why do we call macroeconomics an imperfect science? Explain.

The study of macroeconomics depends mainly upon the
historical data on different economies. Macroeconomists
analyze these data to explain changes occurring in different
economic parameters (income, prices, unemployment, etc.) and
formulate policies. Additionally, macroeconomic studies cannot
be conducted in controlled experiments, as in biology or
chemistry, for example. In this way, macroeconomists are
similar to weather forecasters.
60.
Are the terms “market clearing” and “equilibrium” one and the
same? Explain.
Yes, both terms represent the same notion: the balance between
supply and demand. It is the balancing point at which
everything that is produced gets sold and fulfills the entire
demand. Thus, if all other things remain constant, then there is
no tendency to change the quantity supplied and demanded at
this point.
61.
Do you agree with the statement, “macroeconomics rests on the
foundation of microeconomics”? Explain.
Macroeconomics involves studying the aggregate of economic
variables related to individual decision making parameters,
which are microeconomic (think of individuals' expenses,
investments, etc.). That is to say, the total expenditure in an
economy is the aggregate (sum) of all the expenditures done by
all consumers in that economy, or the total investment done in
an economy is the aggregate (sum) of all individual investments
done by firms in that economy. This reflects that
macroeconomic study rests on the foundation of

microeconomics.
62.
Give two examples of macroeconomic variables and
microeconomic variables.
The income of your father is a microeconomic variable, while
the gross domestic product (GDP) of your country is a
macroeconomic variable. The money your father saves in the
bank is a microeconomic variable, while the total money in all
banks and post offices of your country is a macroeconomic
variable.
.
64.
What is the difference between sticky prices and flexible
prices? Explain.
With flexible prices, instantaneous adjustment in changes
between demand and supply brings market forces into
equilibrium. In contrast, sticky prices delay the adjustment
process due to their adherence to predetermined levels (though
such delays are released over the long-run).
65.
What is an exogenous variable? Illustrate with graphs the effect
of a change in the exogenous variable on a demand and supply
relationship. Mark the x-axis and y-axis clearly.
An exogenous variable is the variable which an economic model
assumes to be given. For example, in the supply and demand
models below the income of consumers (Graph 1) and the cost
of materials (Graph 2) are assumed to be given.
Now if there is an change in the income of consumers, this
effects the market.
In Graph 1 (below), increase in income shifts the demand curve
upward from D1 to D2,with increased quantity from Q1 to Q2,

and also increases the prices from P1 to P2.
In Graph 2 (below), the exogenous variable is the cost of
materials. A rise in the cost of materials decreases the supply
from S1 to S2. Quantity falls from Q1 to Q2 and prices rise
from P1 to P2.
Chapter 2
116.
Assume two countries have the same nominal GDP (measured in
the same currency using the same accounting rules). Explain at
least three reasons why you cannot assume that citizens in each
country enjoy approximately the same level of economic well-
being.
Answer :Some possible, but not all, explanations include:
a.
different price levels in the two countries would result in
different amounts of real GDP, i.e., different quantities of
goods and services available in each country;
b.
different-sized populations could result in different quantities
of goods and services available per person in each country;
c.
different levels of nonmarket production in the two countries
would alter the quantity of goods and services available in each
country;
d.
different amounts of leisure time available (not captured in
nominal GDP figures) would cause economic well-being to
differ in the two countries;
e.
different distributions of income in the two countries could alter
the quantity of goods and services available to the typical

citizen in each country;
f.
different quantities of both positive and negative externalities
associated with producing GDP, such as pollution and
congestion, which are not measured in GDP, would cause the
different levels of economic well-being between the two
countries.
117.
Economic statistics are not perfect. Explain at least one way in
which each of the following statistics as currently calculated in
the United States fails to completely or accurately measure the
corresponding economic concept (in parentheses):
a.
real GDP per person (economic well-being);
b.
CPI (cost of living);
c.
unemployment rate (involuntary unemployment).
Answer:
a.
The official measure of GDP does not include measurements of
leisure time available, nonmarket production, production in the
underground economy, the distribution of income, or production
externalities (e.g., pollution).
b.
The CPI does not allow substitution away from products with
rising prices and has difficulty distinguishing between price
changes and quality changes in products included in the index.
c.
The official unemployment rate does not take into account
discouraged workers, part-time workers who desire full-time

employment, and workers employed in jobs not matching their
skill level, such as taxi drivers with PhDs in physics.
118.
There are a number of statistics computed to measure the price
level, such as the GDP deflator and the CPI. The choice of
which of these measures to use depends in many cases on the
specific question in which you are interested. For each of the
following situations, state whether the CPI or GDP deflator is a
more appropriate measure to use and explain why the statistic is
preferred.
a.
You are interested in looking at the impact of higher prices of
imported oil in the overall cost of living.
b.
The government is interested in whether increases in defense
spending are affecting the price level.
c.
An economic consulting firm is investigating the impact on the
aggregate price level of more computers and electronic
technology used in production.
Answer:
a.
The CPI is the more appropriate statistic, because the price of
imports is not included in the GDP deflator.
b.
The GDP deflator is the more appropriate statistic, because the
CPI does not include the prices of goods and services purchased
by the government sector.
c.
The GDP deflator is more appropriate, because the CPI does not
include prices of goods and services purchased by businesses or
the government sector.

