Solution Manual for Macroeconomics in Modules 3rd Edition

Krugman Wells 1464143412 9781464143410

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section 3

Macroeconomic
Measurement
1. How do economists in the United States determine when a recession begins and
when it ends? How do other countries determine whether or not a recession is
occurring?

S1o. lution
In th e U nite d States, economists assign the task of identifying recessions to
an independent panel of experts at the National Bureau of Economic Research
who determine when a recession begins and when it ends. It makes this deter-
mination by looking at a variety of economic indicators, with the main focus
on employment and production. In many other countries, economists adopt
the rule that a recession is a period of at least two consecutive quarters during
which the overall output of the economy shrinks.

2. The U.S. Department of Labor reports statistics on employment and earnings

that are used as key indicators by many economists to gauge the health of the
economy. Figure 9-2 in the text plots historical data on the unemployment rate
each month. Noticeably, the numbers were high during the recessions in the
early 1990s, in 2001, and in 2007–2009.
a. Locate the latest data on the national unemployment rate. (Hint: Go to the
website of the Bureau of Labor Statistics, www.bls.gov, and locate the latest
release of the Employment Situation.)
b. Compare the current numbers with the recessions in the early 1990s, in 2001,
and in 2007–2009 as well as with the periods of relatively high economic
growth just before the recessions. Are the current numbers indicative of a
recessionary trend?

S2o. lution
a. Answers will vary. In the December 2012 Employment Situation, the Bureau of
Labor Statistics states that the December 2012 unemployment rate was 7.8%.
b. During the recession of the early 1990s, the unemployment rate rose from
5.5% to 6.8%. During the recession of 2001, the unemployment rate rose from
4.3% to 5.5%. During the recession of 2007–2009, the unemployment rate rose
from 5% to 9.5%. The unemployment rate continued to rise for a time after the
official end of the recession, reaching a high of 10% in November of 2009. The
current numbers are not indicative of a recessionary trend. The current rate
of 7.8% is lower than the highest unemployment rates during the 2007–2009
recession and the unemployment rate has been falling.
 S-39

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 S-40 SECTION 3 MACROECONOMIC MEASUREMENT

3. The accompanying figure shows the annual rate of growth in employment for the
United Kingdom and Japan from 1991 to 2010. (The annual growth rate is the
percent change in each year’s employment over the previous year.) Comment on
the business cycles of these two economies. Are their business cycles similar or
dissimilar?
Annual
percent
change in
employment

3% Japan United Kingdom

2
1
0
–1
–2
–3

Year
Sources: The Office for National Statistics; The Statistics Bureau of Japan.

S3o. lution
Ja pa n an d the United Kingdom do not appear to have similar business cycles
during the 1990s. While employment was falling in the United Kingdom in the
early 1990s, growth in employment was positive in Japan. The reverse occurred
in the late 1990s. However, their business cycles were very similar in the 2000s,
with a nearly identical dip in the 2007–2009 recession.

4. a. What three measures of the economy tend to move together during the busi-
ness cycle? Which way do they move during an upturn? During a downturn?
b. Who in the economy is hurt during a recession? How?
c. How did Milton Friedman alter the consensus that had developed in the after-
math of the Great Depression on how the economy should be managed? What
is the current goal of policy makers in managing the economy?

S4o. lution
a. The three measures that tend to move together are (1) industrial output, called
real gross domestic product, (2) employment, and (3) inflation. All three tend to
rise during an upturn and fall during a downturn.
b. Workers and their families experience a great deal of pain and hardship during
recessions because many people lose their jobs and many who retain their jobs
see their wages suffer. As a result, living standards decline and the number
of people living in poverty rises. Corporations also experience a fall in profits
during recessions.

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 MACROECONOMIC ME ASUREMENT SECTION 3 S-41

c. According to the Keynesian view that developed after the Great Depression, it
was the government’s responsibility to manage the economy to reduce the
severity of downturns. According to Milton Friedman, booms in the economy
should also be managed in order to reduce their magnitude. So the current goal
of economic policy makers is to “smooth out” the business cycle—to reduce the
magnitude of both booms and busts.

5. Why do we consider a business-cycle expansion different from long-run economic

growth? Why do we care about the size of the long-run growth rate of real GDP
versus the size of the growth rate of the population?

