Unemployment

1. Suppose that Congress passes a law requiring employers to provide

employees some benefit (such as healthcare) that raises the cost of an
employee by $4 per hour.
a. What effect does this employer mandate have on the demand for labor?
=> If a firm was not providing such benefits prior to the legislation, the
curve showing the demand for labor would shift to the left by exactly $4
at each quantity of labor, because the firm would not be willing to pay as
high a wage given the increased cost of the benefits.
b. If employees place a value on this benefit exactly equal to its cost, what
effect does this employer mandate have on the supply of labor?
=> If employees value the benefit by exactly $4 per hour, they would be
willing to work the same amount for a wage that is $4 less per hour, so
the supply curve of labor shifts to the right by exactly $4.
c. If the wage can freely adjust to
balance supply and demand, how
does this law affect the wage and
the level of employment? Are
employers better or worse off? Are
employees better or worse off?
=> The figure shows the equilibrium in
the labor market. Because the
demand and supply curves of labor both shift by $4, the equilibrium
quantity of labor is unchanged and the wage declines by $4. Both
employees and employers are just as well off as before.
d. Suppose that, before the mandate, the wage in this market was $3
above the minimum wage. In this case, how does the employer
mandate affect the wage, the level of employment, and the level of
unemployment?
=> If the minimum wage prevents
the wage from falling to the new
equilibrium level, the result will
be increased unemployment, as
shown next. Initially, the
equilibrium quantity of labor is L1
and the equilibrium wage is w1,
which is $3 higher than the
minimum wage wm. After the law is passed, demand falls to D2 and
supply rises to S2. Because of the minimum wage, the quantity of labor
demanded (LD2) will be smaller than the quantity supplied (LS2). Thus,
there will be unemployment equal to LS2 – LD2.
e. Now suppose that workers do not
value the mandated benefit at all.
How does this alternative
assumption change your answers
to parts (b) and (c)?
=> If the workers do not value the
mandated benefit at all, the supply
curve of labor does not shift. As a
result, the wage rate will decline by
less than $4 and the equilibrium quantity of labor will decline, as shown
beside. Employers are worse off, because they now pay a greater total
wage plus benefits for fewer workers. Employees are worse off,
because they get a lower wage and fewer are employed.
2. Are the following workers more likely to experience short-term or long-term
unemployment? Explain.
a. a construction worker who is laid off because of bad weather
=> A construction worker who is laid off because of bad weather is likely to
experience short-term unemployment, because the worker will be back
to work as soon as the weather clears up.
b. a manufacturing worker who loses his job at a plant in an isolated area
=> A manufacturing worker who loses a job at a plant in an isolated area is
likely to experience long-term unemployment, because there are
probably few other employment opportunities in the area. The worker
may need to move somewhere else to find a suitable job, which means
the worker will be unemployed for some time.
c. a stagecoach-industry worker who is laid off because of competition
from railroads
=> A worker in the stagecoach industry who was laid off because of the
growth of railroads is likely to be unemployed for a long time. The
worker will have a lot of trouble finding another job because the entire
stagecoach industry is shrinking. The worker will probably need to gain
additional training or skills to get a job in a different industry.
d. a short-order cook who loses his job when a new restaurant opens
across the street
=> A short-order cook who loses a job when a new restaurant opens is
likely to find another job fairly quickly, perhaps even at the new
restaurant, and thus will probably have only a short spell of
unemployment.
e. an expert welder with little formal education who loses his job when the
company installs automatic welding machinery
=> An expert welder with little education who loses a job when the
company installs automatic welding machinery is likely to be without a
 job for a long time, because the worker lacks the technological skills to
keep up with the latest equipment. To remain in the welding industry,
the worker may need to go back to school and learn the newest
techniques.

3. Consider an economy with two labor markets—one for manufacturing

workers and one for service workers. Suppose initially that neither is
unionized.
a. If manufacturing workers formed a union, what impact would you predict
on the wages and employment in manufacturing?
=> The figure illustrates the effects of a union being established in the
manufacturing labor market. In the manufacturing labor market (figure
on the left), the wage rises from the non-union wage, wNU, to the union
wage, wU, and the quantity of labor demanded declines from the
non-union quantity of labor, LNU, to the union quantity of labor
demanded, LUD. Because the wage is higher, the quantity supplied of
labor increases to the union quantity of labor supplied LUS, so there are
LUS – LUD unemployed workers in the unionized manufacturing sector.
b. How would these changes in the manufacturing labor market affect the
supply of labor in the market for service workers? What would happen
to the equilibrium wage and employment in this labor market?

