The fall in investment was the proximate cause of the recession.

d. Investment fell in the 2001:III and fell by a bigger percentage in 2001:IV.

Nonresidential fixed investment continued to fall in the first two quarters of 2002,
although overall investment (gross private domestic investment) grew. Consumption
picked up strongly in the 4th quarter of 2001. Lower interest rates and discounts offered
by automakers played a role. Perhaps psychology played a role as well. The recession
was clearly underway before the events of September 11.

CHAPTER 6
Quick Check
1. a. False.
b. False.
c. False. 44% of unemployed workers leave the unemployment pool each month.
d. True.
e. False.
f. Uncertain/False. Most workers have some bargaining power, depending upon how easy
they are to replace. Workers in low skill, entry level jobs may have very little or no
bargaining power.
g. True.
h. False.

2. a. Putting aside the 3.5 million who move from job to job, the average flow is
(1.5+1.7+1.8+1.5)/127=5.1%

b. 1.8/7.0=25.7%

c. (1.8+1.3)/7.0=44.3%. Duration is 1/.443 or 2.3 months.

d. (1.5+1.1+1.7+1.3)/66.7=5.6=8.4%.

e. As a percentage of flows into the labor force, new workers account for
0.4/(1.5+1.8)=12%. As a percentage of flows into and out of the labor force, new
workers account for 0.4/5.6=7%.

3. a. W/P=1/(1+µ )=1/1.05=.95

b. From the wage setting relation, un=1-W/P=5%

c. W/P=1/1.1=.91; u=1-.91=9%. The natural rate of unemployment rises. The increase in

the markup is essentially a fall in labor demand (actually a shift of the labor demand
curve). Intuitively, less competition in the product market leads to lower desired output
by firms and therefore to a fall in labor demand. The fall in labor demand increases
unemployment and reduces the real wage.

Dig Deeper
4. a. Answers will vary.

144
 b-c. Most likely, the job you will have ten years later will pay a lot more than your reservation
wage at the time (relative to your typical first job).

d. The later job is more likely to require training and will probably be a much harder job to
monitor. So, as efficiency wage theory suggests, your employer will be willing to pay a
lot more than your reservation wage for the later job, to ensure low turnover and low
shirking.

5. a. The computer network administrator has more bargaining power. She is much harder to
replace.

b. The rate of unemployment is a key statistic. For example, when there are many
unemployed workers it becomes easier for firms to find replacements. This reduces the
bargaining power of workers.

c. Given the constant returns to labor assumption, the real wage is always determined by the
price setting relation alone. Worker bargaining power has no effect.

6. a. As the unemployment rate gets very low, it gets very difficult for firms to find workers to
hire. Therefore, worker bargaining power increases, and so does the wage.

b. As the unemployment rate gets lower and lower, the wage gets higher and higher
(tending toward infinity as the unemployment rate goes to zero). So, there is some
unemployment rate at which the wage becomes so high that firms will not want to hire
more workers.

7. a. EatIn EatOut
employment 70 95
unemployment 5 5
labor force 75 100
unemployment rate 6.7% 5%
participation rate 75% 100%

Measured GDP is higher in EatOut.

b. Measured employment, the measured labor force, the measured participation rate, and
measured GDP increasae in EatIn. Unemployment is unchanged, but the measured
unemployment rate falls.

c. It is difficult to measure the value of work at home. In this case, you could attempt to
value food preparation at home by using the market price of food preparation in
restaurants (assuming that eating at home has the same value for a given meal as eating
out). This would be difficult in EatIn before there are restaurants. Likewise, you could
count workers involved in food preparation at home as employed.

d. If food preparation at home is counted in GDP and workers involved in food preparation
at home are counted as employed, then the labor market statistics and measured GDP
would be the same in the two economies and the experiment in part (b) would have no
effect.

145
Explore Further
8. a. 2/3=67%; (2/3)2= 44%; (2/3)6 = 9%

b. 2/3

c. second month: (2/3)2=44%; sixth month: (2/3)6 = 9%

d. Average proportion 27 weeks or more over 1990-1999= 16.1%

2000: 11.4% 2003: 22.1%
2001: 11.8% 2004: 21.8%
2002: 18.3%

Long-term unemployed exit unemployment less frequently than the average.

9. a-b. Answers will depend on when the page is accessed.

c. The decline in unemployment does not equal the increase in employment, because the
labor force is not constant.

