1. The opportunity cost of going on the training course is €9,600 of goods and services.

The opportunity cost of going on the training course this summer is the highest-valued activity that you will give up so that you can go to summer school. In going on the training course, you will forgo all the goods and services that you could have Billught with the income from your summer job (€6,000) plus the expenditure on tuition (€2,000), textBilloks (€200), and living expenses (€1,400).

3. No, parking at this mall is not free. Yes, you did impose a cost on

Harry. Finding a parking space takes aBillut 30 minutes, so you incur an opportunity cost when you park your car. The opportunity cost is the highest-valued activity that you forgo by spending 30 minutes parking your car. If you would have spent those 30 minutes studying, then the opportunity cost of parking at this mall is 30 minutes of studying.

The cost that you imposed on Harry is the additional 30 minutes that Harry will

have to spend searching for a parking space.

1a. Peter's opportunity cost of an hour of tennis is 2.5 percentage points. When Peter increases the time he plays tennis from 4 hours to 6 hours, his grade in economics falls from 75 percent to 70 percent. His opportunity cost of 2 hours of tennis is 5 percentage points. So his opportunity cost of 1 hour of tennis is 2.5 percentage points.

1b. Peter's opportunity cost is 10 percentage points. When Peter increases the time he plays tennis from 6 hours to 8 hours, his grade in economics falls from 70 percent to 60 percent. His opportunity cost of 2 hours is 10 percentage points. So his opportunity cost of 1 hour is 5 percentage points.

3. Peter's opportunity cost of playing tennis increases as he spends more time on tennis. When Peter increases the time he plays tennis from 4 hours to 6 hours, his opportunity cost is 5 percentage points. But when he increases the time he plays tennis from 6 hours to 8 hours, his opportunity cost is 10 percentage points. Peter’s opportunity cost of playing tennis increases as he spends more time on tennis.

5a. Peter's grade in economics is 66 percent. When Peter increases the time he plays tennis from 4 hours to 6 hours, his opportunity cost of the additional 2 hours of tennis is 5 percentage points. So his opportunity cost of an additional 1 hour is 2.5 percentage points. But when he increases the time he plays tennis from 6 hours to 8 hours, his opportunity cost of the additional 2 hours of tennis is 10 percentage points. So his opportunity cost of the additional 1 hour of tennis is 5 percentage points.

Peter's opportunity cost of playing tennis increases as he spends more time on tennis. Opportunity cost is plotted at the midpoint of the range. This curve is Peter's marginal cost of a additional hour of tennis.

Peter uses his time efficiently if he plays tennis for 7 hours a week—marginal benefit from tennis equals its marginal cost. Peter's marginal benefit is 5 percentage points and his marginal cost is 5 percentage points. When Peter plays 7 hours of tennis, his grade in economics (from his PPF) is 66 percent.

5b. If Peter studied for enough hours to get a higher grade, he would have fewer hours to play tennis. Peter's marginal benefit from tennis would be greater than his marginal cost, so he would be more efficient if he played more hours of tennis and took a lower grade.

7a. Leisureland's PPF is a straight line.

To make a graph of Leisureland's PPF measure the quantity of one good on the x-axis and the quantity of the other good on the y-axis. Then plot the quantities in each row of the table and join up the points.

7b. The opportunity cost of 1 kilogram of food is 1/2 litre of sunscreen.

The opportunity cost of the first 100 kilograms of food is 50 litres of sunscreen. To find the opportunity cost of the first 100 kilograms of food, increase the quantity of food from 0 kilograms to 100 kilograms. In doing so,

Leisureland's production of sunscreen decreases from 150 litres to 100 litres. The opportunity cost of the first 100 kilograms of food is 50 litres of sunscreen. Similarly, the opportunity costs of producing the second 100 kilograms and the third 100 kilograms of food are 50 litres of sunscreen.

The opportunity cost of 1 litre of sunscreen is 2 kilograms of food. The opportunity cost of producing the first 50 litres of sunscreen is 100 kilograms of food. To calculate this opportunity cost, increase the quantity of sunscreen from 0 litres to 50 litres.

Leisureland's production of food decreases from 300 kilograms to 200 kilograms. Similarly, the opportunity cost of producing the second 50 litres and the third 50 litres of sunscreen are 100 kilograms of food.

9a. The marginal benefit curve slopes downward.

To draw the marginal benefit from sunscreen, plot the quantity of sunscreen on the x-axis and the willingness to pay for sunscreen (that is, the number of kilograms of food that they are willing to give up to get a litre of sunscreen) on the y-axis.

9b. The efficient quantity is 75 litres a month.

The efficient quantity to produce is such that the marginal benefit from the last litre equals the opportunity cost of producing it. The opportunity cost of a litre of sunscreen is 2 kilograms of sunscreen. The marginal benefit of the 75th litre of sunscreen is 2 kilograms of food. And the marginal cost of the 75th litre of sunscreen is 2 kilograms of food.

11. Busyland's opportunity cost of a kilogram of food is 2 litres of sunscreen, and its opportunity cost of a litre of sunscreen is 1/2 kilogram of food.

When Busyland increases the food it produces by 50 kilograms a month, it produces 100 litres of sunscreen less. The opportunity cost of 1 kilogram of food is 2 litres of sunscreen. Similarly, when Busyland increases the sunscreen it produces by 100 litres a month, it produces 50 kilograms of food less. The opportunity cost of 1 litre of sunscreen is 1/2 kilogram of food.

13a.Leisureland sells food and buys sunscreen.

Leisureland sells the good in which it has a comparative advantage and buys the other good from Busyland. Leisureland’s opportunity cost of 1 kilogram of food is 1/2 litre of sunscreen, while Busyland’s opportunity cost of 1 kilogram of food is 2 litres of sunscreen. Leisureland’s opportunity cost of food is less than Busyland’s, so Leisureland has a comparative advantage in producing food.

Leisureland’s opportunity cost of 1 litre of sunscreen is 2 kilograms of food, while Busyland’s opportunity cost of 1 litre of sunscreen is 1/2 kilogram of food. Busyland’s opportunity cost of sunscreen is less than Leisureland’s, so Busyland has a comparative advantage in producing sunscreen.

13b.The gains from trade for each country are 50 kilograms of food and 50 litres of sunscreen.

With specialization and trade, together they can produce 300 kilograms of food and 300 litres of sunscreen. So each will get 150 kilograms of food and 150 litres of sunscreen—an additional 50 kilograms of food and 50 litres of sunscreen.

1a. The price of a tape will rise, and the quantity of tapes sold will increase. CDs and tapes are substitutes. If the price of a CD rises, people will buy more tapes and fewer CDs. The demand for tapes will increase. The price of a tape will rise, and more tapes will be sold.

1b. The price of a tape will fall, and fewer tapes will be sold. Walkmans and tapes are complements. If the price of a Walkman rises, fewer Walkmans will be Billught. The demand for tapes will decrease. The price of a tape will fall, and people will buy fewer tapes.

1c. The price of a tape will fall and fewer tapes will be sold.

The increase in the supply of CD players will lower the price of a CD player. With CD players cheaper than they were, some people will buy CD players. The demand for CDs will increase, and the demand for tapes will decrease. The price of a tape will fall, and people will buy fewer tapes.

1d. The price of a tape will rise, and the quantity sold will increase.

1e. The price of a tape will rise, and the quantity sold will decrease.

If the workers who make tapes get a pay raise, the cost of making a tape increases and the supply of tapes decreases. The price will rise, and people will buy fewer tapes.

1f. The quantity sold will decrease, but the price might rise, fall, or stay the same.

Walkmans and tapes are complements. If the price of a Walkman rises, fewer Walkmans will be Billught and so the demand for tapes will decrease. The price of a tape will fall, and people will buy fewer tapes.

If the wages paid to workers who make tapes rise, the supply of tapes decreases. The quantity of tapes sold will decrease, and the price of a tape will rise. Taking the two events together, the quantity sold will decrease, but the price might rise, fall, or stay the same.

3a. (ii), (iii), and (iv)

The demand for petrol will change if the price of a car changes, all speed limits on highways are aBilllished, or roBillt production cuts the cost of producing a car. If the price of a car rises, the quantity of cars Billught decrease. So the demand for petrol decreases. If all speed limits on highways are aBilllished, people will drive faster and use more petrol. The demand for petrol increases. If roBillt production plants lower the cost of producing a car, the supply of cars will increase. With no change in the demand for cars, the price of a car will fall and more cars will be Billught. The demand for petrol increases.

3b. (i)

The supply of petrol will change if the price of crude oil changes. If the price of crude oil rises, the cost of producing petrol will rise. So the supply of petrol decreases.

3c. (i)

If the price of crude oil (a resource used to make petrol) rises, the cost of producing petrol will rise. So the supply of petrol decreases. The demand for petrol does not change, so the price of petrol will rise and there is a movement up the demand curve for petrol. The quantity demanded of petrol decreases.

3d. (ii), (iii), and (iv)

If the price of a car rises, the quantity of cars Billught decrease. So the demand for petrol decreases. The supply of petrol does not change, so the price of petrol falls and there is a movement down the supply curve of petrol. The quantity supplied of petrol decreases.

If all speed limits on highways are aBilllished, people will drive faster and use more petrol. The demand for petrol increases. The supply of petrol does not change, so the price of petrol rises and there is a movement up along the supply curve. The quantity supplied of petrol increases.

If roBillt production plants lower the cost of producing a car, the supply of cars will increase. With no change in the demand for cars, the price of a car will fall and more cars will be Billught. The demand for petrol increases. The supply of petrol does not change, so the price of petrol rises and the quantity of petrol supplied increases.

5a. The demand curve is the curve that slopes down toward to the right. The supply curve is the curve that slopes up toward to the right.

5b. The equilibrium price is €14 a pizza, and the equilibrium quantity is 200 pizzas a day.

Market equilibrium is determined at the intersection of the demand curve and supply curve.

7a. The equilibrium price is 50 pence a pack, and the equilibrium quantity is 120 million packs a week.

The price of a pack adjusts until the quantity demanded equals the quantity supplied. At 50 pence a pack, the quantity demanded is 120 million packs a week and the quantity supplied is 120 million packs a week.

7b. At 70 pence a pack, there will be a surplus of gum and the price will fall.

At 70 pence a pack, the quantity demanded is 80 million packs a week and the quantity supplied is 160 million pack a week. There is a surplus of 80 million packs a week. The price will fall until market equilibrium is restored—50 pence a pack.

9. The supply curve has shifted leftward.

As the number of gum-producing factories decreases, the supply of gum decreases. There is a new supply schedule, and the supply curve shifts leftward.

9b. There has been a movement along the demand curve.

The supply of gum decreases, and the supply curve shifts leftward. Demand does not change, so the price rises along the demand curve.

9c. The equilibrium price is 60 pence, and the equilibrium quantity is 100 million packs a week.

Supply decreases by 40 millions packs a week. That is, the quantity supplied at each price decreases by 40 million packs. The quantity supplied at 50 pence is now 80 million packs, and there is a shortage of gum. The price rises to 60 pence a pack, at which the quantity supplied equals the quantity demanded (100 million packs a week).

11. The new price is 70 pence a pack, and the quantity is 120 million packs a week.

The demand for gum increases, and the demand curve shifts rightward. The quantity demanded at each price increases by 40 million packs. The result of the fire is a price of 60 pence a pack. At this price, there is now a shortage of gum. The price of gum will rise until the shortage is eliminated.

1a. The price elasticity of demand is 1.25.

The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The price rises from €4 to €6 a Billx, a rise of €2 a Billx. The average price is €5 a Billx. So the percentage change in the price equals €2 divided by €5, which equals 40 percent.

The quantity decreases from 1,000 to 600 Billxes, a decrease of 400 Billxes. The average quantity is 800 Billxes. So the percentage change in quantity equals 400 divided by 800, which equals 50 percent.

The price elasticity of demand for strawberries equals 50 divided by 40, which is 1.25.

