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Chapter1—TheScienceofMacroeconomics1AnswerstoTextbookQuestionsandProblemsCHAPTER1TheScienceofMacroeconomicsQuestionsforReview1.Microeconomicsisthestudyofhowindividualfirmsandhouseholdsmakedecisions,andhowtheyinteractwithoneanother.Microeconomicmodelsoffirmsandhouseholdsarebasedonprinciplesofoptimization—firmsandhouseholdsdothebesttheycangiventheconstraintstheyface.Forexample,householdschoosewhichgoodstopurchaseinordertomaximizetheirutility,whereasfirmsdecidehowmuchtoproduceinordertomaximizeprofits.Incontrast,macroeconomicsisthestudyoftheeconomyasawhole;itfocusesonissuessuchashowtotaloutput,totalemployment,andtheoverallpricelevelaredetermined.Theseeconomy-widevariablesarebasedontheinteractionofmanyhouseholdsandmanyfirms;therefore,microeconomicsformsthebasisformacroeconomics.2.Economistsbuildmodelsasameansofsummarizingtherelationshipsamongeconomicvariables.Modelsareusefulbecausetheyabstractfromthemanydetailsintheeconomyandallowonetofocusonthemostimportanteconomicconnections.3.Amarket-clearingmodelisoneinwhichpricesadjusttoequilibratesupplyanddemand.Market-clearingmodelsareusefulinsituationswherepricesareflexible.Yetinmanysituations,flexiblepricesmaynotbearealisticassumption.Forexample,laborcontractsoftensetwagesforuptothreeyears.Or,firmssuchasmagazinepublisherschangetheirpricesonlyeverythreetofouryears.Mostmacroeconomistsbelievethatpriceflexibilityisareasonableassumptionforstudyinglong-runissues.Overthelongrun,pricesrespondtochangesindemandorsupply,eventhoughintheshortruntheymaybeslowtoadjust.ProblemsandApplications1.MonetarypolicyintheUnitedStatesandtheEuropeanUnionhasbeenabigtopicofconversationinearly2015.TheEUembarkeduponaquantitativeeasingpolicyinMarch2015inanattempttostimulategrowthandpreventdeflation.TherehasbeensomeconcernthattheinflationrateinEuropewillturnnegative.IntheUnitedStates,thereiscontinueddiscussionandspeculationconcerningwhentheFederalReservemightchoosetoincreasethetargetfederalfundsrate.AlsointheUnitedStates,theunemploymentratehasdeclinedtoabout5.5percentandthissuggeststhatwagesmaybegintoincrease.TheFederalReservewillbewatchingforwageandpriceincreasesastheydecidewhentoincreaseinterestrates.2.Manyphilosophersofsciencebelievethatthedefiningcharacteristicofascienceistheuseofthescientificmethodofinquirytoestablishstablerelationships.Scientistsexaminedata,oftenprovidedbycontrolledexperiments,tosupportordisproveahypothesis.Economistsaremorelimitedintheiruseofexperiments.Theycannotconductcontrolledexperimentsontheeconomy;theymustrelyonthenaturalcourseofdevelopmentsintheeconomytocollectdata.Totheextentthateconomistsusethescientificmethodofinquiry,thatis,developinghypothesesandtestingthem,economicshasthecharacteristicsofascience.3.Wecanuseasimplevariantofthesupply-and-demandmodelforpizzatoanswerthisquestion.Assumethatthequantityoficecreamdemandeddependsnotonlyonthepriceoficecreamandincome,butalsoonthepriceoffrozenyogurt:Qd=D(PIC,PFY,Y).Weexpectthatdemandforicecreamriseswhenthepriceoffrozenyogurtrises,becauseicecreamandfrozenyogurtaresubstitutes.Thatis,whenthepriceoffrozenyogurtgoesup,Iconsumelessofitand,instead,fulfillmoreofmyfrozendesserturgesthroughtheconsumptionoficecream.Chapter1—TheScienceofMacroeconomics2Thenextpartofthemodelisthesupplyfunctionforicecream,Qs=S(PIC).Finally,inequilibrium,supplymustequaldemand,sothatQs=Qd.YandPFYaretheexogenousvariables,andQandPICaretheendogenousvariables.Figure1-1usesthismodeltoshowthatafallinthepriceoffrozenyogurtresultsinaninwardshiftofthedemandcurveforicecream.Thenewequilibriumhasalowerpriceandquantityoficecream.4.Thepriceofhaircutschangesratherinfrequently.Fromcasualobservation,hairstyliststendtochargethesamepriceoveraone-ortwo-yearperiodirrespectiveofthedemandforhaircutsorthesupplyofcutters.Amarket-clearingmodelforanalyzingthemarketforhaircutshastheunrealisticassumptionofflexibleprices.Suchanassumptionisunrealisticintheshortrunwhenweobservethatpricesareinflexible.Overthelongrun,however,thepriceofhaircutsdoestendtoadjust;amarket-clearingmodelisthereforeappropriate.Chapter2—TheDataofMacroeconomics3AnswerstoTextbookQuestionsandProblemsCHAPTER2TheDataofMacroeconomicsQuestionsforReview1.GDPmeasuresthetotalincomeearnedfromtheproductionofthenewfinalgoodsandservicesintheeconomy,anditmeasuresthetotalexpendituresonthenewfinalgoodsandservicesproducedintheeconomy.GDPcanmeasuretwothingsatoncebecausethetotalexpendituresonthenewfinalgoodsandservicesbythebuyersmustbeequaltotheincomeearnedbythesellersofthenewfinalgoodsandservices.Asthecircularflowdiagraminthetextillustrates,thesearealternative,equivalentwaysofmeasuringtheflowofdollarsintheeconomy.2.ThefourcomponentsofGDPareconsumption,investment,governmentpurchases,andnetexports.TheconsumptioncategoryofGDPconsistsofhouseholdexpendituresonnewfinalgoodsandservices,suchasthepurchaseofanewtelevision.TheinvestmentcategoryofGDPconsistsofbusinessfixedinvestment,residentialfixedinvestment,andinventoryinvestment.Whenabusinessbuysnewequipmentthiscountsasinvestment.Governmentpurchasesconsistsofpurchasesofnewfinalgoodsandservicesbyfe