119.
One senator criticizes the government for making an inadequate
effort to stimulate the economy based on data from the BLS
establishment survey that shows the number of jobs in the
economy has fallen. Another senator counters that the number
of employed workers in the economy has increased over the
same period, based on the BLS household survey. Explain how
both senators can be correct.
Answer:
If the number of self-employed workers and workers employed
in new start-up firms (who are included in the household
survey, but not in the establishment survey) has increased more
rapidly than the decline in payroll jobs counted in the
establishment survey, then the number of employed workers as
measured in the household survey could increase while the
number of payroll jobs decreases.
120.
There are a number of measures of aggregate economic activity,
such as GDP, GNP, national income, personal income, and
disposable personal income. Each of these measures can be a
good indicator depending on the issue under consideration. For
each of the following issues, give your reasons for selecting one
of the measures just mentioned as the best indicator to use in
studying the issue:
a.
the proportion of income households save;
b.
the relative share of earnings going to labor versus capital;
c.
the total output of final goods and services.
Answer:

a.
Disposable personal income provides a measure of the income
households have to use for either consumption or saving after
they pay taxes.
b.
National income provides a measure of the income going to the
factors of production.
c.
GDP is the most complete measure of the value of newly
produced goods and services in the economy. In contrast,
personal income includes transfer payments, which do not
represent newly produced goods and services.
121.
Real GDP per capita is an imperfect measure of economic well-
being because it does not value home production or production
in the underground economy, among other factors. Give at least
two examples that show why the omission of these types of
items will make a difference in evaluating economic well-being.
One example should explain how the omissions distort
comparisons of economic well-being across countries and the
other example should explain how the omission distorts
comparisons of economic well-being in the same country over
time.
Answer
Answers will vary, but one example could show that measured
GDP in one country could be much lower than in another
country, but the amount of home production in the first country
could be very large. In this case, measured real GDP indicates a
much larger difference in economic well-being than actually
exists between the countries.
The other example could explain how changes in the amount of
home production in a country over time make it difficult to
compare economic well-being over time. For example, if most

people grew their own food initially and then over time moved
to commercial agriculture, the increase in real GDP per person
would overstate the increase in the amount of goods and
services available in the country, since the food grown at home
was not counted in real GDP in the early period.
122.
Based on the data in the table below, explain what happened to
output and prices in the economy between 2009 and 2010.
2009
2010
Nominal GDP ($ billions)
$14,700
$15,200
Real GDP ($ billions 2000 chain weighted)
$12,100
$11,900
Answer:
Real GDP decreased, indicating that the production of final
goods and services was lower in 2010 than in 2009. Nominal
GDP increased, which indicates that prices, on average, were
higher in 2010 than in 2009, given that real GDP decreased.
123.
Explain why the value of GDP in 2012 would or would not
change as a result of each transaction described below:
a.
In 2012, the Smith family purchases a new house that was built
in 2012.
b.
In 2012, the Jones family purchases a house that was built in

2001.
c.
In 2012, a construction company purchases windows to put in
the Smith family home that was built in 2012.
d.
In 2012, Mr. Jones paints all of the rooms of the Jones family
house purchased in 2009, using paint and supplies purchased in
2012.
e.
In 2012, Mr. Smith uses an online brokerage service to
purchases shares of stock in a construction company.
Answer
a.
GDP in 2012 increases by the purchase price of the house,
which is a newly produced good.
b.
GDP in 2012 does not change because the house is NOT a newly
produced good, since it was built in 2001. Transactions
involving used goods are not included in GDP.
c.
GDP in 2012 does not change directly because the windows are
intermediate goods, not final goods. The value of intermediate
goods is not included in GDP to avoid double counting. The
value of the windows is implicitly included in the price of the
house.
d.
GDP in 2012 would change by the purchase price of the paint
and supplies, but not by the implicit value of the painting
services provided by Mr. Jones because home production is not
included in GDP.
e.
GDP in 2012 would increase by the charge for using the online
brokerage
service but not by the amount of stock purchase because

financial
transactions do not represent the production of final goods and
services
and are not included in GDP.
124.
Explain which expenditure category of GDP changes and the
direction of the change that results for each transaction
described.
a.
A domestic business purchases a domestically produced
computer to use in a business office.
b.
A domestic business produces a computer that is sold to a
foreign company.
c.
The federal government purchases a domestically produced
computer to use in a courthouse.
d.
A domestic household purchases a domestically produced
computer to use in a home.
e.
A domestic household purchases a computer produced in a
foreign country to use in a home.
Answer
a.
Investment spending increases by the price of the computer.
b.
Exports (and net exports) increase by the price of the computer.
c.
Government spending increases by the price of the computer.

d.
Consumption spending increases by the price of the computer.
e.
Consumption spending increases by the price of the computer,
but imports also increase by the price of the computer, so that
net exports decrease by the price of the computer, and there will
be no net change in GDP.
125.
Into which of the three categories—employed, unemployed, out
of the labor force—would an interviewer for the Current
Population Survey place each of the following people? Explain.
a.
Jennifer Temple is working as a second-grade schoolteacher.
b.
Frank Peabody is attending college full-time to earn a degree in
elementary education.
c.
Martin Hampton is working as a high school social science
teacher but is at home sick with the flu.
d.
Kyle Brown does not currently have a job. He wants to be an
elementary-school teacher. He has the appropriate degree. He
has not looked for a position in the last month because he
doesn't believe schools are currently hiring.
e.
Brenda Dewey does not currently have a job. She has sent her
resume to several school districts in the past week in hope of
finding a teaching position.
Answer
a.
employed. She is working as a full-time employee.
b.
out of the labor force. Full-time students are not counted in the

labor force.
c.
employed. He is out sick but still an employee of the school.
d.
out of the labor force. Discouraged workers are not counted in
the labor force.
e.
unemployed. She is actively looking for a job.
126.
Assume an economy in which the value of the GDP deflator is 2
and the current inflation rate is 4 percent. Calculate the real
and nominal interest rates.
Answer
Start with the following equations for the known values: (a)
GDP Deflator = Nominal interest rate / Real interest rate and (b)
Nominal interest = Real interest + inflation
By solving the above equations we get the following: (c) Real
interest =Inflation / (GDP Deflator – 1)
Plugging in the given values of inflation and GDP deflator, we
find that: Real interest rate = 4 percent and Nominal interest
rate = 8 percent.
127.
Sam wants a loan from Dean. While discussing the interest,
Dean told Sam that he will give him two options. Which one
should Sam choose and why? The options are:
a. Sam will pay the nominal interest of 8 percent per annum.
b. Sam will pay real interest of 4 percent per annum.
Answer
Remember that Nominal interest = Real interest + inflation. The
answer actually depends upon the inflation rate. If the inflation
rate is less than 4 percent, Sam should choose option (b). If the
inflation rate is more than 4 percent, then option (a) is a more