CHAPTER 7
Quick Check
1. a. True.
b. True.
c. False.
d. False.
e. True.
f. False.
g. False.

2. a. IS right, AD right, AS up, LM up, Y same, i up, P up

b. IS left, AD left, AS down, LM down, Y same, i down, P down

3. WS PS AS AD LM IS
Short run: up same up same up same
Medium run: up same up further same up further same

Y i P
Short run: down up up
Medium run: down further up further up further

4. a. Money is neutral in the sense that the nominal money supply has no effect on output or
the interest rate in the medium run. Output returns to its natural level. The interest rate is
determined by the position of the IS curve and the natural level of output. Despite the
neutrality of money in the medium run, an increase in money can increase output and
reduce the interest rate in the short run. In particular, expansionary monetary policy can
be used to speed up the economy's return to the natural level of output when output is
low.

b. In the medium run, investment and the interest rate both change with fiscal policy.

146
 c. False. Labor market policies, such as unemployment insurance, can affect the natural
level of output.

Dig Deeper
5. a. Open answer. Firms may be so pessimistic about sales that they do not want to borrow at
any interest rate.

b. The IS curve is vertical; the interest rate does not affect equilibrium output.

c. No change.

d. The AD curve is vertical; the price level does not affect equilibrium output.

e. The increase in z reduces the natural level of output and shifts the AS curve up. Since the
AD curve is vertical, output does not change, but the price level increases. Note that
output is above its natural level.

f. The AS curve shifts up forever, and the price level increases forever. Output does not
change; it remains above its natural level forever.

6. a. The LM curve is flat.

b. No effect.

c. The AD curve is vertical. A change in P, which affects M/P, has no effect on the interest
rate or output.

d. There is no effect on output in the short run or the medium run. Since the money stock
does not affect the interest rate, it does not affect output.

7. a. The AD curve shifts left in the short run. Output and the price level fall in the short run.
In the medium run, the expected price level falls, and AS shifts right, returning the
economy to the original natural level of output, but at a lower price level.

b. The unemployment rate rises in the short run, but returns to its original level (the natural
rate, which is unchanged) in the medium run.

c. The Fed should increase the money supply, which shifts the AD curve right. A monetary
expansion of the proper size exactly offsets the effect of the decline in business
confidence on the AD curve. The net effect is that the AD curve does not move in the
short run or medium run, and neither does the AS curve.

d. Under the policy option in part (c), output and the price level are higher in the short run.
In the medium run, output is the same in parts (a) and (c), but the price level is higher in
part (c).

e. The unemployment rate is lower in the short run in part (c). In the medium run, the
unemployment rate is the same in parts (b) and (c).

147
8. a. The AS curve shifts up in the short run and shifts up further in the medium run.
Output falls in the short run and falls further in the medium run. The price level rises in
the short run and rises further in the medium run.

b. The unemployment rate rises in the short run and rises further in the medium run.

c. The Fed could increase the money supply in the short run and shift the AD curve to the
right. The AS curve would shift up over time.

d. Output and the price level are higher in the short run in part (c). Output is the same in the
medium run in parts (a) and (c), but the price level is higher in part (c).

e. The unemployment rate in the short run is lower in part (c), but the same in the medium
run in parts (a) and (c).

9. The Fed’s job is not so easy. It has to distinguish changes in the actual rate of unemployment from
changes in the natural rate of unemployment. The Fed can use monetary policy to keep the
unemployment rate near the natural rate, but it cannot affect the natural rate.

10. a. The unemployment rate rises in the short run and rises further in the medium run. The
real wage falls immediately to its new medium-run level.

b. The unemployment rate falls in the short run but returns to the original natural rate in the
medium run. The real wage is unaffected. However, after tax income rises.

c. In our model, the real wage depends only upon the markup. A fall in the markup
increases the real wage. Policy measures that improve product market competition – for
example, more vigorous anti-trust enforcement – could increase the real wage.

d. The fall in income taxes tended to increase the after-tax real wage. The increase in oil
prices tended to reduce the after-tax real wage. Intuitively, the immediate effect of an oil
price increase is to reduce the real wage by increasing gas prices. Thus, the increase in
gas prices tends to absorb the extra after-tax income provided by the tax cut.