S5o. lution
Long-run economic growth is the sustained upward trend in the economy’s out-
put over long periods of time. Long-run growth per capita is the key to rising
wages and sustained increases in the standard of living. A business-cycle expan-
sion results in a short-run (many months or a few years) increase in real GDP,
but long-run growth results in a long-run (many decades) increase in real GDP
per capita. We care about the relative size of the long-run growth rate of real
GDP and the population growth rate because living standards will fall unless
the long-run growth rate of real GDP is at least as high as the growth rate of the
population.

6. College tuition has risen significantly in the last few decades. From the 1979–
1980 academic year to the 2009–2010 academic year, total tuition, room, and
board paid by full-time undergraduate students went from $2,327 to $15,041 at
public institutions and from $5,013 to $35,061 at private institutions. This is an
average annual tuition increase of 6.4% at public institutions and 6.7% at pri-
vate institutions. Over the same time, average personal income after taxes rose
from $7,956 to $35,088 per year, which is an average annual rate of growth of
personal income of 5.1%. Have these tuition increases made it more difficult for
the average student to afford college tuition?

S6o. lution
To determine whether it is more or less difficult for a typical person to afford
college, we would need to know how much tuition had increased relative to aver-
age income in the United States. Average personal income after taxes rose from
$7,956 to $35,088 from 1979 to 2009, or an average annual increase of 5.1%. So
it was more difficult for the average person to afford to attend either a public
institution, where tuition increased 6.4% annually, or a private institution, where
tuition increased 6.7% annually.

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 S-42 SECTION 3 MACROECONOMIC MEASUREMENT

7. Each year, The Economist publishes data on the price of the Big Mac in different
countries and exchange rates. The accompanying table shows some data used
for the index from 2007 and 2011. Use this information to answer the following
questions.
a. Where was it cheapest to buy a Big Mac in U.S. dollars in 2007?
b. Where was it cheapest to buy a Big Mac in U.S. dollars in 2011?
c. Using the increase in the local currency price of the Big Mac in each country
to measure the percent change in the overall price level from 2007 to 2011,
which nation experienced the most inflation? Did any of the nations experi-
ence deflation?

2007 2011
Price of Price of Price of Price of
Big Mac Big Mac Big Mac Big Mac
(in local (in U.S. (in local (in U.S.
Country currency) dollars) currency) dollars)
Argentina peso8.25 $2.65 peso20.0 $4.84
Canada C$3.63 $3.08 C$4.73 $5.00
Euro area €2.94 $3.82 €3.44 $4.93
Japan ¥280 $2.31 ¥320 $4.08
United States $3.22 $3.22 $4.07 $4.07

S7o. lution
a. In U.S. d ollars, a Big Mac was cheapest in Japan in 2007.
b. In U.S. dollars, a Big Mac was cheapest in the United States in 2011.
c. First we must calculate the percent change of the local currency price of the
Big Mac during the period from 2007 to 2011.
Percent price change in Argentina = (peso20.0 − peso8.25)/peso8.25 = 142%
Percent price change in Canada = (C$4.73 − C$3.63)/C$3.63 = 30%
Percent price change in Euro area = (€3.44 − €2.94)/€2.94 = 17%
Percent price change in Japan = (¥320 − ¥280)/¥280 = 14%
Percent price change in the United States = (US$4.07 − US$3.22)/US$3.22 = 26%
Argentina experienced the highest inflation over the period, a price change
of 142%. Every country experienced a positive change in its price level, so no
country experienced deflation.

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 MACROECONOMIC ME ASUREMENT SECTION 3 S-43

8. The accompanying figure illustrates the trade deficit of the United States since
1992. The United States has been consistently and, on the whole, increasingly
importing more goods than it has been exporting. One of the countries it runs a
trade deficit with is China. Which of the following statements are valid possible
explanations of this fact? Explain.

U.S. trade
deficit
(billions)
$700
600
500
400
300
200
100
0
Year
Source: Bureau of Economic Analysis.

a. Many products, such as televisions, that were formerly manufactured in the

United States are now manufactured in China.
b. The wages of the average Chinese worker are far lower than the wages of the
average American worker.
c. Investment spending in the United States is high relative to its level of savings.

