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ECO102

Principles of
Macroeconomics
Problem Session-1
by
Research Assistant
Serkan Deirmenci
02.03.2012

Today
Mankiw (2008), Principles of Economics:
- Chapter 23: Measuring A Nations Income:
Questions for Review (QfR): 1-8 (page: 525)
Problems and Applications (P&A): 1-11 (page:
525-527)
- Chapter 24: Measuring the Cost of Living:
Questions for Review (QfR): 1-5 (page: 543)
Problems and Applications (P&A): 1-10 (page: 543545)
- Chapter 25: Production and Growth:
Questions for Review (QfR): 1-8 (page: 573)
Problems and Applications (P&A): 1-10 (page: 574)
- Chapter 26: Saving, Investment, and the
Financial System:
Questions for Review (QfR): 1-6 (page: 594)

CHAPTER 23
MEASURING A NATIONS INCOME

Chapter 23: QfR-1 (page:


525)

Explain why an economys income must equal its


expenditure.
income = expenditure (why?)
ANSWER: (page: 508) => please see Figure 1
(page: 509)

An economy's income must equal its expenditure,


because every transaction has a buyer and
a seller.
Thus, expenditure by buyers must equal
income by sellers.

Chapter 23: QfR-2 (page:


525)

Which contributes more to GDPthe production


of an economy car or the production of a luxury
car? Why?
GDP: the market value of all officially recognized
final goods and services produced within a
country in a given period.
ANSWER: (page: 510-512)

The production of a luxury car contributes more


to GDP than the production of an economy car
because the luxury car has a higher market
value.
because market prices measure the amount people

Chapter 23: QfR-3 (page:


525)

A farmer sells wheat to a baker for $2.


The baker uses the wheat to make bread, which is
sold for $3. What is the total contribution of
these transactions to GDP?
ANSWER: (page: 511)

The contribution to GDP is $3,


the market value of the bread,
which is the final good that is sold.

Chapter 23: QfR-4 (page:


525)

Many years ago, Peggy paid $500 to put together


a record collection.
Today, she sold her albums at a garage sale for
$100.
How does this sale affect current GDP?
ANSWER: (page: 511)

The sale of used records does not affect GDP at


all
because it involves no current production.

Chapter 23: QfR-5 (page:


525)

List the four components of GDP. Give an


example of each.
ANSWER: (page: 512-513-514)

The four components of GDP are


consumption, such as the purchase of a music
CD;
investment, such as the purchase of a computer
by a business;
government purchases, such as an order for
military aircraft;
and net exports, such as the sale of American
wheat to Russia.

Chapter 23: QfR-6 (page:


525)

Why do economists use real GDP rather than


nominal GDP to gauge economic well-being?
ANSWER: (page: 515-516-517)

Economists use real GDP rather than nominal


GDP to gauge economic well-being
because real GDP is not affected by changes
in prices,
so it reflects only changes in the amounts
being produced.
You cannot determine if a rise in nominal GDP has
been caused by increased production or higher
prices.

Chapter 23: QfR-7 (page:


525)
In the year 2010, the economy produces 100 loaves
of bread that sell for $2 each. In the year 2011, the
economy produces 200 loaves of bread that sell for $3
each.
Calculate nominal GDP, real GDP, and the GDP
deflator for each year. (Use 2010 as the base year.)
By what percentage does each of these three statistics
rise from one year to the next?
Year
ANSWER:
(page:
Nominal
GDP 516-518)
Real GDP
GDP Deflator
2010

100 X $2 =
100 X $2 =
($200/$200) X 100 =
100
$200
$200
2011
200 X $3 =
200 X $2 =
($600/$400) X 100 =
$600
$400 GDP is (600 150
The percentage
change in nominal
200)/200 x

100 = 200%.
The percentage change in real GDP is (400 200)/200 x 100
= 100%.

Chapter 23: QfR-8 (page:


525)

Why is it desirable for a country to have a large


GDP?
Give an example of something that would raise
GDP and yet be undesirable.

ANSWER: (page: 519-522)


It is desirable for a country to have a large GDP
because people could enjoy more goods and
services.
But GDP is not the only important measure of
well-being.
For example, laws that restrict pollution cause GDP
to be lower. If laws against pollution were
eliminated, GDP would be higher but the pollution
might make us worse off.

Chapter 23: P&A-1


(page:
525)
The government purchases component of GDP
does not include spending on transfer payments
such as Social Security. Thinking about the
definition of GDP, explain why transfer payments
are excluded.
ANSWER: (page: 514)

With transfer payments, nothing is produced,


so there is no contribution to GDP.

