Chapter 1: Economic Issues and Concepts Question Traditional systems: Behaviour is based primarily on tradition, custom, and habit Command systems: Decisions about production and consumption are determined by a central planning authority Free-market systems: Production and consumption decisions are made privately, by decentralized producers and consumers Mixed systems: Economic systems in which there are elements of tradition, command, and free markets Question a) At point A, 2.5 tonnes of clothing and tonnes of food are being produced per year At point B, annual production is 2.5 tonnes of clothing and tonnes of food At point C, annual production is 6.5 tonnes of clothing and tonnes of food b) At point A the economy is either using its resources inefficiently or it is not using all of its available resources Point B and C represent full and efficient use of available resources because they are on the PPB c) At point B, the opportunity cost of producing one more tonne of food (and increase from to 8) is the 2.5 tonnes of clothing that must be given up The opportunity cost of producing one more tonne of clothing (from 2.5 to 3.5) appears, from the graph, to be approximately 0.75 tonnes of food d) Point D is unattainable given the economy’s current technology and resources Point D can become attainable with a sufficient improvement in technology or increase in available resources Question a) As the table shows, there are only 250 workers in Choiceland, and to construct the production possibilities boundary we must imagine all the combinations of workers in each sector Using the two middle columns from the table, we can plot the output levels on a graph to get the following: © 2005 Pearson Education Canada Inc b) If the economy is already producing 60 units of X and 600 units of Y, then 10 extra units of X can only be produced by reducing the production of Y by 250 units The opportunity cost of 10 units of X is therefore 250 units of Y (or 25 units of Y per unit of X) If the economy is already producing 70 units of X, the opportunity cost of producing an additional units of X is the forgone 350 units of Y (or 70 units of Y per unit of X) Thus, we see that the opportunity cost of X rises when more of X is already being produced c) If any given amount of labour can now produce 10 percent more of good Y, then the PPB shifts up in a particular way Specifically, the Y values increase by 10 percent for any given X value, as shown below Question In general, the opportunity cost for any activity includes three things: • the direct cost of the activity, plus • whatever you give up in order to the activity, minus • whatever “savings” the activity generates In this case, the direct cost of transportation, lift tickets and accommodation of $300 is definitely included The income of $120 that you give up also counts Finally, we must deal with the restaurant meals of $75 Surely you would have eaten some food even if you hadn’t gone skiing, so the full $75 is not included But given the relatively high price of restaurant meals compared to buying your own groceries, you will probably include most of the $75 Thus the opportunity cost of the ski trip is $420 plus some (large) fraction of the $75 © 2005 Pearson Education Canada Inc Chapter 2: How Economists Work Question a) These data are best illustrated with a time-series graph, with the month shown on the horizontal axis and the interest rate shown on the vertical axis b) These cross-sectional data are best illustrated with a bar chart c) These cross-sectional data are best illustrated in a scatter diagram; the “line of best fit” is clearly upward sloping, indicating a positive relationship between average investment rates and average growth rates © 2005 Pearson Education Canada Inc Question Given the tax-revenue function T = 10 + 25Y, the plotted curve will have a vertical intercept of 10 and a slope of 0.25 The interpretation is that when Y is zero, tax revenues will be $10 billion And for every increase in Y of $100 billion, tax revenues will rise by $25 billion The diagram is as shown below: © 2005 Pearson Education Canada Inc Question a) Using Calgary as the “base university” means that we choose $6.25 as the base price This means dividing all prices by $6.25 and then multiplying by 100 In this way, we will determine, in percentage terms, how prices at other universities differ from Calgary prices The index values are as follows: University Dalhousie Laval McGill Queen’s Waterloo Manitoba Saskatchewan Calgary UBC Victoria Price per pizza $6.50 5.95 6.00 8.00 7.50 5.50 5.75 6.25 7.25 7.00 Index of pizza prices (6.50/6.25) × 100 = 104 (5.95/6.25) × 100 = 95.2 (6.00/6.25) × 100 = 96 (8.00/6.25) × 100 = 128 (7.50/6.25) × 100 = 120 (5.50/6.25) × 100 = 88 (5.75/6.25) × 100 = 92 (6.25/6.25) × 100 = 100 (7.25/6.25) × 100 = 116 (7.00/6.25) × 100 = 112 b) The university with the most expensive pizza is Queen’s, at $8.00 per pizza The index value for Queen’s is 128, indicating that pizza there is 28 percent more expensive than at Calgary c) The university with the least expensive pizza is Manitoba, at $5.50 per pizza The index value for Manitoba is 88, indicating that the price of pizza there is only 88 percent of the price at Calgary It is therefore 12 percent cheaper than at Calgary d) These are cross-sectional data The variable is the price of pizza, collected at different places at a given point in time (March 1, 2004) If the data had been the prices of pizza at a single university at various points in time, they would be time-series data Question This is a good question to make sure the student understands the importance of using weighted averages rather than simple averages in some situations a) The simple average of the three regional unemployment rate is equal to (5.5 + 7.2 + 12.5)/3 = 8.4 Is 8.4% the “right” unemployment rate for the country as a whole? The answer is no because this simple, unweighted (or, more correctly, equally weighted) average does not account for the fact that the Centre is much larger in terms of the labour force than either the West or East, and thus should be given more weight than the other two regions b) To solve this problem, we construct a weighted average unemployment rate We so by constructing a weight for each region equal to that region’s share in the total labour © 2005 Pearson Education Canada Inc force These weights are: West: weight = 5.3/17.2 = 0.308 Centre: weight = 8.4/17.2 = 0.488 East: weight = 3.5/17.2 = 0.203 These weights should sum exactly to 1.0, but due to rounding they not quite so Using these weights, we now construct the average unemployment rate as the weighted sum of the three regional unemployment rates Canadian unemployment rate = (.308 × 5.5) + (.488 × 7.2) + (.203 × 12.5) = 7.75 This is a better measure of the Canadian unemployment rate because it correctly weights each region’s influence in the national total Keep in mind, however, that for many situations the relevant unemployment rate for an individual or a firm may be the more local one rather than the national average © 2005 Pearson Education Canada Inc Chapter 3: Demand, Supply, and Price Question a) The reduction in the size of the peach harvest due to bad weather is a decrease in the supply of peaches a leftward shift of the supply curve For a given demand curve, this leads to an increase in equilibrium price b) An increase in income leads to an increase in the demand for all normal goods Assuming beef is a normal good, there will be a rightward shift in the demand curve for beef For a given upward-sloping supply curve, this shock leads to an increase in the equilibrium price and quantity of beef This is an increase in the quantity supplied of beef (caused by the price increase) c) Technological improvements in microchips reduce the cost of producing computers and therefore cause an increase in supply — a rightward shift of the supply curve for computers This causes a fall in the equilibrium price and an increase in equilibrium quantity d) Greater awareness of the health risks leads to a reduction in demand for cigarettes and thus, for a given supply curve, to a reduction in the equilibrium price and quantity As price falls, there is a reduction in the quantity of cigarettes supplied Question Keep in mind for this question that we must distinguish between variables whose changes will cause a shift in the demand for chicken and a change in the price of chicken that will move us along the demand curve for chicken a) The finding that eating chicken can improve your health should lead to an increase in the demand for chicken (and presumably a reduction in the demand for less healthy meats) This will be shown by a rightward shift in the demand curve for chicken b) As the price of beef rises, consumers will substitute away from beef and toward other meats, including chicken This will