Class Notes for The Economics of Macro Issues, 7th Edition

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Online Instructor’s ManualByNinos P. MalekSan Jose State University & De Anza CollegeForThe Economics of Macro IssuesSeventhEditionRoger LeRoy MillerResearch Professor of EconomicsUniversity of Texas,ArlingtonDaniel K. BenjaminClemson University, South CarolinaandPERC, Bozeman, Montana

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PrefaceYou don’t have to search far to find macroeconomic issues, and you certainly don’t need to look muchfurther for helpunderstandingthem. This Instructor’s Manual is geared to help you take what is printed inThe Economics of Macro Issues,seventhedition, and to put it to use in the classroom. As Roger LeRoyMiller and Daniel K. Benjamin have said, macroeconomics comes from a universal, basic knowledge thatcan be used in a variety of time-relevant events, debates, and situations. This Instructor’sManual helpsyou tap into this knowledge in an effective and enjoyable manner.◼Chapter OverviewThis short synopsis tells the overarching points to remember for each chapter. It cuts to the core of thechapter’s economic issues. This overview can be helpful as you’re deciding where to assign the chapter foryour own unique course. It can be used as a quick refresher before your lecture on a particular topic. Byindicating the most important specific points, this section can help you decide what kinds of test questionswould be the most effective for your course.◼Descriptive AnalysisThis section goes behind the scenes to the economic analysis upon which the discussion in the text isbased. These descriptions may sometimes go beyond what you would want to include in your class, buthaving this in-depth yet concisebackground will give you what you need to proceed with a well-roundeddiscussion ofthe economic issues for each chapter. While not every angle of an issue can be explored inthis short section, the descriptive analysis should help you as you organize your syllabus, and allow foryour students to dig deeper into the reading.◼Teaching TipsThese tips aren’t found in every chapter of the Instructor’s Manual, but where they have been included,they point out key areas of the text that your students might struggle with. They also provide possiblediscussion questions for you to ask the class so that they can work out the answers themselves, helping tocement the learning process.◼Answers to End of Chapter QuestionsA section has been included in every chapter to answer the Discussion Questions at the end of eachchapter in the text. These questions may bring about a variety of discussions and answers, and the answersthat are supplied here give you a connection to the work that researchers are doing in the field now. Theseanswers further develop basic economic analysis and skill sets—as well as introduce new and differentavenues of discussion.◼And More. . .As always, discussion in the classroom doesn’t stop at this Instructor’s Manual. The manual is intendedto help guide you toward a course that is more informative and more enjoyable to the students in yourclassroom.

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Chapter 1Rich Nation, Poor Nation◼Chapter OverviewPerhaps the most important determinants of a country’s economic growth are the laws and institutionsunder which its citizens operate. Stable laws and mechanisms to protect citizens from thegovernment andeach other are necessary for economic growth to be significant and lasting. The rationale behind this issimple: individuals will not choose to invest if they do not have a reasonable expectation of reaping therewards of their investment. This investment, in both physical and human capital, is required forprolonged economic growth.◼Descriptive AnalysisEconomic growth requires institutions that protect investment and its proceeds. Two major types of legalsystems are outlined in this chapter: common law and civil law. Common law legal systems grant judgesthe authority to decide the law when there is noother authoritative statement of the law. These decisionsare binding for all other cases that are similar until there is another authoritative statement of the law bya legislature or higher court. This statement of the law announces the “rules of the game” and enableseconomic participants to make investment decisions under relative certainty.Unlike the English-based common law system, civil law has its roots in Roman law. Civil law legalsystems draw on abstract rules that judges must apply to cases before them. Rather than relying onjudicial precedents, judges in civil law nations base theirjudgments on the provisions of codes andstatutes or the general principles of these codes. This tends to generate incentives for governing bodies inthese countries to pass statutes that deal with specific situations and can lead to preferential treatment ofspecial interests.Besides mixtures of common and civil law systems, two general other legal systems exist in the world:the Islam Fiqh system and legal systems based upon custom.The importance of the legal system to economic growth is tied to the protection of property rights.Citizens under the common law system, who can turn to precedents where courts have protected propertyrights, are more likely to make long-term investmentsthat can lead to increased human and physicalcapital. Civil law nations, where property rights are more easily overturned through new codes, generate aless secure investment environment and hence generate lower amounts of capital. One study by Mahoneyargues that between 1960 and the 1990s, growth was one-third higher in common law nations relative tocivil law nations.The type of legal institution developed within a nation has much to do with its history. English coloniestended to adopt the common law system. However, other factors have influenced the development ofinstitutions. Tropical colonies tended to be affectedby disease more than temperate colonies. As disease

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Chapter 1: Rich Nation, Poor Nationshortened life expectancy, colonists were more interested in extracting resources rather than establishingpermanent institutions that would lead to long-term growth. Lacking these institutions historically mayexplain one reason why growth is much higherin temperate areas of the world.◼Teaching TipsOften students have trouble seeing the importance of institutions, especially if they have not traveled toother countries. To make this easier, start a discussion by asking a student to imagine a situation whereinstitutions do less to protect their investment. One simple method is to have students imagine that theircollege registrar has the habit of changing graduation requirements every few years. If all registrars actedthis way, how many students would seek to enroll in college? What would happen to the number ofeducated adults? What would happen to economic productivity?◼Chapter Answers1.In Country A, where profits are subject to confiscation by the government, few people wouldchoose to enter mining. While using fewer of their natural resources, the citizens of Country Aalso would have less employment, lower incomes, and lower productionof goods than CountryB. Thus, in one sense, while the physical endowments are the same between A and B, the abilityto utilize those endowments is considerably lower in A than B.2.Often, situations like the one asked about in this question arise from a desire for income or wealthequality. Much of the rationalization for these policies ignores the importance of property rights.For instance, if we should confiscate miner’s profits so that all in society can benefit, then minerswill choose to reduce the amount of ore mined. The end result is that no mining occurs, no profitsare taxed and no income is generated, which perversely achieves the goal of equity espoused bythe group thatwants to redistribute resources.3.This law would have far-reaching consequences. I will endeavor to outline only a few. Afirstreaction might be to think that migration out of the state of college-bound students will occur. Toany extent this happens, this will benefit surrounding states, which will increase their talent poolin college and future labor markets. Of course, this will decrease the academic talent in thesubject state. The decrease in college applicants may cause in-state universities to lower tuition,which would attract out-of-state students (who probably wouldn’t stay in state to work upongraduating) and perhaps induce some in-state students to remain (especially if they were likely tomove out of state upon taking a job). At the same time, hoping to receive the benefits of thehigher tax base, it is likely that non-college-bound citizens will move to this state,whichperverselyfrom the governor’s standpointwould drive down the wages of those not attendingcollege and, possibly, make the wage gap between education levels larger. Campaigncontributions to the governor are more difficult to predict. Parents of students who have beendriven from local collegeswill dislike this policy, as will citizens who support higher education inthat state. On the other hand, those not subject to the tax may think their overall tax burden willfall and thus be in favor of the governor. These individuals are likely to be disappointed, though,given that the governor will probably not earn significant tax revenue from this policy becausecollege graduates are less likely to remain in the state.

