Solution Manual For Macroeconomics, 10th Edition

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Solution ManualforMacroeconomicsTenth EditionDean CroushoreRobins School of BusinessUniversity of Richmond

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ContentsChapter 1Introduction to Macroeconomics .............................................................................1Chapter 2The Measurement and Structure of the National Economy.......................................16Chapter 3Productivity, Output, and Employment....................................................................39Chapter 4Consumption, Saving, and Investment.....................................................................69Chapter 5Saving and Investment in the Open Economy..........................................................109Chapter 6Long-Run Economic Growth ..................................................................................133Chapter 7The Asset Market, Money, and Prices .....................................................................156Chapter 8Business Cycles ......................................................................................................177Chapter 9TheIS-LM/AD-ASModel: A GeneralFramework for Macroeconomic Analysis ................................................................198Chapter 10Classical Business Cycle Analysis:Market-Clearing Macroeconomics...........................................................................229Chapter 11Keynesianism: The Macroeconomicsof Wage and Price Rigidity .....................................................................................260Chapter 12Unemployment and Inflation...................................................................................296Chapter 13Exchange Rates, Business Cycles, andMacroeconomic Policy in the Open Economy .........................................................324Chapter 14Monetary Policy and the Federal Reserve System....................................................368Chapter 15Government Spending and Its Financing .................................................................393

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Chapter 1Introduction to MacroeconomicsnLearning ObjectivesI.Goals of Part IA.Introduce students to the main concepts in macroeconomics (Ch. 1)B.Introduce national income accounting and major economic magnitudes (Ch. 2)II.Section GoalsA.Summarize the primary issues addressed in macroeconomics (Sec. 1.1)B.Describe the activities and objectives of macroeconomists (Sec. 1.2)C.Differentiate between the classical and Keynesian approaches to macroeconomics (Sec. 1.3)III.Notes to Ninth Edition Users:This chapter is little changed; the data were updated.

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2Abel/Bernanke/Croushore•Macroeconomics,Tenth EditionnTeaching NotesI.What Macroeconomics Is About (Sec. 1.1)Macroeconomics: the study of structure and performance of national economies and governmentpolicies that affect economic performance. Macroeconomists study:A.Long-run economic growth1. Growth of output in United States over timea.Text Fig. 1.1: Output of United States since 1869b. Note decline in output during recessions; increase in output during some wars2. Sources of growth—population, average labor productivity growthThis may be a good place to introduce students to the calculation of a growth rate, which is usedthroughout the textbook. You can write it first in general terms, as%DX=[(Xt+1-Xt)/Xt]´100%=[(Xt+1/Xt)-1]´100%.Then you might use an example with something you’re talking about, such as real GDP growthover the past year, or the inflation rate.Throughout the text, students may come across mathematical calculations that are unfamiliarto them. The appendix to the textbook contains some helpful basic guidance to mathematicaltopics, including discussions of functions and graphs, slopes of functions, elasticities, functions ofseveral variables, shifts of a curve, exponents, and growth-rate formulas.3. Average labor productivitya.Average labor productivity: output produced per employed workerb. Text Fig. 1.2: Average labor productivity of United States since 1900c.Average labor productivity growth:(1) 2.6% per year from 1949 to 1973(2) 1.1% per year from 1973 to 1995(3) 1.9% per year from 1995 to 2007(4) 0.9% per year from 2007 to 2017Working with Macroeconomic Data Problem 1 gives students practice in calculating average laborproductivity and dealing with growth rates.B.Business cycles1. Business cycle: short-run contractions and expansions in economic activity2. Downward phase is called recessionC.Unemployment1. Unemployment: the number of people who are available for work and actively seeking workbut cannot find jobs2. U.S. experience shown in text Fig. 1.3, showing unemployment rate (unemployment as apercent of labor force)3. Recessions cause unemployment rate to riseAnalytical Problem 1 asks students to think about average labor productivity and unemploymentand their relationship to output. Working with Macroeconomic Data Problem 2 has studentsexamine data on the unemployment rate and to see how it behaves in recessions.