S8o. lution
a. This is not a valid possible explanation. The determination of where goods are
produced around the world is a microeconomic phenomenon, based on com-
parative advantage. Macroeconomics, not microeconomics, determines whether
a country runs a trade deficit or surplus.
b. This is not a valid possible explanation. Low Chinese wages could possibly
explain why some goods are produced in China and not in the United States,
a microeconomic question. Macroeconomics, not microeconomics, deter-
mines whether a country runs a trade deficit or surplus.
c. This is a valid explanation. A country’s levels of savings and investment spend-
ing are macroeconomic phenomena that determine whether it runs a trade sur-
plus or deficit.

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 S-44 SECTION 3 MACROECONOMIC MEASUREMENT

9. Below is a simplified circular-flow diagram for the economy of Micronia. (Note

that there is no investment spending in Micronia.)
a. What is the value of GDP in Micronia?
b. What is the value of net exports?
c. What is the value of disposable income?
d. Does the total flow of money out of households—the sum of taxes paid and
consumer spending—equal the total flow of money into households?
e. How does the government of Micronia finance its purchases of goods and
services?
Government purchases of
goods and services = $100
Government

Taxes = $100
Households
Consumer Wages,
spending = $650 profit,
interest,
rent = $750
Markets for goods Factor
and services markets

Gross Wages, profit,

domestic interest,
product rent = $750
Firms

Exports = $20
Rest of world
Imports = $20

S9o. lution
a. W e c a n measure GDP in Micronia as the sum of all spending on domestically
produced final goods and services. Spending consists of consumer spending,
government purchases of goods and services, and exports less imports, or $750
($650 + $100 + $20 − $20).
b. Net exports are exports less imports. In Micronia, net exports equal zero
($20 − $20).
c. Disposable income is income received by households less taxes plus govern-
ment transfers. In Micronia, disposable income equals $650 ($750 − $100).
d. Yes. Consumer spending plus taxes equals $750—the same as the wages, profit,
interest, and rent received by households.
e. The government finances its purchases of goods and services with tax revenue.

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 MACROECONOMIC ME ASUREMENT SECTION 3 S-45

10. A more complex circular-flow diagram for the economy of Macronia is shown
below. (Note that Macronia has investment and financial markets.)
a. What is the value of GDP in Macronia?
b. What is the value of net exports?
c. What is the value of disposable income?
d. Does the total flow of money out of households—the sum of taxes paid, con-
sumer spending, and private savings—equal the total flow of money into
households?
e. How does the government finance its spending?

Government purchases of
goods and services = $150 Government borrowing = $60
Government

Taxes = $100 Government transfers = $10

Private savings = $200
Households
Consumer Wages, profit,
spending = $510 interest,
rent = $800

Markets for goods Factor Financial

and services markets markets

Gross Wages, profit,

domestic interest, Borrowing and
product rent = $800
stock issues by
Firms firms = $110

Investment

spending = $110
Foreign borrowing
Exports = $50 and sales of stock = $130
Rest of world
Imports = $20 Foreign lending and
purchases of stock = $100

S10o. lution
a. W e c a n measure GDP in Macronia as the sum of all spending on domestically
produced final goods and services. Spending consists of consumer spending,
investment spending, government purchases of goods and services, and exports
less imports, or $800 ($510 + $110 + $150 + $50 − $20).
b. Net exports are exports less imports. In Macronia, net exports equal
$30 ($50 − $20).
c. Disposable income is income received by households less taxes plus govern-
ment transfers. In Macronia, disposable income equals $710 ($800 − $100 +
$10).
d. Yes. Consumer spending plus taxes plus private savings equals $810—the
same as the wages, profit, interest, rent, and government transfers received
by households.
e. In Macronia, the government needs to finance $160 in spending ($150 on pur-
chases of goods and services and $10 in government transfers). The govern-
ment finances $100 of its spending with tax revenue and the other $60 through
borrowing in financial markets.
KrugMacro3eModsPS_Sec03.indd S-45 4/17/14 10:12 AM
 S-46 SECTION 3 MACROECONOMIC MEASUREMENT