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Chapter 1: Rich Nation, Poor Nation4.2014Real GDP Per CapitaCommon Law NationsCivil Law NationsAustralia46,600Brazil15,200Canada44,500Egypt11,100India5,800France40,400Israel33,400Greece25,800New Zealand35,000Italy34,500United Kingdom37,700Mexico17,900United States54,800Sweden44,700Note: All figures calculated using PPP. Source: CIA World Factbook.5.This chapter stresses the importance of property rights. In this light, aid in the form of capitalmay have less of a positive impact than the giving nation hopes. Capitalthatcan be transferred orconfiscated may not be used optimally. For instance, when property rights are guaranteed, anindividual given a tractor may be more likely to buy a field and work it. Absent property rights, afarmer is less likely to buy the fieldand the tractor becomes less useful. Grants of consumergoods may reduce incentives for individuals to create their own consumer goods, which in turnmay reduce political pressure to force governments into protecting property rights.6.In2014, Louisiana had a GDP per person of$42,287thatranked it30thamong the 50 states andDC. In2013, Quebec had a GDPper person of CAN$44,499thatranked it 10thamong the 13provinces and territories. Both are below their national GDP per person averages.11Information for Louisiana:http://www.bea.gov/regional/bearfacts/action.cfm?geoType=3&fips=22000&areatype=22000Information for Quebec:https://en.wikipedia.org/wiki/List_of_Canadian_provinces_and_territories_by_gross_domestic_product(Sources from Wikipedia were based on information provided by Statistics Canada and Canada Revenue Agency.)

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Chapter 2Innovation and Growth◼Chapter OverviewInnovation is necessary to transform prior inventions into something useful for our everyday lives.Profitis the incentive for businesses to innovate and, when firms are successful, our standard ofliving increases.It is the introduction of new products that improvesour lives andit isthe potential profitfor businessesthat leads tonew investment, whichcontributeto economic growth.Property rights to ideas must besecure and being able to keep the fruits of one’s labor are necessary in order to create the properincentives to innovate.Governments need taxes to operate but the unintended consequence of taxingprofits isthat there isless incentive for firms to innovate.◼Descriptive AnalysisEach of us today benefits from prior inventions and innovations to those inventions. We can communicatewith each other or send pictures to each other from across theworld;we are able to obtain information ina matter of secondsthatpreviously tookhours; we can purchase groceries, other essentialhomeproducts,and even electronic “toys” that entertain us at much lower prices due to innovation. Innovation eitherreduces production costs, which leads to lower prices, or it brings us new goods and services that makeour lives easier or give us more utility (pleasure, satisfaction).Just because someone invents something does not mean it will automatically reach the masses. In fact,some inventions in hindsight seem to be useless or haveonly narrow applications. It is innovation—theprocess of transforming the invention—that leads to the increase in the welfare of the masses.Innovation does not just happen by chance. In fact, inventions and innovation are a function of how muchis spent on research and development (R&D). Large,private firms andgovernmentagencies spendbillions of dollars on R&D trying to create new inventions, but only a few actually are created that haveuseful applications, and even fewer might be successful commercially. However, not all innovation isdone by largefirmsor government. Small businesses and individuals invent and innovate, too.Regardless of whom does the R&D,ourstandard of livingincreaseswhen newproductsare brought tomarket and when innovation transforms already made products or lowersproduction costs,which leadtolower prices for consumers. These lower prices, in a very real sense, areequivalent to getting a pay raise.Historically, when the rate of innovation was slow in the United States, thestandardof living was low.However, as the rate ofinnovation has increased, so has the standard of living for the average American.It is innovation that is the foundation for economic growth. Innovation does not just happen in anyeconomic system. The institutions(rules of the game)of a country affect the incentives to innovate. Ifthere is no stable judicial system that enforces property rights such as patents, then firms andindividuals

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Chapter 2: Innovation and Growthwill not have an incentive to invent or innovate. Moreover, if taxes are imposed on the profits of largefirms or small businesses, then the incentive to create a better product or to innovate will be diminished.The notion that everything important has already been invented ignores the fact that previous inventionsand innovations werebuilt on previousknowledge. So, the fact that we have more inventions andinnovationstoday than ever beforemeans that there is fertile ground forevenmore inventions andinnovationsthat will improve and change our lives.◼Teaching TipsStudents might not appreciate how their lives have been impacted byentrepreneurswho had an idea andmade it into the “next big thing.” Our lives today are so much easier and we have so many more productsthat entertain us,allow us to communicatemore easilyand moreproductively,or even go on dates. Youcan use the television showShark Tankon ABC as an example. Askyourstudentswhy they think thesepeoplecomeon the show? (They will most likelysay,“To make money!”and that’s fine. It is this pursuitof money for themselves that gives others the value-enhancing goods and services.) Students mightunderestimate or negatively view the pursuit of profit. Some students might protest that profits are “evil”and companies take advantage of us. But then ask students if theyneedtheir iPhone orSonyPS4/Microsoft X-Boxvideo game console that is currently in their hand or in their dorm room? Ask themif Apple or Sonyor Microsoftforcedthem to buy their product?You can also turnthetables by askingthemif they would go to work if they did not receive apaycheck.What you want your students tounderstand is that those firms and individuals who invent and innovate respond to incentives just like theydo. This is also a good time to remind students of Adam Smith’s famous quote, “It is not from thebenevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard totheir own interest.” It isbecause of their own interest,thatwe don’t have to produceour own steak, bread,or beer that we enjoy eating and drinking.◼ChapterAnswers1.It is better to live today. If the famous kings and queens of the past or John D. Rockefeller gotsickor suffered from medical problems, theywere worse off than theaverage person today whocan get high-tech medical treatment and medicine.Individuals today can get better relief by justgoing to the pharmacy let alonetoa physician who has much more human capital and physicalcapital to work with today than during the times of the kings and queens or Rockefeller.As far as homes, cars, communication devices, and entertainment products, the average income-earner today lives in a safer home, drives a more luxurious and safer car, can communicate bothverbally and visually with anyone across the globe, and can enjoy a beautiful high-definitionpicture on their flat television.2.Human beings are always thinking of new things to createordevisingways of makinga bettermousetrap. The problem is that just because someone invents something, it does notnecessarilymean others will benefit from it. First, the invention has to be something that truly has a benefit.Moreover, in order for it to be commercially successful, it has to benefit many people. This iswhy innovation is necessaryandnot just invention.