1b. The price elasticity of demand for Spanish strawberries exceeds 1, so the demand for strawberries is elastic.

3a. The price elasticity of demand is 2.

When the price of a videotape rental rises from €3 to €5, the quantity demanded of videotapes decreases from 75 to 25 a day. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price.

The price increases from €3 to €5, an increase of €2 a videotape. The average price is €4 a videotape. So the percentage change in the price equals €2 divided by €4, which equals 50 percent.

The price elasticity of demand for videotape rentals equals 100 divided by 50, which is 2.

3b. The price elasticity of demand for videotape rentals in Germany equals 1 at €3 a videotape. The price elasticity of demand equals infinity at €6 a videotape. The price elasticity of demand equals zero at €0 a videotape.

The price elasticity of demand equals 1 at the price halfway between the origin and the price at which the demand curve hits the y-axis. That price is €3 a videotape.

The price elasticity of demand equals infinity at the price at which the demand curve hits the y-axis. That price is €6 a videotape.

The price elasticity of demand equals zero at the price at which the demand curve hits the x-axis. That price is €0 a videotape.

5. The demand for dental services is unit elastic.

The price elasticity of demand for dental services equals the percentage change in the quantity of dental services demanded divided by the percentage change in the price of dental services.

The price elasticity of demand equals 10 divide by 10, which is 1. The demand is unit elastic.

7a. Total revenue increases.

When the price of a chip is €400, 30 million chips are sold and total revenue equals €12,000 million. When the price of a chip falls to €350, 35 million chips are sold and total revenue is €12,250 million. Total revenue increases when the price falls.

7b. The question for 7b should read "What will happen to total revenue if the price of a chip falls from €350 to €300"?

Total revenue decreases. When the price is €350 a chip, 35 million chips are sold and total revenue is €12,250 million. When the price of a chip is €300, 40 million chips are sold and total revenue decreases to €12,000 million. Total revenue decreases as the price falls.

7c. Total revenue is maximized at €350 a chip.

When the price of a chip is €300, 40 million chips are sold and total revenue equals €12,000 million. When the price is €350 a chip, 35 million chips are sold and total revenue equals €12,250 million.

Total revenue increases as the price rises from €300 to €350 a chip. When the price is €400 a chip, 30 million chips are sold and total revenue equals €12,000 million. Total revenue decreases as the price rises from €350 to €400 a chip. Total revenue is maximized when the price is €350 a chip.

7d. The quantity will be 35 million chips a year.

The demand schedule tells us that when the price is €350 a chip, the quantity of chips demanded is 35 million chips a year.

7e. The demand for chips is unit elastic.

The total revenue test says that if the price changes and total revenue remains the same, the demand is unit elastic at the average price. For an average price of €350 a chip, cut the price from €400 to €300 a chip. When the price of a chip falls from €400 to €300, total revenue remains at €12,000 million. So at the average price of €350 a chip, demand is unit elastic.

9. The demand for chips is inelastic.

The total revenue test says that if the price falls and total revenue falls, the demand is inelastic. When the price falls from €300 to €200 a chip, total revenue decreases from €12,000 million to €10,000 million. So at an average price of €250 a chip, demand is inelastic.

11. The cross elasticity of demand between orange juice and apple juice is 1.17.

The cross elasticity of demand is the percentage change in the quantity demanded of one good divided by the percentage change in the price of another good. The rise in the price of orange juice resulted in an increase in the quantity demanded of apple juice.

So the cross elasticity of demand is the percentage change in the quantity demanded of apple juice divided by the percentage change in the price of orange juice. The cross elasticity equals 14 divided by 12, which is 1.17.

13. Income elasticity of demand for (i) bagels is 1.33 and (ii) bread rolls is -1.33.

Income elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in income. The change in income is €2,000 and the average income is €4,000, so the percentage change in income equals 50 percent.

(i) The change in the quantity demanded is 4 bagels and the average quantity demanded is 6 bagels, so the percentage change in the quantity demanded equals 66.67 percent. The income elasticity of demand for bagels equals 66.67/50, which is 1.33.

(ii) The change in the quantity demanded is -6 bread rolls and the average quantity demanded is 9 bread rolls, so the percentage change in the quantity demanded is -66.67. The income elasticity of demand for bread rolls equals -66.67/50, which is -1.33.

15a.The elasticity of supply is 1.

The elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in the price. When the price falls from 40 cents to 30 cents, the change in the price is 10 cents and the average price is 35 cents. The percentage change in the price is 28.57.

When the price falls from 40 cents to 30 cents, the quantity supplied decreases from 800 to 600 calls. The change in the quantity supplied is 200 calls, and the average quantity is 700 calls, so the percentage change in the quantity supplied is 28.57.

The elasticity of supply equals 28.57/28.57, which equals 1.

15b.The elasticity of supply is 1.

The formula for the elasticity of supply calculates the elasticity at the average price. So to find the elasticity at 20 cents, change the price such that 20 cents is the average price—for example, a fall in the price from 30 cents to 10 cents.

When the price falls from 30 cents to 10 cents, the change in the price is 20 cents and the average price is 20 cents. The percentage change in the price is 100. When the price falls from 30 cents to 10 cents, the quantity supplied decreases from 600 to 200 calls. The change in the quantity supplied is 400 calls and the average quantity is 400 calls. The percentage change in the quantity supplied is 100.

The elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in the price. The elasticity of supply is 1.

1a. Equilibrium price is €1.00 a floppy disk, and the equilibrium quantity is 3 floppy disks a month.

1b. Consumer surplus is €2.25.

The consumer surplus is the area of the triangle under the demand curve aBillve the price. The price is €1.00 a disk. The area of the triangle equals (2.50 - 1.00)/2 multiplied by 3, which is €2.25.

1c. Producer surplus is €0.75.

The producer surplus is the area of the triangle aBillve the supply curve below the price. The price is €1.00 a disk. The area of the triangle equals (1.00 - 0.50)/2 multiplied by 3, which is €0.75.

1d. The efficient quantity is 3 floppy disks a month.

The efficient quantity is the quantity that makes the marginal benefit from the last disk equal to the marginal cost of producing the last disk. The demand curve shows the marginal benefit and the supply curve shows the marginal cost. Only if 3 floppy disks are produced is the quantity produced efficient.

3a. The maximum price that consumers will pay is £3.

The demand schedule shows the maximum price that consumers will pay for each sandwich. The maximum price that consumers will pay for the 250th sandwich is £3.

3b. The minimum price that producers will accept is £5.

The supply schedule shows the minimum price that producers will accept for each sandwich. The minimum price that produces will accept for the 250th sandwich is £5.

3c. 250 sandwiches exceeds the efficient quantity.

The efficient quantity is such that marginal benefit from the last sandwich equals the marginal cost of producing it. The efficient quantity is the equilibrium quantity—200 sandwiches an hour.

3d. Consumer surplus is £400.

The equilibrium price is £4. The consumer surplus is the area of the triangle under the demand curve aBillve the price. The area of the triangle is (8 - 4)/2 multiplied by 200, which is £400.

3e. Producer surplus is £400.

The producer surplus is the area of the triangle aBillve the supply curve below the price. The price is £4. The area of the triangle is (4 - 0)/2 multiplied by 200, which is £400.

3f. The deadweight loss is £50.

Deadweight loss is the sum of the consumer surplus and producer surplus that is lost because the quantity produced is not the efficient quantity. The deadweight loss equals the quantity (250 - 200) multiplied by (5 - 3)/2, which is £50.

5a. Ben's consumer surplus is £122.50. Beth's consumer surplus is £22.50, and Bill's consumer surplus is £4.50.

Consumer surplus is the area under the demand curve above the price. At 40 pence, Ben will travel 350 kilometres, Beth will travel 150 kilometres, and Bill will travel 30 kilometres. To find Ben's consumer surplus extend his demand schedule until you find the price at which the quantity demanded by Ben is zero—the price at which Ben's demand curve cuts the y-axis. This price is 110 pence. So Ben's consumer surplus equals (110 - 40)/2 multiplied by 350, which equals £122.50. Similarly, Beth's consumer surplus equals (70 - 40)/2 multiplied by 150, which equals £22.50. And Bill's consumer surplus equals (70 - 40)/2 multiplied by 30, which equals £4.50.

5b. Ben's consumer surplus is the largest because he places a higher value on each unit of the good than the other two do.

5c. Ben's consumer surplus falls by £2.50. Beth's consumer surplus falls by £2.50, and Bill's consumer surplus falls by £.50.

At 50 pence a kilometre, Ben travels 300 kilometres and his consumer surplus is £90. Ben's consumer surplus equals (110 - 50)/2 multiplied by 300, which equals £90. Ben's consumer surplus decreases from £122.50.to £90, a decrease of £32.50.

Beth travels 100 kilometres and her consumer surplus is £10, a decrease of £12.50. Bill travels 20 kilometres and her consumer surplus is £2.00, a decrease of £2.50.

1a. Equilibrium price is €200 a month and the equilibrium quantity is 10,000 housing units.

1b. The quantity rented is 5,000 housing units. The quantity of housing rented is equal to the quantity supplied at the rent

1c. The shortage of housing is 10,000 housing units. At the rent ceiling, the quantity of housing demanded is 15,000 but the quantity supplied is 5,000, so there is a shortage of 10,000 housing units.

1d. The maximum price that someone is willing to pay for the 5,000th unit available is €300 a month. The demand curve tells us the maximum price that someone is willing to pay for the 5,000th unit.

3a. The equilibrium wage rate is £4 an hour, and employment is 2,000 hours a month.

3b. Unemployment is zero. Everyone who wants to work for £4 an hour is employed.

3c. They work 2,000 hours a month. A minimum wage rate is the lowest wage rate that a person can be paid for an hour of work. Because the equilibrium wage rate exceeds the minimum wage rate, the minimum wage is ineffective. The wage rate will be £4 an hour and employment is 2,000 hours.

3d. There is no unemployment

The wage rate rises to the equilibrium wage—the quantity of labour demanded equals the quantity of labour supplied. So there is no unemployment.

3e. At £5 an hour, 1,500 hours a month are employed and 1,000 hours a month are unemployed.

The quantity of labour employed equals the quantity demanded at £5 an hour. Unemployment is equal to the quantity of labour supplied at £5 an hour minus the quantity of labour demanded at £5 an hour. The quantity supplied is 2,500 hours a month, and the quantity demanded is 1,500 hours a month. So 1,000 hours a month are unemployed.

3f. The wage rate is £5 an hour, and unemployment is 500 hours a month. At the minimum wage of £5 an hour, the quantity demanded is 2,000 hours a month and the quantity supplied is 2,500 hours a month. So 500 hours a month are unemployed.

5a. With no tax on chocolate brownies in the UK, the price is 60 pence a brownie and 4 million a day are consumed.

5b. The price is 70 pence a brownie, and 3 million brownies a day are consumed. Consumers and producers each pay 10 pence of the tax on a brownie.

The tax decreases the supply of brownies and raises the price of a brownie. With no tax, producers are willing to sell 3 million brownies a day at 50 pence a brownie. But with a 20 pence tax, they are willing to sell 3 million brownies a day only if the price is 20 pence higher at 70 cents a brownie.

1a. To draw a graph of Jason's total utility from rock CDs, plot the number of CDs on the x-axis and Jason's utility from CDs on the y-axis. The curve will look similar to Fig. 7.2(a). To draw a graph of Jason's total utility from spy novels, repeat the above procedure but use the spy novel data.

1b. Jason gets more utility from any number of rock CDs than he does from the same number of spy novels.

1c. To draw a graph of Jason's marginal utility from rock CDs plot the number of CDs on the x-axis and Jason's marginal utility from CDs on the y-axis. The curve will look similar to Fig. 8.2(b). To draw a graph of Jason's marginal utility from spy novels, repeat the above procedure but use the spy novel data. Jason's marginal utility from rock CDs is the increase in total utility he gets from one additional rock CD. Similarly, Jason's marginal utility from spy novels is the increase in total utility he gets from one additional spy novel.

