Macroeconomics Canadian 14th Edition Mcconnell Solutions Manual

Macroeconomics Canadian 14th Edition
Mcconnell Solutions Manual

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Chapter 09 - Business Cycles, Unemployment, and Inflation
McConnell, Brue, Flynn, Barbiero Macro 14ce
DISCUSSION QUESTIONS
1. What are the four phases of the business cycle? How long do business cycles last? Why does
the business cycle affect output and employment in capital goods industries and consumer
durable goods industries more severely than in industries producing consumer nondurables?
LO9.1
Answer: The four phases of a typical business cycle, starting at the bottom, are trough,
recovery, peak, and recession. As seen in Table 9.1, the length of a complete cycle varies
from about 2 to 3 years to as long as 15 years.
Because capital goods and durable goods last, purchases can be postponed. This may
happen when a recession is forecast. Capital and durable goods industries therefore
suffer large output declines during recessions. In contrast, consumers cannot long
postpone the buying of nondurables such as food; therefore recessions only slightly
reduce non-durable output. Also, capital and durable goods expenditures tend to be
“lumpy.” Usually, a large expenditure is needed to purchase them, and this shrinks to
zero after purchase is made.
2. How, in general, can a financial crisis lead to a recession? How, in general, can a major new
invention lead to an expansion? LO9.1
Answer: Unexpected financial bubbles (rapid asset price increases) followed by bursts
(abrupt asset price decreases) can spill over to the general economy by contracting
lending and eroding the confidence of consumers and businesses.
For example, the severe recession of 2008-2009 was precipitated by a combination of
excessive money and a financial frenzy in the U.S. that led to overvalued real estate and
unsustainable mortgage debt. The U.S. recession quickly spilled into Canada. Institutions
bundled this debt into new securities (“derivatives”), which were sold to financial
investors, including Canada. Some of the investors in the U.S.in turn bought insurance
against losses that might arise from the securities. As real estate prices plummeted and
mortgage defaults unexpectedly rocketed, the U.S. securitization and insurance structure
buckled and nearly collapsed. Credit markets froze, pessimism prevailed, and spending
by businesses and households tanked.
Significant new products or production methods such as those associated with the
railroad, automobile, computer, and the Internet can rapidly spread through the economy,
sparking sizeable increases in investment, consumption, output, and employment.
9-1
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
3. How is the labour force defined and who measures it? How is the unemployment rate
calculated? Does an increase in the unemployment rate necessarily mean a decline in the size of
the labour force? Why is a positive unemployment rate—one more than zero percent—fully
compatible with full employment? LO9.2
Answer: Statistics Canada measures the labour force. Statistics Canada defines the
labour force by dividing the total population in Canada into three groups. One group is
made up of people under 15 years of age and people who are institutionalized, for
example, in mental health hospitals or correctional institutions. Such people are not
considered potential members of the labour force. A second group, labeled “Not in labour
force,” is composed of adults who are potential workers but are not employed and are not
seeking work. For example, they are homemakers, full-time students, or retirees. The
third group is the labour force, which constituted slightly more than 50 percent of the
total population in 2014. The labour force consists of people who are able and willing to
work. Both those who are employed and those who are unemployed but actively seeking
work are counted as being in the labour force.
No, an increase in the unemployment rate does not necessarily mean a decline in the size
of the labour force. For example, individuals who were not in the labour force before
(students just graduating college) may start looking for a job. In this case, the number of
unemployed increases, the labour force increases, and the unemployment rate increases.
The natural rate of unemployment is the sum of frictional and structural unemployment.
This value is always positive because people are transitioning to new jobs by choice or
because the industry they were in is no longer globally competitive. This is why a
positive rate of unemployment is fully compatible with full employment.
4. How, in general, do unemployment rates vary by gender, occupation, and education? Why does
the average length of time people are unemployed rise during a recession? LO9.2
Answer: Gender: The unemployment rates for men and women are very similar.
Occupation: Workers in lower-skilled occupations (for example, labourers) have higher
unemployment rates than workers in higher-skilled occupations (for example,
professionals).
Education: Less-educated workers, on average, have higher unemployment rates than
workers with more education. Less education is usually associated with lower-skilled,
less-permanent jobs; more time between jobs; and jobs that are more vulnerable to
cyclical layoff.
Duration: The number of persons unemployed for long periods— 15 weeks or more—as
a percentage of the labour force is much lower than the overall unemployment rate. But
that percentage rises significantly during recessions because businesses lay-off workers
as a result of the decrease in demand or increase in other production cost.
9-2
5. Why is it difficult to distinguish between frictional, structural, seasonal and cyclical

