CHAPTER 8

Page 216
Would the following transactions be included in GSP? Which expenditure or income
component?
1a.Used TV No. Purchases of used goods are not included.
b. Toy store buys inventory. Yes. An addition to inventories represents investment.
c. Consumer buys a new car. Yes, Purchases by a household represent consumption.
d. CDN corporation pays interest to bond owners. Yes. Interest on a private business's debt is
included in interest income
e. Provincial govt repaves a highway. Yes. This expenditure represents a government purchase.
f. Wealth holder places $1K in the bank. No. Financial transactions are not included.
g. Unemployed worker receives an EI payment from govt. No. Government transfer
payments are not included.
h. French farmer purchases a Canadian made piece of farm machinery. Yes. This purchase
represents an export.

2
$ billions
Govt purchases 43
Proprietors income & rents 29
Exports 14
Indirect taxes 25
Gross investment 35
Wages and salaries 76
Corporate profits 38
Interest Income 17
Imports 15
Net Investment 26
Personal Consumption 85
Statistical Discrepancy ?

a. The expenditure-based estimate of GDP is $162 billion [= $85 b. + $35 b. + 43 b. + ($14 b. –

15 b.].
b. The income-based estimate of GDP is $194 billion [= $76 b. + $38 b. + 17 b. + $29 b. + $25 b.
+ ($35 b. - $26 b.)].
c. The statistical discrepancy is $16 billion, found by taking the difference between the two GDP
estimates [$32 billion = $194 b. - $162 b.] and then dividing by two [= ($32 billion/2)].
d. The economy's GDP is halfway between the two estimates, or $178 billion [= $162 b. + $16 b.
= $194 b. - $16 b.].
e. This economy's depreciation is $9 billion, found by deducting net investment ($26b.) from
gross investment ($35b.).

Page 221

1 In a given year, a country’s GDP in terms of the country’s own dollars is $235 billion.
a. If the population is 6 million what is per capita GDP? Per capita GDP in terms of the
country's own dollars is $39 167 [= ($235 billion/6 million)].
b. If each of the country’s own dollars is worth US$0.56, what is the country’s per capita
GDP in terms of USD? Per capita GDP in terms of US dollars is $21 933 [= ($235 billion/6
million) x 0.56].
c. If each country dollar is worth US$0.60, after adjusting for Purchasing Power Parity,
what is the country’s per capita GDP in PPP-adjusted USD? Per capita GDP in terms of
PPP-adjusted US dollars is $23 500 [= ($235 billion/6 million) x 0.60].
d. Explain why the country’s per capita GDP in PPP-adjusted USD is higher than its per
capita GDP in unadjusted USD. Because the PPP-adjusted US-dollar value of the country's
currency is higher than the unadjusted US dollar value, prices in this country are lower than in
the United States. Once this difference in the price levels in the two countries is taken into
account, the purchasing power of this country's income, as shown by per capita GDP in PPP-
adjusted US dollars, is higher than is shown by the unadjusted per capita GDP in US dollars.

2
a. When is a country’s GNP higher than its GDP?A country's GNP is higher than GDP when
the country's residents have significant holdings of foreign financial assets that exceed
foreigners' holdings of the country's own financial assets. This means that there is a net inflow of
financial investment income.
b. Do citizens of a country benefit when GNP is higher than GDP? Yes, the country's citizens
benefit, since incomes in the country exceed the country's production.

CHAPTER 9

Page 237
Consumer’s weekly purchases during 2006 and 2007:
Prices Qty per week
2006 2007 2006 2007
Hamburgers 2.50 2.75 5 4
Bottles of Cola 1.25 1.30 10 11

1a. Calculate the value of the consumer’s 2006 shopping basket using first 2006 then 2007
prices. Using 2006 prices, the 2006 shopping basket has a value of $25 [= ($2.50 x 5) + ($1.25 x
10)]. Using 2007 prices, the 2006 shopping basket has a value of $26.75 [= ($2.75 x 5) + ($1.30
x 10)].
b. With 2006 as the base year, the 2006 value of the index is 100 [= ($25/$25) x 100]. The 2007
value of the index is 107 [= ($26.75/$25) x 100]
c. Using 2006 as the base year what is the inflation rate between 2006 and 2007? The
inflation rate is 7 percent [= ((107 – 100)/100) x 100].