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Chapter 1Introduction to Macroeconomics3D.InflationAnalytical Problem 2 asks students to think about the welfare consequences of having a higherprice level.1. U.S. experience shown in text Fig. 1.42. Deflation: when prices of most goods and services decline3. Inflation rate: the percentage increase in the level of prices4. Hyperinflation: an extremely high rate of inflationYou may wish to discuss how to calculate the inflation rate, which is just the growth rate of theprice level. It can be expressed asp=[(Pt+1/Pt)-1]´100%. Numerical Problem 1 gives studentspractice calculating growth rates, including the growth rate of average labor productivity and theinflation rate. Working with Macroeconomic Data Problem 3 requires students to examine andanalyze historical movements in inflation.E.The international economy1. Open vs. closed economiesa.Open economy: an economy that has extensive trading and financial relationships withother national economiesb. Closed economy: an economy that does not interact economically with the rest ofthe worldWorking with Macroeconomic Data Problem 4 requires students to compare GDP growth ratesacross countries.2. Trade imbalancesa.U.S. experience shown in text Fig. 1.5b. Trade surplus: exports exceed importsc.Trade deficit: imports exceed exportsF.Macroeconomic policy1. Fiscal policy: government spending and taxationa.Effects of changes in federal budgetb. U.S. experience in text Fig. 1.6c.Relation to trade deficit?Numerical Problem 2 serves two purposes: (1) to get students to look at some real data on theeconomy and (2) to give them some idea about how large the trade deficit and government budgetdeficit are. Working with Macroeconomic Data Problem 5 has students look at the ratio of federalgovernment debt to GDP and to think about what causes it to rise.2. Monetary policy: growth of money supply; determined by central bank; the Fed in UnitedStatesG.Aggregation1. Aggregation: summing individual economic variables to obtain economywide totals2. Distinguishes microeconomics (disaggregated) from macroeconomics (aggregated)

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4Abel/Bernanke/Croushore•Macroeconomics,Tenth EditionII.What Macroeconomists Do (Sec. 1.2)A.Macroeconomic forecasting1. Relatively few economists make forecastsData ApplicationThere are many firms that provide forecasts for some macroeconomic variables, but only a fewfirms have complete, large-scale macroeconomic models that include details on every sector ofthe economy. The main forecasting firms in the United States are Macroeconomic Advisers andIHS Global Insight. These firms produce new forecasts every month and analyze the currenteconomic situation.You do not have to subscribe to one of these services to keep up-to-date on forecasts. There areseveral surveys of forecasters available to the general public, including the Blue Chip survey, theNABE (National Association of Business Economists) survey, a survey run by theWall StreetJournal, the Livingston survey, and the Survey of Professional Forecasters. (The latter two arefree of charge and run by the Federal Reserve Bank of Philadelphia.) However, these surveys willnot give you the level of detail that the large forecasting firms provide.2. Forecasting is very difficultData ApplicationAlan Meltzer gives a graphic example of how difficult it is to forecast the macroeconomy in hisarticle, “Limits of Short-Run Stabilization Policy,”Economic Inquiry, January 1987, pp. 1–14. Heshows that the forecast errors for real output made at the beginning of the quarter are very large,making it almost impossible to use the forecasts to make policy. However, he looked only at thevolatile time period from mid-1980 to early 1985. More recent current-quarter forecasts seem tobe better.B.Macroeconomic analysis1. Private and public sector economists—analyze current conditionsData ApplicationWall Street hires a large number of economists, most of whom are engaged in data analysis ona daily basis. Their job is to tell traders what newly released economic data mean for financialmarkets in general, as well as for the prices of individual assets. Many Wall Street economistsalso make their own detailed forecasts of the economy.2. Public sector employs many macroeconomic analysts who provide policy adviceC.Macroeconomic research1. Goal: to make general statements about how the economy works2. Theoretical and empirical research are necessary for forecasting and economic analysis3. Economic theory: a set of ideas about the economy, organized in a logical framework4. Economic model: a simplified description of some aspect of the economyThis is a good point for you to talk about your own research interests. Students are very interestedin learning about the kinds of research their professors do. You may want to talk about yourresearch later, when you come to a section of the textbook that discusses the topic on which youdo your research.