11. The components of GDP in the accompanying table were produced by the Bureau
of Economic Analysis.

Components of GDP in 2012

Category (billions of dollars)
Consumer spending
Durable goods $1,218.80
Nondurable goods 2,563.00
Services 7,337.68
Private investment spending
Fixed investment spending 1,998.98
Nonresidential 1,616.58
Structures 458.48
Equipment and software 1,158.13
Residential 382.38
Change in private inventories 60.63
Net exports
Exports 2,179.70
Imports 2,746.35
Government purchases of goods and
services and investment spending
Federal 1,214.23
National defense 809.10
Nondefense 405.10
State and local 1,849.40
a. Calculate 2012 consumer spending.
b. Calculate 2012 private investment spending.
c. Calculate 2012 net exports.
d. Calculate 2012 government purchases of goods and services and investment
spending.
e. Calculate 2012 gross domestic product.
f. Calculate consumer spending on services as a percentage of total consumer
spending.
g. Calculate 2012 exports as a percentage of imports.
h. Calculate 2012 government purchases on national defense as a percentage of
federal government purchases of goods and services.

S11o. lution
All figures b elow are in billions of dollars.
a. Consumer spending in 2012 was $1,218.8 + $2,563.0 + $7,337.7 = $11,119.5
b. Private investment spending in 2012 was $1,999.0 + $60.6 = $2,059.6.
c. Net exports in 2012 were $2,179.7 − $2,746.4 = −$566.7.
d. Government purchases of goods and services and investment spending in 2012
were $1,214.2 + $1,849.4 = $3,063.6.
e. Gross domestic product in 2012 was $11,119.5 + $2,059.6 + $3,063.6 − $566.7 =
$15,676.0.

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 MACROECONOMIC ME ASUREMENT SECTION 3 S-47

f. Consumer spending on services as a percentage of total consumer spending in

2012 was ($7,337.7/$11,119.5) × 100 = 66.0%.
g. Exports as a percentage of imports in 2012 was ($2,179.7/$2,746.4) × 100 = 79.4%.
h. Government purchases of goods and services on national defense as a percentage of
federal purchases of goods and services in 2012 was ($809.1/$1,214.2) × 100 = 66.6%.

12. The small economy of Pizzania produces three goods (bread, cheese, and pizza),
each produced by a separate company. The bread and cheese companies produce
all the inputs they need to make bread and cheese, respectively. The pizza com-
pany uses the bread and cheese from the other companies to make its pizzas. All
three companies employ labor to help produce their goods, and the difference
between the value of goods sold and the sum of labor and input costs is the firm’s
profit. The accompanying table summarizes the activities of the three companies
when all the bread and cheese produced are sold to the pizza company as inputs
in the production of pizzas.

Bread Cheese Pizza

company company company
Cost of inputs $0 $0 $50 (bread)
35 (cheese)
Wages 15 20 75
Value of output 50 35 200

a. Calculate GDP as the value added in production.

b. Calculate GDP as spending on final goods and services.
c. Calculate GDP as factor income.

S12o. lution
a. To c al cul ate GDP as the value added in production, we need to sum all value
added (value of output less input costs) for each company. Value added in the
bread company is $50; in the cheese company, $35; and in the pizza company,
$115 ($200 − $50 − $35). The total value added in production is $200 ($50 + $35
+ $115).
b. To calculate GDP as spending on final goods and services, we only need to
estimate the value of pizzas because all bread and cheese produced are inter-
mediate goods used in the production of pizzas. Spending on final goods and
services is $200.
c. To calculate GDP as factor income, we need to sum factor income (wages and
profits) for each firm. For the bread company, factor income is $50: labor earns
$15 and profit is $35. For the cheese company, factor income is $35: labor
earns $20 and profit is $15. For the pizza company, factor income is $115:
labor earns $75 and profit is $40 ($200 − $75 − $50 − $35). Factor income is
$200 ($50 + $35 + $115).

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 S-48 SECTION 3 MACROECONOMIC MEASUREMENT

13. In the economy of Pizzania (from Problem 13), bread and cheese produced are
sold both to the pizza company for inputs in the production of pizzas and to con-
sumers as final goods. The accompanying table summarizes the activities of the
three companies.

Bread Cheese Pizza

company company company
Cost of inputs $0 $0 $50 (bread)
35 (cheese)
Wages 25 30 75
Value of output 100 60 200

a. Calculate GDP as the value added in production.

b. Calculate GDP as spending on final goods and services.
c. Calculate GDP as factor income.