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Chapter 2: Innovation and Growth3.It depends on who does the spending.One can argue that government expenditureson basicresearch are necessary since private firms will not undertake this. On the other hand, governmentR&D can be wasteful since they are spending taxpayer dollars and not their ownmoney.Therefore, thegovernmentagencies doing the R&Dmight notbeas good of stewards with theirresources.On the other hand, it can be argued that if our knowledge has increased due to R&D,evenifit isn’t profitable, thatknowledgewill make us better off and lead to more productiveavenues of R&D. Of course, privatefirms have the financial incentive to spend time and moneyresearching and developingproductsthat will make a profit. And if the firm makes a profit, that isevidence that they did something right (solved a problem, alleviated suffering, created somethingpleasurable) since individuals cannot be forced to buy the products of the firms.4.Economic growth has an impact on individual welfare. Even small percentage changes, due tocompounding, have alarge impact. So, while a small change might have a small impact on ourlives in the short-run, in the long-rung our standard of living will be greatly reduced.There is an easy way to determine the number of years it takes for an economy to double in size.The formula is equal to 70 divided by the growth rate (the rule of 70). So, using 2.1%, it wouldtake aneconomy approximately33 years to double; however, using .9 %, it would takeapproximately 78 years.5.In Nation A, the after-tax profit will be $83,000 ($100,000 x .17 = $17,000) while in Nation B itwould be $93,000 ($1000, 000 x .07 = $7,000). Therefore, the preferred location is, of course,Nation B (assuming everything else is equal).The business is not the only one that will benefit by operating in Nation B—the citizens will alsobenefit. First,the business inNation B will provide a service or product that can be directly soldto the citizens ofNationB. Second, the business will have to hire workers from among thecitizenry, thereby increasing employmentin Nation B. Finally, the business in Nation B willinvest in physical capital and will continue to innovate which will lead to more growth.6.Answers will vary but most likely students will list the iPhone/Android phone,popular apps likeGPS navigation (Waze) and online banking,social mediaand dating,websites, improved videogame graphics, picture quality on televisions, online education innovations, and improvements inmedicine.It is difficult to put a precise dollar value onpsychologicalutility, but studentsat leastcould beasked to estimatehowmuch money they spent on the above items over the lastfive years.Students could be asked how much time and money they were able to save by not having tocommute to alloftheir classes on campusorthey could be asked to consider how much moneythey would pay to avoid the pain and suffering they would have without their medicine. Finally, ifthey met someone online, ask how much that is worthto them.

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Chapter3Outsourcing and Economic Growth◼Chapter OverviewBroadly defined, underground economic activity consists of transactions not reported or reportable to thegovernment. Economists estimate that throughout the world, undergroundeconomic activities accountfor about one-third of all production. However, underground activities are not evenly distributed acrosscountries. Much underground activity occurs in order to evade taxes. Countries with low marginal taxrates experience less underground activity because citizens have less incentive to evade taxes.Regulations on products or labor can also encourage underground activity. This chapter highlights someof the factors driving underground economics.◼Descriptive AnalysisWhen Americans first think of the underground economy, they almost immediately think of the illegaldrug trade. By definition, the drug trade is underground; buyers and seller purposefully attempt to hidetheir activities from the government. However, there are numerous other underground activitiesthatcommonly occur. As evidenced by a number of political scandals involving hiring domestic help,payments to workers “under the table” constitute a significant proportion of hidden economic activity.Indeed, in any country where something is banned or taxed there seems to be a black market for thatgood.For obvious reasons, nobody knows exactly the size of the underground economy. Estimates of its size inthe United States range from very little to about 30% with the most reasonable being around ten percent.The underground economy in Europe is thoughtto be larger, perhaps as much as 20%, with somecountries like Italy exceeding 30%. Developing countries, especially those with few property rights, arelikely to have a majority of the economies be hidden from the government.The size of the underground economy between countries varies considerably. The source of this variationdepends upon the marginal tax level, economic regulations, and often the ability for citizens to makepurchases or transport goods to a different jurisdiction. A high marginal tax rate encourages citizens tohide income generating activities from authorities in hopes of evading taxes. Potentially, this explains thehigher rate of European underground activity (where marginal tax rates tend to be high)relative toAmerican levels (where tax rates tend to be low). A related issue not to be confused with this argument istax avoidance. Tax evasion occurs when citizens illegally avoid paying taxes (i.e. not reporting theirearned income) whereas tax avoidance occurs when citizens use legal loopholes to reduce their taxburden. A high marginal tax rate increases both tax evasion and tax avoidance.Market regulations may also induce higher levels of underground activity. Restrictions on firing workersencourage businesses to hire individuals “under the table” so as to avoid these restrictions. Long-termunemployment benefits may induce workers to work in the underground economy so as to not lose their

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Chapter 3: Outsourcing and Economic Growthbenefits. Regulations increasing the marginal cost of hiring a worker may also contribute to increased useof underground labor. For instance, requiring firms to provide health care to employees may induce firmsto illegally contract with employees rather than legally hiring them.Another form of underground activity is smuggling. Whenever two jurisdictions exist with differentregulations or tax structures, one can imagine smugglers earning a profit by exploiting these differences.Cigarettes (between low and high tax American states), Cuban cigars, weapons, and drugs are commonexamples. There is considerable smuggling of petrol and diesel that occurs between Northern Ireland andIreland the flow of which depends upon local tax rates and fluctuations in the value of the Euro andPound. The British government estimates it lost 350 million Pounds worth of taxes because of smugglingcheaper Irish Petrol into Northern Ireland.Finally, participation in the underground economy is best thought of in terms of opportunity cost andcomparative advantage. When individuals lack mobility or skills to succeed in other areas or sectors ofthe economy, they will be more attracted to the underground economy when their economiccircumstances deteriorate. Miller and Benjamin cite Ahmedabad, India as a case in point. When the localtextile industry deteriorated, many workers without the ability to change locations or earn a living in adifferent career, turned to the underground economy including street vending, trash collecting, andrecycling. The authors contrast this to residents of Buffalo, New York who, because of the completion ofthe St. Lawrence Seaway, has suffered a serious declinein economic activity. Rather than turning to theunderground economy, residents of Buffalo simply departed for jobs in other areas of the country.Economic mobility allows individuals to substitute out of the underground economy when under pressure.Finally, it is important to keep in mind that the underground economy is a wealth generating activity inmuch the same way that normal, legal economic activity is. In all but extreme cases, the undergroundeconomy relies upon trade that benefits both seller and buyer. As such, the underground economy issocially beneficial even when it is illegal or frowned upon by governments.◼Chapter Answers1.High marginal tax rates encourage citizens to evade taxes by participating in undergroundactivities. Consider the extreme case of a 100% marginal tax rate,citizens would have noincentive to participate in legal work since all of their earnings would be taxed. One wouldimagine that in this case, all work done would be hidden from the government so employeescould retain their earnings. On the other hand,a 0% tax rate would not cause any evasion; in thiscase citizens would retain all that they earned and have no additional incentive to hide theirproduction from the government.2.Lawsthatdiscourage employee termination likely increase hiring workers in the undergroundeconomy. These laws likely discourage some overall hiring as the total cost of a worker to a firm(including termination costs/uncertainty) is greater. However, some hiringdoes occur in theunderground labor market to counter act this. Interestingly, workers hired in the undergroundeconomy may suffer from these types of laws since they are less well protected by other labormarket safeguards (i.e. safety regulations, workers compensation, etc.).3.From the individual’s perspective, participating in the underground economy is a voluntaryactivitythatpresumably makes the individual better off—otherwise the individual would notparticipate in it. Regardless of the reason why, participating in the underground economy isillegal and puts the individual in jeopardy of the law. One can imagine the socialramificationshaving great differences depending upon the activity undertaken. For instance, hiring a domestic