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Chapter 1Introduction to Macroeconomics55. Usefulness of economic theory or models depends on reasonableness of assumptions,possibility of being applied to real problems, empirically testable implications, andtheoretical results consistent with real-world data6. In Touch with Data and Research: Developing and Testing an Economic Theorya.Step 1: State the research questionb. Step 2: Make provisional assumptionsc.Step 3: Work out the implications of the theoryd. Step 4: Conduct an empirical analysis to compare the implications of the theory withthe datae.Step 5: Evaluate the results of your comparisonsTheoretical ApplicationThe classic discussion of research issues by Milton Friedman is, “The Methodology of PositiveEconomics,”Essays in Positive Economics, Chicago: University of Chicago Press, 1953.Analytical Problem 3 is an exercise in how to formulate and test a theory.D.Data development—very important for making data more usefulData ApplicationAs head of the Council of Economic Advisers in the Bush presidency, Michael Boskin led aneffort to get more accurate and timely statistics in the United States. See “Improving the Qualityof Economic Statistics” in theEconomic Report of the President, 1990.A good example of data development came in early 1994, when the Commerce Departmentrevised its questionnaire for the Current Population Survey. This survey determines theunemployment rate. Prior to 1994 the survey did not do a good job of distinguishing betweenpeople who were unemployed and looking for a job but spending most of their week doing workat home, and those who were out of the labor force and not even looking for a job. As a result ofthe change in the survey, there is a one-time jump in the unemployment rate in January 1994, notbecause of any change in the macroeconomy, but just because the more accurate questionnairefound that more people were unemployed than in the previous survey.In 1996 the national income accounts underwent a major revision, changing how its priceindexes are calculated (moving to a chain-weighted index) and changing how governmentpurchases are measured (accounting more accurately for government capital formation).Also in 1996, a major controversy arose over the calculation of the consumer price index(CPI). Economists argued that the CPI was biased upward significantly, so that inflation asmeasured by the CPI was about one percentage point greater than the true increase in the cost ofliving. This topic is also discussed in Chapter 2.Data must change to keep up with technology. In October 1999, the national income accountswere revised in a significant way by treating computer software as an investment. This changeraised the measured growth rate of the economy in the late 1990s. In 2013, the government beganto explicitly recognize intangible investment, again leading to higher measured levels of GDPthan before.

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6Abel/Bernanke/Croushore•Macroeconomics,Tenth EditionIII.Why Macroeconomists Disagree (Sec. 1.3)A.Positive vs. normative analysis1. Positive analysis: examines the economic consequences of a policy2. Normative analysis: determines whether a policy should be usedAnalytical Problem 4 gives students practice in distinguishing positive from normative analysis.B.Classicals vs. Keynesians1. The classical approacha.The economy works well on its ownb. The “invisible hand”: the idea that if there are free markets and individuals conduct theireconomic affairs in their own best interests, the overall economy will work wellc.Wages and prices adjust rapidly to get to equilibrium(1) Equilibrium: a situation in which the quantities demanded and supplied are equal(2) Changes in wages and prices are signals that coordinate people’s actionsd. Result: Government should have only a limited role in the economyTheoretical ApplicationAt this point in the discussion, you may want to talk about philosophies of economics. Studentsare often fascinated by how philosophical differences arise and what they mean, especially forpolicy. This helps to reinforce the idea that the Keynesian and classical models are very differentin their implications. You might suggest the idea that economists who are skeptical of thegovernment’s role in the economy are more likely to believe in a classical model, while those whobelieve the government can do good are more likely to become Keynesians. You can point out,however, that things are changing; some New Keynesians seem skeptical of governmentintervention.2. The Keynesian approacha.The Great Depression: Classical theory failed because high unemployment was persistentPolicy ApplicationIn a speech discussing what economists have learned from the financial crisis in 2008, FedChairman Ben Bernanke suggested that the financial crisis was the result of a failure of economicengineering or economic management, rather than economic science (“On the Implications of theFinancial Crisis for Economics,” at Princeton University, September 24, 2010). Economic scienceencompasses academic research and the development of theory and empirical estimation.Economic engineering is the development of frameworks that apply economic theory, such asbanks’ risk-management systems and the methods used by bank regulators, which clearly failed,leading to the crisis. Economic management is the operation of economic frameworks in practice,which also failed in the case of banks and investment firms, who failed to understand the risksthey were taking, and of bank supervisors, who also failed to understand the risks that banks weretaking. The crisis was thus less a problem with economic theory, but with how it was put intopractice.