Chapter 23: P&A-2


(page:
525)
As the chapter states, GDP does not

include the value of used goods that are


resold.
Why would including such transactions make
GDP a less informative measure of economic
well-being?
ANSWER: (page: 511)
If GDP included goods that are resold, it would
be counting output of that particular year,
plus sales of goods produced in a previous
year. It would double-count goods that were
sold more than once and would count goods
in GDP for several years if they were

Chapter 23: P&A-3 (page: 525)

What components of GDP (if any) would each of the following transactions
affect? Explain.
a. A family buys a new refrigerator.
b. Aunt Jane buys a new house.
c. Ford sells a Thunderbird from its inventory.
d. You buy a pizza.
e. California repaves Highway 101.
f. Your parents buy a bottle of French wine.
g. Honda expands its factory in Marysville, Ohio.
ANSWER: (page: 512-514)
a. Consumption increases because a refrigerator is a good purchased by
a household.
b. Investment increases because a house is an investment good.
c. Consumption increases because a car is a good purchased by a
household, but investment decreases because the car in Fords
inventory had been counted as an investment good until it was sold.
d. Consumption increases because pizza is a good purchased by a
household.
e. Government purchases increase because the government spent
money to provide a good to the public.
f. Consumption increases because the bottle is a good purchased by a

Chapter 23: P&A-5 (page: 526)


Below are some data from the land of milk
and honey.
200
8
200
9
a. Compute nominal GDP, real GDP, and the GDP
201
0deflator for each year, using 2008 as the base

year.
b. Compute the percentage change in nominal
GDP, real GDP, and the GDP deflator in 2009 and
2010 from the preceding year. For each year,
identify the variable that does not change.
Explain in words why your answer makes sense.
c. Did economic well-being rise more in 2009 or

Chapter 23: P&A-5 (page: 526)-cont.

ANSWER:
a.
Calculating nominal GDP:
2008: ($1 per qt. of milk 100 qts. milk) + ($2 per qt. of honey 50 qts. honey) = $200
100%
2009: ($1 per qt. of milk 200 qts. milk) + ($2 per qt. of honey 100 qts. honey) = $400
100%
2010: ($2 per qt. of milk 200 qts. milk) + ($4 per qt. of honey 100 qts. honey)
= $800
Calculating real GDP (base year 2008):
2008: ($1 per qt. of milk 100 qts. milk) + ($2 per qt. of honey 50 qts. honey) = $200
100%
2009: ($1 per qt. of milk 200 qts. milk) + ($2 per qt. of honey 100 qts. honey) = $400
2010: ($1 per qt. of milk 200 qts. milk) + ($2 per qt. of honey 100 qts. honey)
0%= $400
Calculating the GDP deflator:
2008: ($200/$200) 100 = 100
2009: ($400/$400) 100 = 100 0%
2010: ($800/$400) 100 = 200100%
b.
Calculating the percentage change in nominal GDP:
Percentage change in nominal GDP in 2009 = [($400 $200)/$200] 100 = 100%.
Percentage change in nominal GDP in 2010 = [($800 $400)/$400] 100 = 100%.
Calculating the percentage change in real GDP:
Percentage change in real GDP in 2009 = [($400 $200)/$200] 100 = 100%.
Percentage change in real GDP in 2010 = [($400 $400)/$400] 100 = 0%.
Calculating the percentage change in GDP deflator:
Percentage change in the GDP deflator in 2009 = [(100 100)/100] 100 = 0%.
Percentage change in the GDP deflator in 2010 = [(200 100)/100] 100 = 100%.
Prices did not change from 2008 to 2009. Thus, the percentage change in the GDP
deflator is zero. Likewise, output levels did not change from 2009 to 2010. This
means that the percentage change in real GDP is zero.
c.
Economic well-being rose more in 2009 than in 2010, since real GDP rose in
2009 but not in 2010.

Chapter 23: P&A-6 (page: 526)


Consider the following data on U.S. GDP:

199
6

200
0
199
9

9873
9269

118
113

a. What was the growth rate of nominal GDP between 1999


and 2000? (Note: The growth rate is the percentage change
from one period to the next.)
b. What was the growth rate of the GDP deflator between
1999 and 2000?
c. What was real GDP in 1999 measured in 1996 prices?
d. What was real GDP in 2000 measured in 1996 prices?
e. What was the growth rate of real GDP between 1999 and
2000?
f. Was the growth rate of nominal GDP higher or lower than

Chapter 23: P&A-6 (page: 526)-cont.


ANSWER:
a. The growth rate of nominal GDP is ($9,873
$9,269)/$9,269 100% = 6.5%.
b. The growth rate of the deflator is (118 113)/113
100% = 4.4%.
c. Real GDP in 1999 (in 1996 dollars) is $9,269/
(113/100) = $8,203.
d. Real GDP in 2000 (in 1996 dollars) is $9,873/
(118/100) = $8,367.
e. The growth rate of real GDP is ($8,367 $8,203)/
$8,203 100% = 2.0%.
f. The growth rate of nominal GDP is higher
than the growth rate of real GDP because of
inflation.