unemployment? Why is unemployment an economic problem? What are the consequences of a
negative GDP gap? What are the noneconomic effects of unemployment? LO9.2
Answer: It is not easy to distinguish between these four types of unemployment because
the sum of frictional and structural unemployment is itself changing, thus it is difficult to
determine the full-employment unemployment rate. For example, a person who quits a
job in search of a better one would normally be considered frictionally unemployed. But
suppose the former job then disappears completely because the firm is in a declining
industry and can no longer make money. Our still jobless worker could now be
considered structurally unemployed. And then suppose the economy slips into a severe
recession so that our worker cannot find any job and has become cyclically unemployed.
The sum of frictional and structural unemployment fluctuates as the labour force structure
changes. In other words, there is no automatic label on the type of unemployment when
someone is counted as unemployed.
Unemployment is an economic problem because of the concept of opportunity cost.
Quite apart from any idea of consideration for others, unemployment is economic waste:
A unit of labour resource that could be engaged in production is sitting idle.
The “GDP gap” is the difference between what the economy could produce at its
potential GDP and what it is producing, its actual GDP. The consequence of a negative
GDP gap is that what is not produced – the amount represented by the gap—is lost
forever. Moreover, to the extent that this lost production represents capital goods, the
potential production for the future is impaired. Future economic growth will be less.
The noneconomic effects of unemployment include the sense of failure created in parents
and in their children, the feeling of being useless to society, of no longer belonging.
6. Since Canada has an employment insurance program that provides income for those out of
work, why should we worry about unemployment? LO9.2
Answer: The employment insurance program merely gives the unemployed enough
funds for basic needs. Furthermore, many of the unemployed do not qualify for
unemployment benefits. The programs apply only to those workers who were covered by
the insurance, and this may be as few as one-third of those without jobs. Most of the
unemployed get no sense of self-worth or accomplishment out of drawing this
compensation. Moreover, from the economic point of view, unemployment is a waste of
resources; when the unemployed go back to work, nothing is forgone except undesired
leisure. The unemployed are producing nothing—their supply is zero – but the
compensation helps keep demand in the economy high.
7. What is the Consumer Price Index (CPI) and how is it determined each month? How does the
Statistics Canada calculate the rate of inflation from one year to the next? What effect does
inflation have on the purchasing power of a dollar? How does it explain differences between
nominal and real interest rates? How does deflation differ from inflation? LO9.3
9-3
Answer: The CPI is constructed from a “market basket” sampling of goods that
consumers typically purchase. Prices for goods in the market basket are collected each
month, weighted by the importance of the good in the basket (cars are more expensive
than bread, but we buy a lot more bread), and averaged to form the price level.
To calculate the rate of inflation, Statistics Canada subtracts the CPI for the previous year
from the CPI for the current year, and then divides this difference by the CPI for the
previous year. Multiplying this value by 100 gives us the percentage change in the price
level.
Inflation reduces the purchasing power of the dollar. Facing higher prices with a given
number of dollars means that each dollar buys less than it did before.
The rate of inflation in the CPI approximates the difference between the nominal and real
interest rates. A nominal interest rate of 10% with a 6% inflation rate will mean that real
interest rates are approximately 4%.
Deflation means that the price level is falling, whereas with inflation overall prices are
rising. Deflation is undesirable because the falling prices mean that incomes are also
falling, which reduces spending, output, employment, and, in turn, the price level (a
downward spiral). Inflation in modest amounts (<3%) is tolerable, although there is not
universal agreement on this point.
8. Distinguish between demand-pull inflation and cost-push inflation. Which of the two types is
most likely to be associated with a negative GDP gap? Which with a positive GDP gap, in which
actual GDP exceeds potential GDP? What is core inflation? Why it is calculated? LO9.3
Answer: Demand-pull inflation occurs when prices rise because of an increase in