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Chapter 1Introduction to Macroeconomics7b. Keynes: Persistent unemployment occurs because wages and prices adjust slowly, somarkets remain out of equilibrium for long periodsc.Conclusion: Government should intervene to restore full employmentAnalytical Problem 5 asks students to distinguish between how a classical economist and aKeynesian economist would think about the same issue.3. The evolution of the classical–Keynesian debatea.Keynesians dominated from World War II to 1970b. Stagflation led to a classical comeback in the 1970sc.Last 30 years: excellent research with both approachesTheoretical ApplicationYou may wish to add a discussion of the recent progression of research. You could start by a briefoverview of how the failure of Keynesian models in the stagflation of the 1970s led to the growthof rational-expectations modeling, with its focus on the importance of microfoundations. Thenyou could discuss New Keynesian macroeconomics (discussed in greater detail in Chapter 11)and its attempts to provide some microfoundations for wage and price stickiness in Keynesianmodels.Although the textbook presents just a few versions of classical models and Keynesian models,it is difficult to find a prototypical classical or Keynesian economist who believes fully in thatparticular model. The lack of convincing evidence on which model is correct has ledmacroeconomists to be eclectic, so they often hedge their bets. As a result, a one-armedmacroeconomist is hard to find; analysis tends to be of the “on the one hand, on the other hand”variety. And of course that means that if you laid all the macroeconomists on the earth end to end,they still wouldn’t reach a conclusion!C.A unified approach to macroeconomics1. Textbook uses a single model to present both classical and Keynesian ideas2. Three markets: goods, assets, labor3. Model starts with microfoundations: individual behavior4. Long run: wages and prices are perfectly flexible5. Short run: Classical case—flexible wages and prices; Keynesian case—wages and prices areslow to adjust

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8Abel/Bernanke/Croushore•Macroeconomics,Tenth EditionnAdditional Issues for Classroom Discussion1.What Are Society’s Major Economic Problems Today?In the first class session, it may be interesting to discuss students’ perceptions of the major economicproblems facing the economy today. Public-opinion polls show that Americans’ views on the importanceof different issues vary sharply over the business cycle. In recessions, people perceive unemployment andeconomic growth as the main problems. When inflation is high, reducing it is a high priority.You may wish to ask your students to rank the importance to them of the following economic issues:(1) unemployment; (2) inflation; (3) economic growth; (4) stagnant incomes; (5) the trade deficit;(6) Social Security; (7) the government budget; and (8) income inequality. Some discussion of all thesetopics is covered later in the text.2.Let’s Forecast!Here’s an exercise that will surprise both you and your students. On the first day of class, before they evenknow much about the macroeconomic variables that will be studied in the course, ask them to forecastsuch things as inflation, unemployment, the growth rate of output, and interest rates. You can give them ahandout of the current values of key variables. (By the way, it is easy to get the data online; the easiestway is to use the Federal Reserve Bank of St. Louis FRED database atfred.stlouisfed.org.)Some of your students will have outrageously high forecasts for some variables, but others will be reallylow. If you calculate the median forecast, you and your students may be amazed at how close it is to themedian forecast of the Survey of Professional Forecasters or one of the other macroeconomic surveys.And at the end of the semester, you may be surprised at how accurate your students’ forecasts were.3.Formulating a ModelHere is an exercise in formulating an economic model that will help students learn how to think abouteconomic issues and how to model them. The idea is for you (or them) to pick a current topic like CPIbias, the basis of the business cycle, the effect of government deficits, the effect of trade deficits, orsomething else. It is useful to do this now, before they have learned much about the topic. Follow the stepsoutlined in the textbook for developing and testing an economic theory. This exercise will help them getan idea of how research is actually done, starting from a point when you do not know much about theanswer to a question. It is especially important to emphasize how you could conduct an empirical analysisto test the theory. You can also spend some time talking about what key assumptions you need to make tosimplify the theory.