Chapter 23: P&A-11 (page: 527)


One day Barry the Barber, Inc., collects $400 for
haircuts.
Over
this
day,
his
equipment
depreciates in value by $50. Of the remaining
$350, Barry sends $30 to the government in sales
taxes, takes home $220 in wages, and retains
$100 in his business to add new equipment in the
future. From the $220 that Barry takes home, he
pays $70 in income taxes. Based on this
information, compute Barrys contribution to the
following measures of income:
a. gross domestic product
b. net national product
c. national income
d. personal income

Chapter 23: P&A-11 (page: 526)-cont.


ANSWER:
a. GDP equals the dollar amount Barry collects,
which is $400.
b. NNP = GDP depreciation = $400 $50 =
$350.
c. National income = NNP sales taxes =
$350 $30 = $320.
d. Personal income = national income
retained earnings = $320 $100 = $220.
e. Disposable personal income = personal
income personal income tax = $220 $70
= $150.

CHAPTER 24
MEASURING THE COST OF LIVING

Chapter 24: QfR-1 (page:


543)

Which do you think has a greater effect on the


consumer price index: a 10 percent increase in
the price of chicken or a 10 percent increase in
the price of caviar? Why?

ANSWER:

A 10% increase in the price of chicken has a


greater effect on the consumer price index than a
10% increase in the price of caviar because
chicken is a bigger part of the average
consumer's market basket.

Chapter 24: QfR-2 (page:


543)

Describe the three problems that make the


consumer price index an imperfect measure of
the cost of living.
ANSWER:

The three problems in the consumer price


index as a measure of the cost of living are:
(1) substitution bias, which arises because
people substitute toward goods that have
become relatively less expensive;
(2) the introduction of new goods, which are
not reflected quickly in the CPI; and
(3) unmeasured quality change.

Chapter 24: QfR-3 (page:


543)

If the price of a Navy submarine rises, is the


consumer price index or the GDP deflator affected
more? Why?
ANSWER:

If the price of a Navy submarine rises, there is no


effect on the consumer price index,
because Navy submarines are not consumer
goods.
But the GDP price index is affected,
because Navy submarines are included in GDP as
a part of government purchases.

Chapter 24: QfR-4 (page:


543)

Over a long period of time, the price of a candy


bar rose from $0.10 to $0.60. Over the same
period, the consumer price index rose from 150 to
300. Adjusted for overall inflation, how much did
the price of the candy bar change?
ANSWER:

Because the overall price level doubled,


but the price of the candy bar rose sixfold,
the real price (the price adjusted for
inflation) of the candy bar tripled.

Chapter 24: QfR-5 (page:


543)

Explain the meaning of nominal interest rate and


real interest rate. How are they related?
ANSWER:

The nominal interest rate is the rate of interest


paid on a loan in dollar terms.
The real interest rate is the rate of interest
corrected for inflation.
The real interest rate is the nominal
interest rate minus the rate of inflation.
r=i-

Chapter 24: P&A-2


(page:
543-544)
Suppose that people consume only three goods, as shown in this
table:
Golf
Balls
$4
100
$6
100

2009 price
2009
quantity
2010 price
2010
quantity
a. What
is the percentage change in the price of each of three

goods?
b. Using the method similar to the consumer price index,
compute the percentage change in the overall price level.
c. If you were to learn that a bottle of Gatorade increased in
size from 2009 to 2010, should that information affect your
calculation of the inflation rate? If so, how?
d. If you were to learn that Gatorade introduced new flavors in
2010, should that information affect your calculation of the

Chapter 24: P&A-2 (page: 543544)-cont.

ANSWER:
a. The percentage change in the price of tennis balls is (2
2)/2 100% = 0%.
The percentage change in the price of golf balls is (6 4)/4
100% = 50%.
The percentage change in the price of Gatorade is (2 1)/1
100% = 100%.
b. The cost of the market basket in 2009 is ($2 100) + ($4
100) + ($1 200) = $200 + $400 + $200 = $800.
The cost of the market basket in 2010 is ($2 100) + ($6
100) + ($2 200) = $200 + $600 + $400 = $1,200.
The percentage change in the cost of the market basket
from 2009 to 2010 is (1,200 800)/800 100% = 50%.
c. This would lower my estimation of the inflation rate
because the value of a bottle of Gatorade is now greater than
before. The comparison should be made on a per-ounce basis.
d. More flavors enhance consumers well-being. Thus, this
would be considered a change in quality and would also

Chapter 24: P&A-3 (page: 544)