aggregate spending not fully matched by an increase in aggregate output. It is sometimes
expressed as “too much spending (or money) chasing too few goods.” Cost-push
inflation describes prices rising because of increases in per unit costs of production.
Cost-push inflation is most likely to be associated with a negative GDP gap, as the rising
production costs reduce spending and output.
Demand-pull inflation is more likely to occur with a positive GDP gap, because actual
GDP will exceed its potential only when aggregate spending is strong and rising. As the
economy produces above its potential, bottlenecks and more severe resource scarcity
occur, driving up prices.
9. Explain how an increase in your nominal income and a decrease in your real income might
occur simultaneously. Who loses from inflation? Who gains? LO9.4
Answer: If a person’s nominal income increases by 10 percent while the cost of living
increases by 15 percent, then her real income has decreased from 100 to 95.65 (=
110/1.15). Alternatively expressed, her real income has decreased by 4.35 percent (= 100
- 95.65). Generally, whenever the cost of living increases faster than my nominal
income, real income decreases.
The losers from inflation are those on incomes fixed in nominal terms or, at least, those
with incomes that do not increase as fast as the rate of inflation. Creditors and savers also
lose. Typically those holding debt gain.
9-4
10. Explain how hyperinflation might lead to a severe decline in total output. LO9.5
Answer: With inflation running into the double, triple, quadruple, or even greater
number of digits per year, it makes little sense to save. The only sensible thing to do with
money is to spend it before its value is cut in half within a month, a week, or a day. This
very fact of everyone trying to spend as fast as possible will speed the inflationary spiral
and cause people to spend more and more time trying to figure out what goods are most
likely to go up fastest in price. More and more people will turn away from productive
activity, because wages and salaries are not keeping up with inflation. Instead, they will
spend their time speculating, transferring goods already in existence and producing
nothing.
Eventually, money may become worthless. No one will work for money. Barter and
living by one’s wits become the only means of survival. Production falls for this reason
and also because investment in productive capital practically ceases. Unemployment
soars. A massive depression is at hand.
The LAST WORD Why was the 2009 hike in the minimum wage in the U.S. probably not
responsible for much of the slow growth in employment after the Great Recession? What is
inefficiently long search and how is it affected by the duration of unemployment benefits? How
might Obamacare have discouraged hiring? Why was the Great Recession more severe in the
U.S.?
Answer: At any given time, fewer than 3 percent of workers are employed at minimum-
wage jobs. So it would be hard to blame the increase in the minimum wage for more than
a very small fraction of the slow post-recession recovery in employment.
“Inefficiently long search” means that many unemployed workers used the extended
period during which they could survive on unemployment benefits to keep searching for
perfect jobs even after they had been offered several so-so jobs. As a result, the
unemployment rate stayed higher than it would have if benefits had continued to end after
just 26 weeks and workers had felt financial pressure at an earlier date to accept so-so
jobs rather than to keep on searching for perfect jobs.
Obamacare might discourage companies from hiring because it increases labour costs.
Both the increase in the Medicare payroll tax and the requirement that by 2014 any firm
with more than 50 employees would have to provide health insurance coverage for all of
its full-time workers increased the cost to hire an employee.
The recession was less severe in the Canada because it did not experience a housing
bubble as in the U.S.
9-5
REVIEW QUESTIONS
1. Place the phases of the business cycle in order. LO9.1

Recession
Trough
Peak
Expansion
Answer: Peak, Recession, Trough, Expansion.

The typical business cycle goes through four phases in the following order: peak,
recession, trough, expansion.
2. Most economists agree that the immediate cause of the large majority of cyclical changes in the
levels of real output and employment is unexpected changes in ___________________. LO9.1
a. The level of total spending.
b. The level of the stock market.
c. The level of the trade deficit.
d. The level of unemployment.
Answer: a. The level of total spending.