favorable choice for Sam. If inflation is 4 percent, Sam can go
with either of the options as they will yield the same result.
128.
“GDP deflator is a better price level indicator than CPI.” Give
reasons both supporting and opposing the statement.
Answer
The advantage of using a GDP deflator is that it is calculated
using all goods and services produced, including those bought
only by firms and the government as well as consumers, and
allows a changing basket of goods. This allows it to take
consumers' ability to substitute less expensive goods for more
expensive ones into account. The CPI is calculated using a fixed
basket of goods bought only by consumers and does not take
substitutions into account, so it tends to overstate the cost of
living for consumers. However, the GDP deflator does not
include imported goods, which do impact the CPI. It also
doesn't count for any changes in consumer welfare that may
result from substituting goods, and tends to understate the cost
of living for consumers.
129.
City A has a total population of 10 million, of which 70 percent
are adults. Assume that 20 percent of the adult population is not
looking for a job and 60 percent of the remaining adult
population is employed. Compute:
a. Labor-force participation rate
b. Unemployment Rate
Answer
Adult Population = (10)(70))/100 = 7 million.
Labor force = (7,000,000)(100-20))/100 = 5,600,000
Labor-force participation rate = (5,600,000)(100))/7,000,000 =
80 percent
Unemployed population = ((100-60)(5,600,000))/100 =

2,240,000
Unemployment rate = ((2,240,000)(100))/5,600,000 = 40
percent
130.
Is real GDP a better measure of economic well being of a
country than nominal GDP? Give an explanation for your
answer.
Answer:
Yes. Nominal GDP is the current price multiplied by the
quantity of all the goods and services produced in a country.
Real GDP actually measures the total output, i.e. the quantity,
not the price. A growth in nominal GDP can be due to increase
in quantity or price or both. Real GDP keeps price constant
using a base year, so it provides a clearer picture of economic
well being.
131.
In 2015, John buys a factory built in 2009 and constructs a new
storage house within the premises. The transaction of buying
the factory is not counted in the GDP, but the construction of
the storage house in the same factory is counted in GDP. Why?
Answer:
The factory was built in the year 2009, so it was already
counted in that year’s GDP. The storage house was a new
addition in the year 2015, so only it will be considered in the
current year’s GDP, and not the whole factory.
132.
“GDP as a measurement unit of economic well-being has a flaw
which is removed by imputations.” Explain with an example.
Answer:
Homeowners basically provide themselves with housing
services, but because those services are not being sold in the

market place, they can't be counted in GDP (unlike rental
property, where the rent paid by tenants is income to the
landlord, and therefore shows up in GDP). To remove this
accounting error in the GDP, such values are added as imputed
value.
133.
“I like eating mangoes daily, but when their price rises, I switch
to mango juice.” Does this statement support the fact that CPI
overstates inflation? (Assume mango is included in the goods
basket used to calculate the CPI, but the mango juice is not
included.)
Answer:
While calculating CPI, a fixed basket of goods and services is
used. But as the statement shows, it is quite possible that when
prices rise, people may switch to substitutes which are not
accounted for in CPI. This non-adjusting attribute of CPI
overstates inflation.
134.
Cass was paid $500 in social security from the government.
Though it was expenditure made by the government, it is not
included in the G component of GDP. Explain why.
Answer:
Even though the government paid Cass, it did not receive any
good or service from Cass in return. This is a transfer payment
(a reallocation of existing income). That is why this payment
will not be included in the G component of GDP.
135.
Bob bought $5000 worth of Adobe Systems stock. This
transaction was brokered by John, who received $50 for his
help. I think the $5000 should be included in GDP, and the $50

should not be included in GDP. State whether I am right or
wrong with an explanation for your answer.
Answer:
You are wrong. The buying of shares does not contribute
anything new to the economy: it is just transferring partial
ownership from Adobe to Bob, so it will not be included in
GDP. Help provided by John was actually a service, which add
to the total output of the economy, and so $50 will be added to
the GDP.
Chapter 5
104.
A classical economist wears a T-shirt printed with the slogan
“Fast Money Raises My Interest!” Use the quantity theory of
money and the Fisher equation to explain the slogan.
ANSWER:
According to the quantity theory, if velocity and real output are
constant, then increases in the rate of money growth increase
the rate of inflation. Fast money increases inflation. Based on
the Fisher equation, the nominal interest rate equals the real
interest rate plus the rate of inflation. If the real interest rate is
constant, the higher inflation (from the faster money growth
rate) raises the nominal interest rate.
105.
In classical macroeconomic theory, the concept of monetary
neutrality means that changes in the money supply do not
influence real variables. Explain why changes in money growth
affect the nominal interest rate, but not the real interest rate.
ANSWER:

According to the Fisher equation, the nominal interest rate
equals the real interest rate plus the expected rate of inflation.
The expected rate of inflation depends on the rate of money
growth, so the nominal interest rate depends on the rate of
money growth. According to classical macroeconomic theory,
the real interest rate adjusts to bring the level of saving and
investment (both real variables) into equilibrium without
reference to the rate of money growth.
106.
Econoland finances government expenditures with an inflation
tax.
a.
Explain who pays the tax and how it is paid.
b.
What are costs of the tax, assuming the tax rate is expected?
ANSWER:
a.
Holders of money pay the inflation tax, since the purchasing
power of their money holdings declines as a result of inflation
generated when the government prints more money.
b.
The inflation tax rate is the rate of inflation. If the inflation
(tax) rate is expected, then the costs of expected inflation
include shoeleather costs, menu costs, the costs of relative price
variability, tax distortions, and the inconvenience of making
inflation corrections.
107.
If the demand for money depends positively on real income and
depends inversely on the nominal interest rate, what will happen
to the price level today, if the central bank announces (and