Suppose that the residents of Vegopia spend all of their income on
cauliflower, broccoli, and carrots. In 2008, they buy 100 heads of
cauliflower for $200, 50 bunches of broccoli for $75, and 500
carrots for $50. In 2009, they buy 75 heads of cauliflower for
$225, 80 bunches of broccoli for $120, and 500 carrots for $100.
a. Calculate the price of each vegetable in each year.
b. Using 2008 as the base year, calculate the CPI for each year.
c. What is the inflation rate in 2009?
ANSWER:
a. Find the price of each good in each year:

Year
2008
2009

Cauliflower
$2
$3

Broccoli
$1.50
$1.50

Carrots
$0.10
$0.20

b. If 2008 is the base year, the market basket used to compute the CPI is 100
heads of cauliflower, 50 bunches of broccoli, and 500 carrots. We must now
calculate the cost of the market basket in each year:
2008: (100 x $2) + (50 x $1.50) + (500 x $.10) = $325
2009: (100 x $3) + (50 x $1.50) + (500 x $.20) = $475
Then, using 2008 as the base year, we can compute the CPI in each year:
2008: $325/$325 x 100 = 100
2009: $475/$325 x 100 = 146
c. We can use the CPI to compute the inflation rate for 2009:
(146 100)/100 x 100% = 46%

Chapter 24: P&A-7 (page: 544)


The New York Times cost $0.15 in 1970 and $0.75
in 2000. The average wage in manufacturing was
$3.23 per hour in 1970 and $14.32 in 2000.
a. By what percentage did the price of a newspaper
rise?
b. By what percentage did the wage rise?
c. In each year, how many minutes does a worker
have to work to earn enough to buy a newspaper?
d. Did workers purchasing power in terms of
newspapers rise or fall?
ANSWER:
a. ($0.75 $0.15)/$0.15 x 100% = 400%.
b. ($14.32 $3.23)/$3.23 x 100% = 343%.
c. In 1970: $0.15/($3.23/60) = 2.8 minutes.
In 2000: $0.75/($14.32/60) = 3.1 minutes.
d. Workers' purchasing power fell in terms of
newspapers.

CHAPTER 25
PRODUCTION AND GROWTH

Chapter 25: QfR-1 (page:


573)
What does the level of a nations GDP measure?
What does the growth rate of GDP measure?
Would you rather live in a nation with a high level of
GDP and a low growth rate, or in a nation with a low
level and a high growth rate?
ANSWER:
The level of a nations GDP measures both the total
income earned in the economy and the total
expenditure on the economys output of goods and
services.
The level of real GDP is a good gauge of economic
prosperity, and the growth of real GDP is a good
gauge of economic progress.
You would rather live in a nation with a high level of
GDP, even though it had a low growth rate, than in a

Chapter 25: QfR-2 (page:


573)

List and describe four determinants of


productivity.
ANSWER:
The four determinants of productivity are:
(1) physical capital, which is the stock of
equipment and structures that are used to
produce goods and services;
(2) human capital, which consists of the
knowledge and skills that workers acquire
through education, training, and experience;
(3) natural resources, which are inputs into
production that are provided by nature; and
(4)
technological
knowledge, which is
societys understanding of the best ways to

Chapter 25: QfR-3 (page:


573)
In what way is a college degree a form
of capital?
ANSWER:
A college degree is a form of human
capital. The skills learned in earning a
college degree increase a worker's
productivity.

Chapter 25: QfR-4 (page:


573)
Explain how higher saving leads to a higher
standard of living. What might deter a
policymaker from trying to raise the rate of
saving?
ANSWER:
Higher saving means fewer resources are devoted to
consumption and more to producing capital goods.
The rise in the capital stock leads to rising productivity
and more rapid growth in GDP for a while.

In the long run, the higher saving rate leads


to a higher standard of living.
A policymaker might be deterred from trying to raise
the rate of saving because doing so requires that
people reduce their consumption today and it can take

Chapter 25: QfR-5 (page:


573)
Does a higher rate of saving lead to higher
growth temporarily or indefinitely?
ANSWER:
A higher rate of saving leads to a
higher growth rate temporarily, not
permanently.
In the short run, increased saving
leads to a larger capital stock and
faster growth.
But as growth continues, diminishing
returns to capital mean growth slows

Chapter 25: QfR-6 (page:


573)
Why would removing a trade
restriction, such as a tariff, lead to
more rapid economic growth?
ANSWER:
Removing a trade restriction, such as
a tariff, would lead to more rapid
economic
growth
because
the
removal of the trade restriction
acts like an improvement in
technology. Free trade allows all

Chapter 25: QfR-7 (page:


573)
How
does
the
rate
of
population growth influence
the level of GDP per person?
ANSWER:
The higher the rate of population
growth, the lower is the level
of GDP per person because
there's
less
capital
per
person,
hence
lower

Chapter 25: QfR-8 (page:


573)
Describe two ways in which the U.S.
government tries to encourage advances
in technological knowledge.
ANSWER:
The U.S. government tries to encourage
advances in technological knowledge by
providing research grants through the
National Science Foundation and the
National Institute of Health, with tax
breaks for firms engaging in research
and development, and through the
patent system.