Most economists agree that the immediate cause of the large majority of cyclical changes
in the levels of real output and employment is unexpected changes in the level of total
spending.
Total spending may change for a number of reasons including political events, financial
instability, and monetary factors. But it is unexpected changes in total spending that drive
the large majority of cyclical changes in real GDP.
3. Suppose that an economy has 9 million people working full time. It also has 1 million people
who are actively seeking work but currently unemployed as well as 2 million discouraged
workers who have given up looking for work and are currently unemployed. What is this
economy’s unemployment rate? LO9.2
a. 10 percent.
b. 15 percent.
c. 20 percent.
d. 25 percent.
9-6
Answer: a. 10 percent.
This economy’s unemployment rate is 10 percent because the number of unemployed is 1
million and the size of the labour force is 10 million.
To see why 10 percent is the correct answer, recall that the formula for calculating the
unemployment rate is
To apply the formula, we need numbers for “unemployed” and “labour force.” Let’s start
with the size of the labour force, which by definition is the sum of the number of people
who are employed plus the number of people who are not currently working but who are
actively seeking work. For this economy, the labour force would consequently be 10
million (= 9 million employed + 1 million unemployed but actively seeking work).
We next need to figure out how many “unemployed” workers there are. Remember that
as far as the unemployment statistic is concerned, we are looking for people who want
jobs, are actively seeking jobs, but don’t currently have jobs. That is, we totally exclude
the discouraged workers. They are excluded because, by ceasing to look for work, they
are no longer in the labour force, which by definition consists of everybody willing and
able to work right now. By focusing only on the workers without jobs who are still
actively seeking work, we see that there are 1 million “unemployed” workers in the
labour force.
By plugging in our values for the labour force (10 million) and the number of
“unemployed” (1 million) we see that this economy’s unemployment rate is 10 percent [=
(1 million/10 million) times 100].
4. Label each of the following scenarios as either frictional unemployment, structural

unemployment, or cyclical unemployment. LO9.2
a. Tim just graduated and is looking for a job.
b. A recession causes a local factory to lay off 30 workers.
c. Thousands of bus and truck drivers permanently lose their jobs when driverless, computer-
driven vehicles make human drivers redundant.
d. Hundreds of Toronto legal jobs permanently disappear when a lot of legal work gets
outsourced to lawyers in India.
Answers:
a. frictional unemployment
b. cyclical unemployment
c. structural unemployment
d. structural unemployment
Let’s go through each scenario in order.
Tim just graduated and is looking for a job is an example of frictional unemployment
because Tim is merely transitioning from school to work. He is not unemployed because
of a recession (cyclical unemployment) or because he lacks skills desired by employers
(structural unemployment).
A recession causes a local factory to lay off 30 workers is an example of cyclical
unemployment because the downturn in the business cycle has led to these 30 workers
losing their jobs.
9-7
Thousands of bus and truck drivers permanently lose their jobs when driverless,
computer-driven vehicles make human drivers redundant is an example of structural
unemployment because the drivers are losing their jobs as the result of a technological
innovation which has destroyed the demand for human driving skills.
Hundreds of Toronto legal jobs permanently disappear when a lot of legal work gets
outsourced to lawyers in India is an example of structural unemployment because the
demand for legal skills has permanently dropped in Toronto due to competition from
India.
5. The unemployment rate that is consistent with full employment is known as

_________________________. LO9.2
a. The natural rate of unemployment.
b. The unnatural rate of unemployment.
c. The status quo rate of unemployment.
d. Cyclical unemployment.
e. Okun’s rate of unemployment.
Answer: a. The natural rate of unemployment.