=>
 When those workers who become unemployed in the manufacturing sector
seek employment in the service labor market, shown in the figure on the
right, the supply of labor shifts to the right from S1 to S2. The result is a
decline in the wage in the nonunionized service sector from w1 to w2
and an increase in employment in the nonunionized service sector from
L1 to L2.

The Monetary System

1. Suppose you are a personal friend of the chair of the Board of Governors
of the Federal Reserve System (Jerome Powell). He comes over to your
house for lunch and notices your couch. He is so struck by the beauty of
your couch that he simply must have it for his office. He buys it from you
for $1,000 and, since it is for his office, he pays you with a check drawn on
the Federal Reserve Bank of New York.
a. Are there more dollars in the economy than before? Why or why not?
=> Yes. When the Fed purchases anything, it pays with newly created
dollars, and there are more dollars in the economy.
b. Why do you suppose that the Fed doesn’t buy and sell couches, real
estate, and so on instead of government bonds when they desire to
change the money supply?
=> The transaction costs and storage costs would be staggering. Also, the
value of the inventory of “items” would never be certain. The open
market for government bonds is much more efficient.
c. If the Fed doesn’t want the money supply to rise when it purchases new
furniture, what might it do to offset the purchase?
=> The Fed could sell government bonds of equal value to offset other
purchases.
2. Beleaguered State Bank (BSB) holds $250 million in deposits and
maintains a reserve ratio of 10 percent.
a. Show a T-account for BSB.

Beleaguered State Bank

Assets Liabilities
Reserves $25 million Deposits $250 million
Loans $225 million
b. Now suppose that BSB’s largest depositor withdraws $10 million in
cash from her account. If BSB decides to restore its reserve ratio by
reducing the amount of loans outstanding, show its new T-account.
=> When BSB's largest depositor withdraws $10 million in cash and BSB
reduces its loans outstanding to maintain the same reserve ratio, its
T-account is now:

Beleaguered State Bank

Assets Liabilities
Reserves $24 million Deposits $240 million
Loans $216 million
c. Explain what effect BSB’s action will have on other banks.
=> Because BSB is cutting back on its loans, other banks will find
themselves short of reserves and they may also cut back on their loans
as well.
d. Why might it be difficult for BSB to take the action described in part (b)?
Discuss another way for BSB to return to its original reserve ratio.
=> BSB may find it difficult to cut back on its loans immediately, because it
cannot force people to pay off loans. Instead, it can stop making new
loans. But for a time, it might find itself with more loans than it wants. It
could try to attract additional deposits to get additional reserves, or
borrow from another bank or from the Fed.
3. Happy Bank starts with $200 in bank capital. It then accepts $800 in
deposits. It keeps 12.5 percent (1/8th) of deposits in reserve. It uses the
rest of its assets to make bank loans.
a. Show the balance sheet of Happy Bank.

Happy Bank
Assets Liabilities
Reserves $100 Deposits $800
Loans $900 Bank Capital $200
b. What is Happy Bank’s leverage ratio?
=> The leverage ratio = $1,000/$200 = 5.
c. Suppose that 10 percent of the borrowers from Happy Bank default and
these bank loans become worthless. Show the bank’s new balance
sheet.

Happy Bank

Assets Liabilities
Reserves $100 Deposits $800
Loans $810 Bank Capital $110
d. By what percentage do the bank’s total assets decline? By what
percentage does the bank’s capital decline? Which change is larger?
Why?
=> Assets decline by 9%. The bank's capital declines by 45%. The
reduction in bank capital is larger than the reduction in assets because
all of the defaulted loans are covered by bank capital.

4. Assume that the reserve requirement is 5 percent. All other things being
equal, will the money supply expand more if the Fed buys $2,000 worth of
bonds or if someone deposits in a bank $2,000 that she had been hiding in
 her cookie jar? If one creates more, how much more does it create?
Support your thinking
=> The money supply will expand more if the Fed buys $2,000 worth of
bonds.
Both deposits will lead to monetary expansion, but the Fed’s deposit is new
money.
With a 5% reserve requirement, the multiplier is 20 (1/0.05).
The $2,000 from the Fed will increase the money supply by $40,000
($2,000 x 20).
The $2,000 from the cookie jar is already part of the money supply as
currency. When it is deposited the money supply increases by $38,000.
Deposits increase by $40,000 ($2,000 x 20) but currency decreases by
$2,000.