Chapter 25: P&A-1


(page:
574)
Suppose that society decided to reduce consumption

and increase investment.


a. How would this change affect economic growth?
b. What groups in society would benefit from this
change? What groups might be hurt?
ANSWER:
a. More investment would lead to faster economic
growth in the short run.
b. The change would benefit many people in society who
would have higher incomes as the result of faster
economic growth. However, there might be a
transition period in which workers and owners in
consumption-good industries would get lower
incomes, and workers and owners in investmentgood industries would get higher incomes. In
addition, some group would have to reduce their

Chapter 25: P&A-2


(page:
574)
Societies choose what share of their resources to devote to
consumption and what share to devote to investment. Some of
these decisions involve private spending; others involve
government spending.
a. Describe some forms of private spending that represent
consumption, and some forms that represent investment.
b. Describe some forms of government spending that represent
consumption, and some forms that represent investment.
ANSWER:
a. Private consumption spending includes buying food and buying
clothes; private investment spending includes people buying
houses and firms buying computers. Many other examples are
possible. Education can be considered as both consumption and
investment.
b. Government consumption spending includes paying workers to
administer government programs; government investment
spending includes buying military equipment and building roads.
Many other examples are possible. Government spending on
health programs is an investment in human capital. This is truer

Chapter 25: P&A-3


(page: 574)
Most countries, including the United States, import
substantial amounts of goods and services from
other countries.
Yet the chapter says that a nation can enjoy a high
standard of living only if it can produce a large
quantity of goods and services itself. Can you
reconcile these two facts?
ANSWER:
The facts that countries import many goods and
services yet must produce a large quantity of goods
and services themselves to enjoy a high standard of
living are reconciled by noting that there are
substantial gains from trade. In order to be able to
afford to purchase goods from other countries, an
economy must generate income. By producing

Chapter 25: P&A-4


(page: 574)

What is the opportunity cost of investing in capital? Do you


think a country can over-invest in capital? What is the
opportunity cost of investing in human capital? Do you
think a country can over-invest in human capital? Explain.
ANSWER:
The opportunity cost of investing in capital is the loss of
consumption that results from redirecting resources toward
investment. Over-investment in capital is possible because
of diminishing marginal returns. A country can "overinvest" in capital if people would prefer to have
higher consumption spending and less future
growth. The opportunity cost of investing in human capital
is also the loss of consumption that is needed to provide
the resources for investment. A country could "overinvest" in human capital if people were too highly
educated for the jobs they could get for example, if
the best job a Ph.D. in philosophy could find is managing a

Chapter 25: P&A-5


(page: 574)
Suppose that an auto company owned entirely by
German citizens opens a new factory in South
Carolina.
a. What sort of foreign investment would this
represent?
b. What would be the effect of this investment on
U.S. GDP? Would the effect on U.S. GNP be larger
or smaller?
ANSWER:
a. When a German firm opens a factory in South
Carolina, it represents foreign direct
investment.
b. The investment increases U.S. GDP

Chapter 25: P&A-6


(page: 574)

In the 1990s and the first decade of the 2000s, investors


from the Asian economies of Japan and China made
significant direct and portfolio investments in the United
States. At the time, many Americans were unhappy that
this investment was occurring.
a. In what way was it better for the United States to receive
this Japanese investment than not to receive it?
b. In what way would it have been better still for Americans
to have done this investment?
ANSWER:
a. The United States benefited from the Chinese and
Japanese investment because it made our capital stock
larger, increasing our economic growth.
b. It would have been better for the United States to make
the investments itself because then it would have received
the returns on the investment itself, instead of the returns

Chapter 25: P&A-7


(page:
574)
many developing nations, young women

In
have
lower enrollment rates in secondary school than do
young men. Describe several ways in which greater
educational opportunities for young women could
lead to faster economic growth in these countries.
ANSWER:
Greater educational opportunities for women could
lead to faster economic growth in these developing
countries because increased human capital
would increase productivity and there would
be external effects from greater knowledge in
the country.
Second, increased educational opportunities
for young women may lower the population

Chapter 25: P&A-8


(page:
574)
International data show a positive correlation between income

per person and the health of the population.


a. Explain how higher income might cause better health outcomes.
b. Explain how better health outcomes might cause higher income.
c. How might the relative importance of your two hypotheses be
relevant for public policy?

