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Macroeconomics 7th Edition Blanchard Solutions Manual
Macroeconomics 7th Edition Blanchard Solutions Manual
Solutions Manual
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2. What factors affect output in the short run, the medium run, and long run?
This chapter introduces the basic framework of the book in terms of time. In the short run (a time frame of
a few years), output is determined primarily by demand. In the medium run (a time frame of a decade or
so), output is determined by the level of technology and the size of capital stock, both of which are more or
less fixed. In the long run (a time frame of a half century or more), output is determined by technological
progress and capital accumulation.
ii. The chapter defines formally the basic macroeconomic concepts of nominal and real gross domestic
product (GDP), GDP growth, the GDP deflator, the unemployment rate, the consumer price index
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(CPI), and the inflation rate, as well as associated concepts such as valued added, intermediate inputs,
the labor force, and the participation rate. All of these concepts are defined in the usual manner.
iii. The chapter distinguishes the short run, the medium run, and the long run in the manner described
above in Part I. The distinction establishes the basic theoretical framework for the book.
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Using the first definition, nominal GDP is output valued at current prices. Real GDP is output valued at
constant prices. If the economy produced only one good—say, SUVs—and this good were unchanged over
time, one could measure real GDP by simply counting the number of SUVs produced each year.
Alternatively, one could multiply the number of SUVs by some constant price—say, the price in some base
year. Thus, in the base year, real and nominal GDP would be the same. In practice, the construction of
real GDP involves two complications. First, since the economy produces many goods, one must decide
how to weight the value of the output of each good to produce aggregate real GDP. The text notes that the
United States has adopted a technique—chain weighting—that allows the relative price of goods to change
over time. The appendix to Chapter 2 discusses the construction of GDP and chained indexes in more
detail. Second, the quality of similar goods changes over time. Economists who construct GDP try to
account for quality change in goods through hedonic pricing, an econometric technique that estimates the
market value of a good’s characteristics—speed, durability, and so on.
The growth rate of real (nominal) GDP is the rate of change of real (nominal) GDP. Periods of positive
GDP growth are called expansions; periods of negative growth, recessions.
i. The Unemployment Rate. An unemployed person is someone who does not have a job, but is
looking for one. The labor force is the sum of those who have jobs—the employed—and the unemployed.
The unemployment rate is the ratio of unemployed persons to the labor force. Those persons of working
age who do not have a job and are not looking for one are classified as out of the labor force. The
participation rate is the ratio of the labor force to the size of the working age population.
Economists care about unemployment for two reasons. First, the unemployed suffer. Exactly how much
depends on a number of factors, including the generosity of unemployment benefits and the duration of
unemployment. In the United States, the average duration of unemployment is relatively low, but some
groups (e.g., ethnic minorities, the young, and the less skilled) tend to be more susceptible to unemployment
and to remain unemployed much longer than average. Second, the unemployment rate helps policymakers
assess how well the economy is utilizing its resources. A high rate of unemployment rate means that labor
resources are idle. A low rate of unemployment can also be a problem, if the economy develops labor
shortages. A more precise discussion of what constitutes an unemployment rate that is too high or too low
is offered later in the book.
ii. The Inflation Rate. The inflation rate is the growth rate of the aggregate price level. Since there
are many goods produced and consumed in an economy, constructing the aggregate price level is not trivial.
Macroeconomists use two primary measures of the aggregate price level. The first, the GDP deflator, is the
ratio of nominal to real GDP. Since nominal and real GDP differ only because prices in any given year differ
from the base year, the GDP deflator provides some measure of the average price level in the economy,
relative to the base year. By construction, the GDP deflator equals one in the base year. Since the choice
of base year is arbitrary, the level of the GDP deflator is meaningless. The rate of change of the GDP
deflator, however, is meaningful; it is one measure of inflation.
Measures with arbitrary levels but well-defined rates of change are called index numbers. The GDP
deflator is an index number.
An alternative measure of the price level is the Consumer Price Index (CPI)—another index number. In
the United States, this measure is based on price surveys across U.S. cities. The prices of various goods
are weighted according to average consumer expenditure shares in the United States. The construction of
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the CPI and the construction of real GDP involve similar problems. One can also measure inflation as the
rate of change in the CPI.
The relationship between inflation measured from the GDP deflator and inflation measured from the CPI
is very close, but not perfect. The differences arise because the two price indexes apply to different baskets
of goods. GDP measures production of final goods, so inflation calculated from the GDP deflator provides
a measure of the percentage change in the aggregate price of final goods produced in an economy. The
CPI, on the other hand, measures the price of a representative basket of private consumption, so inflation
calculated from the CPI provides a measure of the percentage change in the price of the domestic
consumption basket. Domestic consumption includes goods imported from abroad, and domestic
production includes final goods used for purposes other than domestic consumption.