Open-Economy Macroeconomics: Basic Concepts

1. How would the following transactions affect U.S. exports, imports, and net
exports?
a. An American art professor spends the summer touring museums in
Europe.
=>When an American art professor spends the summer touring museums
in Europe, they spend money buying foreign goods and services, so
U.S. exports are unchanged, imports increase, and ne
t exports decrease.
b. Students in Paris flock to see the latest movie from Hollywood.
=> When students in Paris flock to see the latest movie from Hollywood,
foreigners are buying a U.S. good, so U.S. exports rise, imports are
unchanged, and net exports increase.
c. Your uncle buys a new Volvo.
 => When your uncle buys a new Volvo, an American is buying a foreign
good, so U.S. exports are unchanged, imports rise, and net exports
decline.
d. The student bookstore at Oxford University in England sells a copy of
this textbook.
=> When the student bookstore at Oxford University sells a copy of this
textbook, foreigners are buying U.S. goods, so U.S. exports increase,
imports are unchanged, and net exports increase.
e. A Canadian citizen shops at a store in northern Vermont to avoid
Canadian sales taxes.
=> When a Canadian citizen shops in northern Vermont to avoid Canadian
sales taxes, a foreigner is buying U.S. goods, so U.S. exports increase,
imports are unchanged, and net exports increase.

2. Would each of the following transactions be included in net exports or net

capital outflow? Be sure to say whether it would represent an increase or a
decrease in that variable.
a. An American buys a Sony TV.
=> When an American buys a Sony TV, there is a decrease in net exports.
b. An American buys a share of Sony stock.
=> When an American buys a share of Sony stock, there is an increase in
net capital outflow.
c. The Sony pension fund buys a bond from the U.S. Treasury.
=> When the Sony pension fund buys a U.S. Treasury bond, there is a
decrease in net capital outflow.
d. A worker at a Sony plant in Japan buys some Georgia peaches from an
American farmer.
=> When a worker at Sony buys some Georgia peaches from an American
farmer, there is an increase in net exports.
3. A case study in the chapter analyzed purchasing- power parity for several
countries using the price of Big Macs. Here are data for a few more
countries:

a. For each country, compute the predicted exchange rate of the local
currency per U.S. dollar. (Recall that the U.S. price of a Big Mac was
$4.93.)
=> Chile: 2100 pesos/$4.93 = 426 pesos/$
Hungary: 900 forints/$4.93 = 182.5 forints/$
Czech Republic: 75 korunas/$4.93 = 15.2 korunas/$
Brazil: 13.5 reales/$4.93 = 2.74 reales/$
Canada: 5.84C$/$4.93 = 1.18C$/$
b. According to purchasing-power parity, what is the predicted exchange
rate between the Hungarian forint and the Canadian dollar? What is the
actual exchange rate?
=> Under purchasing-power parity, the exchange rate of the Hungary
forints to the Canadian dollar is 900 per Big Mac divided by 5.84
Canadian dollars per Big Mac equals 154,1 Hungary forints per
Canadian dollar. The actual exchange rate is 293 Hungary forints per
dollar divided by 1.41 Canadian dollars per dollar equals 207,8 Hungary
forints per Canadian dollar.
 c. How well does the theory of purchasing-power parity explain exchange
rates?
=> The exchange rates predicted by the Big Mac index are somewhat
close to the actual exchange rates.

Aggregate demand and Aggregate supply

1. Suppose the economy is in a long-run equilibrium. Draw a diagram to

illustrate the state of the economy. Be sure to show aggregate demand,
short-run aggregate supply, and
long-run aggregate supply.
=> The current state of the economy is
shown on the right. The
aggregate-demand curve (AD1) and
short-run aggregate-supply curve
(AS1) intersect at the same point on
the long-run aggregate-supply curve.