. ANSWER:
a. Individuals with higher incomes have better access to
clean water, medical care, and good nutrition.
b. Healthier individuals are likely to be more productive.

c. Understanding the direction of causation will help policymakers


place proper emphasis on the programs that will achieve
both greater health and higher incomes.

Chapter 25: P&A-9


(page: 574)
International data show a positive correlation
between political stability and economic growth.
a. Through what mechanism could political
stability lead to strong economic growth?
b. Through what mechanism could strong
economic growth lead to political stability?
ANSWER:
a. Political stability could lead to strong economic growth
by making the country attractive to investors. The
increased investment would raise economic growth.
b. Strong economic growth could lead to political stability
because when people have high incomes they tend
to be satisfied with the political system and are less
likely to overthrow or change the government.

Chapter 25: P&A-10


(page:
574)
From 1950 to 2000, manufacturing employment as a percentage

of total employment in the U.S. economy fell from 28 percent to 13


percent. At the same time, manufacturing output experienced
slightly more rapid growth than the overall economy.
a. What do these facts say about growth in labor productivity
(defined as output per worker) in manufacturing?
b. In your opinion, should policymakers be concerned about the
decline in the share of manufacturing employment? Explain.

. ANSWER:
a. If output is rising and the number of workers is declining, then
output per worker must be rising.

b. Policymakers should not be concerned as long as output in the


manufacturing sector is not declining. The reduction in
manufacturing jobs will allow labor resources to move to other
industries, increasing total output in the economy. An increase in
productivity of workers (as measured by output per worker) is
beneficial to the economy.

CHAPTER 26
SAVING, INVESTMENT, AND
THE FINANCIAL SYSTEM

Chapter 26: QfR-1 (page:


594)
What is the role of the financial system? Name and
describe two markets that are part of the financial
system in our economy. Name and describe two
financial intermediaries.
ANSWER:
The financial system's role is to help match one
person's saving with another person's investment.
Two markets that are part of the financial system are
the bond market, through which large corporations,
the federal government, or state and local
governments borrow, and the stock market, through
which corporations sell ownership shares.
Two financial intermediaries are banks, which take in
deposits and use the deposits to make loans, and
mutual funds, which sell shares to the public and use

Chapter 26: QfR-2 (page:


594)
Why is it important for people who own
stocks and bonds to diversify their
holdings? What type of financial institution
makes diversification easier?
ANSWER:

It is important for people who own stocks


and bonds to diversify their holdings
because then they will have only a small
stake in each asset, which reduces risk.
Mutual funds make such diversification
easy by allowing a small investor to
purchase parts of hundreds of different

Chapter 26: QfR-3 (page:


594)
What is national saving? What is private saving?
What is public saving? How are these three
variables related?
ANSWER:

National saving is the amount of a nation's


income that is not spent on consumption or
government purchases.
Private saving is the amount of income that
households have left after paying their taxes and
paying for their consumption. Public saving is the
amount of tax revenue that the government has
left after paying for its spending. The three
variables are related because national saving
equals private saving plus public saving.

Chapter 26: QfR-4 (page:


594)
What is investment? How is it related to
national saving?
ANSWER:

Investment refers to the purchase of new


capital, such as equipment or buildings.
It is equal to national saving.

S=I

Chapter 26: QfR-5 (page:


594)
Describe a change in the tax code that might
increase private saving. If this policy were
implemented, how would it affect the market for
loanable funds?
ANSWER:

A change in the tax code that might increase


private saving is the expansion of eligibility for
special accounts that allow people to shelter
some of their saving from taxation.
This would increase the supply of loanable funds,
lower interest rates, and increase investment.

Chapter 26: QfR-6 (page:


594)
What is a government budget deficit? How does it
affect interest rates, investment, and economic
growth?
ANSWER:

A government budget deficit arises when the


government spends more than it receives in tax
revenue.
Because a government budget deficit reduces
national saving, it raises interest rates, reduces
private investment, and thus reduces economic
growth.

Chapter 26: P&A-1


(page: 595)
Theodore Roosevelt once said, There is
no moral difference between gambling at
cards or in lotteries or on the race track
and gambling in the stock market. What
social purpose do you think is served by
the existence of the stock market?
ANSWER:
The stock market does have a social
purpose. Firms obtain funds for investment
by issuing new stock. People are more
likely to buy that stock because there are
organized stock markets, so people know

Chapter 26: P&A-2


(page: 595)

When the Russian government defaulted on its debt to


foreigners in 1998, interest rates rose on bonds issued by
many other developing countries. Why do you suppose this
happened?
ANSWER:
When the Russian government defaulted on its debt,
investors perceived a higher chance of default (than they
had before) on similar bonds sold by other developing
countries. Thus, the supply of loanable funds shifted to the
left, as shown in Figure 1. The result was an increase in the
Figur
interest rate.
e1

Chapter 26: P&A-3


(page: 595)

