Answers to end-of-chapter problems

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+m)=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.

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.

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.

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).

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%

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. q might increase because people’s inflation expectations adapt to persistently positive inflation. The increase in q 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+0.1m)/2; Thus, the natural rate of unemployment increases from 5% to 6% as μ

increases from 20% to 40%.

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=(m+z)/a; un = 6% if a=1; un = 3% if a=2

As a increases the natural rate of unemployment falls. Intuitively, higher wage flexibility

allows the economy to respond to any given set of institutions (m and z) with less unemployment.

b. un = 9% if a=1; un = 4.5% if a=2

In absolute terms, less wage flexibility (lower a) 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.