people believe) that it will decrease the money growth rate in
the future, but it does not change the money supply today?
ANSWER:
People will expect lower inflation in the future. The nominal
interest rate will fall. Money demand will increase. Since the
central bank does not immediately decrease the money supply,
prices must fall to keep the newly increased money demand
equal to the constant money supply. Thus, current prices fall as
a result of expected future decreases in money growth rates.
108.
Although “inflation is always and everywhere a monetary
phenomenon,” explain why:
a.
the start of a hyperinflation is typically related to the fiscal
policy situation, and
b.
the end of a hyperinflation is usually related to changes in fiscal
policy.
ANSWER:
a.
Hyperinflations frequently begin when governments require
additional revenue from seigniorage because tax revenue and/or
government borrowing is insufficient to cover government
spending. The additional seigniorage is obtained by printing
money, which leads to hyperinflation.
b.
Hyperinflations usually end when fiscal policy changes,
including tax increases and government spending cuts, are made
to eliminate the need for seigniorage and stops the excessive
increase in money.
109.

Consider two countries, Hitech and Lotech. In Hitech new
arrangements for making payments, such as credit cards and
ATMs, have been enthusiastically adopted by the population,
thereby reducing the proportion of income that is held as real
money balances. Over this period no such changes occurred in
Lotech. If the rate of money growth and the growth rate of real
GDP were the same in Hitech and Lotech over this period, then
how would the rate of inflation differ between the two
countries? Carefully explain your answer.
ANSWER:
The rate of inflation would be higher in Hitech. According to
the quantity theory, if the rates of money growth and real GDP
growth rates are the same, differences in rates of inflation are
related to differences in velocity. An increase in velocity leads
to a higher rate of inflation, holding other factors constant. In
Hitech the reduction in the proportion of income held as real
balances (smaller k) is the equivalent of an increase in velocity
and, consequently, a higher rate of inflation in Hitech than in
Lotech.
110.
Interest rates played a part in the 1984 U.S. presidential
debates. Some politicians claimed that interest rates rose over
the 1981–1983 period, while others claimed rates fell. Below is
a table showing interest rates and annual inflation rates from
1981 to 1983.
Interest Rate
Annual
Year
(annual %)
Inflation Rate
1981

14.03%
10.3%
1982
10.69%
6.2%
1983
8.63%
3.2%
Reconcile these conflicting claims.
ANSWER:
Using the Fisher effect, the nominal interest rate fell from 14
percent to 8.6 percent over the period, but the ex post real
interest rate rose from 3.73 percent to 5.43 percent.
111.
The costs of expected inflation cause productive resources of an
economy to be directed away from their efficient allocation.
Explain how each of the following costs of expected inflation
distort the allocation of productive resources:
a.
shoeleather costs
b.
menu costs
c.
the inconvenience of a changing price level
ANSWER:
a.
Resources are used to go to the bank and in other activities to
reduce cash holding, rather than in producing goods and

services.
b.
Resources are used to update prices on menus, in catalogs, and
on other price lists, rather than in producing goods and service.
c.
Resources are used to specify and compare the value of dollars
at different t
112.
The quantity equation of money can be re-written as the
quantity theory of money when we assume velocity of money
(V) to be constant. Assume there are three possible
developments:
a. There is a rise in the number of shopping malls.
b. There is a rise in the number of banks operating.
c. There is a rise in the number of ATMs.
Which of the above can alter the money velocity, and how?
ANSWER:
A rise in ATMs can lead to people reducing their average
money holding and thereby reducing k of the money demand
function. As V=1/k, this can alter velocity V.
113.
Assume a simple economy where only burgers are traded. In a
year, 100 burgers are traded at the rate of $5 per burger.
Assume two scenarios:
a. The economy has $100 in the form of 20 pieces of $5 bills.
b. The economy has $100 in the form of 100 pieces of $1 bills.
Calculate the velocity of money for both situations.
ANSWER
Velocity of money does not depend on the currency
denominations. It is a measure for each unit of money and not
the unit of the currency. In this example, the velocity of money

V = (PT) / M = (5(100)) / 100 = 5 in both cases.
114.
For a country A, the GDP growth rate is 8 percent and inflation
is 4 percent. If the velocity of money remains constant, what is
the change in real money balances?
ANSWER:
Percent change in M + percent change in V = percent
Change in P + percent change in Y . Here, percent change in
V=0. Percent change in M - percent change in P = percent
change in Y. Given that the GDP growth rate is 8 percent, the
change in real money balances is 8 percent as well.
115.
You are presented with the following equation: (1 + r )= (1 + i
)/(1 +π). Expand the expression to solve for i. What assumption
is required for this expression to be equal to the Fischer
equation?
ANSWER:
On expansion, the equation reads i = r + π +r π. If both r and π
are substantially lowered, their product is much lower, such that
i= r + π is a good enough approximation
116.
If one were to own government bonds or other forms of
financial assets, they would earn a real interest rate. Yet, the
opportunity cost of holding money is equal to the nominal
interest rate. Explain why and how.
ANSWER:
Holding financial assets would give us returns r. The money we
hold earns (– πr) as it loses value due to inflation. The sum total

opportunity cost is r – (– πr) = r + πr = i, the nominal interest
rate, as per the Fisher equation.
117.
The money demand function can be written as L (i, Y). Given
the Fisher equation, this means that the money demand function
of the population already takes into account inflation (i = r + π).
Why do you think people have a problem with inflation?
ANSWER:
There is a difference between expected inflation and actual
inflation rate. In the money demand function, i = r + E π, E π
is the expected inflation rate. The real problem is when actual
inflation rates do not match expected inflation rates. Thus,
variable inflation is the main concern rather than inflation per
se.
118.
Suppose a government has a tax revenue shortfall. Will
hyperinflation inevitably follow unless the government cuts in
its fiscal expenditures?
ANSWER:
No. A government has the option of borrowing money just like
any other economic entity. It is only when a government is
deemed as a poor borrower and lenders refuse to lend to it that
the government is forced to print money to cover its expenses,
which might trigger hyperinflation.
119.
During inflation, does a rise in shoe leather cost signify change
in velocity of money?
ANSWER:

No. V = Y / (M/P). Only when Y and V are fixed does an
increase in M lead to a subsequent rise in P to balance the
equation. Conversely, any rise in P is compensated by an
equivalent rise in M such that the velocity of money does not
actually change.
120.
If there are no unexpected changes in money supply in an
economy, can there still be unexpected inflation in the
economy?
ANSWER:
Yes. If there are shocks in the real economy affecting the
factors of production and production function such that total
output Y is affected (say, falls), for a given money supply M
and fixed velocity of money V, P will rise leading to
unexpected inflation levels.
121.
Under high historical inflation rates, can non-indexation of
contracts be non-damaging for either party?
ANSWER:
Yes. The real damage in a case of non-indexed contracts is high
variable inflation. Thus, even if expected inflation is high, as
long as there is no high variable inflation, non-indexed
contracts may be party neutral.
Chapter 3
155.

In an economy with flexible prices, competitive factor markets
and fixed supplies of the factors of production, graphically
illustrate the impact of a change in immigration policy in a
country that permits a huge influx of foreign workers into the
labor market, ceteris paribus. Be sure to label: i. the axes; ii.
the curves; iii. the initial equilibrium values; iv. the direction
the curve's shift; and v. the terminal equilibrium values. Explain
in words how the equilibrium values of labor, the real wage,
saving, investment, and the real interest rate change.
155
The supply of labor force increases, which forces the real wage
lower and increases the quantity of labor employed, since there
is no unemployment in this model. Output (Y) increases as labor
increases, national saving (Y – C – G) increases, which makes
the equilibrium rate of interest fall to bring national saving and
investment into equilibrium.
156.
In an economy with flexible prices, competitive factor markets,
illustrate the impact of an advance in technology that greatly
improves the productivity of capital, ceteris paribus. Be sure to
label: i. the axes; ii. the curves; iii. the initial equilibrium
values; iv. the direction the curves shift; and v. the terminal
equilibrium values. Explain in words how the equilibrium
values change.
156.

The demand for capital increases, which increases the real
rental price of capital, but the quantity of capital employed is
unchanged at the level of the fixed supply.
157.
In an economy with flexible prices, competitive factor markets,
illustrate the impact of a deadly virus that kills a large part of
the labor force, but leaves the other factors of production
untouched, ceteris paribus. Be sure to label: i. the axes; ii. the
curves; iii. the initial equilibrium values; iv. the direction the
curves shift; and v. the terminal equilibrium values. Explain in
words how the equilibrium values change.

157.
The supply of labor decreases, which increases the real wage.
All of the reduced labor force is employed.
162.
a.
Suppose a government moves to reduce a budget deficit. Using
the long-run model of the economy developed in Chapter 3,
graphically illustrate the impact of reducing a government's
budget deficit by reducing government purchases. Be sure to
label: i. the axes; ii. the curves; iii. the initial equilibrium
values; iv. the direction curves shift; and v. the terminal
equilibrium values.
b.
State in words what happens to: i. the real interest rate; ii.
national saving; iii. investment; iv. consumption; and v. output.
162.
a.
b.
i. real interest rate decreases

ii. national saving increases
iii. investment increases
iv. consumption is unchanged
v. output is unchanged, fixed because it is determined by the
factors of production
163.
a.
Suppose a government moves to reduce a budget deficit. Using
the long-run model of the economy developed in Chapter 3,
graphically illustrate the impact of reducing a government's
budget deficit by increasing (lump-sum) taxes on household
income. Be sure to label: i. the axes; ii. the curves; iii. the
initial equilibrium values; iv. the direction curves shift; and v.
the terminal equilibrium values.
b.
163.
a.
b.
iv. consumption decreases

164.
a.
Suppose a government education program succeeds in getting
households to save more (you may interpret this as a downward
shift in the consumption function). Using the long-run model of
the economy developed in Chapter 3, graphically illustrate the
impact of the higher saving rate by households. Be sure to label:
i. the axes; ii. the curves; iii. the initial equilibrium values; iv.
the direction curves shift; and v. the terminal equilibrium
values.
b.
164.
a.
b.
iv. consumption decreases

165.
a.
Suppose there is a technological breakthrough that increases the
productivity of all capital and, consequently, increases the
demand for investment. Using the long-run model of the
economy developed in Chapter 3, graphically illustrate the
impact of the increased investment demand. Be sure to label: i.
the axes; ii. the curves; iii. the initial equilibrium values; iv. the
direction curves shift; and v. the terminal equilibrium values.
b.
165.
a.
b.
i.
real interest rate increases
ii.
national saving is unchanged
iii.
amount of investment is unchanged
iv.
consumption is unchanged

v.
output is unchanged, fixed because it is determined by the
166.
a.
Suppose a government decides to reduce spending and (lump-
sum) income taxes by the same amount. Using the long-run
model of the economy developed in Chapter 3, graphically
illustrate the impact of the equal reductions in spending and
taxes. Be sure to label: i. the axes; ii. the curves; iii. the initial
equilibrium values; iv. the direction curves shift; and v. the
terminal equilibrium values.
b.
166.
a.
b.
iv. consumption increases

167.
Consider two competitive economies that have the same
quantities of labor (L = 400) and capital (K = 400), and the
same technology (A = 100). The economies of the countries are
described by the following Cobb–Douglas production functions:
North Economy: Y = A L.3K.7
South Economy: Y = A L.7K.3
a.
Which economy has the larger total production? Explain.
b.
In which economy is the marginal product of labor larger?
Explain.
c.
In which economy is the real wage larger? Explain.
d.
In which economy is labor's share of income larger? Explain.
167.
a.
Output is the same in both economies, given the symmetry of
the parameters of the productions function and the equal
quantities of labor and capital.
b.
The MPL is larger in the South Economy. The MPL depends on
the value of (1 –
Since the average productivity of labor is the same in both
countries, differences in the MPL depend on the value of (1 –
Economy (.3).
c.
Since factors are paid according to the values of their marginal
products, the real wage is larger in South Economy, because the