The natural rate of unemployment is in fact defined as the unemployment rate that is
consistent with full employment.
Keep in mind that when we say full employment, we mean that the economy is only
experiencing frictional and structural unemployment. That is, there is no cyclical
unemployment. Thus, while not every worker will be employed, only those temporarily
between jobs (the frictionally unemployed) and those whose skills fail to match the needs
of employers (the structurally unemployed) will be without work.
6. A country’s current unemployment rate is 11 percent. Economists estimate that its natural rate
of unemployment is 6 percent. About how large is this economy’s negative GDP gap? LO9.2
a. 1 percent.
b. 3 percent.
c. 6 percent.
d. 10 percent.
Answer: d. 10 percent.
This economy’s negative GDP gap should be about 10 percent.
This estimate is based upon Okun’s law, which indicates that for every 1 percentage point
by which the actual unemployment rate exceeds the natural rate, a negative GDP gap of
about 2 percentage points occurs.
To apply Okun’s law to the current situation, we first note that actual unemployment
exceeds the natural rate by 5 percentage points (= 11 percent actual rate of unemployment
minus 5 percent natural rate of unemployment). It then follows that the negative GDP gap
must be 10 percent (= 5 percentage points times 2).
9-8
7. Cost-push inflation occurs when there is __________________________. LO9.3

a. Excess inventory.
b. A trade deficit.
c. Rising per-unit production costs.
d. Excess demand for goods and services.
Answer: c. Rising per-unit production costs.

Cost-push inflation occurs when rising per-unit production costs squeeze company
profits, thereby causing firms to reduce the amount of output that they are willing to
supply at the current price level. This leads to higher unemployment because fewer
workers are needed to produce less output.
8. Jimmer’s nominal income will go up by 10 percent next year. Inflation is expected to be -2

percent next year. By approximately how much will Jimmer’s real income change next year?
LO9.3
a. -2 percent.
b. 8 percent.
c. 10 percent.
d. 12 percent.
Jimmer’s real income will rise by 12 percent next year. You can see this by rearranging
the formula that shows the relationship between real income, nominal income, and
inflation:
Percentage Percentage Percentage
change in = change in - change in
real income nominal price level
income
Using that formula, we see that the percentage change in Jimmer’s real income will be
approximately equal to the 10 percent increase in his nominal income minus the
percentage change in the price level (which will be minus 2 percent). Taking into account
the fact that a “minus times a minus is a plus” we see that Jimmer’s real income should
be approximately 12 percent [= 10 percent increase in nominal income – (-2 percent
change in price)].
9. Kaitlin has $10,000 of savings that she may deposit with her local bank. Kaitlin wants to earn a
real rate of return of at least 4 percent and she is expecting inflation to be exactly 3 percent. What
is the lowest nominal interest rate that Kaitlin would be willing to accept from her local bank?
LO9.4
a. 4 percent.
b. 5 percent.
c. 6 percent.
d. 7 percent.
9-9
The lowest nominal interest rate that Kaitlin would be willing to accept is 7 percent.
She would of course be happier to get more than 7 percent. But the lowest nominal rate
that she would accept is 7 percent because that is the lowest nominal interest rate that
would give her the 4 percent real rate of return that she wishes to earn.
To see why that is true, recall the formula that states that
nominal interest rate = real interest rate + inflation premium (the expected rate of
inflation)
Given that the real interest rate that Kaitlin desires is 4 percent and given that she is
expecting inflation to be 3 percent, the right-hand side of the formula tells us to add the
two values together in order to figure out the nominal interest rate that Kaitlin will accept.
Doing so tells us that she will accept a nominal interest rate of 7 percent (= 4 percent real
interest rate + 3 percent expected rate of inflation). She is happy to accept that rate
because it will yield her the real return of 4 percent that she desires.
By contrast, if she were to accept a nominal interest rate of 5 percent, then she would
only make a real rate of return of just 2 percent. You can see this by rearranging the
formula and solving for the real interest rate. Doing so yields,
real interest rate = nominal interest rate − inflation premium (the expected rate of
inflation)
Using this version of the formula, we can see that the real interest rate in this situation
would only be 2 percent (= 5 percent nominal interest rate minus 3 percent expected rate
of inflation). Because that real rate of 2 percent is less than the 4 percent rate that Kaitlin
wants, she will not give the bank her money if the best they offer is a 5 percent nominal
interest rate. She will hold out for at least a 7 percent nominal rate, as that is the only way
for her to get a real return of at least 4 percent.
10. True or False: Lenders are helped by unanticipated inflation. LO9.4
Answer: false.
This statement is false because lenders are actually hurt (rather than helped) by
unanticipated inflation.
Unanticipated inflation hurts lenders by reducing real returns. As an example, suppose
that you loaned out $1000 at a nominal interest rate of 10 percent. Also suppose that you
had been expecting an inflation rate of 2 percent so that you were anticipating a real
interest rate of 8 percent (= 10 percent nominal interest rate minus 2 percent inflation
rate). But then suppose that inflation turns out to be 10 percent. As a result, your real
interest rate will turn out to be zero percent (= 10 percent nominal interest rate minus 10
percent inflation rate).
Thus, you will suffer substantial financial harm because the unexpectedly high inflation
rate lowers your real rate of return down to nothing in this case. But note that things don’t
have to be that extreme for you to be hurt. Any inflation rate that turns out to be higher
than what you were expecting will lower your real rate of return.
9-10
11. Economists agree that______________ inflation reduces real output. LO9.5