be shown by a rightward shift in the demand for chicken c) If chicken is a normal good — meaning that consumers want more of it when their real income rises — then the rise in household income leads to an increase in the demand for chicken This will be shown by a rightward shift in the demand curve for chicken Question The apparent contradiction is solved when we recognize the difference between an increase in supply and an increase in quantity supplied As the price of beef rises, say from p0 to p1, ranchers will sell more cattle to slaughterhouses This is an increase in the quantity of beef supplied, as indicated by a movement from A to B along the supply curve in the figure below An increase in the supply of beef, caused perhaps by a reduction in the price of © 2005 Pearson Education Canada Inc cattle feed, will shift the supply curve to the right (from S to S′) and reduce the equilibrium price from p1 to p3, a move from A to C along the stable demand curve in the figure Question The quotation describes demand as becoming more “voracious” each year—this suggests that demand for cocoa is growing The fungal and viral diseases suggest a reduction in supply as producers find it more expensive to grow cacao trees and thus deliver cocoa to market Since demand is shifting to the right and supply is shifting to the left, it is clear that equilibrium price should be rising in the future What happens to equilibrium quantity depends on the relative sizes of the shifts of demand and supply © 2005 Pearson Education Canada Inc Chapter 4: Elasticity Question a) The table should be completed as shown below Note that elasticities are computed “between the rows,” reflecting the change in quantity and prices between points on the demand curve Price QD Expenditure $11 $11 27 5 11 %∆price %∆quantity Elasticity 20 100 25 50 33.3 33.3 50 25 1/2 100 20 1/5 35 35 27 11 b) The diagram of the demand curve is shown below c) At points higher up the demand curve, price is relatively high and quantity demanded is relatively low Thus a given ∆p (such as the $2 increment shown in the table above) is a small percentage change, whereas a given ∆Q (such as the 2-unit increment shown in the table) is a large percentage change These same absolute changes will be different in © 2005 Pearson Education Canada Inc percentage terms as we move to the right along the demand curve (larger for ∆p and smaller for ∆Q) Since elasticity is a ratio of the percentage change in quantity demanded to the percentage change in price, it follows that elasticity falls as we move to the right along a linear demand curve Question The key to this question is to recognize that own-price elasticity of demand is determined mostly by the availability of substitutes Notice that the products are listed in order of decreasing generality That is, item (e) is a subset of (d), which is a subset of (c), which is a subset of (b), which in turn is a subset of (a) This means there are fewer substitutes for food than for leafy vegetables sold at your local supermarket on Wednesdays Thus we would expect demand for (a) to be the least elastic and demand for (e) to be the most elastic Question a) The concept is that of the own-price elasticity of demand, since we are considering changes in the price and quantity of ticket sales The measure of elasticity in this case is the percentage change in quantity demanded divided by the percentage change in price The average quantity is 1275 and the average price is $12.50 Thus, we have: η = (150/1275)/(3/12.50) = 0.49 b) The concept is that of the income elasticity of demand because we are relating changes in income to changes in quantity demanded The measure of income elasticity is the percentage change in quantity demanded divided by the percentage change in income The average quantity is 61,500 Note that we are given the percentage change in income equal to 10 percent or 0.10 Thus, we have: ηY = (11,000/61,500)/(0.10) = 1.79 The positive sign reveals that Toyota Camrys are a normal good since a rise in income leads to an increase in quantity demanded c) The concept is that of the cross-price elasticity of demand because we are relating changes in the price of coffee to changes in the quantity demanded of tea The measure of cross-price elasticity is the percentage change in the quantity demanded of tea divided by the percentage change in the price of coffee The average coffee price is $3.90 and the