For each of the following pairs, which bond would you expect to pay a
higher interest rate? Explain.
a. a bond of the U.S. government or a bond of an eastern European
government
b. a bond that repays the principal in 2013 or a bond that repays the
principal in 2030
c. a bond from Coca-Cola or a bond from a software company you run
in your garage
d. a bond issued by the federal government or a bond issued by New
York State
ANSWER:
a. The bond of an eastern European government would pay a higher
interest rate than the bond of the U.S. government because there
would be a greater risk of default.
b. A bond that repays the principal in 2030 would pay a higher interest
rate than a bond that repays the principal in 2013 because it has a
longer term to maturity, so there is more risk to the principal.
c. A bond from a software company you run in your garage would pay
a higher interest rate than a bond from Coca-Cola because your
software company has more credit risk.

Chapter 26: P&A-4


(page: 595)

Many workers hold large amounts of stock issued by the firms at which
they work. Why do you suppose companies encourage this behavior?
Why might a person not want to hold stock in the company where he
works?
ANSWER:
Companies encourage their employees to hold stock in the company
because it gives the employees the incentive to care about the firms
profits, not just their own salary. Then, if employees see waste or see
areas in which the firm can improve, they will take actions that benefit
the company because they know the value of their stock will rise as a
result. It also gives employees an additional incentive to work hard,
knowing that if the firm does well, they will profit.
But from an employees point of view, owning stock in the company
for which she or he works can be risky. The employees wages or
salary is already tied to how well the firm performs. If the firm has
trouble, the employee could be laid off or have her or his salary
reduced. If the employee owns stock in the firm, then there is a double
whammy the employee is unemployed or gets a lower salary and the
value of the stock falls as well. So owning stock in your own company
is a very risky proposition. Most employees would be better off

Chapter 26: P&A-5


(page: 595)

Explain the difference between saving and investment as defined by a


macroeconomist. Which of the following situations represent
investment? Saving? Explain.
a. Your family takes out a mortgage and buys a new house.
b. You use your $200 paycheck to buy stock in AT&T.
c. Your roommate earns $100 and deposits it in her account at a bank.
d. You borrow $1,000 from a bank to buy a car to use in your pizza
delivery business.
ANSWER:
To a macroeconomist, saving occurs when a persons income exceeds
his consumption, while investment occurs when a person or firm
purchases new capital, such as a house or business equipment.
a. When your family takes out a mortgage and buys a new house, that
is investment because it is a purchase of new capital.
b. When you use your $200 paycheck to buy stock in AT&T, that is
saving because your income of $200 is not being spent on
consumption goods.
c. When your roommate earns $100 and deposits it in her account at a
bank, that is saving because the money is not spent on consumption

Chapter 26: P&A-6


(page: 595)
Suppose GDP is $8 trillion, taxes are $1.5 trillion,
private saving is $0.5 trillion, and public saving
is $0.2 trillion. Assuming this economy is closed,
calculate consumption, government purchases,
national saving, and investment.
ANSWER:
Given that Y = 8, T = 1.5, Sprivate = 0.5 = Y T C,
Spublic = 0.2 = T G.
Because Sprivate = Y T C, then rearranging gives C
= Y T Sprivate = 8 1.5 0.5 = 6.
Because Spublic = T G, then rearranging gives G = T
Spublic = 1.5 0.2 = 1.3.
Because S = national saving = Sprivate + Spublic = 0.5 +
0.2 = 0.7.

Chapter 26: P&A-7


(page: 595)

Economists i n Funlandia, a closed economy, have collected the following


information about the economy for a particular year:
Y = 10,000
C = 6,000
T = 1,500
G = 1,700
The economist also estimate that the investment function is:
I = 3,300 100r
Where r is the countrys real interest rate, expressed as a percentage. Calculete
private saving, public saving, national saving, investment, and the
equilibrium real interest rate.
ANSWER:
Private saving is equal to (Y C T) = 10,000 6,000 1,500 = 2,500.

Public saving is equal to (T G) = 1,500 1,700 = -200.

National saving is equal to (Y C G) = 10,000 6,000 1,700 = 2,300.

Investment is equal to saving = 2,300.

The equilibrium interest rate is found by setting investment equal to 2,300


and solving for r:
3,300 100r = 2,300.
100r = 1,000.
r = 10 percent.