Explore Further
11. a. 1959:IV – 1969:IV 52.9%
1969:IV – 1979:IV 38.2%
1979:IV – 1989:IV 35.1%
1989:IV – 1999:IV 37.6%

b. The 70s, 80s, and 90s look remarkably similar. The 60s look most unusual.

Note, although the problem did not ask for the growth rates of per capita real GDP, the results
would be similar. The growth rates of per capita GDP are:

1959:IV – 1969:IV 33.9%

1969:IV – 1979:IV 24.4%
1979:IV – 1989:IV 23.0%
1989:IV – 1999:IV 21.8%

148
CHAPTER 8
Quick Check
1. a. True.
b. False.
c. False.
d. True.
e. False.
f. True.

2. a. No. In the 1970s, we experienced high inflation and high unemployment. The
expectations-augmented Phillips curve is a relationship between inflation and
unemployment conditional on the natural rate and inflation expectations. Given inflation
expectations, increases in the natural rate (which result from adverse shocks to labor
market institutions—increases in z—or from increases in the markup—which encompass
oil shocks) lead to an increase in both the unemployment rate and the inflation rate. In
addition, increases in inflation expectations imply higher inflation for any level of
unemployment. (Increases in inflation expectations also tend to increase the
unemployment rate in the short run from the supply side—think of an increase in the
expected price level, given last period’s price, in the AD-AS framework. However,
increases in inflation expectations may tend to increase short run output from the demand
side, because of the real interest rate effect. The real interest rate is introduced in Chapter
14.) In the 1970s, both the natural rate and expected inflation increased, so both
unemployment and inflation were relatively high.

b. No. The expectations-augmented Phillips curve implies that maintaining a rate of

unemployment below the natural rate requires increasing (not simply high) inflation.
This is because inflation expectations continue to adjust to actual inflation.

3. a. un=0.1/2 =5%

b. πt =0.1-2*.03 = 4% every year beginning with year t.

c. πet= 0 and πt=4% forever. Inflation expectations will be forever wrong. This is
unlikely.

d. θ might increase because people’s inflation expectations adapt to persistently positive

inflation. The increase in θ has no effect on un.

e. π5= π 4+.1-.06=4%+4%=8%
π6=12%; π7=16%

f. Inflation expectations will again be forever wrong. This is unlikely.

4. a. A higher cost of production means a higher markup of prices over wages. The markup
reflects all nonwage components of the price of a good.

b. un=(0.08+0.1µ )/2; Thus, the natural rate of unemployment increases from 5% to 6% as

μ
increases from 20% to 40%.

149
Dig Deeper
5. a. π t = π t-1 + 0.1 - 2ut = π t-1 + 2%=2%
π t = 2%; π t+1 = 4%; π t+2 = 6%; π t+3 = 8%.

b. π t = 0.5 π t + 0.5 π t-1 + 0.1 - 2ut

or, π t = π t-1 + 4%

c. π t = 4%; π t+1 = 8%; π t+2 = 12%; π t+3 = 16%

d. As indexation increases, low unemployment leads to a larger increase in inflation over

time.

6. a. Yes. The average rate of unemployment was lower in the 1990s. Indeed, even though
the unemployment rate was at a historical low, inflation rose very little.

b. The natural rate of unemployment probably decreased.

7. a. un=(µ +z)/α ; un = 6% if α =1; un = 3% if α =2

As α increases the natural rate of unemployment falls. Intuitively, higher wage
flexibility
allows the economy to respond to any given set of institutions (µ and z) with less
unemployment.

b. un = 9% if α =1; un = 4.5% if α =2
In absolute terms, less wage flexibility (lower α ) implies that a given supply shock will
lead to a greater increase in the natural rate of unemployment.

Explore Further
8. a-c. The equation that seems to fit well is πt – πt-1 = 6 – ut, which implies a natural rate of
6%.

9. The relationships imply a lower natural rate in the more recent period.

CHAPTER 9
Quick Check
1. a. False.
b. True.
c. True.
d. False.
e. False.
f. True.
g. True.
h. True.
i. True.