average quantity of tea is 750 kg Thus, we have: ηXY = (500/7,750)/(1.80/3.90) = 0.14 The positive sign reveals that coffee and tea are substitute goods since a rise in the price of coffee (which presumably reduces the quantity demanded of coffee) leads people to demand more tea d) The concept is the Canadian own-price elasticity of supply because we are relating changes in the world price of pulp to changes in the quantity of pulp supplied by Canadian firms The measure of supply elasticity is the percentage change in (Canadian) © 2005 Pearson Education Canada Inc Chapter 31: Unemployment Question a) frictional; structural; greater b) structural c) 1.1; cyclical; 6.5; frictional; structural d) rise; frictional e) lower f) recessionary output; fiscal; monetary Question a) The unemployment that exists at E0 is only frictional and structural Since output equals potential, and there is neither excess demand nor excess supply in aggregate factor markets, there is no cyclical unemployment Since the unemployment rate is 8% when Y = Y*, we know that the NAIRU is 8% b) Following the positive AD shock, output rises and the unemployment rate falls to 6.5% There is negative cyclical unemployment of –1.5% In other words, the unemployment rate has fallen below what it would be if labour markets were, in aggregate, in balance Factor markets are in a state of excess demand c) With factor markets in excess demand, wages and other factor prices start to rise This pushes up firms’ costs and shifts the AS curve up and to the left This adjustment continues until the macroeconomic equilibrium gets to E2, at which point factor markets are once again in balance d) At E2, if there has been no change in the NAIRU, the unemployment rate has returned to 8% At this point, all unemployment is either frictional or structural Question a) See the diagram below If wages are fully flexible, then wages will fall to w1 and employment will fall to L1 © 2005 Pearson Education Canada Inc b) Employment has fallen, but every worker who wants a job at the new wage, w1, has one There is no involuntary unemployment This is the view of the labour market in the New Classical theories of business cycles c) If wages cannot fully adjust to the negative shock, then they may only fall to some intermediate wage like w2 This lack of complete wage adjustment forces a larger reduction in employment, to L2 d) Now there is some involuntary unemployment At the wage w2, there are some workers who cannot find jobs but would like them This amount is shown in the diagram Question a) The economy’s NAIRU is the weighted average of the NAIRU for each of the demographic groups, where the weights are given by each group’s proportion in the labour force We are told that in Year output equals potential, and thus the unemployment rate equals NAIRU The aggregate NAIRU in Year is therefore: NAIRU in Year = (0.2 × 0.14) + (0.8 × 0.06) = 0.028 + 0.048 = 0.076 or 7.6% b) We use the same approach for each of the years through NAIRU in Year = (0.21 × 0.14) + (0.79 × 0.06) = 0.029 + 0.047 = 0.076 or 7.6% NAIRU in Year = (0.22 × 0.14) + (0.78 × 0.06) = 0.031 + 0.047 = 0.078 or 7.8% NAIRU in Year = (0.23 × 0.14) + (0.77 × 0.06) = 0.032 + 0.046 = 0.078 or 7.8% NAIRU in Year = (0.25 × 0.14) + (0.75 × 0.06) = 0.035 + 0.045 = 0.080 or 8.0% NAIRU in Year = (0.27 × 0.14) + (0.73 × 0.06) = 0.038 + 0.044 = 0.082 or 8.2% NAIRU in Year = (0.29 × 0.14) + (0.71 × 0.06) = 0.041 + 0.043 = 0.084 or 8.4% NAIRU in Year = (0.31 × 0.14) + (0.69 × 0.06) = 0.043 + 0.041 = 0.084 or 8.4% c) Output is, by assumption, always equal to potential for this 8-year period But still the NAIRU rises This occurs because the composition of the labour force is changing The share of the labour force made up by the higher-unemployment group (youth) is rising and the share made up by the lower-unemployment group (adults) is falling Even though the unemployment rate within each group is not changing, the demographic shift results in a change in the aggregate NAIRU This is another example of why understanding the behaviour of aggregate variables requires an understanding of the micro component variables © 2005 Pearson Education Canada Inc Chapter 32: Government Debt and Deficits Question a) national income (real GDP) rises b) falls; rises c) potential GDP; taxing and spending policies d) primary budget surplus e) increase; $8.5; rise; less than $8.5 Question a) Recall that the overall