Chapter 26: P&A-8


(page:
Suppose that Intel
is considering595)
building a new chipmaking

factory.
a. Assuming that Intel needs to borrow money in the bond market,
why would an increase in interest rates affect Intels decision
about whether to build the factory?
b. If Intel has enough of its own funds to finance the new factory
without borrowing, would an increase in interest rates still affect
Intels decision about whether to build the factory? Explain.
ANSWER:
a. If interest rates increase, the costs of borrowing money to build
the factory become higher, so the returns from building the new
plant may not be sufficient to cover the costs. Thus, higher
interest rates make it less likely that Intel will build the new
factory.
b. Even if Intel uses its own funds to finance the factory, the rise in
interest rates still matters. There is an opportunity cost on the use
of the funds. Instead of investing in the factory, Intel could invest
the money in the bond market to earn the higher interest rate
available there. Intel will compare its potential returns from

Chapter 26: P&A-9


(page:
595)
Suppose the government borrows $20 billion more next
year than this year.
a. Use a supply-and-demand diagram to analyze this policy.
Does the interest rate rise or fall?
b. What happens to investment? To private saving? To
public saving? To national saving? Compare the size of the
changes to the $20 billion of extra government borrowing.
c. How does the elasticity of supply of loanable funds affect
the size of these changes? (Hint: See Chapter 5 to review
the definition of elasticity.)
d. How does the elasticity of demand for loanable funds
affect the size of these changes?
e. Suppose households believe that greater government
borrowing today implies higher taxes to pay off the
government debt in the future. What does this belief do to
private saving and the supply of loanable funds today?
Does it increase or decrease the effects you discussed in

Chapter 26: P&A-9 (page: 595)continued


Figure
2

Chapter 26: P&A-9


(page: 595)

ANSWER:
a. Figure 2 illustrates the effect of the $20 billion increase in government
borrowing. Initially, the supply of loanable funds is curve S1, the equilibrium
real interest rate is i1, and the quantity of loanable funds is L1. The increase
in government borrowing by $20 billion reduces the supply of loanable
funds at each interest rate by $20 billion, so the new supply curve, S2, is
shown by a shift to the left of S1 by exactly $20 billion. As a result of the
shift, the new equilibrium real interest rate is i2. The interest rate has
increased as a result of the increase in government borrowing.
b. Because the interest rate has increased, investment and national saving
decline and private saving increases. The increase in government
borrowing reduces public saving. From the figure you can see that total
loanable funds (and thus both investment and national saving) decline by
less than $20 billion, while public saving declines by $20 billion and private
saving rises by less than $20 billion.
c. The more elastic is the supply of loanable funds, the flatter the supply
curve would be, so the interest rate would rise by less and thus national
saving would fall by less, as Figure 3 shows.

Chapter 26: P&A-9 (page: 595)continued


Figure
3

Figure
4

Chapter 26: P&A-9


(page: 595)

ANSWER:
d. The more elastic the demand for loanable funds, the
flatter the demand curve would be, so the interest rate
would rise by less and thus national saving would fall by
more, as Figure 4 shows.
e. If households believe that greater government borrowing
today implies higher taxes to pay off the government debt
in the future, then people will save more so they can pay
the higher future taxes. Thus, private saving will increase,
as will the supply of loanable funds. This will offset the
reduction in public saving, thus reducing the amount by
which the equilibrium quantity of investment and national
saving decline, and reducing the amount that the interest
rate rises.
If the rise in private saving was exactly equal to the
increase in government borrowing, there would be no shift
in the national saving curve, so investment, national saving,

Chapter 26: P&A-10


(page: 595)

Some economists worry that the aging populations of industrial countries


are going to start running down their savings just when the investment
appetite of emerging economies is growing (Economist, May 6, 1995).
Illustrate the effect of these phenomena on the world market for loanable
funds.
ANSWER:
If world savings declines at the same time world investment rises, the
supply curve of loanable funds shifts to the left and the demand curve
shifts to the right. Figure 6 illustrates the result. The world interest rate will
rise, while the overall effect on the equilibrium quantity of loanable funds is
ambiguous it depends on the relative sizes of the shifts of the two curves
and on their elasticities.

Chapter 26: P&A-11


(page: 595)

This chapter explains that investment can be increased both by reducing


taxes on private saving and by reducing the government budget deficit.
a. Why is it difficult to implement both of these policies at the same time?
b. What would you need to know about private saving in order to judge
which of these two policies would be a more effective way to raise
investment?
ANSWER:
a. Investment can be increased by reducing taxes on private saving or by
reducing the government budget deficit. But reducing taxes on private
saving has the effect of increasing the government budget deficit, unless
some other taxes are increased or government spending is reduced. So it is
difficult to engage in both policies at the same time.
b. To know which of these policies would be a more effective way to raise
investment, you would need to know: (1) what the elasticity of private
saving is with respect to the after-tax real interest rate, because that would
determine how much private saving would increase if you reduced taxes on
saving; (2) how private saving responds to changes in the government
budget deficit, because, for example, if Ricardian equivalence holds, the
decline in the government budget deficit would be matched by an equal
decline in private saving, so national saving would not increase at all; and
(3) how elastic investment is with respect to the interest rate, because if

to be continued