1d. Jason gets more marginal utility from an additional rock CD than he gets from an additional spy novel when he has the same number of each.

3a. To draw a graph of Max's budget line, plot the hours spent on one activity (say, windsurfing) on the x-axis and the hours spent on the other activity of the y-axis. The budget line is a straight line running from 3.5 hours of windsurfing on the x-axis to 7 hours of snorkeling on the y-axis. If Max spends all of his €35 on windsurfing, he can rent the windsurfing equipment for €35/€10 an hour, which is 3.5 hours. If Max spends all of his €35 on snorkeling, he can rent the snorkeling equipment for €35/€5 an hour, which is 7 hours.

3b. To maximize his utility, Max windsurfs for 3 hours and snorkels for 1 hour. Max will spend his €35 such that all of the €35 is spent and that the marginal utility per euro spent on each activity is the same. When Max windsurfs for 3 hours and snorkels for 1 hour, he spends €30 renting the windsurfing equipment and €5 renting the snorkeling equipment—a total of €35. The marginal utility from the third hour of windsurfing is 80 and the rent of the windsurfing equipment is €10 an hour, so the marginal utility per euro spent on windsurfing is 8. The marginal utility from the first hour of snorkeling is 40 and the rent of the snorkeling equipment is €5 an hour, so the marginal utility per euro spent on snorkeling is 8. The marginal utility per euro spent on windsurfing equals the marginal utility per euro spent on snorkeling.

5a. Max's budget line is the straight line running from 5.5 hours of windsurfing and no snorkeling to 11 hours of snorkeling and no windsurfing.

5b. To maximize his utility, Max windsurfs for 4 hours and snorkels for 3 hour.

Max will spend his €55 such that all of the €55 is spent and that the marginal utility per euro spent on each activity is the same. When Max windsurfs for 4 hours and snorkels for 3 hours, he spends €40 renting the windsurfing equipment and €15 renting the snorkeling equipment—a total of €55.

The marginal utility from the fourth hour of windsurfing is 60 and the rent of the windsurfing equipment is €10 an hour, so the marginal utility per euro spent on windsurfing is 6. The marginal utility from the third hour of snorkeling is 30 and the rent of the snorkeling equipment is €5 an hour, so the marginal utility per euro spent on snorkeling is 6. The marginal utility per euro spent on windsurfing equals the marginal utility per dollar spent on snorkeling.

7. To maximize his utility, Max windsurfs for 6 hours and snorkels for 5

hours.

Max will spend his €55 such that all of the €55 is spent and that the marginal utility per euro spent on each activity is the same. When Max windsurfs for 6 hours and snorkels for 5 hours, he spends €30 renting the windsurfing equipment and €25 renting the snorkeling equipment—a total of €55.

The marginal utility from the sixth hour of windsurfing is 12 and the rent of the windsurfing equipment is €5 an hour, so the marginal utility per euro spent on windsurfing is 2.4. The marginal utility from the fifth hour of snorkeling is 12 and the rent of the snorkeling equipment is €5 an hour, so the marginal utility per euro spent on snorkeling is 2.4. The marginal utility per euro spent on windsurfing equals the marginal utility per euro spent on snorkeling.

9. To maximize his utility, Max windsurfs for 5 hours and snorkels for 1 hour. Because the equipment is free, Max does not have to allocate his income between the two activities; instead, he allocates his time between the two activities.

Max spends 6 hours on these activities. Max allocates the 6 hours such that the marginal utility from each activity is the same. When Max windsurfs for 5 hours and snorkels for 1 hour, he spends 6 hours. His marginal utility from the fifth hour of windsurfing is 40 and his marginal utility from the first hour of snorkeling is 40—so the marginal utilities are equal.

11. The market demand curve passes through the following points: 90 cents and 3 cartons; 70 cents and 6 cartons; 50 cents and 10 cartons; 30 cents and 14 cartons; and 10 cents and 18 cartons. At each price, the quantity demand by the market is equal to the sum of the cartons of popcorn that Shirley demands and the cartons of popcorn that Dan demands. For example, at 50 cents a carton, the quantity demanded by Shirley and Dan is 10, the sum of Shirley's 6 and Dan's 4.

1a. Sara's real income is 4 cans of cola. Sara’s real income in terms of cans of cola is equal to her money income divided by the price of a can of cola. Sara’s money income is €12, and the price of cola is €3 a can. Sara's real income is €12 divided by €3 a can of cola, which is 4 cans of cola.

1b. Sara's real income is 4 bags of popcorn.

Sara’s real income in terms of popcorn is equal to her money income divided by the price of a bag of popcorn, which is €12 divided by €3 a bag or 4 bags of popcorn.

1c. The relative price of cola is 1 bag per can.

The relative price of cola is the price of cola divided by the price of popcorn. The price of cola is €3 a can and the price of popcorn is €3 a bag, so the relative price of cola is €3 a can divided by €3 a bag, which equals 1 bag per can.

1d. The opportunity cost of a can of cola is 1 bag of popcorn.

The opportunity cost of a can of cola is the quantity of popcorn that must be forgone to get a can of cola. The price of cola is €3 a can and the price of popcorn is €3 a bag, so to buy one can of cola Sara must forgo 1 bag of popcorn.

1e. The equation that describes Sara's budget line is

Q_P = 4 – Q_C Call the price of popcorn P_P and the quantity of popcorn Q_P, the price of cola P_C and the quantity of cola Q_C, and income y. Sara’s budget equation is P_PQ_P + P_CQ_C = Y If we substituting €3 for the price of popcorn, €3 for the price of cola, and €12 for the income, the budget equation becomes €3 X Q_P + €3 X Q_C = €12

Dividing Both sides by €3 gives

Q_P + Q_C = 4.

Subtract Q_C from Both sides to give

Q_P = 4 – Q_C

1f. To draw a graph of the budget line, plot the quantity of cola on the x-axis and the quantity of popcorn on the y-axis. The budget line is a straight line running from 4 bags on the y-axis to 4 cans on the x-axis.

1g. The slope of the budget line, when cola is plotted on the x-axis is minus

1. The magnitude of the slope is equal to the relative price of cola. The slope of the budget line is "rise over run." If the quantity of cola decreases from 4 to 0, the quantity of popcorn increases from 0 to 4. The rise is 4 and the run is -4. Therefore the slope equals 4/-4, which is -1.

3a. Sara buys 2 cans of cola and 2 bags of popcorn.

Sara buys the quantities of cola and popcorn that gets her onto the highest indifference curve, given her income and the prices of cola and popcorn. The graph shows Sara's indifference curves. So draw Sara's budget line on the graph.

The budget line is tangential to indifference curve I0 at 2 cans of cola and 2 bags of popcorn. The indifference curve I0 is the highest indifference curve that Sara can get onto.

3b. Sara's marginal rate of substitution is 1.

The marginal rate of substitution is the magnitude of the slope of the indifference curve at Sara's consumption point, which equals the magnitude of the slope of the budget line. The slope of Sara's budget line is -1, so the marginal rate of substitution is 1.

5a. Sara buys 6 cans of cola and 1 bag of popcorn.

Draw the new budget line on the graph with Sara's indifference curves. The budget line now runs from 8 cans of cola on the x-axis to 4 bags of popcorn on the y-axis. The new budget line is tangential to indifference curve I1 at 6 cans of cola and 1 bag of popcorn. The indifference curve I1 is the highest indifference curve that Sara can now get onto.

5b. Two points on Sara's demand for cola are the following: At €3 a can of cola, Sara buys 2 cans of cola. At €1.50 a can of cola, Sara buys 6 cans.

5c. The substitution effect is 2 cans of cola and -1.5 bags of popcorn.

To divide the price effect into a substitution effect and an income effect, take enough income away from Sara and gradually move her new budget line back toward the origin until it just touches Sara's indifference curve I0. The point at which this budget line just touches indifference curve I0 is 4 cans of cola and 0.5 bag of popcorn. The substitution effect is the increase in the quantity of cola from 2 cans to 4 cans and the decrease in the quantity of popcorn from 2 bags to 0.5 bag along the indifference curve I0. The substitution effect is 2 cans of cola and -1.5 bags of popcorn.

5d. The income effect is 2 cans of cola and 0.5 bag of popcorn.

The income effect is the change in the quantity of cola from the price effect minus the change from the substitution effect. The price effect is 4 cans of cola (6 cans minus the initial 2 cans) and -1 bag of popcorn (1 bag minus the initial 2 bags). The substitution effect is an increase in the quantity of cola from 2 cans to 4 cans and the decrease in the quantity of popcorn from 2 bags to 0.5 bag of popcorn. So the income effect is 2 cans of cola and 0.5 bag of popcorn.

5e. Cola is a normal good for Sara because the income effect is positive. An increase in income increases the quantity of cola she buys from 4 to 6 cans.

5f. Popcorn is a normal good for Sara because the income effect is positive.

An increase in income increases the quantity of popcorn she buys from 0.5 bags to 1 bag.

1. Explicit costs are €30,000. Explicit costs are all the costs for which there is a payment. Explicit costs are the sum the wages paid (€20,000) and the goods and services bought from other firms (€10,000).

Implicit costs are the sum of the costs that do not involve a payment. Implicit costs are the sum of the interest forgone on the €50,000 put into the firm; the €30,000 income forgone by Jack not working at his previous job; €15,000, which is the value of 500 hours of Jill's leisure (10 hours a week for 50 weeks); and the economic depreciation of €2,000 (€30,000 minus €28,000).

3a. All methods other than "pocket calculator with paper and pencil" are technologically efficient.

To use a pocket calculator with paper and pencil to complete the tax return is not a technologically efficient method because it takes the same number of hours as it would with a pocket calculator but it uses more capital.

3b. The economically efficient method is to use (i) a pocket calculator, (ii) a pocket calculator, (iii) a PC.

The economically efficient method is the technologically efficient method that allows the task to be done at least cost. When the wage rate is €5 an hour: Total cost with a PC is €1,005, total cost with a pocket calculator is €70, and total cost with paper and pencil is €81. Total cost is least with a pocket calculator.

When the wage rate is €50 an hour: Total cost with a PC is €1,050, total cost with a pocket calculator is €610, and the total cost with paper and pencil is €801. Total cost is least with a pocket calculator. When the wage rate is €500 an hour: Total cost with a PC is €1,500, total cost with a pocket calculator is €6,010, and total cost with pencil and paper is €8,001. Total cost is least with a PC.

5a. Methods a, b, c, and d are technologically efficient. Compare the amount of labour and capital used by the four methods. Start with method a. Moving from a to b to c to d, the amount of labour increases and the amount of capital decreases in each case.

5b. The economically efficient method in (i) is method d, in (ii) is methods c and d, and in (iii) is method a. The economically efficient method is the technologically efficient method that allows the 100 shirts to be washed at least cost.

(i) Total cost with method a is €1,001, total cost with method b is €805, total cost with method c is €420, and total cost with method d is €150. Method d has the lowest total cost.

(ii) Total cost with method a is €505, total cost with method b is €425, total cost with method c is €300, and total cost with method d is €300. Methods c and d have the lowest total cost.

(iii) Total cost with method a is €100, total cost with method b is €290, total cost with method c is €1,020, and total cost with method d is €2,505. Method a has the lowest total cost.

7a. The four-firm concentration ratio is 60.49.

The four-firm concentration ratio equals the ratio of the total sales of the largest four firms to the total industry sales expressed as a percentage. The total sales of the largest four firms is €450 + €325 + €250 + €200, which equals €1,225. Total industry sales equal €1,225 + €800, which equals €2,025. The four-firm concentration ratio equals (€1,225/€2,025) ´ 100, which is 60.49 percent.

7b. This industry is highly concentrated because the four-firm concentration ratio exceeds 60 percent.