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Chapter 3: Outsourcing and Economic Growthworker “under the table” and not paying the associated taxes cheats the government out ofrevenue but increases the utility for the employer and employee. Selling drugs, on the other hand,has a negative externality on societyand possibly forms or abets an addiction thatone party to thetransaction (the buyer) may really want to avoid.4.A highly corrupt government, defined here as one that does not respect property rights, wouldhave citizens more likely to participate in the underground economy. In these types of nations, acorrupt government may take the proceeds or capital of a citizen. In this case, citizensparticipating in the underground economy may not rise to the notice of such governments andtherefore may be able to accumulate more wealth than if they were participating in the legaleconomy.5.Yes. One can imagine that being paid “on the books” allows others in society, most notably thelegal system, to recognize your job as legitimate. Legitimate work may be associated with legalprotections such as workers compensation, protection from arbitrary termination, and the abilityto use the job as collateral for loans. Many of thesethings are expensive for a firm that, in orderto reduce expenses, may desire to pay “off the books.” In an underground economy, these thingsmay be bargained over.In short, anemployee may be willing to receive a wage above the marketrate in exchange for being hired “off the books” and foregoing the benefits that come with beinghired legally.6.In either case, as long as the hiring (by the employer) and working (by the employee) wasvoluntary, then it is hard to imagine an employee systematically ending up worse off by takingeither a “on the books” or “off the books” job. Of course, some jobs turn out badly for anemployee but, presumably, if the employee knew of this in advance she would not have acceptedthe job to begin with.

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Chapter4Poverty, Capitalism, and Growth◼Chapter OverviewWhile it is easy to see that wealth can be accumulated quickly by a few “lucky ones” in capitalisticcountries, it is more difficult to evaluate how the poor in these countries farerelative to the poor in othernations. Do the poor in capitalistic countries do better than those in countries following other economicsystems? Does capitalism tend to improve the poor’s standard of living? Does capitalism improve theopportunities for movement out of poverty? This chapter provides affirmative answers to these questions.◼Descriptive AnalysisSince the beginnings of the Industrial Revolution 250 years ago, the ratio of the world’s population livingin abject poverty—that is, on less than $1 per day—has fallen from nine out of ten to one out of seven. Asa matter of fact, fewer people live in abject poverty today than fifty years ago despite the doubling of theworld’s population. In itself, this simple observation really is the most impressive and importanteconomic fact of the past century. However, a cursory inspection will reveal that thesegains have beenuneven. For instance, the extent of poverty in some African nations has changed little over this time,while poverty has declined dramatically in countries like China and South Korea.One common thread that explains economic growth is the presence of capitalism. Capitalism allocatesresources more efficiently than other economic systems, which tends to encourage economic growth. Atthe same time, capitalism is often viewed as causing agreater income disparity within a country. If someindividuals command a high wage while others cannot, the end result of capitalism may be incomedisparity. However, when analyzing cross-country data, this does not appear to be the case. First, whenranking countries by the degree of market openness, a number of studies, including that of the FraserInstitute cited by the authors, find that capitalistic countries grow faster than countries utilizing othersystems.Within the 40 most capitalist countries in the world, the poorest 10% of residents earn about 2.5% of totalincome. While there is some variation between nations, when looking across all countries, the poorest10% of residents receive between 2% and 2.5% of total income. Thus, while the shares may be somewhathigher for capitalist countries, the big impact on the poor is through the better performing rich countries.A 2.5% share of U.S. income provides a much better standard of living than a 2.5% share ofa communistcountry. Further, the higher growth rates experienced by the capitalist countries inevitably aids the poorin those countries. A 2.5% share in a country that is continuously growing implies a much better long-term standard of living than a 2.5% share in a country with little or no growth. It appears that a rising tide(caused by capitalism) lifts all boats.These differences are reflected in other measures of life quality. Life expectancy is higher in capitalistcountries, while child labor and infant mortality is lower. All three of these increase the standard of livingsignificantly for the poor. Longer life expectancy allows the poor greater opportunity to accumulate

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Chapter4: Poverty, Capitalism, and Growthwealth, while less child labor provides an opportunity for education and growth out of poverty. As amatter of fact, some economists have argued that reducing poverty requires education, which occurs onlyas poverty is reduced. Non-capitalistic countries that grow slowly and do not provide markets that rewardhuman capital are less likely to see their citizens educating children, and thereby guarantee slow growthand high poverty rates in the future.◼Teaching TipsAlan Heston and Robert Summers have compiled perhaps the most frequently used data set to examineeconomic growth: the Penn World Tables (http://pwt.econ.upenn.edu/). These are an outstanding resourceto instructors wishing to find easy-to-use data that can be shared with students or presented duringlectures. The tables contain data on about 30 variables for about 189 countries over some or all of theyears 1950-2010. The data provide purchasing power parity and national income accounts that arecomparableacross nations. The data are easy to access and can be downloaded into an Excel spreadsheetwith relative ease.◼Chapter Answers1.The empirical evidence suggests that noncash benefits are more prevalent in wealthy countriesthan poor countries. The reason behind this is simple: Wealthy countries are more able to fundbenefits for the poor thanare poor countries. Of course, these types of benefits improve the livesof the poor in wealthy countries relative to those in poor countries. If non-cash benefits arehigher in rich countries than poor countries, then the data on average income of impoverishedcitizens presented in this chapter understate the actual incomes of the poor in rich countries morerelative to those in poor countries.2.It is easy for political leaders to exploit those with little ability to oppose them. In a nation with arule of law, it may continue to be difficult to protect the poor’s interests, but it is easier than in anation governed by the whims of the few. In other words, it is relatively less expensive and easyfor the poor to enforce their property rights in a system established on the rule of the law than it isfor the poor to curry the necessary political favor to accomplish their goals in a system withoutthe rule of law.3.Certainly strengthening the rule of law is something that could be done to help the poor, aswouldbe methods governments could use to encourage capitalism’s spread. These are difficult eventsfor a foreigner to cause to happen, though. Instead, foreigners could focus on the laws andregulations of their own governments that prevent the poor in other countries from prospering.Perhaps the domestic laws that have the most impact on the foreign poor are the laws that preventa free exchange of goods and services across borders. For instance, a domestic tariff or quota thatprevents foreigners from selling goods in the domestic country has the effect of reducing foreigndemand for labor, which in turn eliminates jobs and reduces wages for all foreigners, includingthe poor. By keeping foreigners from enjoying the benefits of trade, there is less reasonto fightfor capitalism in the foreign country, as the benefits are not clearly seen. Of course, this cansimply prolong the cycle of poverty in those countries.4.Many factors make implementing capitalism difficult in countries under other regimes. Theserange from the religious, to historical, to protecting the interests of the ruling class from a moreopen society. One all too common occurrence is that nations follow a charismatic leader whoconsolidates political and economic power and thereby deters capitalism.

