Answers to Textbook Questions and Problems
CHAPTER 1 The Science of Macroeconomics
Questions for Review
1. Microeconomics is the study of how individual firms and households make decisions,
and how they interact with one another. Microeconomic models of firms and
households are based on principles of optimization—firms and households do the best
they can given the constraints they face. For example, households choose which goods
to purchase in order to maximize their utility, whereas firms decide how much to
produce in order to maximize profits. In contrast, macroeconomics is the study of the
economy as a whole; it focuses on issues such as how total output, total employment,
and the overall price level are determined. These economy-wide variables are based on
the interaction of many households and many firms; therefore, microeconomics forms
the basis for macroeconomics.
2. Economists build models as a means of summarizing the relationships among economic
variables. Models are useful because they abstract from the many details in the
economy and allow one to focus on the most important economic connections.
3. A market-clearing model is one in which prices adjust to equilibrate supply and demand.
Market-clearing models are useful in situations where prices are flexible. Yet in many
situations, flexible prices may not be a realistic assumption. For example, labor
contracts often set wages for up to three years. Or, firms such as magazine publishers
change their prices only every three to four years. Most macroeconomists believe that
price flexibility is a reasonable assumption for studying long-run issues. Over the long
run, prices respond to changes in demand or supply, even though in the short run they
may be slow to adjust.
Problems and Applications
,1. Monetary policy in the United States and the European Union has been a big topic of
conversation in early 2015. The EU embarked upon a quantitative easing policy in
March 2015 in an attempt to stimulate growth and prevent deflation. There has been
some concern that the inflation rate in Europe will turn negative. In the United States,
there is continued discussion and speculation concerning when the Federal Reserve
might choose to increase the target federal funds rate. Also in the United States, the
unemployment rate has declined to about 5.5 percent and this suggests that wages may
begin to increase. The Federal Reserve will be watching for wage and price increases as
they decide when to increase interest rates.
2. Many philosophers of science believe that the defining characteristic of a science is the
use of the scientific method of inquiry to establish stable relationships. Scientists
examine data, often provided by controlled experiments, to support or disprove a
hypothesis. Economists are more limited in their use of experiments. They cannot
conduct controlled experiments on the economy; they must rely on the natural course of
developments in the economy to collect data. To the extent that economists use the
scientific method of inquiry, that is, developing hypotheses and testing them, economics
has the characteristics of a science.
3. We can use a simple variant of the supply-and-demand model for pizza to answer this
question. Assume that the quantity of ice cream demanded depends not only on the
price of ice cream and income, but also on the price of frozen yogurt:
Qd = D(PIC, PFY, Y).
We expect that demand for ice cream rises when the price of frozen yogurt rises,
because ice cream and frozen yogurt are substitutes. That is, when the price of frozen
yogurt goes up, I consume less of it and, instead, fulfill more of my frozen dessert urges
through the consumption of ice cream.
The next part of the model is the supply function for ice cream, Qs = S(PIC). Finally, in
equilibrium, supply must equal demand, so that Qs = Qd. Y and PFY are the exogenous
variables, and Q and PIC are the endogenous variables. Figure 1-1 uses this model to
show that a fall in the price of frozen yogurt results in an inward shift of the demand
curve for ice cream. The new equilibrium has a lower price and quantity of ice cream.
,4. The price of haircuts changes rather infrequently. From casual observation, hairstylists
tend to charge the same price over a one- or two-year period irrespective of the demand
for haircuts or the supply of cutters. A market-clearing model for analyzing the market
for haircuts has the unrealistic assumption of flexible prices. Such an assumption is
unrealistic in the short run when we observe that prices are inflexible. Over the long run,
however, the price of haircuts does tend to adjust; a market-clearing model is therefore
appropriate.