Chapter 10

1. Go to Economics in Action, Chapter 19, Problem 1, and use the graph

provided to find the solution to this problem.

3a. The growth rate in India was positive in every year from 1989 to 1996. The

growth rate was fastest in 1989.

3b. The growth rate was not negative in Pakistan in this period. The growth

rate was slowest in 1993.

3c. Between 1989 and 1990, growth rates in Pakistan and India both decreased.

Between 1990 and 1991, the growth rate in Pakistan increased while the growth

rate in India decreased. Between 1991 and 1992, both growth rates increased.

Between 1992 and 1993, both growth rates decreased. From 1993 to 1995, both

growth rates increased. In 1996, the two growth rates were approximately equal.

5a. Germany had one recession in the fourth quarter of 1992 and the first

quarter of 1993.

The large black dots are the first quarter of each year and the small grey dots

are the second, third, and fourth quarter. A recession is a period during which

real GDP decreases for at least two successive quarters. Real GDP decreased in

the fourth quarter of 1992 and the first quarter of 1993.

5b. Germany experienced a business cycle peak in the first quarter of 1992.

A business cycle peak is the upper turning point. A peak occurs when real GDP

stops growing and starts to decrease.

5c. Germany experienced a business cycle trough in the first quarter of 1993.

A business cycle trough is the lower turning point of a business cycle where a

recession ends and an expansion begins.

5d. Germany experienced an expansion during the fourth quarter of 1991 and the

first quarter of 1992 and in every quarter after the first quarter of 1993.

An expansion is a period during which real GDP increases.

7. Go to Economics in Action, Chapter 19, Problem 7, and use the graph

provided to find the solution to this problem.

9. Go to Economics in Action, Chapter 19, Problem 9, and use the graph

provided to find the solution to this problem.

1. Martha’s initial capital stock is 5 copiers, depreciation is 1 copier per

year, gross investment is 3 copiers, net investment is 2 copiers, and the final

capital stock is 7 copiers.

Final capital stock equals initial capital stock plus net investment. Net

investment equals gross investment minus depreciation.

3a. Aggregate expenditure is £60 million.

Aggregate expenditure is the sum of consumption expenditure, investment,

government expenditures, and net exports. In the figure, B is consumption

expenditure, D is investment, C is government expenditures, and E is net

exports. Therefore aggregate expenditure equals £30 million plus £15 million

plus £12 million plus £3 million, which is £60 million.

3b. Aggregate income is £60 million.

Aggregate income equals aggregate expenditure, which from 3a is £60 million.

3c. GDP is £60 million.

GDP equals aggregate expenditure, which from 3a is £60 million.

3d. Government budget deficit is £2 million.

Government budget deficit equals government expenditures minus taxes. C is

government expenditures, and A is taxes. So the government budget deficit equals

£12 million minus £10 million, which is £2 million.

3e. Household saving is £20 million.

Household saving equals aggregate income minus consumption expenditure minus

taxes. In the figure, B is consumption expenditure and A is taxes. Therefore

household saving equals £60 million minus £30 million minus £10 million, which

is £20 million.

3f. Government saving is minus £2 million.

Government saving equals taxes minus government expenditures. In the figure, A

is taxes and C is government expenditures. Therefore government saving equals

£10 million minus £12 million, which is minus £2 million.

3g. Foreign borrowing is £3 million.

Foreign borrowing equals net exports. E is net exports, and net exports equals

£3 million. Lotus Island is in surplus, so foreigners are in deficit and they

must borrow from us to pay for their deficit. Foreign borrowing equals £3

million.

3h. National saving is £18 million.

National saving equals the sum of household saving and government saving.

Household saving is £20 million (see answer 3e). Government saving is minus £2

million (see answer 3f). Therefore national saving equals £20 million minus £2

million, which is £18 million.

5a. Ecoland's GDP is €1,100,000.

GDP equals the sum of consumption expenditure plus investment plus government

expenditures plus net exports. That is, GDP equals €600,000 plus €250,000 plus

€200,000 plus €300,000 minus €250,000. GDP equals €1,100,000.

5b. Expenditure approach. Income approach cannot be used because there are no

data on interest, rent, profits, depreciation, and indirect taxes and subsidies.

5c. Injections equal leakages.

Injections are investment, government expenditures, and exports. Total

injections are €250,000 plus €200,000 plus €300,000 which equals €750,000.

Leakages are saving, net taxes, and imports. Total leakages are €300,000 plus

€200,000 plus €250,000 which equals €750,000.

7a. The basket used in the CPI is 10 bottles of juice and 5 lengths of cloth.

The basket used in the CPI is the typical basket consumed in the base year. In

the base year, the typical family spends £40 on juice and juice costs £4 a

bottle, so the family buys 10 bottles of juice. In the base year, the typical

family spends £25 on cloth and cloth costs £5 a length, so the family buys 5

lengths of cloth.

7b. The CPI in the current year is 107.69

Expenditure on the CPI basket in the current year is 10 bottles of juice @ £4 a

bottle plus 5 lengths of cloth @ £6 a length, which is £70. The expenditure on

the CPI basket in the base year is £40 plus £25, which is £65. The CPI in the

current year equals the expenditure on the basket in the current year divided by

the expenditure on the basket in the base year, multiplied by 100. The CPI is

107.69.

7c. The inflation rate in the current year is 7.69 percent.

The CPI in the base year is 100 and the CPI in the current year is 107.69, and

the inflation rate is the rate of change of the CPI. The inflation rate equals

(107.69 - 100)/100, which is 7.69 percent.

9a. In 1997, GDP is £7,000 and real GDP is £7,000. In 1998, GDP is £7,500 and

real GDP is £7,450.

GDP is equal to total expenditure on the goods and services produced by

Bananaland in 1997. Expenditure on bananas is 1,000 bunches @ £2 a bunch, which

is £2,000. Expenditure on sunscreen is 500 bottles @ £10 a bottle, which is

£5,000. Total expenditure is £7,000. So GDP in 1997 is £7,000.

Real GDP in 1997 is equal to Bananaland’s 1997 output valued at base-year prices. Because 1997 is the base year, real GDP in 1997 equals £7,000.

GDP in 1998 is equal to total expenditure on the goods and services produced by

Bananaland in 1998. Expenditure on bananas is 1,100 bunches @ £3 a bunch, which

is £3,300. Expenditure on sunscreen is 525 bottles @ £8 a bottle, which is

£4,200. Total expenditure is £7,500. So GDP is £7,500.

Real GDP in 1998 is equal to Bananaland’s 1998 output valued at base-year prices

(1997 prices). To value the 1998 output at 1997 prices, expenditure on bananas

is 1,100 bunches @ £2 a bunch (which is £2,200), expenditure on sunscreen is 525

bottles @ £10 a bottle (which is £5,250). So real GDP in 1998 is £7,450.

9b. The growth rate of real GDP in 1998 is 6.43 percent.

The growth rate equals the increase in real GDP from 1997 to 1998 expressed as a

percentage of real GDP in 1997. That is, the growth rate equals (£7,450 -

£7,000)/£7,000, which is 6.43 percent.

9c. The GDP deflator in 1998 is 100.67.

GDP deflator equals GDP in 1998 divided by real GDP in 1998, multiplied by 100.

GDP deflator equals (£7,500/£7,450) ´ 100 = 100.67.

1a. Unemployment rate is 6.3 percent.

The unemployment rate is the percentage of the labour force that is unemployed.

The labour force is the sum of the people unemployed and the people employed.

The labour force is 29,049,000 and the number of people employed is 27,227,000,

so the number of people who are unemployed equals 29,049,000 minus 27,227,000,

which is 1,822,000.

The unemployment rate equals (the number of people unemployed divided by the

labour force) multiplied by 100. That is, (1,822,000/29,049,000)x100, which is

6.3 percent.

1b. The labour force participation rate (or sometimes known as economic activity rate) is 62.8 percent.

The labour force participation rate is the percentage of the working-age

population that is in the labour force. The working-age population is 46,253,000

and the labour force is 29,049,000, so the labour force participation rate

equals (29,049,000/46,253,000)x100, which equals 62.8 percent.

1c. The employment-to-population ratio is 58.7 percent.

The employment-to-population ratio is the percentage of the people of working

age who have jobs. The employment-to-population ratio is the number of people

employed divided by the working-age population all multiplied by 100. The

employment-to-population ratio is (27,227,000/46,253,000)x100, which is 58.9

percent.

3. Unemployment increased by 51,000. The number of discouraged workers has

increased.

During 1999, employment in the UK increased by 333,000 and the labour force

increased by 307,000. The number of unemployed is calculated as the labour force

minus the number employed. When the labour force increased by 307,000 and

employment increased by 333,000, unemployment decreased by 26,000.

Discouraged workers are people who leave the labour force temporarily during a

recession and re-enter the labour force and become job seekers during an

expansion. To measure the number of discouraged workers, we need to know about

new entrants and retirements. Because the labour force increased by more than

the increase in the working-age population, it is likely that the number of

discouraged workers decreased.

5a. The number of job losers probably decreased. The number of job leavers

probably did not change much.

The decrease in the unemployment rate is an indication that the economy was in

an expansion, and normally, in an expansion, the number of job losers decreases

but the number of job leavers does not change much.

5b. Labour force entrants and re-entrants probably increased.

In an expansion, discouraged workers re-enter the labour force. So it is likely

that entrants and re-entrants increased.

7a. The labour force in July is 15,344,000. It is the number employed plus the

number unemployed.

7b. The unemployment rate in July is 10.1 percent. It is the number unemployed

as a percentage of the labour force.

7c. The working-age population is 22,729,000. It is the sum of the labour force

and the number of people not in the labour force.

7d. The employment-to-population ratio is 60.7. It is the number employed as a

percentage of the working-age population.

7e. The number of people who are unemployed at the end of August is 1,546,995.

It equals the number unemployed in July plus job losers, job leavers, entrants,

and reentrants minus hires, recalls, and withdrawals.

7f. The number of people who are employed at the end of August is 13,796,971.

It equals the number employed in July minus job losers and job leavers plus

hires and recalls.

7g. The labour force at the end of August is 15,343,966. It equals the number

employed plus the number unemployed.

7h. The unemployment rate at the end of August is 10.1 percent. It equals the

number unemployed as a percentage of the labour force.

7i. The employment-to-population ratio at the end of August is 58.9. It equals

the number employed as a percentage of the working-age population. The

working-age population is the labour force multiplied by 100 and divided by the

labour force participation rate.

9. At the peak of a business cycle, the labour force participation rate is

high, employment is high, the unemployment rate is low, the duration of

unemployment is low, and fewer workers are discouraged.

1a. A deep recession in the world economy will decrease real GDP, and the price

level will fall. A sharp rise in oil prices will decrease real GDP, and the

price level will rise. When businesses expect huge losses in the near future,

real GDP will decrease and the price level will fall.

(i) A deep recession in the world economy will decrease world income, which in

turn will reduce Toughtimes' exports of goods and services. Toughtimes'

aggregate demand curve will shift leftward. In Toughtimes, real GDP will

decrease and the price level will fall.

(ii) A sharp rise in oil prices will decrease short-run aggregate supply and

shift the short-run aggregate supply curve leftward. In Toughtimes, the real GDP

will decrease and the price level will rise.

(iii) When businesses expect huge losses in the near future, they will reduce

investment now. Aggregate demand will decrease, and the aggregate demand curve

will shift leftward. In Toughtimes, real GDP will decrease and the price level

will fall.

1b. Real GDP will decrease and the price level might rise, fall, or stay the

same.

In 1a, each of the events decreases real GDP, so together they will decrease

real GDP. But the recession and the expected business losses will lead to a fall

in the price level, while the sharp rise in the oil price will lead to a rise in

the price level. So together, the price level might rise, fall, or stay the

same.

1c. To increase aggregate demand, the government might increase its

expenditures or cut taxes and the central bank might increase the quantity of

money and decrease interest rates. These policies will increase real GDP.