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Chapter 1Introduction to Macroeconomics9nAnswers to Textbook ProblemsReview Questions1.Both total output and output per worker have risen strongly over time in the United States. Outputitself has grown by a factor of 150 in the last 148 years. Output per worker is more than 7 times whatit was in 1900. These changes have led to a much higher standard of living today.2.The business cycle refers to the short-run movements (expansions and recessions) of economicactivity. The unemployment rate rises in recessions and declines in expansions. The unemploymentrate never reaches zero, even at the peak of an expansion.3.A period of inflation is one in which prices (on average) are rising over time. Deflation occurs whenprices are falling on average over time. Before World War II, prices tended to rise during war periodsand fall after the wars ended; over the long run, the price level remained fairly constant. Since WorldWar II, however, prices have risen fairly steadily.4.The budget deficit is the annual excess of government spending over tax collections. The U.S. federalgovernment has been most likely to run deficits during wars or recessions. From the early 1980s tothe mid-1990s, deficits were very large, even without a major war. The U.S. government ransurpluses for several years, from 1998 to 2001. But the deficit became enormous from 2008 to 2010because of the depth of the recession caused by the financial crisis.5.The trade deficit is the amount by which imports exceed exports; the trade surplus is the amount bywhich exports exceed imports, so it is the negative of the trade deficit. In recent years, the UnitedStates has had huge trade deficits. But from 1900 to 1970, the United States mostly had tradesurpluses.6.Macroeconomists engage in forecasting, macroeconomic analysis, macroeconomic research, and datadevelopment. Macroeconomic research can be useful in investigating forecasting models to improveforecasts, in providing more information on how the economy works to help macroeconomic analysts,and in telling data developers what types of data should be collected. Research provides the basis(results and ideas) for forecasting, analysis, and data development.7.These are the steps in developing and testing an economic model or theory: (1) state the researchquestion; (2) make provisional assumptions that describe the economic setting and the behavior of theeconomic actors; (3) work out the implications of the theory; (4) conduct an empirical analysis tocompare the implications of the theory with the data; and (5) evaluate the results of yourcomparisons. The criteria for a useful theory or model are that (1) it has reasonable and realisticassumptions; (2) it is understandable and manageable enough for studying real problems; (3) itsimplications can be tested empirically using real-world data; and (4) its implications are consistentwith the data.8.Yes, it is possible for economists to agree about the effects of a policy (that is, to agree on the positiveanalysis of the policy), but to disagree about the policy’s desirability (normative analysis). For example,suppose economists agreed that reducing inflation to zero within the next year would cause a recession(positive analysis). Some economists might argue that inflation should be reduced, because they preferlow inflation even at the cost of higher unemployment. Others would argue that inflation is not asharmful to people as unemployment is, and would oppose such a policy. This is normative analysis,as it involves a value judgment about what policy should be.

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10Abel/Bernanke/Croushore•Macroeconomics,Tenth Edition9.Classicals see wage and price adjustment occurring rapidly, while Keynesians think that wages andprices adjust only slowly when the economy is out of equilibrium. The classical theory implies thatunemployment will not persist because wages and prices adjust to bring the economy rapidly back toequilibrium. But if Keynesian theory is correct, then the slow response of wages and prices meansthat unemployment may persist for long periods of time unless the government intervenes.10.Stagflation was a combination of stagnation (high unemployment) and inflation in the 1970s. Itchanged economists’ views because the Keynesian approach could not explain stagflationsatisfactorily.

