CHAPTER 6

1. Answer the following questions using the information provided in this chapter.

a. As a percentage of the employed workers, what is the size of the flows into and out of
employment (i.e., hires and separations) each month?
b. As a percentage of the unemployed workers, what is the size of the flows from
unemployment into employment each month?
c. As a percentage of the unemployed, what is the size of the total flows out of
unemployment each month? What is the average duration of unemployment?
d. As a percentage of the labor force, what is the size of the total flows into and out of the
labor force each month?
e. In the text we say that there is an average of 400,000 new workers entering the labor
force each month. What percentage of total flows into the labor force do new workers
entering the labor force constitute?

Answer:

a. (Monthly hires + monthly separations)/monthly employment=(5.4+5.4)/132.4=8.1%

b. 2.1/8.4=25%
c. (2.1+1.9)/8.4=47.6%. Duration is 1/0.476 or 2.1 months.
d. (3.6+3.3+1.9+1.8)/(132.4+8.4)=7.5%.
e. new workers: 0.4/(3.3+1.8)=7.8%.

4. The informal labor market

You learned in Chapter 2 that informal work at home (e.g., preparing meals, taking care
of children) is not counted as part of GDP. Such work also does not constitute
employment in labor-market statistics. With these observations in mind, consider two
economies, each with 100 people, divided into 25 households, each composed of four
people. In each household, one person stays at home and prepares the food, two people
work in the nonfood sector, and one person is unemployed. Assume that the workers
outside food preparation produce the same actual and measured output in both
economies.

In the first economy, EatIn, the 25 food-preparation workers (one per household) cook
for their families and do not work outside the home. All meals are prepared and eaten at
home. The 25 food-preparation workers in this economy do not seek work in the formal
labor market (and when asked, they say they are not looking for work). In the second
economy, EatOut, the 25 food-preparation workers are employed by restaurants. All
meals are purchased in restaurants.
 a. Calculate measured employment and unemployment and the measured labor force for
each economy. Calculate the measured unemployment rate and participation rate for each
economy. In which economy is measured GDP higher?

b. Suppose now that EatIn’s economy changes. A few restaurants open, and the food
preparation workers in 10 house-holds take jobs restaurants. The members of these 10
households now eat all of their meals in restaurants. The food-preparation workers in the
remaining 15 households continue to work at home and do not seek jobs in the for-mal
sector. The members of these 15 households continue to eat all of their meals at home.
Without calculating the numbers, what will happen to measured employment and
unemployment and to the measured labor force, unemployment rate, and participation
rate in EatIn? What will happen to measured GDP in EatIn?

c. Suppose that you want to include work at home in GDP and the employment statistics.
How would you measure the value of work at home in GDP? How would you alter the
definitions of employment, unemployment, and out of the labor force?

d. Given your new definitions in part (c), would the labor-market statistics differ for EatIn
and EatOut? Assuming that the food produced by these economies has the same value,
would measured GDP in these economies differ? Under your new definitions, would the
experiment in part (b) have any effect on the labor market or GDP statistics for EatIn?

Answer:

a. EatIn EatOut
Population 100 Population 100
Labor Force 75 Labor Force 100
Employment 50 Employment 75
Unemployment 25 Unemployment 25
Unemployment Rate 33% Unemployment Rate 25%
Participation Rate 75% Participation Rate 100%

b. The measured labor force and participation rate rise. Measured employment
rises. Measured unemployment does not change, but the measured
unemployment rate falls. Measured GDP rises.

c. To adjust the labor market statistics, you would have to estimate the number of
workers informally employed at home and add them to the measured employed. To the
extent that workers employed informally at home were measured as unemployed, you
would have to reduce measured unemployment accordingly. To the extent that workers
employed informally at home were considered out of the labor force, counting these
workers as employed would increase the size of the labor force.

d. To adjust the GDP statistics, you would have to estimate the value-added of final goods
produced at home. You could make comparisons to similar goods produced outside the
home or make comparisons to workers involved in similar industries outside the home,
estimate the relevant wage and hours worked, and calculate value-added as the cost of
 labor, as is done for government services. In either case, you need to calculate value-
added, since intermediate goods—groceries, cleaning supplies, child care supplies, and so
on—involved in the production of at-home goods are already counted in GDP as final
goods in the formal sector.

