# 1. An Overview of Macroeconomics - Sample Problems

### 1. What Is Macroeconomics

1. The branch of economics that is primarily concerned with aggregate economic performance is called:
1. macroeconomics
2. marginal analysis
3. microeconomics
4. normative economics
5. positive economics
7. ceteris paribus analysis

Answer: The best answer is (a). All other answers, except (c), apply to economic theory on both the aggregate (macroeconomic) and individual (microeconomic) levels.

2. Would you expect the consequences of a war to be covered in a macroeconomics class or a microeconomics class?

Answer: Although wars have very personal consequences, the economic outcome of war is mainly a macroeconomics topic since it impacts entire economies. There is of course room for microeconomic discussion of the effects of wars on individuals, businesses, and industries.

### 2. Unemployment

1. The following statistics characterize the U.S. labor force in May 1999. What is the size of the total labor force? What is the unemployment rate?

 U.S. Labor Force, May 1999 (thousands) Employed Workers 133,224 Unemployed Workers 5,795 Source: U.S. Bureau of Labor Statistics (http://www.bls.gov)

Answer: The total labor force is the sum of employed and unemployed workers (133,224 + 5,795 = 139,019). The unemployment rate is the number of unemployed workers divided by the total labor force:

```Unemployment rate =   5,795  * 100 = 4.2%
139,019```

### 3. Price Stability

1. What is inflation? What is deflation?

Answer: Inflation is an increase in the average level of prices. Deflation is a decline in the average level of prices. The inflation rate is the percentage increase in the average level of prices over a specified period of time. Note the key word is average. Even in periods of high inflation you can still have prices of some products declining.

2. By price stability we mean that
1. the inflation rate is constant
2. we do not have deflation
3. the unemployment rate is zero
4. the inflation rate is zero
5. the prices of all goods and services are constant

Answer: (d). Answers (a) and (b) do not imply price stability because we could have a constant inflation rate of 100 percent per year in (a) and any positive inflation rate in (b). If both income and prices increase at the same rate we would have constant purchasing power, answer (f), but not price stability (i.e., while price stability may imply constant purchasing power, constant purchasing power does not necessarily imply price stability.) Price stability does not require that all prices in the economy remain constant as in answer (e). Some prices may rise, other prices fall, and on average they cancel each other out.

3. At the beginning of this year you deposited \$1,000 is a bank savings account that pays 4 percent interest (in fact you loan the money to the bank for their use). If the expected inflation rate this year is 5 percent, will you end up making or losing money? What is the nominal interest rate? What is the real interest rate?

Answer: You will actually end up worse off because the average level of prices is expected to rise more than the balance in your savings account. The purchasing power of your savings will decline. At the beginning of the year your \$1,000 could purchase \$1,000 worth of goods. By the end of the year those same goods will cost \$1,050 while your savings account will only total \$1,040. The nominal interest rate is 4 percent (what the bank pays you). The real interest rate is negative 1 percent -- the nominal interest rate minus the expected rate of inflation.

4. If the purchasing power of your savings account is expected to decline because the expected inflation rate is higher than the nominal savings rate, why would you want make that deposit?

Answer: There are other motivations for savings other than making a profit. For example, savings may be held for precautionary purposes. If you didn't have any savings you may have to borrow money at a very high interest rate to cover a large unexpected expense. There are also many forms of savings or investment that pay higher interest rates than simple bank passbook savings accounts. Generally interest rates are related to the size of the account, liquidity, risk, and other factors (discussed in a later chapter).

### 4. Economic Growth

1. Can average labor productivity fall even though total output is rising?

Answer: If we consider a simple calculation that total output equals the total number of workers times the average productivity of each worker, we can still have an increase in output even when the average productivity of each worker falls if the total number of workers increases by more than the decline in average productivity.

2. Can the unemployment rate rise even though total output is rising?

Answer: Again, if we consider a simple calculation that total output equals the total number of workers times the average productivity of each worker, we can still have an increase in output even when the total number of workers declines (i.e., higher unemployment) if the average productivity of each worker increases by more than the decline in the number of workers.

3. What is a business cycle?

Answer: Business cycles are recurrent cycles of booms and busts in economic growth (as well as unemployment and inflation). The typical business cycle includes a period of economic expansion, a peak of activity and growth, a period of contraction with declining economic activity, and a low point, usually referred to as a trough. The trough in the business cycle may be classified as a recession or, in a severe case, a depression.

### 5. Complementary and Conflicting Goals

1. Which of the following pairs of goals may be complementary and which may be conflicting in the short-run?
1. Low unemployment rate and low inflation rate.
2. Low unemployment and price stability.
3. Low unemployment rate and high economic growth rate.
4. Low inflation rate and high economic growth rate.
5. Low unemployment rate and a low poverty rate.