Economists care about inflation because it can distort relative prices, produce uncertainty about relative
prices, and redistribute income. Inflation distorts relative prices because some nominal variables do not
adjust immediately to the rise in the aggregate price level. Inflation redistributes income because some
transactions involve fixed nominal payments. For example, some retirees receive fixed nominal incomes
(although the text notes that U.S. Social Security payments rise with the CPI).
Inflation may be costly, but there are also economic problems associated with deflation (negative inflation).
For example, some of the costs of inflation would also apply to deflation. Moreover, deflation limits the
ability of monetary policy to affect output. Consideration of the costs of inflation and the costs of deflation
seems to suggest that there is an optimal rate of inflation. Most economists favor a stable inflation rate
somewhere between 1 and 4%.
There are two relationships that connect the three main dimensions of economic activity. The relationship
between unemployment and output is described by Okun’s law. American economist Arthur Okun found
that when output increases unemployment falls and vice versa. Intuitively this relationship makes sense
because higher output in general requires employing more workers. Figure 2-5 highlights this relationship.
The second relationship was identified by economist A.W. Phillips and is shown graphically as the Phillips
curve (see Figure 2-6). Phillips discovered that inflation tends to increase as unemployment falls. This
finding also seems intuitive given that as economic activity increases, and most people are working, the
remaining potential workers must be paid higher wages to get them off the couch. In addition, firms will
begin sniping employees from other firms by paying higher wages. The net result is an increase in inflation
while unemployment falls.
3. The Basic Macroeconomic Framework and a Road Map for the Book
Macroeconomists view the economy in terms of three time frames. In the short run—a few years or so—
demand for goods and services determines output. In the medium run—a decade or so—the level of
technology and the size of the capital stock determine output. Since these variables change slowly, it is a
useful simplification to assume that they are fixed in the medium run. Finally, in the long run, technological
progress and capital accumulation are the primary determinants of output growth.
The remainder of the book can be divided into three sections: “Core” material (Chapters 3-13), extensions
to the Core, and concluding chapters on macroeconomic policy and the state of macroeconomic thinking.
The Core is organized around the three time frames. It discusses the short run in terms of the IS-LM model,
the medium run in terms of the AS-AD model (which incorporates IS-LM), and the long run in terms of the
Solow growth model, with some additional discussion of other approaches. After the Core, there are three
extensions: expectations (Chapters 14-16), the open economy (Chapters 178-20), and monetary and fiscal
policy issues (Chapters 21-23). The final chapter (Chapter 24) focuses on the history of thought in
macroeconomics.
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The book is constructed so that the three extensions can be addressed in any order after the Core. Indeed,
most of the material in the extension chapters can be discussed without covering the growth section of the
Core. In addition, much of the material in the policy chapters can be discussed immediately after the Core,
without any of the extensions. Thus, there are a number of options for constructing a course around the
text.
V. PEDAGOGY
1. Points of Clarification
The use of subscripts to index time will be new for many students. A few minutes of clarification may be
worthwhile at the outset.
2. Alternative Sequencing
The chapter does not discuss national income accounting in any detail. Instead the relevant accounting
identities are presented in the main text as they become relevant for the development of the analytical model.
For example, Chapter 3 presents the expenditure side of the accounts in the course of explaining the
composition of aggregate demand. A complete treatment of the real GDP and chain-type indexes is also
presented in Appendix 1. Instructors may prefer to introduce the material from Appendix 1 immediately
after Section 1 of this chapter.
VI. EXTENSIONS
1. GDP as a Measure of Welfare
The chapter discusses briefly why economists care about inflation and unemployment, but does not do the
same for GDP. It is probably obvious that economists use GDP as a gross measure of aggregate welfare,
but instructors may wish to point out that there are (at least) three limitations on GDP as a welfare measure.
i. Measured GDP values goods and services at market prices, since these reflect the relative values
placed on them by consumers. However, some valuable things are not sold on markets, and their
values thus have to be imputed, a process that undoubtedly introduces some errors. Two important
services that do not have a market price are government services and owner-occupied housing.
ii. Some goods and services not traded in markets are omitted altogether from the GDP calculation.