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Chapter 1Introduction to Macroeconomics11Numerical Problems1.(a)Average labor productivity is output divided by employment:2017: 12,000 tons of potatoes divided by 1000 workers=12 tons of potatoes per worker2018: 14,300 tons of potatoes divided by 1100 workers=13 tons of potatoes per worker(b) The growth rate of average labor productivity is [(13/12)-1]´100%=8.33%.(c) The unemployment rate is:2017: (100 unemployed/1100 workers)´100%=9.1%2018: (50 unemployed/1150 workers)´100%=4.3%(d) The inflation rate is [(2.5/2)-1]´100%=25%.2.The answers to this problem will vary depending on the current date. The answers here are based onthe data as of July 2018. Numbers are at annual rates in billions of dollars. There does not appear tobe a trend in the data; all the ratios are fairly stable.201520162017GDP18120.7118624.4819390.61Exports2264.9162214.5662343.988Imports2788.9582735.8052915.551Receipts3441.3923452.0733588.048Expenditures4028.0444149.3514252.472a.Exports/GDP12.5%11.9%12.1%Imports/GDP15.4%14.7%15.0%Trade Imbalance/GDP-2.9%-2.8%-2.9%b.Receipts/GDP19.0%18.5%18.5%Expenditures/GDP22.2%22.3%21.9%Deficit/GDP-3.2%-3.7%-3.4%

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12Abel/Bernanke/Croushore•Macroeconomics,Tenth EditionAnalytical Problems1.Yes, average labor productivity can fall even when total output is rising. Average labor productivityis total output divided by employment. So average labor productivity can fall if output andemployment are both rising but employment is rising faster.Yes, the unemployment rate can also rise even though total output is rising. This can occur in anumber of different ways. For example, average labor productivity might be rising with employmentconstant, so that output is rising; but the labor force may be increasing as well, so that theunemployment rate is rising. Or average labor productivity might be constant, and both employmentand unemployment could rise at the same time because of an increase in the labor force, with thenumber of unemployed rising by a greater percentage.2.Just because prices were lower in 1890 than they are in 2018 does not mean that people were betteroff back then. People’s incomes have risen much faster than prices have risen over the last 100 years,so they are better off today in terms of real income.3.There are many possible theories. One possibility is that people whose last names begin with thelettersAthroughMvote Democratic, while those whose names begin with the lettersNthroughZvote Republican. You could test this theory by taking exit polls or checking the lists of registeredvoters by party. However, this theory fails the criterion of being reasonable, since there is no goodreason to expect the first letters of people’s last names to matter for their political preferences.A better theory might be one based on income. For example, you might make the assumption that theRepublican Party promotes business interests, while the Democratic Party is more interested inredistributing income. Then you might expect people with higher incomes to vote Republican andpeople with lower incomes to vote Democratic. Taking a survey of people as they left the polls couldtest this. In this case the assumptions of the theory seem reasonable and realistic, and the model issimple enough to understand and to apply. So it is potentially a useful model.4.(a)Positive. This statement tells whatwillhappen, not whatshouldhappen.(b) Positive. Even though it is about income-distribution issues, it is a statement of fact, not opinion.If the statement said “The payroll tax should be reduced because it . . . ,” then it would be anormative statement.(c)Normative. Saying taxes are too high suggests that theyshouldbe lower.(d) Positive. Says whatwill happenas a consequence of an action, not whatshould be done.(e)Normative. This is a statement of preference about policies.5.A classical economist might argue that the economy would work more efficiently without thegovernment trying to influence trade. The imposition of tariffs increases trade barriers, interferingwith the invisible hand. The tariffs simply protect an industry that is failing to operate efficiently andis not competitive internationally.A Keynesian economist might be more sympathetic to concerns about the steel industry. Keynesiansmight argue that there may need to be a long-run adjustment in the steel industry, but would want toprevent workers in the steel industry from becoming unemployed in the short run.

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Chapter 1Introduction to Macroeconomics13Working with Macroeconomic Data1.The data as they existed in July 2018 were as follows:YearGDPC1PAYEMS19492,004.743,51719593,055.154,17519694,715.571,24019796,503.990,67319898,850.2108,849199912,323.3130,789200914,541.9129,781Based on these data, average labor productivity at the end of each decade is as follows:YearAverage LaborProductivity194946.1195956.4196966.2197971.7198981.3199994.22009112.0The growth rate of average labor productivity in each decade is as follows:YearAverage LaborProductivityGrowth Rate1950s2.0%1960s1.6%1970s0.8%1980s1.3%1990s1.5%2000s1.7%a.Using these data, labor productivity grew the most quickly in the 1950s and most slowly in the1970s.b.Annual growth rates are:

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