S13o. lution
a. To c al cul ate GDP as the value added in production, we need to sum all value
added (value of output less input costs) for each company. Value added in the
bread company is $100; in the cheese company, $60; and in the pizza company,
$115 ($200 − $50 − $35). The total value added in production is $100 + $60 +
$115 = $275.
b. To calculate GDP as spending on final goods and services, we need to sum the
value of bread, cheese, and pizzas sold as final goods. GDP equals $275 because
the bread company sells $50 worth as final goods, the cheese company sells $25
worth as final goods, and all $200 worth of pizzas are final goods.
c. To calculate GDP as factor income, we need to sum factor income (labor and
profits) for each firm. For the bread company, factor income is $100: labor
earns $25 and profit is $75. For the cheese company, factor income is $60:
labor earns $30 and profit is $30. For the pizza company, factor income is
$115: labor earns $75 and profit is $40 ($200 − $75 − $50 − $35). As factor
income, GDP equals $275 ($100 + $60 + $115).

14. Which of the following transactions will be included in GDP for the United
States?
a. Coca-Cola builds a new bottling plant in the United States.
b. Delta sells one of its existing airplanes to Korean Air.
c. Ms. Moneybags buys an existing share of Disney stock.
d. A California winery produces a bottle of Chardonnay and sells it to a customer
in Montreal, Canada.
e. An American buys a bottle of French perfume in Paris.
f. A book publisher produces too many copies of a new book; the books don’t sell
this year, so the publisher adds the surplus books to inventories.

S14o. lution
a. W he n Co ca-Cola builds a new bottling plant, it is investment spending and
included in GDP.
b. If Delta sells one of its airplanes to Korean Air, this transaction is not included
in GDP because it does not represent production during the current time peri-
od. The airplane would have been included in GDP when it was produced; now
it is just a sale of a used item.
c. When an individual buys an existing share of stock, the transaction is not
included in GDP because there is no production.

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 MACROECONOMIC ME ASUREMENT SECTION 3 S-49

d. If a California winery sells a bottle of Chardonnay to a customer in Montreal, it

is a U.S. export and is entered as such in U.S. GDP.
e. When an American buys a bottle of French perfume, it is a consumption expen-
diture as measured by GDP. But since it does not represent production in the
United States of either perfume manufacture or perfume retailing, it is also
deducted from GDP as an import. The net effect of the transaction does not
change GDP in the United States.
f. If a book publisher produces too many copies of a new book and the books
don’t sell in the year they are produced, the publisher adds the surplus books
to inventories. These books are considered investment spending and added to
GDP. It is as if the publisher bought the books itself.

15. The economy of Britannica produces three goods: computers, DVDs, and pizza.
The accompanying table shows the prices and output of the three goods for the
years 2010, 2011, and 2012.

Computers DVDs Pizzas

Year Price Quantity Price Quantity Price Quantity

2010 $900 10 $10 100 $15 2

2011 1,000 10.5 12 105 16 2
2012 1,050 12 14 110 17 3

a. What is the percent change in production of each of the goods from 2010 to
2011 and from 2011 to 2012?
b. What is the percent change in prices of each of the goods from 2010 to 2011
and from 2011 to 2012?
c. Calculate nominal GDP in Britannica for each of the three years. What is the
percent change in nominal GDP from 2010 to 2011 and from 2011 to 2012?
d. Calculate real GDP in Britannica using 2010 prices for each of the three years.
What is the percent change in real GDP from 2010 to 2011 and from 2011 to 2012?

S15o. lution
a. From 2010 to 2011, the percent change in the production of computers is 5.0%
(equal to ((10.5 − 10)/10) × 100); of DVDs, 5.0% (equal to ((105 − 100)/100)
× 100); and of pizza, 0% (equal to ((2 − 2)/2) × 100). From 2011 to 2012, the
percent change in the production of computers is 14.3% (equal to ((12 −
10.5)/10.5) × 100); of DVDs, 4.8% (equal to ((110 − 105)/105) × 100); and of
pizza, 50.0% (equal to ((3 − 2)/2) × 100).
b. From 2010 to 2011, the percent change in the price of computers is 11.1%
(equal to (($1,000 − $900)/$900) × 100); of DVDs, 20.0% (equal to
(($12 − $10)/$10) × 100); and of pizza, 6.7% (equal to (($16 − $15)/$15) ×
100). From 2011 to 2012, the percent change in the price of computers
is 5.0% (equal to (($1,050 − $1,000)/$1,000) × 100); of DVDs, 16.7%
(equal to (($14 − $12)/$12) × 100); and of pizza, 6.25% (equal to
(($17 − $16)/$16) × 100).
c. Nominal GDP for each year is calculated by summing up the value of the three
goods produced in that year:

Year Nominal GDP Percent change in nominal GDP

2010 $10,030
2011 11,792 17.6% = (($11,792 − $10,030)/$10,030) × 100
2012 14,191 20.3% = (($14,191 − $11,792)/$11,792) × 100

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 S-50 SECTION 3 MACROECONOMIC MEASUREMENT

d. Real GDP in 2010 prices is calculated by summing up the value of the three
goods produced each year using 2010 prices:

Real GDP
Year (2005 dollars) Percent change in real GDP
2010 $10,030
2011 10,530 5.0% = (($10,530 − $10,030)/$10,030) × 100
2012 11,945 13.4% = (($11,945 − $10,530)/$10,530) × 100

16. The accompanying table shows data on nominal GDP (in billions of dollars), real
GDP (in billions of 2005 dollars), and population (in thousands) of the United
States in 1960, 1970, 1980, 1990, 2000, and 2010. The U.S. price level rose consis-
tently over the period 1960–2010.

Nominal GDP Real GDP

(billions of (billions of Population
Year dollars) 2005 dollars) (thousands)
1960 $526.4 $2,828.5 180,760
1970 1,038.5 4,266.3 205,089
1980 2,788.1 5,834.0 227,726
1990 5,800.5 8,027.1 250,181
2000 9,951.5 11,216.4 282,418
2010 14,526.5 13,088.0 310,106

a. Why is real GDP greater than nominal GDP for all years until 2000 and lower
for 2010?
b. Calculate the percent change in real GDP from 1960 to 1970, 1970 to 1980, 1980 to
1990, 1990 to 2000, and 2000 to 2010. Which period had the highest growth rate?
c. Calculate real GDP per capita for each of the years in the table.
d. Calculate the percent change in real GDP per capita from 1960 to 1970, 1970
to 1980, 1980 to 1990, 1990 to 2000, and 2000 to 2010. Which period had the
highest growth rate?
e. How do the percent change in real GDP and the percent change in real GDP per
capita compare? Which is larger? Do we expect them to have this relationship?

S16o. lution
a. Real GDP is greater than nominal GDP for all years until 2000 because the base
year is 2005, and from 1960 to 2005, prices rose. So to calculate real GDP for
the years 1960, 1970, 1980, 1990, and 2000, we would multiply output in those
years by the higher prices that existed in 2005. To calculate nominal GDP, we
would multiply output by the lower prices that existed in those particular years.
Since prices rose from 2005 to 2010, valuing the output in 2010 using 2005
prices (real GDP) will result in a lower number than valuing the output in 2010
using 2010 prices (nominal GDP). By the way, real GDP would equal nominal
GDP in 2005 because 2005 is the base year and we use the same set of prices to
value both real and nominal GDP in that year.

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 MACROECONOMIC ME ASUREMENT SECTION 3 S-51

b. The accompanying table shows the percent change in real GDP from 1960 to
1970, 1970 to 1980, 1980 to 1990, 1990 to 2000, and 2000 to 2010. The percent
change in real GDP was the highest during the 1960s.

Real GDP Percent

(billions of change in
Year 2005 dollars) real GDP
1960 $2,828.5
1970 4,266.3 50.8%
1980 5,834.0 36.7
1990 8,027.1 37.6
2000 11,216.4 39.7
2010 13,088.0 16.7

c.
Real GDP per capita (2005 dollars)
1960 $15,648
1970 20,802
1980 25,619
1990 32,085
2000 39,716
2010 42,205

d. The years from 1960 through 1970 had the highest growth rate, as shown in the
table.

Percent change in real GDP per capita

1960–1970 32.9%
1970–1980 23.2
1980–1990 25.2
1990–2000 23.8
2000–2010 6.3

e. For a given time period, the percent change in real GDP is consistently larger
than the percent change in real GDP per capita. We should expect this pattern
because the U.S. population was growing from 1960 to 2010.

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