a. Cost-push.
b. Demand-pull.
Answer: a. cost-push.
The correct answer is that economists agree that cost-push inflation reduces real output.
Cost-push inflation reduces real output because the unexpected increases in resource
prices that drive cost-push inflations reduce firm profits. Those falling profits then cause
firms to reduce output and lay off workers.
By contrast, economists disagree about whether demand-pull inflation increases or
decreases real output. On the one hand, some economists argue that demand-pull inflation
reduces output because people divert time that could otherwise be spent producing output
into attempts to hedge against inflation. On the other hand, a different group of
economists argue that mild levels of demand-pull inflation may help to increase output
because the high levels of spending that cause demand-pull inflation also create high
profits and a powerful incentive for firms to expand their plants, increase their output,
and hire more workers.
PROBLEMS
1. Suppose that a country’s annual growth rates were 5, 3, 4, -1, -2, 2, 3, 4, 6, and 3 in yearly
sequence over a 10-year period. What was the country’s trend rate of growth over this period?
Which set of years most clearly demonstrates an expansionary phase of the business cycle?
Which set of years best illustrates a recessionary phase of the business cycle? LO9.1
Answers: 2.7 percent (rounded to the nearest decimal); years 6-9; years 4 and 5.
Feedback: The trend rate of growth equals the average for the 10-year period, which is
2.7 percent. (= (5 + 3 + 4 – 1 – 2 + 2 + 3 + 4 + 6 + 3) / 10).
The set of years that clearly demonstrate an expansionary phase is years 6 through 9. The
rate of growth is positive and increasing over this period.
The set of years that best illustrate a recessionary phase is years 4 and 5. Growth is
negative (declining GDP) for these years.
2. Assume the following data for a country: total population, 500; population under 15 years of
age or institutionalized, 120; not in labour force, 150; unemployed, 23; part-time workers looking
for full-time jobs, 10. What is the size of the labour force? What is the official unemployment
rate? LO2
Answer: 230; 10%.
Feedback: To find the size of the labour force subtract population under 16 years of age
or institutionalized (120) and those not in the labour force (150) from the population
(500).
The size of the labour force is 230 (= 500 - 120 -150).
The official unemployment rate is the number of individuals unemployed divided by the
labour force converted into percentage form.
The unemployment rate for the values above is 10% (= (23/230) x 100).
9-11
3. Suppose that the natural rate of unemployment in a particular year is 5 percent and the actual
rate of unemployment is 9 percent. Use Okun’s law to determine the size of the GDP gap in
percentage-point terms. If the potential GDP is $500 billion in that year, how much output is
being forgone because of cyclical unemployment? LO9.2
Answer: GDP gap = 8%; $40 billion.
Feedback: On the basis of recent estimates, Okun’s law indicates that for every 1
percentage point by which the actual unemployment rate exceeds the natural rate, a
negative GDP gap of about 2 percent occurs.
The actual rate of unemployment exceeds the natural rate of unemployment by 4% (= 9%
- 5%), which is cyclical unemployment.
Using Okun’s law, this translates into an 8% GDP gap in percentage-point terms (= 2 x
4%).
Since potential GDP is $500 billion and we are 8% below this amount, the output forgone
is $40 billion (= 0.08 x $500 billion).
4. If the CPI was 110 last year and is 121 this year, what is this year’s rate of inflation? In
contrast, suppose that the CPI was 110 last year and is 108 this year. What is this year’s rate of
inflation? What term do economists use to describe this second outcome? LO9.3
Answers: 10 percent; -1.8 percent; deflation.
Feedback: The inflation rate is the percentage change in the CPI over a period of time.