Answer: Goals in (c) and (e) are usually considered complementary, while (a), (b) and (d) represent conflicting goals in the short-run. A simple explanation is that as unemployment rates decline, output and economic growth increase. However, a lower unemployment rate may also mean companies must compete for labor, leading them to increase wage rates, which increases product prices and means a higher inflation rate. Of course the relationships are much more complicated than described here. Moreover, the long-run relationships may be very different. For example, an increase in worker productivity over time (e.g., from development of new technologies) contributes to lower product prices and lower inflation rates.

### 6. Limited Resources, Unlimited Wants, Scarcity and Opportunity Cost

1. Economics is the study of:
1. how to become a successful entrepreneur.
2. ways to successfully operate a profitable business.
3. how limited resources are employed to partly satisfy unlimited wants.
4. how to employ free goods to increase our production of non-scarce goods.
5. the problem of unlimited wants and limited resources.
6. methods to eliminate scarcity.

Answer: The best answers are (c) and (e). Choice (d) would work if we replace the word "free" with "scarce" or "economic". Recognize that economics is not the study of how to reduce scarcity, so answer (f) is not correct; that is the province of the physical and engineering sciences. Economics generally takes the level of resources and degree of peoples' wants and desires (their "tastes") as given, and attempts to determine how those limited resources are allocated among the competing desires for them.

2. What are resources? How is the resource capital different from the resources land and labor?

Answer: Resources are scarce inputs that are used to produce goods and services. Resources can be human (labor, management, and entrepreneurship) or nonhuman (such as land, natural resources, and capital). Nonhuman resources can be man-made (real capital) or natural (land).

Capital resources include any resources that are used to produce other goods and are themselves produced. Capital resources consist of such items as machines, tools, and buildings. Capital differs from land and labor in the fact that capital is the result of investment and forgone current consumption while land and labor are not.

3. Which of the following assets owned by America On-Line (AOL) are considered real capital (or capital goods) by an economist?
1. Stock shares in AOL.
2. Computer servers owned by AOL.
3. A stapler on the desk of the president of AOL.
4. "Working capital" such as cash deposits in a bank in the account of AOL.
5. Government Treasury Bills owned by the AOL retirement fund.
6. The land under the AOL headquarters building.

Answer: Real capital has a rather precise definition in economics. Real capital represents goods or resources that are used to produce goods and services and are themselves produced. Real capital does not include financial capital represented by answers (a), (d), and (e). Financial capital is simply a piece of paper that represents a claim of ownership to a nonhuman resource. The financial capital itself does not produce anything. Real capital also does not include natural resources such as (f). The land was not produced. Answers (b), (c) and (g) are correct. The computer servers in (b) qualify as real capital because they were produced and they provide a service by connecting consumers to the Internet. The stapler in (c) produces goods in the form of bound letters and reports. The building in (g) may itself not directly produce goods and services but it is part of the production process since the AOL equipment wouldn't last very long in an open field.

4. What is an "economic" good? What is a "free" good?

Answer: An economic good is a good or service that is scarce. The desire for the good exceeds the available supply at a zero price. This implies that the price of the good or service must be greater than zero to balance available supply and demand, i.e., efficiently allocate limited resources. The demand for free goods is less than the amount available (supplied) at a price of zero.

For example, we would consider air to be a free good. The amount demanded is less than the amount available (supplied) at a price of zero. But clean air in certain areas is not a free good. Clean air requires an expenditure of scarce resources; that is, the production of some goods must decrease in order to achieve clean air. Clean air is not a free good because there is an opportunity cost for supplying it.

5. The need for making choices arises because:
1. the cost of living is rising.
2. per capital income has been falling.
3. our wants are practically unlimited, while our resources are limited.
4. prices are rising, making it harder for us to meet our needs.
5. our wants are practically unlimited, while our resources are limited.
6. because more and more goods have become available, such as computer games and generic drugs.

Answer: A question very similar to question number 2 in this section. The correct answers are (c) and (e). Whether income is high or low or we have just a few or many different types of goods to purchase we must still make choices.

6. Why are choices costly?

Answer: With scarcity, whenever we choose one option we also choose to do without something else that we desire. The need that we choose not to satisfy is the opportunity cost of the choice made.

7. Opportunity cost is:
2. the value of the best foregone opportunity.
3. the price an individual pays for making a mistake.
4. opportunity knocks but once; if you miss your chance it will never come again.
5. since goods are scarce, getting more of one good requires the sacrifice of some amount of another good.
6. the amount of money lost by one individual in an exchange process so that another individual might gain.