For example, the value of leisure and the value of services performed in the household are not included
in GDP. From a broader perspective, one might also cite civil liberties and other political “goods” as
nonmarket goods produced by a nation, but not included in GDP.
iii. GDP does not account for the fact that some of a nation’s wealth is depleted in the process of
producing it. NDP corrects this to some extent by subtracting the value of depreciated physical
capital, but depletion of natural and environmental resources is still omitted. The Department of
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Commerce and others have experimented with adjustments to GDP to account for resource and
environmental depletion, but there is no consensus among economists about the proper methodology.
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How the states are to exercise this high power of interposition
which constitutes so essential a portion of their reserved rights that it
cannot be delegated without an entire surrender of their sovereignty,
and converting our system from a federal into a consolidated
government, is a question that the states only are competent to
determine. The arguments which prove that they possess the power,
equally prove that they are, in the language of Jefferson, “the rightful
judges of the mode and measure of redress.” But the spirit of
forbearance, as well as the nature of the right itself, forbids a
recourse to it, except in cases of dangerous infractions of the
Constitution; and then only in the last resort, when all reasonable
hope of relief from the ordinary action of the government has failed;
when, if the right to interpose did not exist, the alternative would be
submission and oppression on the one side, or resistance by force on
the other. That our system should afford, in such extreme cases, an
intermediate point between these dire alternatives, by which the
government may be brought to a pause, and thereby an interval
obtained to compromise differences, or, if impracticable, be
compelled to submit the question to a constitutional adjustment,
through an appeal to the states themselves, is an evidence of its high
wisdom; an element not, as is supposed by some, of weakness, but of
strength; not of anarchy or revolution, but of peace and safety. Its
general recognition would of itself, in a great measure, if not
altogether, supersede the necessity of its exercise, by impressing on
the movements of the government that moderation and justice so
essential to harmony and peace, in a country of such vast extent and
diversity of interests as ours; and would, if controversy should come,
turn the resentment of the aggrieved from the system to those who
had abused its powers (a point all important), and cause them to
seek redress, not in revolution or overthrow, but in reformation. It is,
in fact, properly understood, a substitute where the alternative would
be force, tending to prevent, and if that fails, to correct peaceably the
aberrations to which all political systems are liable, and which, if
permitted to accumulate, without correction, must finally end in a
general catastrophe.
Speech of Henry Clay
Whilst we thus behold the entire failure of all that was foretold
against the system, it is a subject of just felicitation to its friends, that
all their anticipations of its benefits have been fulfilled, or are in
progress of fulfillment. The honorable gentleman from South
Carolina has made an allusion to a speech made by me, in 1824, in
the other House, in support of the tariff, and to which, otherwise, I
should not have particularly referred. But I would ask any one, who
can now command the courage to peruse that long production, what
principle there laid down is not true? what prediction then made has
been falsified by practical experience?
It is now proposed to abolish the system, to which we owe so much
of the public prosperity, and it is urged that the arrival of the period
of the redemption of the public debt has been confidently looked to
as presenting a suitable occasion to rid the country of evils with
which the system is alleged to be fraught. Not an inattentive observer
of passing events, I have been aware that, among those who were
most early pressing the payment of the public debt, and upon that
ground were opposing appropriations to other great interests, there
were some who cared less about the debt than the accomplishment of
other objects. But the people of the United States have not coupled
the payment of their public debt with the destruction of the
protection of their industry, against foreign laws and foreign
industry. They have been accustomed to regard the extinction of the
public debt as relief from a burthen, and not as the infliction of a
curse. If it is to be attended or followed by the subversion of the
American system, and an exposure of our establishments and our
productions to the unguarded consequences of the selfish policy of
foreign powers, the payment of the public debt will be the bitterest of
curses. Its fruit will be like the fruit
“Of that forbidden tree, whose mortal taste
Brought death into the world, and all our woe,
With loss of Eden.”
January 22, 1840, which gave rise to the “ten cent” charge.
“We are also charged by the Senator from Kentucky with a desire
to reduce the wages of the poor man’s labor. We have often been
termed agrarians on our side of the House. It is something new
under the sun, to hear the Senator and his friends attribute to us a
desire to elevate the wealthy manufacturer, at the expense of the
laboring man and the mechanic. From my soul, I respect the laboring
man. Labor is the foundation of the wealth of every country; and the
free laborers of the North deserve respect, both for their probity and
their intelligence. Heaven forbid that I should do them wrong! Of all
the countries on the earth, we ought to have the most consideration
for the laboring man. From the very nature of our institutions, the
wheel of fortune is constantly revolving, and producing such
mutations in property, that the wealthy man of to-day may become
the poor laborer of to-morrow. Truly, wealth often takes to itself
wings and flies away. A large fortune rarely lasts beyond the third
generation, even if it endure so long. We must all know instances of
individuals obliged to labor for their daily bread, whose grandfathers
were men of fortune. The regular process of society would almost
seem to consist of the efforts of one class to dissipate the fortunes
which they have inherited, whilst another class, by their industry and
economy, are regularly rising to wealth. We have all, therefore, a
common interest, as it is our common duty, to protect the rights of
the laboring man: and if I believed for a moment that this bill would
prove injurious to him, it should meet my unqualified opposition.