For the values above we have:
If the CPI was 110 last year and is 121 this year, the inflation rate was 10%
(= ((121-110)/110) x 100).
If the CPI was 110 last year and is 108 this year, the inflation rate was approximately -
1.8%
(= ((108-110)/110) x 100). This outcome is referred to as deflation by economists.
5. How long would it take for the price level to double if inflation persisted at (a) 2, (b) 5, and (c)
10 percent per year? LO9.3
Answer: (a) 35 years; (b) 14 years; (c) 7 years.
Feedback: The “Rule of 70,” which is to divide 70 by the inflation rate, gives us the time
it takes for the price level to double.
Years to double = (70 / Inflation Rate)
Using this formula we have:
(a) The price level will double in 35 years if the inflation rate is 2% (= 70/2).
(b) The price level will double in 14 years if the inflation rate is 5% (= 70/5).
(c) The price level will double in 7 years if the inflation rate is 10% (= 70/10).
9-12
6. If your nominal income rose by 5.3 percent and the price level rose by 3.8 percent in some
year, by what percentage would your real income (approximately) increase? If your nominal
income rose by 2.8 percent and your real income rose by 1.1 percent in some year, what must
have been the (approximate) rate of inflation? LO9.4
Answer: 1.5 percent; 1.7 percent.
Feedback: To find the approximate percentage change in the real value of your income,
subtract the rate of inflation from the nominal percentage change in your income.
Percentage change in real income = Percentage change in nominal income - Inflation rate
This implies the percentage change in real income is approximately 1.5% (= 5.3% -
3.8%).
We can also rearrange the equation above as follows:
Inflation rate = Percentage change in nominal income - Percentage change in real income
This implies the inflation rate is approximately 1.7% (= 2.8% - 1.1%) for the second set
of values.
7. Suppose that the nominal rate of inflation is 4 percent and the inflation premium is 2 percent.
What is the real interest rate? Alternatively, assume that the real interest rate is 1 percent and the
nominal interest rate is 6 percent. What is the inflation premium? LO9.4
Answers: 2 percent; 5 percent.
Feedback:
To find the approximate real interest rate subtract the inflation premium from the nominal
interest rate.
Real interest rate = nominal interest rate - inflation premium
This implies the real interest rate is 2% (= 4% - 2%).
We can also rearrange the equation above as follows:
Inflation premium = nominal interest rate - real interest rate
This implies the inflation premium is 5% (= 6% - 1%).
9-13

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Chapter 09 - Business Cycles, Unemployment, and Inflation

McConnell, Brue, Flynn, Barbiero Macro 14ce

5. Why is it difficult to distinguish between frictional, structural, seasonal and cyclical

Answer: Demand-pull inflation occurs when prices rise because of an increase in

1. Place the phases of the business cycle in order. LO9.1

Answer: Peak, Recession, Trough, Expansion.

Answer: a. The level of total spending.

4. Label each of the following scenarios as either frictional unemployment, structural

5. The unemployment rate that is consistent with full employment is known as

Answer: a. The natural rate of unemployment.

7. Cost-push inflation occurs when there is __________________________. LO9.3

Answer: c. Rising per-unit production costs.

8. Jimmer’s nominal income will go up by 10 percent next year. Inflation is expected to be -2

10. True or False: Lenders are helped by unanticipated inflation. LO9.4

11. Economists agree that______________ inflation reduces real output. LO9.5

Answer: 230; 10%.

Answer: GDP gap = 8%; $40 billion.

Answers: 10 percent; -1.8 percent; deflation.

Answer: (a) 35 years; (b) 14 years; (c) 7 years.

Answer: 1.5 percent; 1.7 percent.

Answers: 2 percent; 5 percent.

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