2. a. The unemployment rate will increase by 1% per year when g=0.5%. Absent output
growth, productivity growth tends to increase the unemployment rate, since fewer
workers are required to produce a given quantity of goods. Absent output growth, labor

150
 force growth also tends to increase the unemployment rate, since more workers are
competing for the same number of jobs. Therefore, unemployment will increase unless
the growth rate exceeds the sum of productivity growth and labor force growth.

b. We want the unemployment rate to decrease by 0.5% per year for the next four years.
We need growth of 4.25% per year for each of the next four years.

c. Okun’s law is likely to become: ut-ut-1=-0.4*(gyt-5%)

3. a. un= 5%

b. Assume the economy has been at the natural rate of unemployment for two years (this
year and last year). Then, gyt = 3%; gmt = gyt + πt = 11%

c. π u gyt gmt
t-1: 8% 5% 3% 11%
t: 4% 9% -7% -3%
t+1: 4% 5% 13% 17%
t+2: 4% 5% 3% 7%
t+3: 4% 5% 3% 7%

4. a. See text for full answer. Gradualism reduces need for large policy swings, with effects
that are difficult to predict, but immediate reduction may be more credible and encourage
rapid, favorable changes in inflation expectations. On the other hand, the staggering of
wage decisions suggests that, if the policy is credible, a gradual disinflation is the option
consistent with no change in the unemployment rate.

b. Not clear. Based in Ball's evidence, probably fast disinflation, depending on the features
listed in part (c).

c. Some important features: the degree of indexation, the nature of the wage-setting process,
and the initial rate of inflation.

5. a. Inflation will start increasing.

b. It should let unemployment increase to its new, higher, natural rate.

Dig Deeper
6. a. sacrifice ratio=1

b. πt = 11%; πt+1 = 10%; πt+2 = 9%; πt+3 = 8%; πt+4 = 7%

c. 10 years; sacrifice ratio=(10 point years of excess unemployment)/(10 percentage point

reduction in inflation)=1

d. πt = 8.5%; πt+1 = 5.875%; πt+2 = 3.906%; πt+3 = 2.430%; πt+4 = 1.322%

Less than 5 years are required.
sacrifice ratio: 5/(12-1.322)=.468
The sacrifice ratio is lower because people are somewhat forward looking and
incorporate the target inflation rate into their expectations.

151
 e. The central bank can let the unemployment rate return to the natural rate beginnng at time
t+1. The ex post sacrifice ratio from this scenario = (1 point year of excess
unemployment)/(10 point reduction of inflation) = 0.1

f. Take measures to enhance credibility.

7. a. πt-πt-1= -(ut-.05)
ut- ut-1= -.4*(gmt-πt-.03)

b. Assuming gm,t-1=13%, πt-1= 10%, ut-1=5%, and gm=3% beginning in year t:

π u
t: 7.1% 7.9%
t+1: 3.1% 9.1%
t+2: -0.7% 8.8%
t+3: -3.2% 7.5%
t+4: -4.1% 5.9%
t+5: -3.5% 4.4%
t+6: -2.1% 3.6%
t+7: -0.5% 3.4%
t+8: 0.8% 3.7%
t+9: 1.5% 4.3%
t+10: 1.6% 4.9%

c. Inflation does not decline smoothly. In the early years, the large unemployment rates
(relative to the natural rate) reduce inflation to negative values. Since money growth = 3
% = normal output growth in this example, negative inflation drives real money growth
(and hence output growth) above the normal output growth rate, and unemployment falls.
Eventually, unemployment falls below the natural rate, inflation begins to increase again.
These cycles continue, with decreasing amplitude.

d. u=5% and π=0% in the medium run.

Explore Further
8. a. Yes.

b. The unemployment rate increased from 5,8% in June 2002 to 6.3% in June 2003.

c. Although growth was positive, it was low – well below 3% for most of the period.
Growth was too low to prevent the unemployment rate.

d. Employment fell by 0.7%.

e. Yes.

f. Productivity grew.

CHAPTER 10

152
 Computer systems analysts – technological change.
Home health aides – aging

c. More occupations that are forecast to grow require degrees as

opposed to on-the-job training.

10. a. For a given markup, the real wage grows at the rate of technological progress.

b. 1973: $8.98; 2003: 8:27

c. The real wage of low skill workers has fallen markedly.

d. The relative demand for low skill workers has fallen markedly.

CHAPTER 14
Quick Check
1. a. True.
b. True.
c. True.
d. False.
e. True.
f. False.
g. True.
h. True. The nominal interest rate is always positive.
i. False. The real interest rate can be negative.