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Chapter4: Poverty, Capitalism, and Growth5.Numerous answers can be given to this question.6.The most recent (2014) rankings by the Fraser Institute places the Democratic Republic of Congoat a very low 144 out 152 nations on their Economic Freedom Index.

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Chapter5The Threat to Growth◼Chapter OverviewAs discussed in Chapters 1 through4, components to successful long-run economic growth include secureproperty rights in a system that allows individuals to freely participate in marketactivities. One possiblebarrier to free trade between individuals is government involvement in economic decisions. Whetherdirectly through regulation or indirectly through taxation, government involvement in economic decisionsmay lower social welfareand has the potential for reducing economic growth. Given the recent largebudget deficit run by the U.S. government, this chapter argues that a big threat to U.S. growth is a futureincrease in taxes.◼Descriptive AnalysisOver the past decade, the U.S. government has represented an increasing share of the economy. Federalgovernment spending represents one-quarter of gross domestic product (GDP). Combined withincreasing shares of state and local government spending, allgovernments in the U.S. account for almostone-half of GDP. The reasons for this expansion are many including war, recession, expansion ofentitlement programs, and subsidies. What is obvious from this experience is that taxes have not risen tomeet increased government spending resulting in growing budget deficits and debt.Regardless of changing the amount of government spending, the economy’s budget constraint remainsunchanged. In other words, U.S. output is dictated by the amount of labor, capital, entrepreneurship,innovation, and human capital available at any given time. As the government expands, the productioncreated by these inputs are redirected from consumers, investors, and foreigners to the government. Thisoccurs regardless of if the government pays for goods using tax revenues or by using borrowed funds. Inshort, increased government spending is paid for by citizens either immediately through taxes or overtime through increased taxes used to repay borrowed money.At first glance, it may appear that increased government spending has no impact on economic growth.After all, if the government spends taxed money something is being purchased and, presumably, thecitizen who was taxed is not spending. This is much likerobbing Peter to pay Paul; Peter (the citizen)does not spend but Paul (the government) does. However, this analogy is not correct. The act of taxingPeter may influence Peter’s decisions in such a way as to reduce Peter’s future economic productivity.Because the U.S. government is in debt, it will need to repay that debt through increased future taxes.Higher taxes reduces the incentives for citizens to work, innovate, and invest. In short, increased tax ratesreduce the after-tax profits individualsearn on their economic activities and thus discourage the pursuit ofthose activities. The end result is that higher government spending today coupled with increased deficitsproduces higher future taxes and lower economic growth rates.

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Chapter 5: The Threat toGrowthThe link between higher taxes and reduced economic growth is straightforward tounderstand. First,consider apotential investor choosing between investing in a projectthatwill create some future returnsand spending on a consumable good today. An increase in taxes reduces the after-tax returns on theinvestment and makes that investment less desirable relative to consumption. The end result is areduction in investment demand and, in equilibrium, less capital created. Less capital means fewer inputsto production to create future GDP.The same occurs in labor supply decisions. Individuals choosing between working and an alternative(leisure, school, etc.) weigh the benefits and costs of each. Increased taxes reduce the benefits of workand make supplying labor less attractive. Individuals who were deciding between working and notworking will be less likely to work; those deciding between working overtime and not may be less likelyto work overtime. In short, higher taxes reduce labor supply and again, reduce inputs to production.While lower economic growth in and of itself is a poor outcome, one should remember that this is theresult of increased government purchases. If those purchases benefited society more than the decreasedfuture growth, then the government spending may beeconomically efficient.◼Teaching TipsThe connection between tax rates and labor supply is easy to demonstrate in a class if you are willing topay out a small amount of cash to a student. One way to do so is to create an auction for student labor todo a menial task during every remaining class in the semester (clean the chalkboard, etc.). Start with ahigh price ($5) and ask how many students would be willing to receive that price in exchange forcompleting the menial task. Reduce the price and count how many students supply labor. Repeatthisexercise and graph the labor supply curve. Finally, repeat the entire exercise after imposing a 25%income tax. Graphing both resulting labor supply curves demonstrates a decrease in the effective laborsupply curve under an income tax. It is easyto generate discussions involving the equilibrium effects ofan income tax (lower employment, raise the hiring cost of labor) and you get somebody to clean yourblackboards for you.◼Chapter Answers1.Higher debt implies thatfuture taxes will be higher, though the extent of this increase is unclear.If the government can perpetually borrow to make payments on its current debt, then the timingof higher taxes can be postponed, perhaps indefinitely if the government’s ability to borrowremains unimpeded. For instance, if the economy grows quickly, individuals may have both theability and desire to make additional loans to the government. However, for most countries,including currently Greece, Spain and Italy, eventually investors are unwilling to lend togovernments and these governments respond by raising taxes and by reducing expenditures. Theend result seems to be that more debt today leads to higher future taxes.2.Any tax reduces the incentives for individuals to pursue the thing being taxed. A wealth tax willreduce the incentive to accumulate wealth, or at least cause individuals to try to avoid the tax(either legally or illegally). One possible response wouldbe for individuals to reduce their networth by borrowing against paid-for assets. Another, which appears to be happening in someEuropean countries, is for the very wealthy to renounce citizenship and leave the country.Ultimately, a wealth tax will have long-run consequences on citizen’s work effort and holdings ofthings considered wealth by the taxing authorities.