“Although this bill will not have as great an influence as I could
desire, yet, as far as it goes, it will benefit the laboring man as much,
and probably more than any other class of society. What is it he
ought most to desire? Constant employment, regular wages, and
uniform reasonable prices for the necessaries and comforts of life
which he requires. Now, sir, what has been his condition under our
system of expansions and contractions? He has suffered more by
them than any other class of society. The rate of his wages is fixed
and known; and they are the last to rise with the increasing
expansion and the first to fall when the corresponding revulsion
occurs. He still continues to receive his dollar per day, whilst the
price of every article which he consumes is rapidly rising. He is at
length made to feel that, although he nominally earns as much, or
even more than he did formerly, yet, from the increased price of all
the necessaries of life, he cannot support his family. Hence the
strikes for higher wages, and the uneasy and excited feelings which
have at different periods, existed among the laboring classes. But the
expansion at length reaches the exploding point, and what does the
laboring man now suffer? He is for a season thrown out of
employment altogether. Our manufactures are suspended; our public
works are stopped; our private enterprises of different kinds are
abandoned; and, whilst others are able to weather the storm, he can
scarcely procure the means of bare subsistence.
“Again, sir; who, do you suppose, held the greater part of the
worthless paper of the one hundred and sixty-five broken banks to
which I have referred? Certainly it was not the keen and wary
speculator, who snuffs danger from afar. If you were to make the
search, you would find more broken bank notes in the cottages of the
laboring poor than anywhere else. And these miserable shinplasters,
where are they? After the revulsion of 1837, laborers were glad to
obtain employment on any terms; and they often received it upon the
express condition that they should accept this worthless trash in
payment. Sir, an entire suppression of all bank notes of a lower
denomination than the value of one week’s wages of the laboring
man is absolutely necessary for his protection. He ought always to
receive his wages in gold and silver. Of all men on the earth, the
laborer is most interested in having a sound and stable currency.
“All other circumstances being equal, I agree with the Senator
from Kentucky that that country is most prosperous where labor
commands the highest wages. I do not, however, mean by the terms
‘highest wages,’ the greatest nominal amount. During the
revolutionary war, one day’s work commanded a hundred dollars of
continental paper; but this would have scarcely purchased a
breakfast. The more proper expression would be, to say that that
country is most prosperous where labor commands the greatest
reward; where one day’s labor will procure not the greatest nominal
amount of a depreciated currency, but most of the necessaries and
comforts of life. If, therefore, you should, in some degree, reduce the
nominal price paid for labor, by reducing the amount of your bank
issues within reasonable and safe limits, and establishing a metallic
basis for your paper circulation, would this injure the laborer?
Certainly not; because the price of all the necessaries and comforts of
life are reduced in the same proportion, and he will be able to
purchase more of them for one dollar in a sound state of the
currency, than he could have done, in the days of extravagant
expansion, for a dollar and a quarter. So far from injuring, it will
greatly benefit the laboring man. It will insure to him constant
employment and regular prices, paid in a sound currency, which, of
all things, he ought most to desire; and it will save him from being
involved in ruin by a recurrence of those periodical expansions and
contractions of the currency, which have hitherto convulsed the
country.
“This sound state of the currency will have another most happy
effect upon the laboring man. He will receive his wages in gold and
silver; and this will induce him to lay up, for future use, such a
portion of them as he can spare, after satisfying his immediate wants.
This he will not do at present, because he knows not whether the
trash which he is now compelled to receive as money, will continue
to be of any value a week or a month hereafter. A knowledge of this
fact tends to banish economy from his dwelling, and induces him to
expend all his wages as rapidly as possible, lest they may become
worthless on his hands.
“Sir, the laboring classes understand this subject perfectly. It is the
hard-handed and firm-fisted men of the country on whom we must
rely in the day of danger, who are the most friendly to the passage of
this bill. It is they who are the most ardently in favor of infusing into
the currency of the country a very large amount of the precious
metals.”
Lewis Cass on the Missouri Compromise.