2. Hypothetical Economy fill in the blanks:

Year Nominal GDP GDP Deflator Real GDP (2005
billions)
2004 $ 97.458 $210.7
2005 234.3
2006 245.9 101.340
2007 258.7 251.3
2009 105.438 261.4

Rearranging the formula for deriving real GDP, nominal GDP in 2004 is found by multiplying
real GDP by the GDP deflator expressed as a decimal, or $205.3 billion [= ($210.7 billion x
0.97458)]. Because 2005 is the reference year, the 2005 value of the GDP deflator is 100, and
real GDP has the same value as nominal GDP ($234.3 billion). The 2006 value of real GDP is
$242.6 billion [= ($245.9 billion/1.01340)], found by dividing the year's nominal GDP by the
value of the GDP deflator expressed as a decimal. Rearranging the formula for deriving real
GDP, the 2007 value of the GDP deflator is found by dividing nominal GDP by real GDP, then
multiplying by 100 [102.945 = ($258.7 billion/$251.3 billion) x 100]. Nominal GDP in 2008 is
found by multiplying real GDP by the GDP deflator expressed as a decimal, or $275.6 billion [=
($261.4 billion x 1.05438)].

Page 244

1Hypothetical Economy:
Unemployed members of labor force 2.3 million
Total Population 15 yo and over 58.9 m
Participation Rate 64 percent
Workers w full time jobs 21.4 m
Part time workers who do not wish full time 4.2 million
Part time workers who wish full time 3.5 million
Total population less than 15 yo 14.6 million

a. The labour force is found by adding the number of unemployed members of the labour force,
workers with full-time jobs, part-time workers who wish to have full-time jobs, and part-time
workers who do not wish to have full-time jobs [31.4 million = (2.3 million + 21.4 million + 3.5
million + 4.2 million)].
b. The labour force population is found by rearranging the formula used to derive the
participation rate, by dividing the labour force by the participation rate expressed as a decimal
[49.1 million = (31.4 million/0.64)].
c. The official unemployment rate is found by dividing the total number of unemployed members
of the labour force by the labour force, then multiplying by 100 [7.3 percent = (2.3 million/31.4
million) x 100].

2. Using the info in the table in question 1, derive an estimate of this hypothetical
economy’s unemployment rate that includes underemployment. An unemployment rate that
includes underemployment is found by summing the number of unemployed members of the
labour force and the number of part-time workers who wish to have full-time jobs, dividing this
amount by the labour force, then multiplying by 100 [18.5 percent = ((2.3 million + 3.5
million)/31.4 million) x 100].
CHAPTER 11

Page 300

1 In each of the following cases, state whether policy makers should raise or reduce
government purchases. If an action is being taken, explain the policy makers rationale for
taking this action.
a. Real output is less than its potential level. Because real output falls short of its potential
level, an expansionary fiscal policy is called for, which means government purchases should be
increased.
b. Unemployment is below its natural rate. With unemployment below its natural rate, a
contractionary fiscal policy should be used. This means government purchases should be
decreased.
c. Real output equals its potential level and unemployment is at its natural rate. With the
economy already at potential output and the corresponding natural rate of unemployment, there
is no need for fiscal policy.

2 Explain how automatic stabilizers work during the following periods.

a. The economy is experiencing a recession, with shrinking incomes and spending. With
shrinking incomes and spending, tax revenues fall. Meanwhile government transfer payments
and subsidies rise. The result is a reduction in net tax revenues, which has a stabilizing
expansionary effect on the economy.
b. The economy is in an expansionary phase, with rising incomes and spending. With
expanding incomes and spending, tax revenues rise. Government transfer payments and
subsidies, meanwhile, fall. This leads to a rise in net tax revenues, which has a stabilizing
contractionary impact on the economy.

Page 307

1a. If an economy is initially in equilibrium and injections rise by $1 million,then by how

much will withdrawals have to rise in order to bring injections and withdrawals back in
balance? Withdrawals will have to rise by the same amount of $1 million to bring injections and
withdrawals back into balance.
b. If the economy’s MPW is 0.67 then by how much will incomes and output have to rise to
create the required additional expenditures? With an MPW of 0.67, then incomes and output
must rise by $1.5 million, since each $1.50 in extra income will create $1 [= (0.67 x $1.50)] in
additional withdrawals.
c. Explain how your answer to part b. is based on the formula for the spending multiplier.
The $1.5 million found in part b can be derived by multiplying the initial $1 million increase in
injections by the spending multiplier [= ($1 million x (1/0.67))].