MPL is larger in South Economy than in North Economy (from
part b).
d.
Labor's share of income equals (1 –
Economy (.7) than in North Economy (.3).
168.
Assume that a competitive economy can be described by a
constant returns to scale (Cobb–Douglas) production function
and all factors of production are fully employed. Holding other
factors constant, including the quantity of capital and
technology, carefully explain how a one-time, 10-percent
increase in the quantity of labor (perhaps the result of a special
immigration policy) will change each of the following:
a.
the level of output produced;
b.
the real wage of labor;
c.
the real rental price of capital;
d.
labor's share of total income.
168.
a.
Output increases by less than 10 percent because of diminishing
returns to labor.
b.
The real wage decreases because the average productivity of
labor decreases (Y/L decreases, as Y increases less in
proportion than the increase in L), so the MPL, which equals (1
–
c.

The real rental price of capital increases because the average
productivity of capital increases (Y/K increases, as Y increases
d.
Labor's share of income is unchanged, since it depends only on
the parameter (1 – unction, which does
not change.
169.
Assume that a competitive economy can be described by a
constant returns to scale (Cobb–Douglas) production function
and all factors of production are fully employed. Holding other
factors constant, including the quantity of labor and technology,
carefully explain how a one-time, 50-percent decrease in the
quantity of capital (perhaps the result of war damage) will
change each of the following:
a.
the level of output produced;
b.
the real wage of labor;
c.
the real rental price of capital;
d.
capital's share of total income.
169.
a.
Output decreases by less than 50 percent because of diminishing
returns to capital.
b.
The real wage decreases because the average productivity of
labor decreases (Y/L decreases, as Y decreases and L is

constant), so the MPL, which equals (1 –
c.
The real rental price of capital increases because the average
productivity of capital increases (Y/K increases, as Y decreases
proportionally less than K decreases), so the MPK
increases.
d.
Capital's share of income is unchanged since it depends only on
change.
170.
Consider a competitive economy in which factor prices adjust to
keep the factors of production fully employed and the interest
rate adjusts to keep the supply and demand for goods and
services in equilibrium. The economy can be described by the
following set of equations:
–
Y = C + I + G
C = C (Y – T)
I = I(r)
Suggest at least two policies that a government could use to
increase the equilibrium quantity of investment in the economy,
and carefully explain how these policies produce this result.
170.
The government could cut spending (G), which would increase
national saving (Y – C – G), lower the equilibrium interest rate,
and produce an increase in the equilibrium quantity of
investment. The government could increase taxes (T), which
would increase national saving (Y – C – G) by reducing

consumption, lower the equilibrium interest rates and produce
an increase in the equilibrium quantity of investment.
171.
Consider a competitive economy in which factor prices adjust to
keep the factors of production fully employed, and the interest
rate adjusts to keep the supply and demand for goods and
services in equilibrium. The economy can be described by the
following set of equations:
–
Y = C + I + G
C = C(Y – T)
I = I(r)
How does an increase in government spending, holding other
factors constant, affect the level of:
a.
public saving?
b.
private saving?
c.
national saving?
d.
the equilibrium interest rate?
e.
the equilibrium quantity of investment?
171.
a.
Public saving equals T – G. An increase in government
spending, G, reduces public saving.
b.

Private saving equals Y – T – C. An increase in government
spending does not affect private saving.
c.
National saving equals Y – C – G. An increase in government
spending reduces national saving by an amount equal to the
increase in government spending.
d.
The equilibrium interest rate increases to bring desired
investment into equilibrium with the reduced quantity of
national saving.
e.
The equilibrium quantity of investment is reduced via the
increase in the interest rate by an amount equal to the increase
in government spending.
172.
Price flexibility plays a key role in the classical model by
ensuring that the markets reach equilibrium.
a.
Explain which price adjusts to bring equilibrium in the labor
market. Describe how the price adjusts when demand exceeds
supply in this market.
b.
Explain which price adjusts to bring equilibrium in the loanable
funds market. Describe how the price adjusts when supply
exceeds demand in this market.
172.
a.
The real wage adjusts to make labor demand equal to labor
supply. If labor demand is greater than labor supply, the real
wage rises, decreasing the quantity of labor demanded until the
quantity demanded equals the fixed supply of labor.

b.
The real interest rate adjusts to make the supply of loanable
funds equal to the demand for loanable funds. If the supply of
loanable funds is greater than the demand for loanable funds the
interest rate will decrease, increasing the desired quantity of
investment spending, which is the demand for loanable funds,
until the demand and supply are equal.
173.
Consider a production function for an economy:
Y = 20(L.5K.4N.1)
where L is labor, K is capital, and N is land. In this economy
the factors of production are in fixed supply with L = 100, K =
100, and N = 100.
a.
What is the level of output in this country?
b.
Does this production function exhibit constant returns to scale.
Demonstrate by example.
c.
If the economy is competitive so that factors of production are
paid the value of their marginal products, what is the share of
total income will go to land?
173.
a.
2,000
b.
Yes, the production function exhibits constant returns to scale.
Doubling each factor of production to 200 will double output to
4,000.
c.
10 percent

176.
The production of an economy is explained by a function: Y =
20 (L.5K.5) where L is labor and K is capital with L = 400 and
K = 400. Does this economy support constant returns to scale?
176.
When increase in percentage of output equals the increased
percentage of all factors of production it is called constant
returns to scale. Here output is 8000 units, so if we double the
factors of production, i.e., L = 800 and K = 800, we see that the
output becomes 16000 units, double of 8000 units supporting
the constant returns to scale.
177.
After studying the circular flow of dollars in the economy,
explain with an example how saving done by households goes
back into the circular flow. In reality, does all saving go back as
an investment?
177.
According to the circular flow of dollars diagram, households
save their money in financial markets and then financial
markets lend this money to markets of goods and service for
investment. In reality, not all saving is done in the financial
markets, some of the money is kept by people to themselves as
cash, which does not get converted to investment.
178.
Suppose people in an economy reduce their saving. What will
be the effect on real interest rate and investment?