Answers to Textbook Questions and Problems
CHAPTER 2 The Data of Macroeconomics
Questions for Review
1. GDP measures the total income earned from the production of the new final goods and
services in the
economy, and it measures the total expenditures on the new final goods and services
produced in the economy. GDP can measure two things at once because the total
, expenditures on the new final goods and services by the buyers must be equal to the
income earned by the sellers of the new final goods and services. As the circular flow
diagram in the text illustrates, these are alternative, equivalent ways of measuring the
flow of dollars in the economy.
2. The four components of GDP are consumption, investment, government purchases, and
net exports.
The consumption category of GDP consists of household expenditures on new final
goods and services, such as the purchase of a new television. The investment category of
GDP consists of business fixed investment, residential fixed investment, and inventory
investment. When a business buys new equipment this counts as investment.
Government purchases consists of purchases of new final goods and services by federal,
state, and local governments, such as payments for new military equipment. Net exports
measures the value of goods and services sold to other countries minus the value of
goods and services foreigners sell us. When the U.S. sells corn to foreign countries, it
counts in the net export category of GDP.
3. The consumer price index (CPI) measures the overall level of prices in the economy. It
tells us the price of a fixed basket of goods relative to the price of the same basket in the
base year. The GDP deflator is the ratio of nominal GDP to real GDP in a given year. The
GDP deflator measures the prices of all goods and services produced, whereas the CPI
only measures prices of goods and services bought by consumers. The GDP deflator
includes only domestically produced goods, whereas the CPI includes domestic and
foreign goods bought by consumers. Finally, the CPI is a Laspeyres index that assigns
fixed weights to the prices of different goods, whereas the GDP deflator is a Paasche
index that assigns changing weights to the prices of different goods. In practice, the two
price indices tend to move together and do not often diverge.
4. The CPI measures the price of a fixed basket of goods relative to the price of the same
basket in the base year. The PCE deflator is the ratio of nominal consumer spending to
real consumer spending. The CPI and the PCE deflator are similar in that they both only
include the prices of goods purchased by consumers, and they both include the price of
imported goods as well as domestically produced goods. The two measures differ
because the CPI measures the change in the price of a fixed basket whereas the goods
measured by the PCE deflator change from year to year depending on what consumers
are purchasing in that particular year.
CHAPTER 1 The Science of Macroeconomics
Questions for Review
1. Microeconomics is the study of how individual firms and households make decisions,
and how they interact with one another. Microeconomic models of firms and
households are based on principles of optimization—firms and households do the best
they can given the constraints they face. For example, households choose which goods
to purchase in order to maximize their utility, whereas firms decide how much to
produce in order to maximize profits. In contrast, macroeconomics is the study of the
economy as a whole; it focuses on issues such as how total output, total employment,
and the overall price level are determined. These economy-wide variables are based on
the interaction of many households and many firms; therefore, microeconomics forms
the basis for macroeconomics.
2. Economists build models as a means of summarizing the relationships among economic
variables. Models are useful because they abstract from the many details in the
economy and allow one to focus on the most important economic connections.
3. A market-clearing model is one in which prices adjust to equilibrate supply and demand.
Market-clearing models are useful in situations where prices are flexible. Yet in many
situations, flexible prices may not be a realistic assumption. For example, labor
contracts often set wages for up to three years. Or, firms such as magazine publishers
change their prices only every three to four years. Most macroeconomists believe that
price flexibility is a reasonable assumption for studying long-run issues. Over the long
run, prices respond to changes in demand or supply, even though in the short run they
may be slow to adjust.
Problems and Applications
,1. Monetary policy in the United States and the European Union has been a big topic of
conversation in early 2015. The EU embarked upon a quantitative easing policy in
March 2015 in an attempt to stimulate growth and prevent deflation. There has been
some concern that the inflation rate in Europe will turn negative. In the United States,
there is continued discussion and speculation concerning when the Federal Reserve
might choose to increase the target federal funds rate. Also in the United States, the
unemployment rate has declined to about 5.5 percent and this suggests that wages may
begin to increase. The Federal Reserve will be watching for wage and price increases as
they decide when to increase interest rates.