Answer: Opportunity cost is represented by (b) and (e). Don't confuse the cost of opportunities or missed opportunities with opportunity cost. Opportunity cost is the highest-valued alternative not pursued (foregone) because a choice was made.

8. Assume this class meets on Tuesday evening and Friday evening every week. What does it cost you to attend an economics class on Tuesday evening? On Friday evening?

Answer: The cost of attending class is not tuition. You have already paid that whether you attend or not. The opportunity cost of attending class on a given evening is the value of the best alternative to attending class, that is, whatever you give up to attend class. My personal feeling is the opportunity cost of attending class on Friday evening is usually higher than the opportunity cost of attending on Tuesday evening. The best alternatives to attending class are different on different days of the week. Moreover, the best alternatives are different for different people. So, the cost of attending class for you will likely be different than for me beause we have different preferences and opportunities. Nevertheless, I would expect fewer students to show up on Friday evening than on Tuesday evenings.

### 7. Individual Behavior and Rational Self-Interest

1. According to rational self-interested behavior, would you do more or less of something if its expected cost increased?

Answer: The answer should be obvious, you do less of it. But the reason of course is more complicated. First you should think of cost in terms of opportunity cost. What do you have to give up to do something? What do you give up to study one more hour? What do you give up when you spend your money on a hamburger? An increase in opportunity cost means that the value of an alternative action increases and you are more likely to pursue that alternative. A friend drops by and invites you to go to a party. The cost of studying just went up. You find out your discount coupon for the hamburger had already expired. The value of buying a hot dog with the change in your pocket just got better relative to the value of the higher-priced hamburger.

2. What is the difference between acting in one's self-interest and acting selfishly?

Answer: An individual acting in his or her own self-interest will base decisions on the costs and benefits involved in the decision in order to maximize the net benefits. The word selfish connotes action without regard for the well-being of others. Self-interested behavior may (or may not) include selfish motives. But self-interested behavior can also include altruistic motives. A person can get pleasure from helping others such as through working with or contributing to charities. The charitable person is still acting in his or her own self-interest.

### 8. Decisions Made at the Margin

1. Which of the following is not an example of using marginal thinking?
1. the decision to eat one more donut.
2. the decision to retire 1 year early.
3. the decision to buy a car.
4. attempting to decide whether to finish a nuclear power plant.

Answer: All are examples of marginal decision making. Some marginal decisions may be larger than others. These large marginal decisions relate to what could be called "lumpy" goods. You don't have the choice of purchasing part of a car today and another piece next month, or to build part of a nuclear power plant. But you do have the decision to buy 1, 2, or more cars. You could chose to delay your purchase by 1 day, or 1 week, or longer. And you have the decision on how much to spend on a car. The decision to retire 1 year early could be reformulated as a series of small marginal decisions to retire one day early, two days early, etc. Here marginal analysis would suggest that an individual would engage in any activity up to the point where net benefit is at a maximum.

### 9. Fallacy of Composition

1. Which of the following is an example of the fallacy of composition?
1. what is true for the individual may not be true for the group.
2. if I stand up in a concert I will get a better view of the stage; if everyone stands up all will get a better view of the stage.
3. if I had more money I could consume more scarce goods; if the everyone in the nation had more money then everyone could consume more scarce goods.
4. if I get a tax cut then I would spend more money; if everyone received a tax cut then everyone would spend more money.

Answer: All are examples of the fallacy of composition except the last one. The fallacy of composition says that the action of an individual will lead to a certain outcome, but that same action taken by everyone may lead to a very different outcome. Consider answer (c). The number of consumers and their needs and desires do not change and the availability of scarce goods does not change. An individual receiving more money would result in the reallocation of a very small portion of the scarce resources from everyone else to the one person. Everyone receiving more money, on the other hand, would not really change anything. The same scarce goods will be distributed to the same consumers, only the money-price of the goods may be higher. Answer (d) does not represent a fallacy because it really addresses only behavior, not economic outcomes. It would become a fallacy if we describe the outcome as we did in answer (c).

### 10. Normative Versus Positive Economics

1. Which of the following statements are positive in nature and which are normative?
1. The distribution of income is fair.
2. A tax cut will increase the inflation rate.
3. Tax rates are too high.
4. A reduction in the unemployment rate will improve the President's reelection chances.
5. Universal health care will improve worker productivity.
6. Everyone should have universal health care.

Answer: The positive statements are (b), (d), and (e). The normative statements are (a), (c), and (f). Positive statements or theories describe the expected outcome from a given action. Normative theories involve judgements or personal values that one outcome is preferred over another outcome, which may imply the desirability of a certain action.