3a. To plot the aggregate demand curve, plot the price and the quantity of real

GDP demanded. To plot the short-run aggregate supply curve, plot the price and

the quantity of real GDP supplied in the short-run.

3b. Real GDP is €400 billion, and the price level is 100.

Short-run macroeconomic equilibrium occurs at the intersection of the aggregate

demand curve and the short-run aggregate supply curve.

3c. The long-run aggregate supply curve is a vertical line at real GDP of €500

billion.

5. Real GDP increases to €450 billion, and the price level rises to 110.

Aggregate demand increases by €100 billion at each value of the price level, and

the aggregate demand curve shifts rightward by €100 billion. The new aggregate

demand curve intersects the short-run aggregate supply curve at a real GDP of

E450 billion and a price level of 110.

7. Real GDP decreases to €350 billion, and the price level rises to 110.

Short-run aggregate supply decreases by €100 billion at each value of the price

level and the short-run aggregate supply curve shifts leftward by €100 billion.

The new short-run aggregate supply curve intersects the aggregate demand curve

at a real GDP of €350 billion and a price level of 110.

9a. The equilibrium point is point c.

The aggregate demand curve is the red curve AD1. The short-run aggregate supply

curve is the blue curve SAS0. These curves intersect at point c.

9b. The equilibrium point is point d.

The short-run aggregate supply curve is the red curve SAS1. The aggregate demand

curve is now the red curve AD1 These curves intersect at point d.

9c. Aggregate demand increases if (1) expected future incomes, inflation, or

profits increase; (2) the government increases its expenditures or reduces

taxes; (3) the central bank increases the quantity of money and decrease

interest rates; or (4) the exchange rate decreases or foreign income increases.

9d. Short-run aggregate supply decreases if resource prices increase.

1a. The marginal propensity to consume is 0.5.

The marginal propensity to consume is the fraction of a change in disposable

income that is consumed. On Heron Island, when disposable income increases by

€10 million per year, consumption expenditure increases by €5 million per year.

The marginal propensity to consume is 0.5.

1b. The table that shows Heron Island’s saving lists disposable income from

zero to €40 million in increments of €10 milion. Against each level of disposable income are the amounts of saving, which equal disposable income minus consumption expenditure. These amounts run from –€5 million at zero disposable income to €15 milion at a disposable income of €40 million. For each increase in disposable income of €1, saving increases by 50 cents.

1c. Marginal propensity to save is 0.5

The marginal propensity to consume plus the marginal propensity to save equals

1. Because consumption expenditure and saving exhaust disposable income, 0.5 of

each euro increase in disposable income is consumed and the remaining part

(0.5) is saved.

3a. Autonomous expenditure is €2.0 billion

Autonomous expenditure is expenditure that does not depend on real GDP.

Autonomous expenditure equals the value of aggregate planned expenditure when

real GDP is zero.

3b. Marginal propensity to consume is 0.6

When the country has no imports or exports and no income taxes, the slope of the

AE curve equals the marginal propensity to consume. When income increases from 0

to €6 billion, aggregate planned expenditure increases from €2 billion to €5.6

billion. That is, when real GDP increases by €6 billion, aggregate planned

expenditure increases by €3.6 billion. The marginal propensity to consume is

€3.6 billion/€6 billion, which is 0.6.

3c. Equilibrium expenditure is €5 billion.

Equilibrium expenditure is the level of aggregate expenditure at which aggregate

planed expenditure equals real GDP. In terms of the graph, equilibrium

expenditure occurs at the intersection of the AE curve and the 45° line. The

equation to the AE curve is AE = 2 + 0.6y where y is real GDP. The equation to

the 45° line is AE = y. The AE curve intersects the 45° line at a real GDP of E5

billion.

3d. Unplanned inventory investment is negative.

When real GDP is €4 billion, aggregate planned expenditure exceeds real GDP, so

firms sell more than they produce. Inventories run down.

3e. Firms are accumulating inventories. That is, unplanned inventory investment

is positive.

When real GDP is €6 billion, aggregate planned expenditure is less than real

GDP, so firms cannot sell all that they produce. Inventories pile up.

3f. The multiplier is 2.5.

The multiplier equals 1/(1 - MPC). The marginal propensity to consume is 0.6, so

the multiplier equals 1/(1 - 0.6), which equals 2.5.

5a. The consumption function is C = 100 + 0.9(Y – T).

The consumption function is the relationship between consumption expenditure and

disposable income, other things remaining the same.

5b. The equation to the AE curve is:

AE = 600 + 0.9Y,where Y is real GDP.

Aggregate planned expenditure is the sum of consumption expenditure, investment,

government expenditure, and net exports. Using the symbol AE for aggregate

planned expenditure, aggregate planned expenditure is:

AE = 100 + 0.9(Y – 400) + 460 + 400

AE = 100 + 0.9Y – 360 + 460 + 400

AE = 600 + 0.9Y

5c. Equilibrium expenditure is €6,000 billion.

Equilibrium expenditure is the level of aggregate expenditure that occurs when

aggregate planned expenditure equals real GDP. That is,

AE = 600 + 0.9Y

and

AE = Y

Solving these two equations for Y gives equilibrium expenditure of €6,000

billion.

5d. Equilibrium real expenditure decreases by €1,000 billion, and the

multiplier is 10.

The multiplier equals 1/(1 - the slope of the AE curve). The equation to the AE

curve tells us that the slope of the AE curve is 0.9. So the multiplier is 1/(1

- 0.9), which is 10.

The change in equilibrium expenditure equals the change in investment multiplied

by 10.

7a. The quantity demanded increases by €1,000 billion.

The increase in investment shifts the aggregate demand curve rightward by the

change in investment times the multiplier. The multiplier is 10 and the change

in investment is €100 billion, so the aggregate demand curve shifts rightward by

€1,000 billion.

7b. In the short-run, real GDP increases by less than €1,000 billion

Real GDP is determined by the intersection of the AD curve and the SAS curve. In

the short run, the price level will rise and real GDP will increase but by an

amount less than the shift of the AD curve.

7c. In the long-run, real GDP will equal potential GDP, so real GDP does not

increase.

Real GDP is determined by the intersection of the AD curve and the SAS curve.

After the initial increase in investment, money wages increase, the SAS curve

shifts leftward, and in the long run, real GDP moves back to potential GDP.

7d. In the short run, the price level rises.

7e. In the long run, the price level rises.

1a. Equilibrium expenditure decreases by €100 billion.

The government expenditures multiplier is the amount by which a change in

government expenditures on goods and services is multiplied to determine the

change in equilibrium expenditure that results. Zap has no induced taxes or

imports, so the government expenditures multiplier is 1/(1 - MPC), which equals

10. The multiplier tells us that when government expenditures decrease by €10

billion, equilibrium expenditure decreases by 10 times as much or €100 billion.

1b. The government expenditures multiplier is 10.

1c. Equilibrium expenditure increases by €90 billion.

The autonomous tax multiplier equals -MPC/(1 - MPC), which is -9. That is, when

autonomous taxes are changed by €10 billion, equilibrium expenditure changes by

-9 times the change in autonomous taxes. A cut in autonomous taxes of €10

billion will increase equilibrium expenditure by €90 billion.

1d. The autonomous tax multiplier is -9.

1e. Equilibrium expenditure decreases by €10 billion.

The decrease in government expenditures decreases equilibrium expenditure by

€100 billion and the cut in taxes increases equilibrium expenditure by €90

billion. So together, equilibrium expenditure decreases by €10 billion.

3a. The quantity of real GDP demanded increases by €100 billion.

The government expenditures multiplier tells us that when government

expenditures increase by €10 billion, equilibrium expenditure increases by 10

times as much, or €100 billion. At the price level 100, the quantity of real GDP

demanded increases by an amount equal to the change in equilibrium expenditure.

That is, the quantity of real GDP demanded increases by €100 billion.

3b. The aggregate demand curve shifts rightward by €100 billion at each price

level.

The AE curve shifts upward by €10 billion, equilibrium expenditure increases by

€100 billion, and the AD curve shifts rightward by €100 billion.

3c. In the short run, real GDP increases by less than the €100 billion increase

in the quantity of real GDP demanded.

In the short run, short-run aggregate supply and aggregate demand determine real

GDP. Because the short-run aggregate supply curve slopes upward, the price level

rises and real GDP increases but by less than €100 billion.

3d. In the long run, the increase in real GDP will be zero. Real GDP will

return to potential GDP.

In the short run, real GDP exceeds potential GDP and wage rates will start to

rise. The short-run aggregate supply will begin to decrease and the price level

will rise. The short-run aggregate supply will continue to decrease and the

price level will continue to rise until real GDP equals potential GDP.

3e. The price level rises.

In the short run, aggregate demand and short-run aggregate supply determine the

price level. Because the short-run aggregate supply curve slopes upward and

because aggregate demand increases, the price level rises.

3f. The price level rises.

In the long run, aggregate demand and long-run aggregate supply determine the

price level. The short-run aggregate supply curve shifts leftward because the

money wage rate rises. Because the long-run aggregate supply curve is vertical

and because aggregate demand increases, the price level rises. And it rises by

more in the long run than it does in the short run.

5a. The government budget balance is zero.

The government's revenues equal its outlays, so its budget is balanced.

5b. Dreamland does not have a structural or a cyclical deficit.

Because at potential GDP, the budget is balanced, Dreamland does not have a

structural surplus or deficit. Because real GDP equals potential GDP, Dreamland

does not have a cyclical surplus or deficit.

5c. The budget balance is a deficit of €40 million.

At a real GDP of €30 million, revenues equal €80 million and outlays equal €120

million, so the budget is in deficit. The size of the deficit is €40 million.

5d. Dreamland does not have a structural deficit, but it does have a cyclical

deficit of €40 million.

Because at potential GDP, the budget is balanced, Dreamland does not have a

structural surplus or deficit. Because real GDP is less than potential GDP and

it has a deficit, Dreamland's deficit is a cyclical deficit. The cyclical

deficit is €40 million.

5e. Dreamland does not have a structural deficit but it does have a cyclical

surplus of €40 million.

Because at potential GDP, the budget is balanced, Dreamland does not have a

structural surplus or deficit. Because real GDP exceeds potential GDP and it has

a surplus, Dreamland's surplus is a cyclical surplus. The cyclical surplus is

€40 million.

1. Money in the UK includes the notes and coins you keep in your wallet and the coins in the public phone. Money is composed of currency outside the banks and deposits at banks and other financial institutions. Currency inside the cash machines, Visa cards, cheques, and loans are not money.

3. M1 increases by £1,000; M4 does not change.

M1 is the sum of currency outside the banks plus demand deposits at banks and building societies that are owned by individuals and businesses. M4 is the sum of M1 plus personal and nonpersonal time deposits at chartered banks plus all types of savings deposits at building societies. The withdrawal of £1,000

from a savings account leaves M4 unchanged because the £1,000 goes into M1 types of money, which is part of M4. The £50 held as cash and the £950 held in a demand deposit account increase M1 by £1,000.

5a. The balance sheet has the following assets: Reserves, £250 million; Loans,

£1,000 million; Other assets, £1,250 million. It has the following liabilities:

Deposits, £2,000 million; Other liabilities, £500 million.

5b. The reserve ratio is 12.5 percent.

The reserve ratio is the percentage of deposits that are held as reserves.

Reserves are £250 million and deposits are £2,000, so the reserve ratio is 12.5

percent.

5c. The deposit multiplier is 8.

The deposit multiplier equals 1/(desired reserve ratio). The desired reserve

ratio is 12.5, so the deposit multiplier is 8.

7a. People buy bonds, and the interest rate falls.

7b. People sell bonds, and the interest rate rises.

7c. People neither buy nor sell bonds, and the interest rate remains constant

at 4 percent a year.