178.
If households develop a tendency of saving less, there will be
less money to lend, so the supply of loanable funds will be less.
This will increase the real interest rates r, and due to the
increase in r investors will find it more costly to take a loan, so
investment will decrease.
180.
What effect does advancement in technology have upon the
equilibrium between real rental price and capital (assuming
supply of capital is fixed)?
180.
Provided that the supply of capital is fixed, advancement in
technology will increase the demand for capital. But as the
supply is fixed, the real rental price will increase. So the new
equilibrium will be in same supply amount of capital with
increased real rental price.
181.
The government of an economy has increased its spending and
taxes by the same amount. What is the effect on investment?
181.
With increased taxes, people will have less money to consume
and save, so there will be reduction in private saving. With
increased government spending, public saving will also be
reduced. Reduction in both private saving and public saving
will lead to a reduction in national saving, and as national
saving is equal to investment, this implies a decrease in
investment.

182.
What is the effect of an increase in interest rate on keeping
government spending constant on consumption and investment?
182.
With increase in interest rates, firms find taking loans for
investments to be more costly, so they will decrease
investments. And households start looking to saving as a better
option than consuming, so consumption will decrease
Chapter 4
101.
Assume that the monetary base (B) is $100 billion, the reserve–
deposit ratio (rr) is 0.1, and the currency–deposit ratio (cr) is
0.1.
a.
What is the money supply?
b.
If rr changes to 0.2, but cr is 0.1 and B is unchanged, what is
the money supply?
c.
If rr is 0.1 and cr is 0.2, but B is unchanged, what is the money
supply?
101.
a.
The money supply is $550 billion.
b.
The money supply is $366.67 billion.
c.
The money supply is $400 billion.

102.
As the U.S. economy approached the millennium, January 1,
2000, many people cautiously began to hold larger than normal
quantities of currency as protection against a possible
disruption of banking services that could result from computer
glitches.
a.
How did this greater preference for currency affect the money
supply?
b.
How could the Federal Reserve offset such an increase in
currency preferences?
102.
a.
The greater preference for currency increased the currency–
deposit ratio, which reduced the money multiplier and reduced
the money supply for a given monetary base.
b.
The Fed could engage in open-market purchases to increase the
monetary base to offset the decline in the money multiplier.
(Reducing the discount rate and reducing reserve requirements
could theoretically achieve the same outcome but are not as
practical).
103.
The Federal Reserve's tools to control the money supply
include: open-market operations, the discount rate, and interest
payments on reserves.
a.
How should each instrument be changed if the Fed wishes to
decrease the money supply?
b.
Will the change affect the monetary base and/or the money

multiplier?
103.
a.
The Fed would conduct open-market sales, raise the discount
rate, and raise interest paid on reserves.
b.
Open-market operations and discount rate changes affect the
monetary base. Changing interest payments on reserves alters
the money multiplier.
104.
Some economists have advocated replacing government deposit
insurance with 100-percent- reserve banking. Under this plan,
banks would hold all deposits as reserves. Deposit insurance
would no longer be necessary, because banks would always
have the reserves to meet customer withdrawals.
a.
What would happen to the money supply (defined as currency
and bank deposits) in the transition from fractional-reserve to
100-percent-reserve, if this plan were implemented, holding
other factors constant?
b.
What will be the value of the money multiplier?
104.
a.
In the process of moving from fractional-reserve to 100-
percent-reserve banking, the money supply would have to
contract if the monetary base remained unchanged. Deposits
will have to contract to equal the quantity of reserves.
b.
The money multiplier equals 1= [(1 + cr)/(1 + cr)].

105.
Why does the Federal Reserve not have complete control over
the size of the money supply? Give at least two reasons.
105.
For a given monetary base, controlled by the Federal Reserve,
the money supply also depends on: (1) the amount of currency
the public chooses to hold relative to deposits, and (2) the
amount of reserves that banks choose to hold relative to
deposits. Therefore, actions of both the public and banks
influence the size of the money supply in addition to the actions
of the Fed.
106.
Construct a bank balance sheet with the following items:
reserves, deposits, loans, securities, capital, and debt. Choose
values so that the reserve–deposit ratio is 10 percent and the
leverage ratio is 10. Give an example of a change in asset
values that would push bank capital to zero. What happens when
bank capital is gone?
106.
Many values are possible in the balance sheet, but (1) assets
should equal liabilities and net worth, (2) items should be
correctly categorized as assets or liabilities, (3) the ratio of
reserves to deposits should be 10 percent, and (4) the ratio of
assets to capital should be 10, as in the example below. If asset
values fall by 10 percent of total assets (for example, if loans
fall from 100,000 to 85,000 in the example below), then capital
equals zero. When capital is exhausted, the bank will not have
sufficient resources to pay off depositors or debt holders if
there is a further decline in asset values.
Bank Balance Sheet
Assets