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Chapter 5: The Threat toGrowth3.Marginal tax rates are the rates paid on the next dollar of income. When making a decision toearn an additional dollar, an individual weighs the benefits and costs of that dollar. The benefitsare the things that dollar purchases. Among other things, the cost of earning the dollar is the timespent working. A higher income tax rate would cause these costs to increase (one has to workmore time to earn a dollar if the marginal tax rate is high). Thus, the decision to work is basedupon the marginal taxrate and not the average tax rate or the overall amount of taxes paid.4.Higher marginal tax rates are associated with increased tax avoidance (the legal reduction of taxbills through things like legal loopholes) and tax evasion (the illegal reduction of tax bills). Whenmarginal tax rates are high, individuals are willing tospend considerable effort avoiding taxesand may be more willing to risk legal action by tax evasion. Individuals fail to save significantamounts of taxes through avoidance and evasion when marginal rates are low, hence less of theseactivities occur asrates fall.5.Individuals who realize that future taxes will rise can protect themselves in a number of ways.Individuals can increase their current work effort in order to generate savings so they can reducetheir work effort under the future higher tax regime. Someindividuals will move out of high taxjurisdictions in favor of lower tax jurisdictions. Others can avoid some future higher taxes byinvesting in tax-exempt or tax-deferred vehicles. After tax rates have increased, people willsubstitute out of activities that are taxed into non-taxed or lower-taxed activities.It is commonlybelieved that responses to increases in taxes will grow over time; in other words the size of theresponse will be larger as time passes and individuals have more opportunity to find ways ofshielding themselves from higher taxes.6.In Country A where a 20% tax rate exists on all income, an individual earning $40,000 per yearwill pay $8,000 and an individual earning$100,000 will pay $20,000. In Country B where thetax rate is 10% on the first $40,000 and 40% thereafter, an individual earning $40,000 will pay$4,000 and an individual earning $100,000 will pay $28,000. The lower income individual isbetter off living in Country B whereas the higher income individual is better off living in CountryA. Without barriers to moving across borders, one would imagine lower income earners to moveto Country B and higher income individuals to move to Country A. As this occurs, one wouldexpect labor markets in each country to adjust. As individuals willing to work low income jobs inCountry A become scarce, one would imagine their wagesbeing bid up. Simultaneously, as highincome individuals become relatively more common in Country A, their wages will be lowered.These effects become smaller if it is more difficult to move between countries.

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Chapter 6What Should GDP Include?◼Chapter OverviewGross Domestic Product (GDP) is one of the key statistics that policymakersuseto help them analyze themacroeconomy.GDP isthe total market value of all final goods and services produced within a countryannually. However, official GDP isunderstated because not all goods produced or services rendered areincluded.Home productionand certain undergroundactivities, both legal and illegal,are not reported tothe government.◼Descriptive AnalysisGDP measures the quantities of final goods and servicesproducedand theirprices in a given year.TheBureau of Economic Analysis, a subdivision of the Department of Commerce, measures GDP.Onlyfinalgoods are counted and not intermediate goods,orinputs in the final good.Aproduct can be a final goodor intermediate good based on whom does the buying. For example, if an individual buys a tomatoat agrocery storeto makeasalad, the purchase of the tomato would count in GDP; however, if Subway buystomatoes to put in their sandwiches(the final product), thetomatoeswould be considered an intermediategood and would not count in GDPcalculations.When GDP is higher in one year compared to another, it could be because more goods were produced,prices were higherdue to inflation, or a combination of bothincreased production and inflation. This iswhy there is a distinction between nominal GDP and real GDP. Just because GDP goes up in one year,itdoes not necessarily mean there was economic growth. Nominal GDP is just a current figure (nominalGDP isexpressed in current dollars) while real GDP has been adjusted for inflation (real GDP isexpressedin constant dollars).Not all goods and services that are producedare included in the official GDP calculation.Income earnedfrom prostitution, illegal drug sales, and illegal gamblingisobviously not reported to the government.Therefore,thereported GDP is actually understated.Ironically, government expenditures on the War onDrugs and personal expenditures on items that are complementary to drug use do get counted.Notall underground activities are illegal. Many servicesprovided each year such as landscaping, homerepairs, and selling home-cooked foodsarenot reportedto the governmentbecauseindividualswant toavoid havingtheir income taxed.Moreover, the goods and services produced in the homeare notincludedin GDPbecause there is no market transactionto record. For example, the contributions that astay-at-home parent provides each dayto his or her familyare not counted in GDP. However, if thatparent goes back to work and now the child is put in a legal daycare, GDP will increase because thatparent is nowreceiving a salary andbecausethe daycarefacilityis getting paid.Therefore,actual GDPishigher than the official statistic.

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Chapter 6: What Should GDP Include?One way to measure GDP is to add consumption (C), investment (I), government spending (G), and netexports (NX). This is known as the expenditures approach. Investment in economics does not mean whatpeople usually mean when using that term. Investment ismainlybusiness spending on capital (factories,tools, machines). But there is also artistic investment, such as authors and songwriters who spendvaluable time creating their product. Until recently, R&D has been considered an intermediate good and,therefore, not counted. However, theBEA now includesR&D asaninvestmentcomponent in GDP.Theartistic investment is an estimate but nevertheless tries to capture this productive process. As a result, ourofficial GDP numbers have increased approximately by 3.6%.Economists are sometimes criticized forfocusingonlyon money. While GDP is a number reflectingdollar value, it cannot accurately measure happiness. Researchers in other socialscienceshave attemptedto measure personal life satisfaction. Of course, one has to be careful about these data because actionsspeak louder than words. When one buys a good or service, they are demonstrating their true preference.However, it is very easy to simply check a box on a “happiness” survey.GDP does not include the value people place upon leisure or happiness. Economists Stevenson andWolfers found that real GDP per capita (GDP per person that has been adjusted for inflation) andhappiness are positively related.Perhaps more income makes people happier but it can also be that theinstitutions that lead to higher GDP per capita also contribute towell-being and happiness inlife.◼Teaching TipsHave students look up and read“Yes, Lady Gaga’s Songs Contribute to GDP,”Wall Street Journal, May27, 2013to help understand how spending time developing music is now considered investment by theBEA.Also, students need to know that someone’s expenditure is another person’s income. You cansimplydemonstrate to students by giving them a dollar for something currently in their hand (i.e., pen, pencil).Your expenditure of adollar is income received by the student.This is a simple way to demonstrate thatthe expenditures approach and income approach are twosides of the same coin.In order to help students understand the distinction between intermediate good and final goods, you canbuy various inputs for chocolate chip cookies—flour, sugar,salt, baking powder,butter, eggs, andchocolate chips(make sure that there are two sets of everything). Then assign one student to represent abaker who runs his or her own business andassign the other student as an amateurbakerwho plans onbaking cookies to enjoy at home.Then give each student the same amount of money to buy these inputsfrom you (the grocery store).Ask the students if the ingredients purchased are considered final goods or intermediate goods?Theyshould be able to conclude that the business baker’s purchases are intermediate goods going into the finalproduct thatwill be sold in the marketplace and that the amateur, home baker’s purchases are consideredfinal goods because the products are purchased for exclusive home use and the cookies will not be sold inthe marketplace.Finally, to help students understand the difference between nominal and realnumbers, you can tell themthat nominal numbers are the current “sticker price.” So, for example, you can have students quicklyresearchon their smartphone or laptopwhich movie is the number one grossing movie of all-timeinnominal terms(Avatar) and then ask them which is the highest grossing movie in real terms (Gone withthe Wind). If they are confused, youtell them that even thoughGone with the Windgrossed less total