2. Many philosophers of science believe that the defining characteristic of a science is the
use of the scientific method of inquiry to establish stable relationships. Scientists
examine data, often provided by controlled experiments, to support or disprove a
hypothesis. Economists are more limited in their use of experiments. They cannot
conduct controlled experiments on the economy; they must rely on the natural course of
developments in the economy to collect data. To the extent that economists use the
scientific method of inquiry, that is, developing hypotheses and testing them, economics
has the characteristics of a science.
3. We can use a simple variant of the supply-and-demand model for pizza to answer this
question. Assume that the quantity of ice cream demanded depends not only on the
price of ice cream and income, but also on the price of frozen yogurt:
Qd = D(PIC, PFY, Y).
We expect that demand for ice cream rises when the price of frozen yogurt rises,
because ice cream and frozen yogurt are substitutes. That is, when the price of frozen
yogurt goes up, I consume less of it and, instead, fulfill more of my frozen dessert urges
through the consumption of ice cream.
The next part of the model is the supply function for ice cream, Qs = S(PIC). Finally, in
equilibrium, supply must equal demand, so that Qs = Qd. Y and PFY are the exogenous
variables, and Q and PIC are the endogenous variables. Figure 1-1 uses this model to
show that a fall in the price of frozen yogurt results in an inward shift of the demand
curve for ice cream. The new equilibrium has a lower price and quantity of ice cream.
,4. The price of haircuts changes rather infrequently. From casual observation, hairstylists
tend to charge the same price over a one- or two-year period irrespective of the demand
for haircuts or the supply of cutters. A market-clearing model for analyzing the market
for haircuts has the unrealistic assumption of flexible prices. Such an assumption is
unrealistic in the short run when we observe that prices are inflexible. Over the long run,
however, the price of haircuts does tend to adjust; a market-clearing model is therefore
appropriate.
Answers to Textbook Questions and Problems
CHAPTER 2 The Data of Macroeconomics
Questions for Review
1. GDP measures the total income earned from the production of the new final goods and
services in the
economy, and it measures the total expenditures on the new final goods and services
produced in the economy. GDP can measure two things at once because the total
, expenditures on the new final goods and services by the buyers must be equal to the
income earned by the sellers of the new final goods and services. As the circular flow
diagram in the text illustrates, these are alternative, equivalent ways of measuring the
flow of dollars in the economy.
2. The four components of GDP are consumption, investment, government purchases, and
net exports.
The consumption category of GDP consists of household expenditures on new final
goods and services, such as the purchase of a new television. The investment category of
GDP consists of business fixed investment, residential fixed investment, and inventory
investment. When a business buys new equipment this counts as investment.
Government purchases consists of purchases of new final goods and services by federal,
state, and local governments, such as payments for new military equipment. Net exports
measures the value of goods and services sold to other countries minus the value of
goods and services foreigners sell us. When the U.S. sells corn to foreign countries, it
counts in the net export category of GDP.
3. The consumer price index (CPI) measures the overall level of prices in the economy. It
tells us the price of a fixed basket of goods relative to the price of the same basket in the
base year. The GDP deflator is the ratio of nominal GDP to real GDP in a given year. The
GDP deflator measures the prices of all goods and services produced, whereas the CPI
only measures prices of goods and services bought by consumers. The GDP deflator
includes only domestically produced goods, whereas the CPI includes domestic and
foreign goods bought by consumers. Finally, the CPI is a Laspeyres index that assigns
fixed weights to the prices of different goods, whereas the GDP deflator is a Paasche
index that assigns changing weights to the prices of different goods. In practice, the two
price indices tend to move together and do not often diverge.
4. The CPI measures the price of a fixed basket of goods relative to the price of the same
basket in the base year. The PCE deflator is the ratio of nominal consumer spending to
real consumer spending. The CPI and the PCE deflator are similar in that they both only
include the prices of goods purchased by consumers, and they both include the price of
imported goods as well as domestically produced goods. The two measures differ
because the CPI measures the change in the price of a fixed basket whereas the goods
measured by the PCE deflator change from year to year depending on what consumers
are purchasing in that particular year.