With real GDP of €20 billion (Y1 in the spreadsheet), column C shows the demand

for money schedule. The quantity of money supplied is €3 billion, so the

equilibrium interest rate is 4 percent a year.

If the interest rate exceeds 4 percent a year, people are holding more money

than they demand. So they try to decrease the amount of money held by buying

bonds. The prices of bonds rise, and the interest rate falls.

If the interest rate is less than 4 percent a year, people are holding less

money than they demand. So they try to increase the amount of money held by

selling bonds. The prices of bonds fall, and the interest rate rises.

If the interest rate equals 4 percent a year, people are holding exactly the

quantity of money that they demand. So they take no actions to try to change the

amount of money held. The interest rate remains constant.

9a. The interest rate rises to 5 percent a year.

9b. The interest rate falls to 3 percent a year.

When real GDP increases in an expansion to €30 billion (Y2 in the spreadsheet),

column D shows the demand for money schedule. The quantity of money supplied is

€3 billion, so the equilibrium interest rate is 5 percent a year.

When real GDP decreases in a recession to €10 billion (Y0 in the spreadsheet),

column B shows the demand for money schedule. The quantity of money supplied is

€3 billion, so the equilibrium interest rate is 3 percent a year.

11a.The money supply curve is vertical at 100 billion 1992 yaks.

When the real money supply is 100 billion 1990 yaks, the equilibrium interest

rate is 3 percent a year at the intersection of the demand for money and supply

of money curves.

11b.Must increase the quantity of real money by 50 billion 1992 yaks.

When the quantity of real money increases to 150 billion 1992 yaks, the

equilibrium interest rate falls to 2 percent a year.

13a. During the expansion phase of the cycle, the interest rate falls. When the

interest rate falls, consumption expenditure increases, investment increases,

the exchange rate falls, and net exports increase.

13b. During the recession phase of the cycle, the interest rate rises. When the

interest rate rises, consumption expenditure decreases, investment decreases,

the exchange rate rises, and net exports decrease.

1a. The monetary base is €45 billion.

The monetary base is the sum of the central bank’s notes outside the bank,

banks’ deposits at the central bank, and coins held by households, firms, and

banks. There are €30 billion in notes held by households and firms, banks’

deposits at the central bank are €10 billion (2/3 of €15 billion), the banks

hold other reserves of €5 billion (which are notes), and there are no coins. The

monetary base is €45 billion.

1b. The quantity of money is €330 billion.

In Nocoin, deposits are €300 billion and currency is €30 billion, so the

quantity of money is €330 billion.

1c. The banks’ reserve ratio is 5 percent.

The banks’ reserve ratio is the percent of deposits that is held as reserves. In

Nocoin, deposits are €300 billion and reserves are €15 billion, so the reserve

ratio equals (€15 billion/€300 billion)x100, which is 5 percent.

1d. The currency drain is 9.09 percent.

The currency drain is the percent of the quantity of money that is held as

currency by households and firms. In Nocoin, deposits are €300 billion and

currency is €30 billion, so the quantity of money is €330 billion. The currency

drain equals (€30 billion/€330 billion)x100, which is 9.09 percent.

3. The money supply increases to €337.33 billion.

The money supply increases by the change in the monetary base multiplied by the

money multiplier. The money multiplier is the ratio of the money supply to the

monetary base, which equals €330 billion divided by €45 billion, which equals

7.33.

So when the monetary base increases by €1 billion, the money supply increases by

€7.33 billion. Initially, the money supply was €330 billion, so the new money

supply is €337.33 billion.

The change in the money supply is not equal to the change in the monetary base

because of the multiplier effect. The open market operation increases bank

reserves and creates excess reserves which banks use to make new loans. New

loans are used to make payments and some of these loans are placed on deposit in

banks. The increase in bank deposits increases banks’ reserves and increases

desired reserves. But the banks now have excess reserves which they loan out and

the process repeats until excess reserves have been eliminated.

5a. The price level is 130 and real GDP is €200 billion.

The intersection of the aggregate demand curve, AD, and the short-run aggregate

supply curve, SASA, determine the price level and real GDP.

5b. Freezone has an unemployment problem.

Potential GDP is €300 billion, but actual real GDP is €200 billion. When real

GDP is less than potential GDP, resources are not fully employed. Unemployment

exceeds that at full employment.

5c. Eventually, the real GDP will increase and full employment will be

restored. The price level will fall.

With unemployment exceeding the natural rate of unemployment, the money wage

rate will eventually fall. The SAS curve will shift rightward, the price level

will fall, and real GDP will gradually increase to potential GDP. At potential

GDP, the economy is at full employment. This automatic adjustment will take a

long time to occur.

5d. By buying securities on the open market, the central bank will increase the

money supply, increase aggregate demand, and return the economy to full

employment more quickly.

Currently real GDP is less than potential GDP and the economy is at a below

full-employment equilibrium. If the central bank buys securities on the open

market, then the quantity of money will increase and the aggregate demand curve

will shift rightward. The economy returns to full employment but the price level

will rise. If this process takes some time, the economy will experience

inflation.

7a. If the central bank buys securities on the open market, the money supply

increases, aggregate demand increases, real GDP increases, and the price level

rises.

When the central bank buys securities on the open market, the quantity of money

increases, the interest rate falls, so consumption, investment, and net exports

increase. Aggregate demand increases, and the aggregate demand curve shifts

rightward. Real GDP increases and the price level rises.

7b. If the central bank sells securities on the open market, the money supply

decreases, aggregate demand decreases, real GDP decreases, and the price level

falls.

When the central bank sells securities on the open market, the quantity of money

decreases, the interest rate rise, so consumption, investment, and net exports

decrease. Aggregate demand decreases, and the aggregate demand curve shifts

leftward. Real GDP decreases and the price level falls.

7c. To return the economy to full employment, the central bank would sell

securities on the open market.

Currently real GDP is greater than potential GDP and the economy is at an above

full-employment equilibrium. If the central bank sells securities on the open

market, then the quantity of money decreases and the aggregate demand curve

shifts leftward. The price level falls and the economy returns to full

employment.

9a. On the average, the interest rate in Minland is 3 percent a year.

The money supply curve is vertical at a quantity of €150 billion. On the

average, the demand for money curve is MDA. The intersection of the demand for

money curve, MDA and the money supply curve determine the interest rate.

9b. The interest rate ranges from 2 percent a year to 4 percent a year.

The demand for money fluctuates around an average level of MDA to a high of MDB

and a low of MDC. As the demand for money fluctuates, the interest rate

fluctuates. The interest rate is 2 percent a year when the demand for money is

MDC, 3 percent a year when the demand for money is MDA, and 4 percent a year

when the demand for money is MDB.

9c. As the demand for money fluctuates, the interest rate changes, which will

lead to changes in real GDP and the price level.

When the demand for money increases, the interest rate rises and aggregate

demand decreases. With aggregate demand decreasing, real GDP decreases and the

price level falls.

When the demand for money decreases, the interest rate falls, and aggregate

demand increases. With aggregate demand increasing, real GDP increases and the

price level rises.

1a. A decrease in government expenditures leads to a decrease in aggregate

demand, which in turn sets up a process in which real GDP starts to decrease and

the price level starts to fall.

The decrease in government expenditures has a multiplier effect on aggregate

demand. Aggregate demand decreases and shifts the AD curve in figure 27.1(a)

leftward. Real GDP begins to decrease and the price level starts to fall towards

the new equilibrium.

1b. Real GDP decreases and the interest rate falls.

In the first round, real GDP begins to decrease and the price level begins to

fall. In the second round, as real GDP decreases the demand for money decreases.

As the price level falls, the quantity of real money increases. As a result, the

interest rate falls. The fall in the interest rate limits the decrease in real

GDP.

1c. Through the second round, real GDP decreases and the price level falls

until the new equilibrium is reached. As real GDP decreases, the demand for

money decreases and the money demand curve in figure 27.1(b), MD, shifts

leftward. The interest rate falls. With a given quantity of nominal money, the

falling price level increases the quantity of real money. In figure 27.1(b), the

supply curve of real money, MS, shifts rightward and the interest rate falls

further. As the interest rate falls, interest-sensitive expenditure increases.

The increase in interest-sensitive expenditure increases aggregate demand and

the aggregate demand curve starts to shift rightward. But aggregate demand

increases by less than the initial decrease in aggregate demand. So at the new

equilibrium, aggregate demand is less than initially.

Comparing the final equilibrium with the initial equilibrium, the decrease in

government expenditures on goods and services has lead to a decrease in real

GDP, a fall in the price level, and a fall in the interest rate.

3a. A decrease in the money supply raises the interest rate and decreases

interest-sensitive expenditure. The decrease in interest-sensitive expenditure

has a multiplier effect on aggregate demand. Aggregate demand decreases. Real

GDP and the price level begin to decrease.

A decrease in the money supply with a constant price level decreases the real

money supply and shifts the real money supply curve in figure 27.1(b) leftward.

The interest rate rises. The higher interest rate decreases interest-sensitive

expenditure in figure 27.1(c). The decrease in interest-sensitive expenditure

decreases aggregate demand and shifts the AD curve leftward in figure 27.1(a).

Real GDP begins to decrease and the price level begins to fall towards the new

equilibrium.

3b. Real GDP decreases and the interest rate rises.

In the first round, real GDP begins to decrease and the price level begins to

fall. In the second round, as real GDP decreases the demand for money decreases.

As the price level falls, the quantity of real money increases. As a result, the

interest rate falls. The fall in the interest rate limits the decrease in

interest-sensitive expenditure and limits the decrease in real GDP.

3c. In the second round, the decreasing real GDP decreases the demand for

money. The money demand curve in figure 27.1(b) shifts leftward and the interest

rate falls. The falling price level increases in the supply of real money and

the real money supply curve shifts rightward. The interest rate falls further.

As the interest rate falls, interest-sensitive expenditure increases. The

increase in interest-sensitive expenditure increases aggregate demand and the

aggregate demand curve starts to shift rightward. But aggregate demand increases

by less than the initial decrease in aggregate demand. So at the new

equilibrium, aggregate demand is less than initially.

5a. An increase in government expenditures on goods and services has a larger

effect on real GDP in Alpha.

The first round effects are the same in Alpha and Beta. In the second round, the

increasing real GDP increases the demand for money. The demand for money curves

in Alpha and in Beta shift rightward. In both countries, the interest rate

rises, but it rises by a greater amount in Beta. The higher interest rate

decreases interest-sensitive expenditure by more in Beta than in Alpha, and in

Beta the aggregate demand curve shifts further to the left. Real GDP increases

by a greater amount in Alpha than in Beta.

5b. The crowding-out effect is weaker in Alpha.

The expansionary fiscal policies in Alpha and Beta increase the interest rates.

As the interest rate rises, the interest-sensitive components of aggregate

expenditure, including investment, decrease. The interest rate rises by more in

Beta than in Alpha, so the decrease in investment will be greater in Beta than

in Alpha. Beta will experience more crowding out.

5c. A change in the money supply has a larger effect on equilibrium real GDP in

Beta.

When the money supply increases, the interest rate falls by a greater amount in

Beta than in Alpha. The lower interest rate in Beta increases interest-sensitive

expenditure by a greater amount than in Alpha and shifts the aggregate demand

curve further to the right than in Alpha. Equilibrium real GDP increases by more

in Beta than in Alpha.

5d. Beta is closer to the monetarist extreme. Alpha is closer to the Keynesian

extreme.

Extreme monetarism hypothesizes that a change in the money supply has a large

effect on aggregate demand. Beta has a money demand curve that is less sensitive

to the interest rate than Alpha. A change in the money supply changes the

interest rate and aggregate demand by a relatively large amount in Beta.

Extreme Keynesianism hypothesizes that a change in the money supply has no

effect on aggregate demand. Alpha has a money demand curve that is more

sensitive to the interest rate than Beta. A change in the money supply changes

the interest rate by a small amount and aggregate demand by a relatively small

amount in Alpha.