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Chapter 6: What Should GDP Include?money, theamount back then (1939) is worth more than whatAvatarmade (2009) because inflationreduces the value of money.◼ChapterAnswers1.A purchase made by an individual would be considered a final good while a purchase made by abusiness would be considered an intermediate good. For example, if someonebuys a tire atGoodyear to replace a worn out tire on theircar, then that tire is considered a final good.However, when Ford purchases tiresfrom Goodyear to put on their brand new cars, those tires areconsideredintermediate goodsbecause they will be sold as part of the new cars. The car pricewill reflect all theintermediate goods that are part of the final product.2.GDP or nominal (unadjusted for inflation) GDP needs to be distinguished from real (adjusted forinflation) GDP because economic growth occurswhenthe economy actually producesmoregoods and services. When GDP is reported as higher, people might mistakenly think the economyis doing better, butin reality it’s just that inflation hasoverstatedthe value of production. This iswhy we must deflate the “hot air” of inflation using the GDP Deflator to get an accuratemeasurement of real production of goods and services.3.a. Intermediate good (assuming that the spare tire is the original provided byauto manufacturer)b. Consumption (spending on a current service)c. Consumption (spending on a current service)d. Consumption,if purchased by someone for just immediate pleasure and he or she has no planson being a professional singer; investment,if thisissomething that is undertaken in order toproduce final products (songs) which will be solde. Consumption (an individual is spending their money for immediate educational consumption).While it is an investment in one’s human capital, the BEA would classify expenditures oneducation as consumption.4.As more women have entered into the labor force, GDP has gone up because the value of theservices they provide (as measured by their salaries and wages using the income approach) iscounted inGDP. Moreover, if these women have hired legal house cleaning and childcareservices that report their income to the government, then this too will havehada positive impacton GDP. Of course, if the labor hired is paid “under the table,” then that cannot be counted inGDP.5.It is difficult to measure “happiness” in an objective manner. However,ceteris paribus, it isprobably the case that people living in a clean environment willfeel happierthan people living ina highly polluted environment. As far as GDP is concerned, when firms pollute, the “bad” doesnot get deducted from GDP. However, if there is an oil spill, the expenditures by the privatesector and thegovernment getcounted in GDP and, therefore, GDP would go up. Of course, wedo notwant to conclude that the economy did better because of that.6.Nations with large underground economies typically have lower measured levels of real GDPpercapitabecause the institutions in these countries are such that are there is little or no protection ofprivate property,noconsistent rule of law,high rates of taxation, and extensivecommand and

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Chapter 6: What Should GDP Include?controlover the economywhich distorts the market process. Therefore, it wouldprobably be thecase that individuals in thesecountries would report less happiness because real GDP per capitaand happiness are positively related.

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Chapter7What’s in a Word? Plenty, When It’s the “R” Word◼Chapter OverviewDefining recessions is a common topic to cover in an introductory course. It is important for politicalreasons as well as for the national psyche. It is also a verydifficult term to define. As pointed out in thischapter, there is no concrete definition of a recession nor is there a governmental agency that declareswhen one exists. This chapter explores these issues with an eye to giving students an idea of the difficultyin evaluation of overall economic performance.◼Descriptive AnalysisThe National Bureau of Economic Research (NBER) is the nation’s leading nonprofit economic researchorganization and has historically proclaimed the beginning and end of recessions. The NBER’s recession-dating committee defines a recession as “a significant decline in activity spread across the economy,lasting more than a few months, visible in industrial production, employment, real income less transfers,and wholesale-retail sales.” Since these four economic concepts may be measured with various statisticsmonthly, the NBER is able to construct a fairly accurate, real-time picture of the economythatit uses todetermine when a recession begins and ends.Because measures of industrial production, employment, income, and sales undergo considerable month-to-month variation, the NBER does not define a recession simply when these measures decline. Rather, arecession is deep, of lasting duration, and dispersed across the economy. These descriptors are all qualitativeand open to argument as to what they precisely mean, but a deep change is one that requires a significantand meaningful fall in the measures of economic activity. Duration refers to the fact thatthis fall must lastlonger than what would be expected to occur given traditional historical variation in the measures. Andthis fall in activity must be dispersed across the economy both spatially and across industries.The NBER does not determine the presence of a recession using real GDP for a number of reasons. First,real GDP is measured only quarterly, which does not allow for precise dating of a recession. Second, realGDP is measured imprecisely and often subject to a number of large revisions that occur over a period ofyears. After a new revision occurs, it may be found that a period that was thought of as a recession wasreally not (or vice versa).An argument can be made that defining a recession as a decrease in economic activity actually may hideperiods of lowering living standards. For instance, if an economy’s potential output grows at 3% butactual economic activity grows at 2%, one might argue that the economy is underperforming (eventhoughit is growing). This issue becomes more transparent if one considers the primary reason whypotentialgrowth may grow at 3%: because of a 3% increase in inputs to production. For instance, if populationgrows at 3% per year, one would expect potential output to also grow at that rate since there is a largelabor force to draw upon. On the other hand, if output grows at 2% per year, then it is clear that on a per

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Chapter 7: What’s in a Word? Plenty, When It’s the “R” Wordcapita basis, citizens are worse off. Yet, with output growing at 2% per year, no recession would bedeclared.◼Teaching TipsDefining recessions is oftenoverdone. Many textbooks attempt to precisely define recessions. Rather thanstressing a technical definition, the goal of labeling a period as a recession is to indicate that, on average,a nation’s output is falling. Help students keep in mind that the differences in growth rates of income orGDP over a short period of time are rather insignificant relative to the long-run average of GDP growth.Also stress that the definition of a recession is much less important than understanding what causes GDPto change from period to period. Finally, point out that even in periods of expansion, it is possible that anation’s standard of living per capita may be falling. Thus, the technical definition of recession may beless important than many students believe.Students are often interested to know when recessions have occurred.On the next pageis a tableproduced by the NBER that defines U.S. recessions. Note the relative infrequency and shorter duration ofrecent recessions compared to earlier ones.

