Macroeconomics Principles and Policy 13th Edition Baumol Solutions Manual

Macroeconomics Principles and Policy
13th Edition Baumol Solutions Manual

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Chapter 9/Demand-Side Equilibrium: Unemployment or Inflation?
CHAPTER 9
DEMAND-SIDE EQUILIBRIUM:
UNEMPLOYMENT OR INFLATION?
TEST YOURSELF
1. From the following data, construct an expenditure schedule on a piece of graph
paper. Then use the income-expenditure (45° line) diagram to determine the
equilibrium level of GDP.
Income Consumption Investment Government Net Exports
Purchases
3,600 $3,220 $240 $120 $40
3,700 3,310 240 120 40
3,800 3,400 240 120 40
3,900 3,490 240 120 40
4,000 3,580 240 120 40
Now suppose investment spending rises to $260, and the price level is fixed. By how
much will equilibrium GDP increase? Derive the answer both numerically and
graphically.
FIGURE 1
© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
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The original equilibrium GDP is at Y = 3,800, where spending equals output. This is
shown by the intersection of the lower of the two expenditure lines in the graph above
with the 45° line. The MPC calculated from the data is 0.90, so the multiplier is 10. If
investment spending rises by $20 (to $260) the equilibrium GDP will increase by $20×10
= $200, which is represented by a vertical shift (by $20) to the upper expenditure function
in the diagram.
2. From the following data, construct an expenditure schedule on a piece of graph

paper. Then use the income-expenditure (45° line) diagram to determine the
equilibrium level of GDP. Compare your answer with your answer to the previous
question.
Income Consumptio Investmen Government Net
n t Purchases Exports
$3,600 $3,280 $180 $120 $40
3,700 3,340 210 120 40
3,800 3,400 240 120 40
3,900 3,460 270 120 40
4,000 3,520 300 120 40
In question 2, the marginal propensity to consume is lower than it was in question 1 (0.6
versus 0.9), but in this case there is induced investment (investment which changes as
GDP changes), while in question 1 investment was constant. The two changes cancel
each other, and the expenditure schedule is the same in both questions. So Figure 1
applies to Question 2, and the equilibrium GDP is 3800.
3. Suppose that investment spending is always $250, government purchases are $100,
net exports are always $50, and consumer spending depends on the price level in the
following way:
Price Consumer
Level Spending
90 $740
95 720
100 700
105 680
110 660
On a piece of graph paper, use these data to construct an aggregate demand curve. Why
do you think this example supposes that consumption declines as the price level rises?
FIGURE 2
At lower prices, the real value of money and other assets that are denominated in money
terms is higher. Since wealth influences consumption, at lower prices consumption is
higher.
4. (More difficult) Consider an economy in which the consumption function takes the
following simple algebraic form:
C = 300 + 0.75DI
and in which investment (I) is always $900 and net exports are always –$100.
Government purchases are fixed at $1,300 and taxes are fixed at $1,200. Find the
equilibrium level of GDP, and then compare your answer to Table 1 and Figure 2. (Hint:
Remember that disposable income is GDP minus taxes: DI = Y – T = Y – 1,200.)
Y = C + I + G + (X – IM)
C = 300 + 0.75DI
C = 300 + 0.75(Y – 1200)
C = 300 + 0.75Y – 900
C = -600 + 0.75Y
Y = -600 + 0.75Y + 900 + 1300 – 100
Y = 0.75Y + 1500
0.25Y= 1500
Y = (1/0.25)  1500
Y = 4  1500 = 6000
This algebraic model yields the same equilibrium GDP as Table 2. (The solution is also
given in the Appendix.)
5. (More difficult) Keep everything the same as in Test Yourself Question 4 except
change investment to I = $1,100. Use the equilibrium condition Y = C + I + G + (X –
IM) to find the equilibrium level of GDP on the demand side. (In working out the
answer, assume the price level is fixed.) Compare your answer to Table 3 and Figure
10. Now compare your answer to the answer to Test Yourself Question 4. What do you
learn about the multiplier?
Y = C + I + G + (X - IM)
C = 300 + 0.75DI
C = 300 + 0.75(Y - 1,200)
C = 300 + 0.75Y - 900
C= -600 + 0.75Y
Y= -600 + 0.75Y + 1,100 + 1,300 - 100
Y = 0.75Y + 1,700
0.25Y = 1,700
Y = 4 × 1,700 = 6,800
This algebraic model yields the same equilibrium GDP as Table 3 and Figure 10 in the
chapter.
Compared to the answer to Test Yourself Question 4, we find $800 more in GDP from a
$200 increase in I. Thus this question demonstrates that the multiplier of 4 applies to
changes in I as well as to changes in C.
6. (More difficult) An economy has the following consumption function:

C = 200 + 0.8DI
The government budget is balanced, with government purchases and taxes both fixed at
$1,000. Net exports are $100. Investment is $600. Find equilibrium GDP.
What is the multiplier for this economy? If G rises by $100, what happens to Y? What
happens to Y if both G and T rise by $100 at the same time?
Y = C + I + G + (X – IM)
C = 200 + 0.8(Y – 1000)
C = 200 + 0.8Y – 800
C = –600 + 0.8Y
Y = –600 + 0.8Y + 600 + 1000 + 100
Y = 1100 + 0.8Y
0.2Y= 1100
Y = 5(1100) = 5500
The multiplier is 5. If G rises by $100, Y will increase by $500 (5  $100). Table 9-3 and
Figure 9-10 in the text. This question demonstrates that the multiplier applies to changes
in I as well as changes in C.
If G and T each increase by $100 Y will increase by $100 as demonstrated below:
Y = C + I + G + (X – IM)
C = 200 + 0.8(Y – 1100)
C = 200 + 0.8Y – 880
C = –680 + 0.8Y
Y = –680 + 0.8Y + 600 + 1100 + 100
Y = 1120 + 0.8Y
0.2Y= 1120
Y = 5(1120) = 5600
7. Use both numerical and graphical methods to find the multiplier effect of the following
shift in the consumption function in an economy in which investment is always $220,
government purchases are always $100, and net exports are always -$40. ( Hint: What
is the marginal propensity to consume?)
Income Consumption Consumption
before Shift after Shift
$1,080 $ 880 $ 920
1,140 920 960
1,200 960 1,000
1,260 1,000 1,040
1,320 1,040 1,080
1,380 1,080 1,120
1,440 1,120 1,160
1,500 1,160 1,200
1,560 1,200 1,240
FIGURE 3
The graph above indicates that equilibrium GDP rises from 1,320 to 1,440, or by 120.
The oversimplified multiplier formula can be used in this case. The marginal propensity
to consume can be calculated between any two income levels. The numbers in the table
above show that each $60 of additional income leads to $40 more in consumer spending,
so the MPC is 40/60 = 2/3, and the multiplier is 1/[1 - (2/3)] = 3. So a shift in
consumption of 40 should raise equilibrium GDP by 120, which it does.
DISCUSSION QUESTIONS
1. For more than 30 years, imports have consistently exceeded exports in the U.S.
economy. Many people consider this imbalance to be a major problem. Does this
chapter give you any hints about why? (You may want to discuss this issue with
your instructor. You will learn more about it in later chapters.)
Some problems are created by the trade deficit. Since net exports are a component of
aggregate demand, the trade deficit represents a reduction in aggregate demand. On the
other hand, there are some advantages to the trade deficit. (These features will be
discussed in future chapters. The trade deficit allows U.S. absorption of goods and
services to exceed production. Also, it facilitates the inflow of foreign capital that covers
the shortage of savings that would otherwise be caused by a federal government deficit).
2. Look back at the income-expenditure diagram in Figure 3 and explain why some level
of real GDP other than $6,000 (say, $5,000 or $7,000) is not an equilibrium on the
demand side of the economy. Do not give a mechanical answer to this question.
Explain the economic mechanism involved.
At any level of GDP other than the single equilibrium, total spending differs from the
amount of production. Hence inventories change, and producers have an incentive to
change the level of output.
3. Does the economy this year seem to have an inflationary gap or a recessionary gap?
(If you do not know the answer from news reports, ask your instructor.)
The answer depends upon the current state of the economy but for the years leading up to
2011, the most appropriate answer would be a recessionary gap.
4. Try to remember where you last spent a dollar. Explain how this dollar will lead to a
multiplier chain of increased income and spending. (Who received the dollar? What
will he or she do with it?)
The answers will, of course, vary. Most students probably spent their last dollar at a retail
store. The money went into the pocket of the proprietor, an employee or a supplier of the
store, who probably spent some portion of it on other goods or services.
ANSWERS TO APPENDIX A QUESTIONS