7a. An increase in government expenditures and a decrease in taxes are

expansionary fiscal policies. Aggregate demand increases in the first round.

Real GDP and the price level begin to increase. In the second round, the

increasing real GDP increases the demand for money and the interest rate rises.

The rising price level decreases the supply of real money and increases the

interest rate further. Interest-sensitive expenditure decreases and limits the

increase in real GDP. The decrease in interest-sensitive expenditure includes a

decrease in investment and net exports.

An increase in the money supply lowers the interest rate, increases

interest-sensitive expenditure and increases aggregate demand in the first

round. Real GDP and the price level begin to increase. In the second round,

increasing real GDP increases the demand for money and the interest rate rises.

The rising price level decreases the supply of real money and the interest rate

rises further. The increase in interest-sensitive expenditure limits the

increase in real GDP. The resulting increase in interest-sensitive expenditure

includes an increase in investment and net exports.

7b. The expansionary fiscal policies raise the interest rate and the

interest-sensitive expenditure component of aggregate demand decrease. The

exchange rate rises, exports decrease, imports increase, and net exports

decrease.

An increase in the money supply lowers the interest rate and the

interest-sensitive expenditure component of aggregate demand increase. The

exchange rate falls, exports increase, imports decrease, and net exports

increase.

7c. All policies increase real GDP and raise the price level.

7d. The best policy is to increase the money supply.

Increasing the money supply results in a lower the interest rate and lowers the

exchange rate. The lower interest rate increases investment and lowers the

exchange rate increasing net exports.

9a. A combination of an increase in the money supply and a decrease in

government expenditures.

9b. An increase in the money supply lowers the interest rate and increases

interest-sensitive expenditure including investment. The aggregate demand curve

shifts rightward. A decrease in government expenditures decreases aggregate

demand and shifts the aggregate demand curve leftward. Real GDP decreases, the

interest rate decreases, and interest-sensitive expenditure, including

investment, increases. If the decrease in government expenditures is of the

correct magnitude, the leftward shift of the aggregate demand curve will offset

the rightward shift created by the increase in the money supply. The price level

will remain the same.

9c. The lower interest rate will increase investment and consumption

expenditure and the lower exchange rate will increase exports.

9d. In the short run, real GDP and the price level do not change. The aggregate

demand curve remains the same—only the composition of aggregate demand changes.

In the long run, the increase in investment will encourage economic growth. Real

GDP will increase and the price level will remain the same.

1a. An increase in the quantity of money, an increase in government

expenditures, a tax cut, an increase in exports.

Anything that increases aggregate demand can set off a demand-pull inflation.

But to sustain such an inflation, the quantity of money must keep increasing.

1b. Starting out on AD0 and SAS0, the price level is 120 and real GDP is at

potential GDP of €7 billion. Aggregate demand increases and the AD curve shifts

rightward to AD1. The price level rises and real GDP increases to the

intersection of AD1 and SAS0. There is now an inflationary gap.

1c. Starting out on AD1 and SAS0 with an inflationary gap, the money wage rate

rises and short-run aggregate supply decreases. The SAS curve starts to shift

leftward toward SAS1. The price level keeps rising, but real GDP now decreases.

The process now repeats. AD shifts to AD2, an inflationary gap opens again, the

money wage rate rises again, and the SAS curve shifts toward SAS2.

3a. The quantity of money is €40 million.

Because MV=PY, we know that M=PY/V. With P=200, Y=€400 million, and V=20, M=€40

million.

3b. The quantity of money is €48 million.

Money grows by 20 percent, which is €8 million. So the quantity of money

increases from €40 million to €48 million.

3c. The price level is 240.

Because the quantity theory holds and because the factors that influence real

GDP have not changed, the price level rises by the same percentage as the

increase in money, which is 20 percent. The price level rises from 200 to 240.

3d. Real GDP is €400 billion.

Because the factors that influence real GDP have not changed, real GDP is

unchanged. It remains at €400 billion.

3e. Velocity of circulation is 20.

Because the factors that influence velocity have not changed, velocity is

unchanged. It remains at 20.

5a. An anticipated increase in the quantity of money, an increase in government

expenditures, a tax cut, an increase in exports.

Anything that increases aggregate demand can set off an anticipated inflation as

long as the event is anticipated. But to sustain such an anticipated inflation,

the quantity of money must keep increasing along its anticipated path.

5b. Starting out on AD0 and SAS0, the price level is 120 and real GDP is at

potential GDP of €7 billion. Aggregate demand increases, and the AD curve shifts

rightward to AD1. The increase in aggregate demand is anticipated so the money

wage rate rises and the SAS curve shifts to SAS1. The price level rises, and

real GDP remains at potential GDP.

5c. Starting out on AD1 and SAS1, a further anticipated increase in aggregate

demand occurs. The AD curve shifts to AD2, and because the increase in aggregate

demand is anticipated, the money wage rate rises again and the SAS curve shifts

to SAS2. Again, the price level rises and real GDP remains at potential GDP.

7a. If the natural unemployment rate and the expected inflation rate remain

constant between 1999 and 2003, the SRPC is linear and passes through the data

points listed in the table provided. Note that one of these points is the

natural rate of unemployment (4 percent) and the expected inflation rate (6

percent). The LRPC is vertical at an unemployment rate of 4 percent.

7b. If the actual inflation rate rises from 6 percent to 8 percent a year, the

unemployment rate decreases from 4 percent to 3 percent. This change would occur

if aggregate demand were expected to increase.

9a. Both the inflation rate and the unemployment rate have increased. So the

expected inflation rate has increased and the natural rate of unemployment might

have increased (but has not definitely increased). Any of the events that can

increase the expected inflation rate might have occurred. Most likely, the

expected growth rate of the money supply has increased. If the natural rate of

unemployment has not increased, the economy is in a recession, despite the fact

that the inflation rate has increased.

9b. If point a is a long-run equilibrium, the LRPC is vertical at an

unemployment rate of 4 percent. The SRPC slopes downward and passes through

point a. If point a is not a long-run equilibrium, the SRPC still passes through

point a but the LRPC is vertical at whatever unemployment rate is the natural

rate.

9c. If point d is a long-run equilibrium, the LRPC is vertical at an

unemployment rate of 8 percent. The SRPC slopes downward and passes through

point d. If point d is not a long-run equilibrium, the SRPC still passes through

point d but the LRPC is vertical at whatever unemployment rate is the natural

rate.

1a. The graph plots leisure on the x-axis and real GDP on the y-axis. As

leisure increases from zero to 12 hours a day, real GDP decreases from £30 to £0

a day.

1b. The table replaces leisure with labour and labour equals 12 hours a day

minus leisure hours. The graph plots labour on the x-axis and real GDP on the

y-axis. As labour increases from zero to 12 hours a day, real GDP increases from

€0 to €30 a day.

1c. When labour increases from 0 to 2 hours a day, the marginal product of

labour is €5. When labour increases from 2 to 4 hours a day, the marginal

product of labour is €4. When labour increases from 4 to 6 hours a day, the

marginal product of labour is €3. When labour increases from 6 to 8 hours a day,

the marginal product of labour is €2. When labour increases from 8 to 10 hours a

day, the marginal product of labour is €1.When labour increases from 10 to 12

hours a day, the marginal product of labour is €0.

Marginal product is the change in real GDP divided by the change in labour

hours.

3a. The demand for labour schedule is the same as the marginal product of

labour schedule The marginal product of labour schedule is described in solution

1c. The marginal product must be aligned with the midpoint of the change in

labour. So, for example, the marginal product of €5 an hour is aligned with 1

hour of work at the midpoint between 0 and 2 hours.

The graph plots a marginal product of €5 at 1 hour and a marginal product of €1

at 9 hours of labour and is a straight line between these points. At 2 hours of

labour, the marginal product is €4.50.

3b. The table lists hours of labour from zero to 12 a day. Against each hour,

the wage rate at which Crusoe is willing to supply labour is €4.50 an hour.

Crusoe’s supply curve is horizontal at €4.50 an hour.

3c. The full-employment equilibrium real wage rate is €4.50 an hour, and the

quantity of labour employed is 2 hours a day.

The full-employment equilibrium real wage rate is €4.50 an hour because Crusoe

is willing to work any number of hours at this wage rate. The equilibrium level

of employment is 2 hours a day because this is the number of hours at which

Crusoe’s marginal product of labour is €4.50 an hour.

3d. Potential GDP is €10 a day.

Potential GDP is €10 a day because this quantity of real GDP is produced when

labour is 2 hours a day.

5a. The new production function table lists real GDP against labour hours. Real

GDP is €15 at 2 hours of labour, €27 at 4 hours, €36 at 6 hours, €42 at 8 hours,

€45 at 10 hours, and €45 at 12 hours.

The new demand for labour schedule has labour of 2 hours at €6.75 and 9 hours at

€1.50.

To calculate the new demand for labour schedule, calculate the new marginal

product (old marginal product multiplied by 1.5) at each level of employment.

5b. The full-employment equilibrium real wage rate is €4.50 an hour and the

quantity of labour employed is 5 hours a day.

The equilibrium level of employment is 5 hours a day because this is the number

of hours at which Crusoe’s marginal product of labour is €4.50 an hour.

5c. Potential GDP is €31.50 a day.

Potential GDP is €31.50 a day because this quantity of real GDP is produced when

labour is 5 hours a day.

5d. The increase in productivity shifts the production function upward by 50

percent. The marginal product of labour increases by 50 percent. Employment

increases and so does potential GDP.

7a. Real wage rate is €3 an hour and employment is 3,000 hours a day.

This wage rate and quantity of labour are at the intersection of the demand

curve and the supply curve in the figure.

7b. Potential GDP is €13,500 a day.

To calculate potential GDP, use the fact that the real wage rate on the demand

for labour curve is the marginal product of labour. Remember that it is plotted

midway between the initial and final level of real GDP from which it is

calculated. Do the marginal product calculation in reverse and obtain the level

of real GDP at 3,000 hours, which is €13,500 a day.

7c. The natural rate of unemployment is 25 percent.

The natural rate of unemployment occurs at full employment when job search is

1,000 hours. Employment is 3,000 hours, and job search, which is unemployment,

is 1,000 hours. The labour force (employment plus unemployment) is 4,000 hours.

The natural rate of unemployment is 25 percent (1,000/4,000 multiplied by 100).

1. The economy dos not conform to the one-third rule. It conforms to a

one-half rule.

In this economy, an x percent increase in the capital stock per hour of work

leads to a 0.5x percent increase in real GDP per hour of work. You can confirm

this fact by calculating the percentage change in capital and real GDP at each

of the levels provided in the table and then dividing the percentage change in

real GDP by the percentage change in capital. For example, when capital

increases by 100 percent from £10 to £20, real GDP increases by 50 percent from

£3.80 to £5.70.

3a. Yes, Longland experiences diminishing returns.

Diminishing returns are present if the marginal product of capital diminishes as

capital increases, holding technology constant. You can calculate the marginal

product of capital from the schedule provided and see that it does diminish. The

increase in real GDP per hour of work that occurred in the question resulted

from an increase in capital and an advance in technology. We know this because

to produce £10.29 in 1999 would have required a capital stock of £60 per hour of

work, and in 2001, this output can be produced by a capital stock of £50. The

change in real GDP divided by the change in capital is not the marginal product

of labour because technology is not constant.

3b. The contribution of the change in capital is £1.04.

Along the productivity function, when capital per hour of work increases from

£40 to £50, real GDP per hour of work increases from £8.31 to £9.35, a

difference of £1.04. This number is also calculated as the percentage increase

in real GDP that is equal to one-half the percentage increase in capital.

3c. The contribution of technological change is £0.94.

This number is calculated as the change in real GDP minus the contribution of

the change in capital to the growth of productivity, which is £1.04.

5a. Employment is 6 billion hours per year and the real wage rate is £7 an

hour.