Liabilities & Net Worth
Reserves
$ 10,000
Deposits
$100,000
Loans
100,000
Debt
35,000
Securities
40,000
Capital
15,000
107.
As the 2008–2009 financial crisis unfolded, one major U.S.
bank had a leverage ratio of 54. In Canada regulators put a
ceiling on bank leverage ratios of 20. Compare the change in
asset values that would push the capital in the U.S. bank to zero
with the change required to eliminate capital in a Canadian bank
at the ceiling-leverage ratio. What is the implication of the
differences in maximum leverage ratios for the stability of the
banking system?
107.
With a leverage ratio of 54, a 1.85 percent fall in asset values
wipes out capital, while with a leverage ratio of 20, a 5 percent
fall in asset values wipes out capital. The higher leverage ratio
of the U.S. bank makes it much more susceptible to losing
capital and being unable to pay off depositors. The higher
leverage ratio puts the U.S. system at greater risk for bank runs,

bank failures, and greater instability.
108.
Economists occasionally speak of “helicopter money” as a
short-hand approach to explaining increases in the money
supply. Suppose the Chairman of the Federal Reserve flies over
the country in a helicopter dropping 10,000,000 in newly
printed $100 bills (a total of $1 billion). By how much will the
money supply increase if, holding everything else constant:
a.
all of the new bills are held by the public?
b.
all of the new bills are deposited in banks that choose to hold
10 percent of their deposits as reserves (and no one in the
economy holds any currency)?
c.
all of the new bills are deposited in banks that practice 100-
percent-reserve banking?
d.
people in the economy hold half of their money as currency and
half as deposits, while banks choose to hold 10 percent of their
deposits as reserves?
108.
a.
$1 billion; b. $10 billion; c. $1 billion; d. $5.5 billion
109.
A macroeconomist threatens to call the Secret Service to have
Mr. Biggy Rich arrested for counterfeiting because Mr. Rich
claims he “makes a lot of money.”
a.

Carefully explain why the macroeconomist is making this threat
based on the macroeconomic definition of money. Be sure to
explain the macroeconomic functions of money.
b.
Suggest an alternative phrase that Mr. Rich can use that will not
result in a charge of counterfeiting.
109.
a.
Money consists of the assets used to make transactions. Money
serves as a store of value, unit of account, and medium of
exchange. In most fiat money economies, the government
maintains a monopoly over the supply of money. If Mr. Rich is
“making money,” i.e., increasing the supply of money, this is
counterfeiting and is illegal.
b.
Mr. Rich could say he “earns a large income,” or “is very
wealthy,” or “has a lot of money,” or “makes big profits.”
110.
Explain at least three factors that will affect the quantity of
reserves that a bank wishes to hold.
110.
Banks' demand for reserves will be affected by: (1) legal
reserve requirements, (2) the size and regularity of customer
deposits and withdrawals, (3) the interest rate paid on reserves
relative to alternative bank investments, and (4) the number of
bank failures and level of uncertainty in the economy.
111.
The development of fiat money is quite perplexing, as people
began to value something that is intrinsically useless. Explain
why fiat money came into use.

111.
Fiat money fulfills all the three purposes of money better than
other types of money. Fiat money provides a store of value, i.e.
it can be stored to be used in future. It has a unit of account,
e.g., dollar, euro, etc. And it is a widely accepted medium of
exchange.
112.
John withdraws $100 from his checking account and deposits it
in his saving account. What will be the effect of this transaction
on different measures of money, i.e. C, M1, and M2?
112.
Checking accounts are included in M1 and M2, but not in C.
Saving accounts are included only in M2. So this transaction
will have no effect on C and M2, but M1 will be reduced by
$100.
113.
How do credit card transactions affect the measurement of
money?
113.
When a credit card is used, there is no actual payment made by
the credit card holder at the moment, since this payment is
deferred. So this transaction does not affect any measure of
money. Only when a credit card payment is made to the bank is
the transaction included in different measures of money.
114.
The monetary base of Moneyland is $500 million. The current-
deposit ratio (cr) is 0.2 and reserve-deposit ratio (rr) is 0.2.
Calculate the money multiplier and money supply.
114.

Money multiplier = (1 + cr) / (rr + cr) = 1.2/0.4 = 3
Money supply = money multiplier x monetary base
Money supply = (3)(500) = $1500 million
115.
How much effect do the purchase and sale of bonds through
open-market operations have on the money supply?
115.
When the Federal Reserve purchases bonds through open-market
operations, it increases the monetary base and the money
supply, while the selling of the bonds to the public decreases
the monetary base and money supply.
116.
“Some economists believe that the large decline in the money
supply was the primary cause of the Great Depression of the
1930s.” Explain how this can be the case.
116.
Banks defaulted on their deposits. This caused current-deposit
ratios to fall, and hence there was a reduction in the money
multiplier. So, despite the increase in the monetary base, the
money supply was reduced further, making the depression
worse.
117.
Why can the Federal Reserve not control the money supply with
complete accuracy?
117.
The Federal Reserve cannot completely control the money
supply because it has no control on how much money the public
will hold as currency and not deposit in banks. Another reason
is that it cannot control how much reserve banks will keep
against the deposits they have.

118.
What is the effect of the following on the money supply?
a. Increase in currency-deposit ratio, keeping all other things
constant
b. Decrease in reserve-deposit ratio, keeping all other things
constant
118.
a. This will decrease the money multiplier and so the money
supply will also decrease.
b. This will increase the money multiplier and so the money
supply will also increase.
119.
The table below represents the balance sheet of a bank. What is
the leverage ratio of the bank, and what does it mean?
Assets
Liabilities and Owners’ Equity
Reserves
500
Deposits
1400
Loans
1000
Debt
400
Securities
500
Owners' equity
200
119.
Leverage ratio = Total assets / capital (owner’s equity) =
2000/200 = 10
This means that for the contribution of every dollar by the bank

owner, nine dollars are contributed through deposits and debts.
120.
The Federal Reserve wants to increase the money supply by
printing and distributing 1 million dollars worth of currency
notes. What will be the actual increase in money supply if the
public holds one fourth of the currency as cash, and deposits
rest of the money in banks that hold 5 percent of their deposits
as reserves?
120.
Money multiplier = 1 / reserve-deposit ratio = 1/.05 = 20. As
0.25 million will be held by the public and 0.75 million will be
deposited in the bank, the money deposited in banks will
increase the money supply by ((.75)(20))($5 million). The net
increase in money supply will be = .25 + 15 = $15.25 million.
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