2 For each of the following cases, calculate the spending multiplier and stae the direction
and size of the shift in the Aggregate Demand (AD) curve.
a. Govt purchases fall by $10 billion in an exonomy with an MPW of 0.60. With a $10 billion
fall in government purchases, the AD curve shifts to the left by -$16.67 billion [= (-$10 billion x
(1/0.60)].
b. A tax cut causes an initial $25 billion rise in spending in an economy with an MPW of
0.80. The initial $25 billion rise in spending due to the tax cut causes the AD curve to shift to the
right by $31.25 billion [= ($25 billion x (1/0.80)].
c. Govt purchases rise by $15 billion in an economy with an MPC of 0.25. An MPC of 0.25
means that the economy's MPW is 0.75 [= (1 – 0.25)]. Therefore, with a $15 billion rise in
government purchases, the AD curve shifts to the right by $20 billion [= ($15 billion x (1/0.75)].
d. A $30 billion tax rise occurs in an economy with an MPC of 0.45. An MPC of 0.45 means
the economy's MPW is 0.55 [= (1 – 0.45)]. With a $30 billion tax rise, the AD curve shifts to the
left by -$22.5 billion [= -(0.45 x $30 billion) x (1/0.60)].

Page 312

1 A govt has an outstanding debt of $100 billion.

a. If, in a given year, the government spends $10 billion and brings in $15 billion in taxes,
then what is the government’s budget deficit or surplus, and what happens to its debt?
With expenditures of $10 billion and tax revenues of $15 billion, there is a budget surplus of $5
billion [= ($15 billion - $10 billion)], and the government's debt falls to $95 billion [= ($100
billion - $5 billion)].
b. If, instead, the government’s expenditures are $12.5 billion and its tax revenues are $10
billion, then what is the government’s budget deficit of surplus, and what happens to its
debt? If expenditures are $12.5 billion and tax revenues are $10 billion, there is a budget deficit
of -$2.5 billion [= ($10 billion - $12.5 billion)]. The government's debt therefore rises instead to
$102.5 billion [= ($100 billion + $2.5 billion)].

2 Outline a potential advantage and a potential problem with each of the three fiscal policy
guidelines:
a. Annually balanced budgets. If a government applies the guideline on annually balanced
budgets, public debt does not rise, which is a potential advantage to the economy. However, this
policy guideline has a potential problem, since its use worsens the severity of the business cycle.
During economic contractions, falling tax revenues mean that the guideline can be met only by
cutting government purchases. This magnifies the contraction in incomes and spending.
Similarly, during economic expansions, the rise in tax revenues allows for an increase in
government purchases, which magnifies the expansion in incomes and spending.
b. Cyclically balanced budgets. If the guideline of cyclically balanced budgets is followed,
public debt does not rise, as in the case of annually balanced budgets. Again, this is a potential
advantage to the economy. The potential problem with this guideline, however, is the fact that
governments may not succeed in meeting it, given the difficulty in ensuring that periods of
budget deficits and budget surpluses exactly balance.
c. Functional Finance. The potential advantage of using the functional finance guideline is that
unemployment is minimized. The potential problem, meanwhile, is the fact that public debt may
rise to unsustainable levels.

Page 318

1 Using both the spending-output and injections-withdrawals approaches, show what

would happen to the hypothetical economy outlined in the appendix if the levels of govt
purchases and taxes both rose from $200 billion to $400 billion.
a. Using the spending-output approach, a further $200 billion increase in G and T has two
effects: the aggregate expenditures (AE) line shifts up by $200 billion due to the increase in G,
and it also shifts down by $150 billion due to the tax-induced decrease in C. Overall the AE line
shifts up by $50 billion, and equilibrium output rises from $1200 billion to $1400 billion. Using
the injections-withdrawals approach, there are three effects: the total injections (I+G+X) line
shifts up by $200 billion due to the increase in G, the total withdrawals (S+T+M) line shifts up
by $200 billion due to the increase in T, and S+T+M also shifts down by $50 billion due to the
tax-induced decrease in S. Overall, total injections rise by $200 billion at every output level
while total withdrawals rise by $150 billion, so that equilibrium output again expands from
$1200 billion to $1400 billion.

2a. Can your answer to question 1 be found using the balanced budget multiplier? Explain.
Total change in output = 1 x (change in G or T) = $200 billion

b. In what way must your answer to question 1 be adjusted once changes in the price level
are taken into account? Explain using a graph of aggregate demand and aggregate supply.
As shown in Figure B on page 303, the multiplier is accurate only if the AS curve is horizontal.
Once changes in the price level are taken into account then the overall change in real output is
less than the balanced budget multiplier would suggest.