CHAPTER 7

1. The neutrality of money

a. In what sense is money neutral? How is monetary policy useful if money is neutral?

b. Fiscal policy, like monetary policy, cannot change the natural level of output. Why then
is monetary policy considered neutral but fiscal policy is not?

c. Discuss the statement “Because neither fiscal nor monetary policy can affect the natural
level of output, it follows that, in the medium run, the natural level of output is in-
dependent of all government policies.”

Answer:

a. Money is neutral in the sense that the nominal money supply has no effect on output or
the interest rate in the medium run. Output returns to its natural level. The interest rate is
determined by the position of the IS curve and the natural level of output. Despite the
neutrality of money in the medium run, an increase in the money supply will increase
output and reduce the interest rate in the short run. Therefore, expansionary monetary
policy can be used to speed up the economy's return to the natural level of output when
output is low.
b. In the medium run, fiscal policy affects the interest rate and investment, so fiscal policy is
not considered neutral.
c. False. Labor market policies, such as the degree of unemployment insurance, can affect
the natural level of output.

2. Aggregate supply shocks and the medium run

Consider an economy with output equal to the natural level of output. Now suppose there
is an increase in unemployment benefits.

a. Using the model developed in this chapter, show the effects of an increase in
unemployment benefits on the position of the AD and AS curves in the short run and in
the medium run.

b. How will the increase in unemployment benefits affect output and the price level in the
short run and in the medium run?
Answer:

a. SR: short run WS: wage-setting curve

MR: medium run PS: price-setting curve

WS PS AS AD IS LM
SR up no up no no up
change change change
MR same no up no no up
as SR change further change change further

b.

Y i P
SR falls rises rises
MR falls rises rises
further further further

4. Aggregate demand shocks and the medium run

Suppose the economy begins with output equal to its natural level. Then, there is a
reduction in income taxes.

a. Using the AS–AD model developed in this chapter, show the effects of a reduction in
income taxes on the position of the AD, AS, IS, and LM curves in the medium run.

b. What happens to output, the interest rate, and the price level in the medium run? What
happens to consumption and investment in the medium run?

Answer:

a. IS shifts right, and LM shifts up. AD shifts right, and AS shifts up.

b. Y returns to its unchanged natural level. The interest rate and the price level increase.
Consumption rises: with taxes falling and income returning to its unchanged natural
level, after tax income rises and so does consumption. Investment falls since the interest
rates rises and the level of income, the other determinant of investment is unchanged.
5. The paradox of saving, one more time
In chapter problems at the end of Chapters 3 and 5, we examined the paradox of saving
in the short run, under different assumptions about the response of investment to output
and the interest rate. Here we consider the issue one last time in the context of the AS–
AD model.

Suppose the economy begins with output equal to its natural level. Then there is a
decrease in consumer confidence as households attempt to increase their saving for a
given level of disposable income.

a. In AS–AD and IS–LM diagrams, show the effects of the decline in consumer confidence
in the short run and the medium run. Explain why the curves shift in your diagrams.

b. What happens to output, the interest rate, and the price level in the short run? What
happens to consumption, investment, and private saving in the short run? Is it possible
that the decline in consumer confidence will actually lead to a fall in private saving in the
short run?

c. Repeat part (b) for the medium run. Is there any paradox of saving in the medium run?

Answer:

a. SR: short run

MR: medium run

IS LM AD AS
SR left down left no
change
MR same down same down
as SR further as SR
b-c.

Y i P
SR falls falls falls
MR back to falls falls
original Yn further further

C I Private S
SR falls ambiguous ambiguous
MR Increases rises (above rises (above
from SR original original
but still level) level)
lower than
original
level

In the medium run, consumption must lower than its original level because disposable
income is unchanged, but consumer confidence is lower.