2. a. Real. Nominal profits are likely to move with inflation; real profits are easier to forecast.

b. Nominal. The payments are nominal.

c. Nominal. If lease payments are in nominal terms, as is typical.

3. a. Exact: r = (1+.04)/(1+.02)-1 = 1.96%; Approximation: r ≈ .04-.02 = 2%

b. 3.60%; 4%

c. 5.48%; 8%

4. a. No. Otherwise, nobody would hold bonds. Money would be more appealing: it pays at
least a zero nominal interest rate and can be used for transactions.

b. Yes. The real interest rate will be negative if expected inflation exceeds the nominal
interest rate. Even so, the real interest rate on bonds (which pay nominal interest) will
exceed the real interest rate on money (which does not pay nominal interest) by the
nominal interest rate.

c. A negative real interest rate makes borrowing very attractive and leads to a large demand
for investment.

160
 d. Answers will vary.

5. a. The discount rate is the interest rate. So EPDV are (i) $2,000*(1-.25) under either
interest rate and (ii) (1-.2)*$2,000 under either interest rate.
b. The interest rate does not enter the calculation. Hence, you prefer (ii) to (i) since
20%<25%.

Note that the answer to part (a) does not imply that saving will not accumulate. By
retirement, the initial investment will have grown by a factor of (1+i)40 in nominal terms
and (1+r)40 in real terms. As long as r is positive, the purchasing power of the initial
investment will grow.

Of course, it is possible that the tax rate you pay upon retirement is lower than the tax
rate you will pay during your working years, which would alter this calculation. In
addition, this simple example omits an important real-world feature of retirement
savings: the tax-free accrual of interest. As a result of this feature, the effective interest
rate on retirement saving is much higher than the effective (after-tax) interest rate on
ordinary saving.

6. a. =$100/0.1 = $1000

b. Since the first payment occurs at the end of the year,

$V = $z[(1+i)n-(1+i)]/[i*(1+i)n].
10 years: $575.90; 20 years: $836.49; 30 years: $936.96; 60 years: $996.39

c. i = 2%: consol $5000; 10 years: $816.22; 20 years: $1567.85; 30 years: $2184.44; 60

years: $3445.61

i = 5%: consol $2000; 10 years: $710.78; 20 years: $1208.53; 30 years: $1514.11; 60

years: $1887.58

7. a. In the medium run, changes in inflation are reflected one for one in changes in the
nominal interest rate. In other words, in the medium run, changes in inflation have no
effect on the real interest rate.

b. Support.

c. The line should not go through the origin. The real interest rate is positive.

d. No. Even if monetary policy does not affect output or the real interest rate in the medium
run, it can be used in the short run.

Dig Deeper
8. a. The IS shifts right. At the same nominal interest rate, the real interest rate is lower, so
output is higher.

b. The LM curve does not shift. Money demand depends on the nominal interest rate, not
the real interest rate.

161
 c. Output increases. The nominal interest rate is higher than in Figure 14-5. Whether the
nominal interest rate is lower or higher than before the increase in money growth is
ambiguous. Thinking in terms of the money market equilibrium, the increase in the
nominal money supply tends to reduce the nominal interest rate, but the increase in
nominal money demand (because of the increase in output) tends to increase the nominal
interest rate.

d. Output is higher than in Figure 14-5. Reasoning from the IS relation, the real interest rate
must be lower, since no exogenous variables in the IS relation have changed. (In other
words, while the nominal interest rate may increase relative to Figure 14-5, it increases
by less than the increase in expected inflation. So the real interest rate decreases.)

Explore Further
9. Answers will vary depending upon when the website is accessed.

CHAPTER 15
Quick Check
1. a. False.
b. True.
c. True.
d. False.
e. True.
f. True.
g. False.
h. Uncertain/False. Some of the increase in the stock market was probably justified.
However, most economists believe that there was a bubble in the stock market as well. A
stock market correction followed.

2. a. 1+i =($F/$P)1/n
i =(1000/800)1/3-1 = 7.7%

b. 5.7%

c. 4.1%

3. The yield is approximately the average of the short term interest rates over the life of the bond.

a. 5%.

b. 5.25%

c. 5.5%

4. a. Unexpected shift down of the LM curve. Unexpected fall in the interest rate and increase
in Y. Stock prices increase.

b. No change in stock prices.

162