The labour market is n equilibrium at the real wage rate at which the quantity

demanded equals the quantity supplied. That real wage rate is £7 an hour.

5b. The real wage rate rises.

When the demand for labour increases, there is a shortage of labour at the

current wage rate. So the real wage rate rises.

5c. The population begins to grow.

The reason for the population growth is that the real wage rate exceeds the

subsistence level.

5d. Employment is 7 billion hours a year.

In long-run equilibrium, employment equals the quantity of labour demanded at

the subsistence real wage rate of £7 an hour. Only when the population has grown

by enough to make the quantity of labour supplied equal 7 billion hours a year

does the population stop growing.

7. When the demand for capital raises the real interest rate above the target

rate, the capital stock and real GDP begin to grow and keep on growing. In

contrast, in the neoclassical Martha’s Island, as the capital stock grows, the

real interest rate falls (because of diminishing returns) and growth eventually

ends.

1a. Possible combinations are a or d, e or g, and i or k.

A Keynesian recession results from a decrease in investment caused by a decrease

in expected profit. In an extreme case, no prices change, so the move is to a,

e, and i. But a more general possibility is that the money wage rate doesn’t

change but the price level falls, real wage rate rises, and the interest rate

falls. In this case, the move is to d, g, and k.

1b. The economy moves to d, g, and l.

A monetarist recession results from a decrease in the quantity of money. The

interest rate rises, and investment decreases. Aggregate demand decreases, but

the money wage rate doesn’t change. Real GDP and the price level decrease, the

real wage rate rises, and employment decreases. The move is to d, g, and l.

1c. The economy moves to d, g, and i, k, or l.

1d. The economy moves to d, g, and i, k, or l.

Either type of rational expectations recession results from an unanticipated

decrease in aggregate demand. Any of several factors could initiate the decrease

in aggregate demand, and the interest rate could rise, fall, or remain constant.

Aggregate demand decreases, but the money wage rate either doesn’t change or

doesn’t change by enough to maintain full employment. So real GDP and the price

level decrease, the real wage rate rises, and employment decreases.

1e. The economy moves to c, e, g, or h, and k.

In a real business cycle recession, a decrease in productivity decreases the

demand for labour and capital. The interest rate and the real wage rate fall,

and investment and employment decrease. Aggregate demand and aggregate supply

decrease, so real GDP decreases but the price level might fall, rise, or remain

unchanged.

3. This recession is consistent with Keynesian or rational expectations

theories (see the solutions 1a, 1c, and 1d).

5. This recession is consistent with real business cycle theory (see the

solution 1e).

7. This recession is not consistent with any of the theories and is an

unlikely combination of events. The price level does not usually rise when the

real wage rate rises.

9. This recession is consistent with the real business cycle theory (see the

solution 1e).

11. This recession is consistent with monetarist theory (see the solution 1b).

13. This recession is not consistent with any of the theories and is an unlikely

combination of events. The real wage rate does not usually fall when the price

level falls.

1. Anything that slows investment in physical or human capital or slows the

pace of technological change will create a productivity growth slowdown. For the

factors at work during the UK productivity growth slowdown, review p. 687-688

of Chapter 30.

Improvements in incentives to invest in physical or human capital or to innovate

and speed up the pace of technological change will counteract a productivity

growth slowdown. See p.687-688 of Chapter 30 and pp. 738-739 of Chapter 32.

3a. Real GDP is €800 billion and the price level is 110.

These values are determined at the intersection of AD0 and SAS.

3b. Real GDP falls to €750 billion and the price level falls to 105. Then, as

aggregate demand returns to AD0, the price level and real GDP return to their

initial levels.

3c. Real GDP falls to €750 billion and the price level falls to 105. The

government increases aggregate demand to AD0, and the price level and real GDP

return to their initial levels. Aggregate demand then increases (because the

decrease is temporary), and real GDP rises above potential GDP. An inflationary

gap arises. The money wage rate rises and so does the price level. Real GDP

moves back toward potential GDP.

3d. Real GDP falls to €750 billion, and the price level falls to 105. The

economy is stuck at this point until the money wage rate falls, short-run

aggregate supply increases, and the economy moves back to potential GDP at an

even lower price level. This move will likely take a long time.

3e. Real GDP falls to €750 billion, and the price level falls to 105. The

government increases aggregate demand to AD0, and the price level and real GDP

return to their initial levels. Because the decrease in aggregate demand is

permanent, this is the end of the action.

5a. The economy might have got into its described state because of a

combination of rapid money supply growth (which brings inflation) and large

structural changes (which bring high unemployment and slow productivity growth).

5b. A slowdown in money growth will lower the inflation rate. Improvements in

incentives to invest in physical or human capital or to innovate and speed up

the pace of technological change will speed productivity growth.

5c. Study pp. 738-739 and pp. 746-750 for explanations of how these policy

actions work.

7a. These policy actions were part of a feedback rule. The actions were taken

because of the crises.

7b. The required domestic policies all decrease aggregate demand. They lower

real GDP and lower the price level (compared with what would have happened).

7c. A possible criticism, and one that some economists have made, is that the

countries should have adopted policies to expand real GDP even at the risk of a

rise in inflation, rather than adopt policies that decrease aggregate demand.

1a. 0.10 computer per TV set at 10 TV sets.

1b. 0.40 computer per TV set at 40 TV sets.

1c. 0.70 computer per TV set at 70 TV sets.

1d. The graph shows an upward-sloping line that passes through the three points

described in solutions 1a, 1b, and 1c.

The opportunity cost of a TV set is calculated as the decrease in the number of

computers produced divided by the increase in the number of TV sets produced as

we move along the PPF. The opportunity cost of a TV set increases as the

quantity of TV sets produced increases.

3a. Virtual Reality exports TV sets to Vital Signs.

At the no-trade production levels, the opportunity cost of a TV set is 0.10

computer in Virtual Reality and 0.30 computer in Vital Signs. Because it costs

less to produce a TV set in Virtual Reality, Vital Signs can import TV sets for

a lower price that it can produce them. And because a computer costs less in

Vital Signs than in Virtual Reality, Virtual Reality can import computers at a

lower cost than it can produce them.

3b. Virtual Reality increases the production of TV sets and Vital Signs

decreases the production of TV sets. Virtual Reality decreases the production of

computers and Vital Signs increases the production of computers.

Virtual Reality increases production of TV sets to export some to Vital Signs

and Vital Signs decreases production of TV sets because it now imports some from

Virtual Reality.

3c. Each country consumes more of at least one good and possibly of both goods.

Because each country has a lower opportunity cost than the other at producing

one of the goods, total production of both goods can increase.

3d. The price of a TV set is greater than 0.10 computer and less than 0.30

computer.

The price will be higher than the no-trade opportunity cost in Virtual Reality

(0.10 computer) and lower than the no-trade opportunity cost in Vital Signs

(0.30 computer).

5a. Free trade increases the production of at least one good (but not

necessarily both goods) in both cases because each country increases the

production of the good at which it has a comparative advantage.

5b. In problem 3, the price of a TV set rises in Virtual Reality. In problem 4,

it falls.

The reason is that in problem 3, Virtual Reality produces a small number of TV

sets with no trade and has the lower opportunity cost per TV set. But in problem

4, Virtual Reality produces a large number of TV sets with no trade and has the

higher opportunity cost per TV set. So in problem 3, Virtual Reality becomes an

exporter and increases production. The price of a TV set rises. In problem 4,

Virtual Reality becomes an importer and decreases production. The price of a TV

set falls.

5c. In problem 3, the price of a computer rises in Vital Signs. In problem 4,

it falls.

The reason is that in problem 3, Vital Signs produces a small number of

computers with no trade and has the lower opportunity cost per computer. But in

problem 4, Vital Signs produces a large number of computers with no trade and

has the higher opportunity cost per computer. So in problem 3, Vital Signs

becomes an exporter of computers and increases production. The price of a

computer rises. In problem 4, Vital Signs becomes an importer of computers and

decreases production. The price of a computer falls.

7a. The prices would be £90 per tonne in the importing country and £10 per

tonne in the exporting country.

These are the prices at which each country wishes to import and export a zero

quantity.

7b. The terms of trade are £50 per tonne.

This is the price at which the quantity demanded by the importer equals the

quantity supplied by the exporter.

7c. The quantity exported and imported is 40 million tonnes.

The quantity exported and imported is the equilibrium quantity—the quantity

demanded and supplied at the equilibrium price.

7d. The balance of trade is zero.

The balance of trade is zero because the value of soybeans imported equals the

value of soybeans exported.

9a. The price in the importing country is £60 per tonne.

The quantity demanded by the importer equals the quantity available under the

quota of 30 million tonnes at this price.

9b. The revenue from the quota is £600 million.

The price at which exporters are willing to sell 30 million tonnes is £40 a

tonne (read off the export supply curve). The price in the importing country is

£60 a tonne (read off the import demand curve), so the revenue from the quota is

£20 a tonne. The total revenue from the quota is 30 million multiplied by £20 a

tonne, which equals £600 million.

9c. The importing agents who have been allocated the quota.

1a. A table like Table 36.1 on p. 826 with the numbers provided in the problem.

The current account shows Imports of goods and services –350 billions of grains,

Exports of goods and services, 500 billions of grains, Net interest payments,

unknown, and Net transfers, unknown. You cannot calculate the current account

balance from these numbers because of the two unknown items.

The capital account shows Foreign investment in Silecon, 60 billions of grains,

Silecon investment abroad, -200 billions of grains, and a capital account

balance of –140 billions of grains (a deficit).

The official settlements account shows Increase in official Silecon reserves,

-10 billions of grains (minus because it is an increase).

Because the sum of the three balances is zero, you can now calculate the current

account balance, 150 billions of grains, a surplus. Exports of goods and

services minus imports of goods and services equal 150 billions of grains. So

the sum of Net interest income and Net transfers is zero, but we don’t know the

values of these two items separately.

1b. The Silecon central bank intervenes in the foreign exchange market.

We know that the central bank intervenes in the foreign exchange market because

its official reserves changed.

3a. Net exports are –€10 million.

Use the fact that

Y = C + I + G + NX and solve for NX as

NX = Y – C – I – G, which equals

NX = 60 – 36 – 20 – 14 = –10.

3b. Saving is €12 million.

Use the fact that

Y = C + S + NT and solve for S as

S = Y – C – NT, which equals

S = 60 – 36 – 12 = 12.

3c. National saving and foreign borrowing finance investment.

I = S + NT – G – NX, which equals

I = 12 + 12 – 14 – (– 10) = 20.

5a. Imports of goods and services are 26 billion bands.

Use the fact that

Y = C + I + G + X – M and solve for M as

M = – Y + C + I + G + X, which is

M = – 100 + 60 + 22 + 24 + 20 = 26.

5b. The current account balance is – 6 billion bands (assuming that net

interest income plus net transfers is zero).

Use the fact that

CAB = X – M

CAB = 20 – 26 = – 6.

5c. The capital account balance is unknown.

The sum of the current account, capital account, and official settlements

account is zero. The capital account balance cannot be calculated unless

information is given about the official settlements account.

5d. Net taxes are 20 billion bands.

Use the fact that

Gov. budget deficit = G – NT, so

NT = G – Gov. budget deficit, which is

NT = 24 – 4 = 20.

5e. The private sector balance is –2 billion bands (a deficit).

Use the fact that

Private sector surplus = S – I, with

S = Y – C – NT, or

Private sector surplus = Y – C – NT – I, which is

Private sector surplus = 100 – 60 – 20 – 22 = – 2.

7a. The country intervenes in the foreign exchange market to limit movements in

the exchange rate.

7b. The central bank might have conducted an open market operation in the bond

market to increase the interest rate.

The Central bank’s intervention in the foreign exchange market did not bring

appreciation. On the contrary, its intervention limited the extent of the

appreciation.

7c. Private traders in the foreign exchange market might have increased their

demand for the currency perhaps because they expected the exchange rate to

appreciate in the future.