2. The economy begins in long-run equilibrium. Then one day, the president
appoints a new chair of the Federal Reserve. This new chairman is well
known for her view that inflation is not a major problem for an economy.
a. How would this news affect the price level that people would expect to
prevail?
=> People will likely expect that the new chair will not actively fight inflation
so they will expect the price level to rise.
b. How would this change in the expected price level affect the nominal
wage that workers and firms agree to in their new labor contracts?
=> If people believe that the price level will be higher over the next year,
workers will want higher nominal wages.
 c. How would this change in the nominal wage affect the profitability of
producing goods and services at any given price level?
=> At any given price level, higher labor costs lead to reduced profitability.
d. How does this change in profitability affect the short-run
aggregate-supply curve?

=>
e. If aggregate demand is held constant, how does this shift in the
aggregate-supply curve affect the price level and the quantity of output
produced?
=> A decline in short-run aggregate supply leads to reduced output and a
higher price level.
f. Do you think this Fed chairman was a good appointment?
=> No, this choice was probably not wise. The end result is stagflation,
which provides limited choices in terms of policies to remedy the
situation.

3. In 1939, with the U.S. economy not yet fully recovered from the Great
Depression, President Roosevelt proclaimed that Thanksgiving would fall a
week earlier than usual so that the shopping period before Christmas
would be longer. Explain what President Roosevelt might have been trying
to achieve, using the model of aggregate demand and aggregate supply.
=> During the Great Depression, equilibrium output (Y1) was lower than the
natural level of output (Y2). The idea of lengthening the shopping period
 between Thanksgiving and Christmas was to increase aggregate demand.
As shown on the right, this could increase output back to its long-run
equilibrium level (Y2).

4. Explain whether each of the following events shifts the short-run

aggregate-supply curve, the aggregate- demand curve, both, or neither.
For each event that does shift a curve, draw a diagram to illustrate the
effect on the economy.
a. Households decide to save a larger share of their income.
=> If households decide to save a larger share
of their income, they must spend less on
consumer goods, so the aggregate-demand
curve shifts to the left, as shown on the right.
The equilibrium changes from point A to
point B, so the price level declines and
output declines.
b. Florida orange groves suffer a prolonged period of below-freezing
temperatures.
=> If Florida orange groves suffer a prolonged period of below-freezing
temperatures, the orange harvest will be reduced. This decline in the
natural level of output is represented on the right by a shift to the left in
both the short-run and long-run aggregate-supply curves. The
 equilibrium changes from point A to point B, so the price level rises and
output declines. (see Figure in (a)).

c. Increased job opportunities overseas cause many people to leave the

country.
=> If increased job opportunities cause
people to leave the country, the long-run
and short-run aggregate-supply curves
will shift to the left because there are
fewer people producing output. The
aggregate-demand curve will also shift to
the left because there are fewer people
consuming goods and services. The
result is a decline in the quantity of output, as shown on the right.
Whether the price level rises or declines depends on the relative sizes
of the shifts in the aggregate-demand curve and the aggregate-supply
curves.

Monetary and Fiscal Policies

1. Explain how each of the following developments would affect the supply of
money, the demand for money, and the interest rate. Illustrate your
answers with diagrams.
a. The Fed’s bond traders buy bonds in
open-market operations.
=> When the Fed’s bond traders buy bonds in
open-market operations, the money-supply
curve shifts to the right from MS1 to MS2, as
 shown on the right. The result is a decline in the interest rate.

b. An increase in credit-card availability reduces

the amount of cash people want to hold.
=> When an increase in credit card availability
reduces the cash people hold, the
money-demand curve shifts to the left from
MD1 to MD2, as shown on the right. The result
is a decline in the interest rate.

c. The Federal Reserve reduces banks’ reserve requirements.

=> When the Fed reduces reserve requirements, the money supply
increases, so the money-supply curve shifts to the right from MS1 to
MS2, as shown in (a). The result is a decline in the interest rate.

d. Households decide to hold more money to

use for holiday shopping.
=> When households decide to hold more
money to use for holiday shopping, the
money-demand curve shifts to the right from
MD1 to MD2, as shown on the right. The
result is a rise in the interest rate.