TEST YOURSELF
1. Find the equilibrium level of GDP demanded in an economy in which investment is
always $300, net exports are always –$50, the government budget is balanced with
purchases and taxes both equal to $400, and the consumption function is described by
the following algebraic equation:
C = 150 + 0.75DI
(Hint: Remember that DI = Y – T.)
Y = C + I + G + (X – IM)
C = 150 + 0.75(Y – 400)
C = 150 + 0.75Y – 300
C = –150 + 0.75Y
Y = –150 + 0.75Y + 300 + 400 – 50
Y = 0.75Y + 500
0.25Y= 500
Y = 4  500 = 2,000
2. Referring to Test Yourself Question 1, do the same for an economy in which

investment is $250, net exports are zero, government purchases and taxes are
both $400, and the consumption function is as follows:
C = 250 + 0.5DI
Y = C + I + G + (X – IM)
C = 250 + 0.5DI
C = 250 + 0.5(Y – 400)
C = 250 + 0.5Y – 200
C= 50 + 0.5Y
Y = 50 + 0:5Y + 250 + 400 + 0
Y = 0.5Y + 700
0.5Y= 700
Y = (1/0.5)  700
Y = 2  700 = 1400
3. In each of these cases, how much saving is there in equilibrium? (Hint: Income not
consumed must be saved.) Is saving equal to investment?
Saving is equal to disposable income minus consumption.
In Question 1: S = (Y - T) - C
S = (2,000- 400) - [-150 + 0.75(2000)]
S = 1,600 - (-150 + 1,500)
S = 1,600 - 1,350
S = 250
S is not equal to I.
In Question 2: S = (Y - T) - C
S = (1,400- 400) - [50 + 0.5(1,400)]
S = 1,000 - (50 + 700)
S = 1,000 - 750
S = 250
In Question 2, S is equal to I. The difference is that X and IM are equal in Question 2 but
unequal in Question 1.
4. Imagine an economy in which consumer expenditure is represented by the following

equation:
C = 50 + 0.75DI
Imagine also that investors want to spend $500 at every level of income (I = $500), net
exports are zero (X – IM = 0), government purchases are $300, and taxes are $200.
a. What is the equilibrium level of GDP?
b. If potential GDP is $3,000, is there a recessionary or inflationary gap? If so, how
much?
c. What will happen to the equilibrium level of GDP if investors become optimistic
about the country’s future and raise their investment to $600?
d. After investment has increased to $600, is there a recessionary or inflationary
gap? How much?
(a) Y = C + I + G + (X – IM)
C = 50 + 0.75(Y – 200)
C = 50 + 0.75Y – 150
C = –100 + 0.75Y
Y = –100 + 0.75Y + 500 + 300 + 0
Y = 0.75Y + 700
0.25Y= 700
Y = (1/0.25)  700
Y = 4  700 = 2800
(b) There is a recessionary gap of 200.
(c) The last five lines in 4(a) above are replaced by:
Y = –100 + 0.75Y + 600 + 300 + 0
Y = 0.75Y + 800
0.25Y= 800
Y = (1/0.25)  800
Y = 4  800 = 3200
(d) There is now an inflationary gap of 200.
5. Fredonia has the following consumption function:

C = 100 + 0.8DI
Firms in Fredonia always invest $700 and net exports are zero, initially. The
government budget is balanced with spending and taxes both equal to $500.
a. Find the equilibrium level of GDP.
b. How much is saved? Is saving equal to investment?
c. Now suppose that an export-promotion drive succeeds in raising net exports to
$100. Answer (a) and (b) under these new circumstances.
(a) Y = C + I + G + (X – IM)
C = 100 + 0.8(Y – 500)
C = 100 + 0.8Y – 400
C = –300 + 0.8Y
Y= –300 + 0.8Y + 700 + 500 + 0
Y = 0.8Y + 900
0.2Y = 900
Y = 5 900 = 4,500
(b) S = (Y – T) – C
S = (4,500 – 500) – [–300 + 0.8(4,500)]
S = 4,000 – 3,300 = 700, which is equal to investment, so S = I.
(c) Now X - IM = 100, so the last four lines of 5(a) above are replaced by
Y = –300 + 0.8Y + 700 + 500 + 100
Y = 0.8Y + 1,000
0.2Y = 1,000
Y = (1/0.2)  1000
Y = 5  1,000 = 5,000
S = (Y – T) – C
S = (5,000 – 500) – [–300 + 0.8(5,000)]
S = 4,500 – 3,700 = 800
Now, S is not equal to I.
1. Explain the basic logic behind the multiplier in words. Why does it require b, the
marginal propensity to consume, to be between 0 and 1?
The multiplier works through consumer spending and disposable income. When
autonomous spending in the economy rises, this increases income paid to the factors of
production, such as labor. When labor receives more income, disposable income rises,
and therefore, consumption rises. This fuels more spending and income payments. Since
people consume only a fraction of each additional dollar earned, the multiplier process
eventually stops when the economy reaches its new equilibrium.
In order for the multiplier process to work, the marginal propensity to consume must be
greater than 0 and less than 1. If it were equal to zero, then workers would not increase
consumer spending when income rises, so there would be no multiplier effect. If the
marginal propensity to consume were greater than 1, then the multiplier effects would
never stop and the economy would never reach an equilibrium where expenditures equal
income.
2. (More difficult) What would happen to the multiplier analysis if b = 0? If b = 1?

See answer to previous question. If b = 0, then the multiplier would be equal to 1. That is,
there would be no multiplier effect because a $1 change in expenditures would lead to a
$1 change in income. If b = 1, then the multiplier would be infinite, so that the economy
would never reach an expenditure-income equilibrium.
ANSWERS TO APPENDIX B QUESTIONS

TEST YOURSELF
1. Suppose exports and imports of a country are given by the following:
GDP Exports Imports
2,500 $400 $250
3,000 400 300
3,500 400 350
4,000 400 400
4,500 400 450
5,000 400 500
Calculate net exports at each level of GDP.
GDP Exports Imports Net Exports

2,500 400 250 150
3,000 400 300 100
3,500 400 350 50
4,000 400 400 0
4,500 400 450 –50
5,000 400 500 –100
2. If domestic expenditure (the sum of C + I + G in the economy described in Test Yourself

Question 1) is as shown in the following table, construct a 45° line diagram and locate
the equilibrium level of GDP.
GDP Domestic
Expenditures
$2,500 $3,100
3,000 3,400
3,500 3,700
4,000 4,000
4,500 4,300
5,000 4,600
In Figure 4, the intersection of the lower expenditure line with the 45-degree line shows
an equilibrium GDP of 4,000.
FIGURE 4
3. Now raise exports to $650 and find the equilibrium again. How large is the multiplier?
In Figure 4, the intersection of the upper expenditure line with the 45° line shows an
equilibrium GDP of 4,500. (The lower expenditure line shows the solution to Test
Yourself Question 2, with a GDP of 4,000.) Exports have risen by 250, and GDP has
risen by 500, so the multiplier is 2.
1. Explain the logic behind the finding that variable imports reduce the numerical value
of the multiplier?
Variable imports imply that consumer spending on imports will change when income
changes. When consumers experience an increase in disposable income, they consume
not only more domestic goods (consumption), but more foreign goods as well (imports).
Consider how an increase in government spending would affect the economy. In a closed
economy without variable imports, consumers would increase consumption spending on
domestic goods because their disposable income rises, leading to a multiplier effect. In
an economy with variable imports, disposable income rises, causing consumers to spend
more on both domestic goods (increasing consumption) and imported goods (reducing
net exports). Within the formula Y = C + I + G + (X – IM), the reduction in net exports
partially offsets the increase in consumption of domestic goods, reducing the multiplier
effects.

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Macroeconomics Principles and Policy

13th Edition Baumol Solutions Manual

2. From the following data, construct an expenditure schedule on a piece of graph

6. (More difficult) An economy has the following consumption function:

ANSWERS TO APPENDIX A QUESTIONS

2. Referring to Test Yourself Question 1, do the same for an economy in which

4. Imagine an economy in which consumer expenditure is represented by the following

5. Fredonia has the following consumption function:

2. (More difficult) What would happen to the multiplier analysis if b = 0? If b = 1?

ANSWERS TO APPENDIX B QUESTIONS

GDP Exports Imports Net Exports

2. If domestic expenditure (the sum of C + I + G in the economy described in Test Yourself

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