The short-run change in investment is ambiguous, because the interest rate falls, which
tends to increase investment, but output also falls, which tends to reduce investment. In
the medium run, investment must rise (as compared to its short-run and original levels),
because the interest rate falls but output returns to its original level.

Since the budget deficit does not change in this problem, the change in private saving
equals the change in investment. It is possible that private saving will fall in the short run,
but private saving must rise (above its short-run and original levels) in the medium run.
CHAPTER 10

1.Assume that the average consumer in Mexico and the average consumer in the United States buy the
quantities and pay the prices indicated in the following table:

Food Transportation Services

Price Quantity Price Quantity
Mexico 5 pesos 400 20 pesos 200
United States $1 1,000 $2 2,000

a) Compute U.S. consumption per capita in dollars.

b) Compute Mexican consumption per capita in pesos.
c) Suppose that 1 dollar is worth 10 pesos. Compute Mexico’s consumption per capita in dollars.
d) Using the purchasing power parity method and U.S. prices, compute Mexican consumption
per capita in dollars.
e) Under each method, how much lower is the standard of living in Mexico than in the United
States? Does the choice of method make a difference?
Answer

1. a. U.S. consumption per person = $1(1000) + $2(2,000)=$5000

b. Mexican consumption per person=5(400) pesos + 2(2000) pesos = 6000 pesos
c. From the U.S. point of view, the exchange rate (E)=10 pesos/$.
Mexican consumption per person in dollars = 6000 pesos/E=$600
d. Mexican consumption per person ($PPP)=$1(400)+$2(200)=$800
e. Mexican standard of living relative to the United States
Exchange rate method: 600/5000 =0.1
PPP method: 800/5000=0.16

CHAPTER 11
4.Suppose that the production function is given by
! = 0.5√'√(
a) Derive the steady-state levels of output per worker and capital per worker in terms of the
saving rate, s, and the depreciation rate, d.
b) Derive the equation for steady-state output per worker and steady-state consumption per
worker in terms of s and d.
 c) Suppose that d = 0.05. With your favorite spreadsheet software, compute steady-state output
per worker and steady-state consumption per worker for s = 0; s = 0.1; s = 0.2;… ; s = 1.
Explain the intuition behind your results.
d) Use your favorite spreadsheet software to graph the steady-state level of output per worker and
the steady-state level of consumption per worker as a function of the saving rate (i.e., measure
the saving rate on the horizontal axis of your graph and the corresponding values of output per
worker and consumption per worker on the vertical axis).
e) Does the graph show that there is a value of s that maximizes output per worker? Does the
graph show that there is a value of s that maximizes consumption per worker? If so, what is
this value?
Answer

4. a. K/N=[s/(2d)]2; Y/N=s/(4d)

b. C/N=(1-s)Y/N=s(1-s) / (4d)

c-e. Y/N increases with s. C/N increases until s=0.5, then decreases.
(Please also refer to the attached excel file.)

8.Deficits and the capital stock

For the production function, ! = √'√( equation (11.8) gives the solution for the steady-state
capital stock per worker.
a) Retrace the steps in the text that derive equation (11.8).
b) Suppose that the saving rate, s, is initially 15% per year, and the depreciation rate, d, is 7.5%.
What is the steady-state capital stock per worker? What is steady-state output per worker?
c) Suppose that there is a government deficit of 5% of GDP and that the government eliminates
this deficit. Assume that private saving is unchanged so that total saving increases to 20%.
What is the new steady-state capital stock per worker? What is the new steady-state output per
worker? How does this compare to your answer to part (b)?
Answer

8. b. K/N = (0.15/.075)2 = 4
Y/N= (4)1/2=2

c. K/N=(0.2/0.075)2 =7.11
Y/N=(7.11)1/2=2.67
Capital per worker and output per worker increase.