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Chapter 7: What’s in a Word? Plenty, When It’s the “R” WordNBER-Defined PeakNBER-Defined TroughContractionPeak to Trough(Months)ExpansionTrough toPeak(Months)Trough fromPreviousTrough(Months)Peak fromPreviousPeak(Months)June 1857(II)December 1858 (IV)183048—October 1860(III)June 1861(III)8223040April 1865(I)December 1867 (I)32467854June 1869(II)December 1870 (IV)18183650October 1873(III)March 1879 (I)65349952March 1882(I)May 1885 (II)383674101March 1887(II)April 1888 (I)13223560July1890(III)May 1891 (II)10273740January 1893(I)June 1894 (II)17203730December 1895(IV)June 1897 (II)18183635June 1899(III)December 1900 (IV)18244242September 1902(IV)August 1904 (III)23214439May 1907(II)June 1908 (II)13334656January 1910(I)January 1912 (IV)24194332January 1913(I)December 1914 (IV)23123536August 1918(III)March 1919 (I)7445167January 1920(I)July 1921 (III)18102817May 1923(II)July 1924 (III)14223640October1926(III)November 1927 (IV)13274041August 1929(III)March 1933 (I)43216434May 1937(II)June 1938 (II)13506393February 1945(I)October 1945 (IV)8808893November 1948(IV)October 1949 (IV)11374845July 1953(II)May 1954 (II)10455556August 1957(III)April 1958 (II)8394749April 1960(II)February 1961 (I)10243432December 1969(IV)November 1970 (IV)11106117116November 1973(IV)March 1975 (I)16365247January 1980(I)July 1980 (III)6586474July1981(III)November 1982 (IV)16122818July 1990 (III)March 1991 (I)892100108March 2001(I)November 2001 (IV)8120128128December 2007 (IV)June 2009 (II)18739181Source:NBER◼Chapter Answers1.The NBER relies upon theperception of being unbiased arbiters of recessions. If the NBERredefines a recession, especially if the redefinition occurs at a time when it may benefit a politicalparty, then it will lose its credibility and lack any following to which to declare recessions.

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Chapter 7: What’s in a Word? Plenty, When It’s the “R” Word2.My guess is that people care more about their individual circumstances and those of theirimmediate acquaintances than the proclamations of officials regarding the national economy. Ofcourse, when the national economy is undergoing a recession, the situation of individuals is likelyto be worse, so some value is placed upon these declarations.In the competitive world of politics, politicians will use whatever tools are available to gain anadvantage. Poor economic performance can always be attributed (correctly or not) to incumbentpoliticians. The declaration of a recession by an apolitical body like the NBER can be powerfulammunition to use against one’s political foes.3.According to the NBER, the durations of the last 6recessions, in months, were:November 1973 (IV)March 1975 (I)16January 1980 (I)July 1980 (III)6July 1981 (III)November 1982 (IV)16July 1990 (III)March 1991 (I)8March 2001(I)November 2001 (IV)8December 2007 (IV)June 2009 (II)18Compared to long-term U.S. experience, these were very short recessions.Severity is more difficult to determine. One could measure this by the unemployment rate. Usingthis measure, the July 1981−November 1982 recession would be the most severe (10.8%unemploymentin Nov. 1982) followed closely by the 2007-2009 recession (10.1%unemployment in Oct. 2008). Unfortunately, the unemployment rate usually lags recessions and itis not a good measure for what happens to the average employee. A second option would be tomeasure the percent decline in real income from previous peak to thetrough of the recession.Since personal income is measured monthly, this data could correspond with the officiallydeclared recession dates. A third option would be to measure the percent change in real GDP orthe percent deviation of actual GDP from potential GDP (this third option requires one toestimate potential GDP). As one can see, it is easy to think of different ways to determine theseverity of a recession,which, of course, can engender discussions and arguments over which isbest.4.When comparing unemployment rates, the peak unemployment rate of the “great recession” doesnot match that of the 1981-1982 recession. Nor is the “great recession” substantially longer thanthe recessions encountered in 1973-1975 or 1981-1982. Howevertotal employment fell 6percentage points from the prior economic peak, the largest postwar decline. Further, total outputin the economy fell by 4.8% between 2007-2009; the largest previous postwar decline was 3.2%in 1973-1974.5.In looking at U.S. Civilian Unemployment rate and economic recession data between 1948 and2011 from the FRED, it is apparent that the unemployment rate begins rising at the onset of arecession and peaks near or shortly after a recession ends. Becausethe unemployment rateappears to follow recessions, it is said to be a lagging indicator.6.In looking at year-to-year percent change in the S&P 500 index plotted against U.S. recessionsbetween 1957 and 2011 from the FRED, it appears that the S&P 500 index falls (or trendsdownward) preceding a recession and then rebounds at the end of a recession. Since it appearsthat the S&P 500 index precedes events, it is referred to as a leading indicator.

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Chapter8Capital, Wealth, and Inequality◼Chapter OverviewKarl Marx argued that capitalism exploits workers by extracting what he called“surplus value”—the fullvalue of their service. Marx believed that the rich would get richer and the poor would get poorer.However, since Marx wrote his famous bookDas Kapitalin 1867, the average standard of living for allgroupshas gone up, especially in capitalist, market-based countries.The critics of capitalism,whofocuson income inequality,use data incorrectly to portray a situation that istrulynot the case. The mainfocusshould be on the sources of income inequality.◼Descriptive AnalysisFrench economist Thomas Pikettyargues that the top marginal tax rate should be 80 percent. His concernis that wealth isbecomingconcentrated among fewer individualsat the top. The problem with thisproposed solutionis that people respond to incentives. A marginal tax rate that high willdiscourageproductive activity, whichharmseveryone,not just the rich.The Laffer curve illustrates this principle.Piketty points outthe well-known fact that the rate of return on individual capital assets exceeds theoverall growthrate of the economy; however, because people save over theirlifetimeand because ofexistinginheritance taxes (“death taxes”), there is little changeinincome inequality.Pikettyalsofocuseson the last thirty years to prove his case.Usinga different thirty year timeperiodweget different results.Wars, depressions, andshocks change outcomes unevenly and unpredictably.Pikettyalsoignores that many low-incomeand middle-incomeindividualsreceive government transferpayments and have lower average tax burdens. He claims that the elderly are among the poorestin societybuthe ignores the fact that the elderly receiveMedicarebenefitsand SocialSecuritychecks.The CongressionalBudgetOffice (CBO)has analyzed the last 35 years of income distribution and foundtwo important facts. First, everyone has seen their incomes rise. For every single quintile, real (adjustedfor inflation) incomes have risen and after taxincomesfor those in the bottom quantile have risen thefastest. The secondkey finding is that incomes increasedmore for the topquintilesthan for the bottomones. However, while the rich are getting the richer, so are the poor, even though not at the samerate.This is what bothers Piketty.Peoplemove up and down the income ladderover time so we should not focusononly one time period.People exhibit a life-cycle pattern of earnings,meaning incomes are low for young people, peak aroundthe mid-50s, and then diminish in retirement age (but the income ishigherat the end than at thebeginning).

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