e. A wave of optimism boosts business investment and expands

aggregate demand.
=> When a wave of optimism boosts business investment and expands
aggregate demand, money demand increases from MD1 to MD2 on the
right. The increase in money demand increases the interest rate.
2. The Federal Reserve expands the money supply by 5 percent.
a. Use the theory of liquidity preference to illustrate in a graph the impact
of this policy on the interest rate.
=> The increase in the money supply will
cause the equilibrium interest rate to
decline, as shown on top right.
Households will increase spending and
will invest in more new housing. Firms
too will increase investment spending.
This will cause the aggregate demand
curve to shift to the right as shown bottom right

b. Use the model of aggregate demand and

aggregate supply to illustrate the impact of
this change in the interest rate on output
and the price level in the short run.
=> The increase in aggregate demand will
cause an increase in both output and the
price level in the short run (bottom right,
point B).

c. When the economy makes the transition

from its short-run equilibrium to its new long-run equilibrium, what will
happen to the price level?
=> When the economy makes the transition from its short-run equilibrium
to its new long-run equilibrium, short-run aggregate supply will decline,
causing the price level to rise even further (point C in the figure above).
 d. How will this change in the price level affect the demand for money and
the equilibrium interest rate?
=> The increase in the price level will cause an increase in the demand for
money, raising the equilibrium interest rate.
e. Is this analysis consistent with the proposition that money has real
effects in the short run but is neutral in the long run?
=> Yes. While output initially rises because of the increase in aggregate
demand, it will fall once short-run aggregate supply declines. Thus,
there is no long-run effect of the increase in the money supply on real
output.

3. Consider two policies—a tax cut that will last for only one year and a tax
cut that is expected to be permanent. Which policy will stimulate greater
spending by consumers? Which policy will have the greater impact on
aggregate demand? Explain.
=> A tax cut that is permanent will have a bigger effect on consumer
spending and aggregate demand. If the tax cut is permanent,
consumers will view it as adding substantially to their financial
resources, and they will increase their spending substantially. If the tax
cut is temporary, consumers will view it as adding just a little to their
financial resources, so they will not increase spending as much.

4. Consider an economy described by the following equations:

Y=C+I+G
C = 100 + 0.75(Y − T)
I = 500 – 50 r
G=125
T = 100
where Y is GDP, C is consumption, I is investment, G is government
purchases, T is taxes, and r is the interest rate. If the economy were at full
employment (that is, at its natural rate), GDP would be 2,000.
a. Explain the meaning of each of these equations.
=> Y=C+I+G is the equilibrium condition for GDP in a closed economy
(output equals the sum of consumption, investment, and government
spending); C=100+.75(Y-T) is the equation for consumption which
depends on disposable income; I=500–50r is the equation for
investment which depends on the interest rate; G=125 means that
government spending is fixed at 125; T=100 means that taxes are fixed
at 100.
b. What is the marginal propensity to consume in this economy?
=> The marginal propensity to consume is 0.75.
c. Suppose the central bank’s policy is to adjust the money supply to
maintain the interest rate at 4 percent, so r = 4. Solve for GDP. How
does it compare to the full-employment level?
=> When the interest rate, r, is 4 percent,
Y = 100 + .75(Y – 100) + 500 – 50(4) + 125
Y = 100 + .75Y – 75 + 500 – 200 + 125
Y = 450 + .75Y.25Y = 450
Y = 1800, which is less than the full employment level.
d. Assuming no change in monetary policy, what change in government
purchases would restore full employment?
=> Assuming no change in monetary policy, an increase in government
purchases of 50 (to 175) would restore full employment. Because the
marginal propensity to consume is .75, the multiplier is 1/(1–.75) or 4.
To increase GDP from 1800 to 2000, or by 200, government spending
would need to increase by 200/4 = 50.
e. Assuming no change in fiscal policy, what change in the interest rate
would restore full employment?
=> Assuming no change in fiscal policy, a decrease of 1 percent (from 4
percent to 3 percent) in the interest rate would restore full employment.
2000 = 100 + .75(2000 – 100) + 500 – 50r + 125
2000 = 2150 – 50r
50r = 150
r=3

MCQs

1. b 13. b 25. b 37. a 49. c

2. c 14. d 26. c 38. d 50. c

3. b 15. a 27. d 39. a 51. b

4. a 16. b 28. c 40. c 52. d

5. d 17. d 29. c 41. d 53. b

6. b 18. b 30. d 42. b 54. c

7. c 19. c 31. c 43. a 55. a

8. c 20. c 32. c 44. a 56. c

9. d 21. d 33. c 45. d 57. d

10. d 22. c 34. d 46. d 58. d

11. b 23. d 35. b 47. d 59. b

12. c 24. d 36. c 48. d 60. c