budget deficit is equal to total government expenditure, including debt-service payments, minus total government net tax revenues See the completed table below b) The primary budget deficit is equal to the overall deficit minus the debt-service payments Or, equivalently, it is equal to non-debt-service expenditures minus government net tax revenues See the table below Total Deficit Primary Deficit Stock of Debt Year G + iD – T G–T Dt = Dt-1 + ∆Dt 1999 2000 2001 2002 2003 2004 2005 2006 175 + 25 – 175 = 25 180 + 26 – 180 = 26 185 + 27 – 185 = 27 188 + 26 – 190 = 24 185 + 25 – 195 = 15 185 + 24 – 200 = 180 + 23 – 205 = –2 175 + 22 – 210 = –13 175 – 175 = 180 – 180 = 185 – 185 = 188 – 190 = –2 185 – 195 = –10 185 – 200 = –15 180 – 205 = –25 175 – 210 = –35 400 + 25 = 425 425 + 26 = 451 451 + 27 = 478 478 + 24 = 502 502 + 15 = 517 517 + = 526 526 – = 524 524 – 13 = 511 c) The overall budget deficit in any given year is equal to the change in the stock of debt, from that year to the next Thus, the overall deficit of $25 billion in 1999 adds to the initial stock of debt of $400 billion so that by the end of 1999, the new stock of debt is $425 billion This is shown in the first row d) The same method as used in (c) is used for the remaining years The stock of debt rises from 1999 to 2004 because the overall budget deficits in those years are positive But beginning in 2005, the budget surpluses (negative deficits) imply that the stock of debt begins to fall © 2005 Pearson Education Canada Inc e) The stock of debt grew from $400 billion in 1998 to $511 billion at the end of 2006, an increase of 111/400 = 27.8 percent If the debt-to-GDP ratio was unchanged over this period, then GDP must have also increased by 27.8 percent between 1998 and 2006 Question a) See the figure below b) The stance of fiscal policy is best measured by the change in the cyclically adjusted deficit (which is a shift of the budget deficit function) A rise in the CAD reflects an expansionary fiscal policy; a fall reflects a contractionary fiscal policy Thus U.S fiscal policy was expansionary from 1989 through 1993, as the CAD increased from 2.9% to 3.7% c) After 1993, U.S fiscal policy was quite contractionary, as the CAD fell from 3.7% in 1993 to 1.0% in 1997 d) U.S fiscal policy began its contraction in 1993, and the CAD fell by 2.7 percentage points between 1993 and 1997 Canadian fiscal policy (combined governments) also began its contraction in about 1993, but the dramatic contraction did not really begin until 1995 From 1995 to 2000, the CAD in Canada declined by approximately percentage points Thus the Canadian fiscal contraction was considerably sharper than the one in the United States (reflecting, in part, the perception that the deficit was a larger problem in Canada than in the United States) Question a) At E1 there has been an increase in both real GDP and the price level On both counts there will be an increase in the demand for money If the money supply is unchanged during this fiscal expansion, the excess demand for money will push up interest rates relative to those that existed at E0 © 2005 Pearson Education Canada Inc b) The higher interest rate tends to reduce the amount of desired investment expenditure Recall that we assume desired investment to be autonomous with respect to the level of real GDP c) The inflationary output gap at E1 implies that factor markets are in a state of excess demand This drives wages and other factor prices up and causes the AS curve to shift up and to the left At the new long-run equilibrium, real GDP is back to Y* but the price level is higher than at E0 So we know that the demand for money and thus interest rates are higher at E2 than at E0 Desired investment expenditure is therefore lower at E2 than at E0 This is the crowding out of investment by the fiscal expansion d) In the long run (or perhaps the very long run), the reduction in investment caused by the fiscal expansion implies that the economy’s capital stock is not rising by as much as it otherwise would have Thus, the long-run growth path of Y* will be reduced For example, instead of Y* growing by percent per year, it might now be growing by only 2.5 percent per year © 2005 Pearson Education Canada Inc Chapter 33: The Gains from International Trade Question a) one price; a single b) supply; export; less than c) demand; world; domestic d) exports; imports; improvement e) imports; exports Question a) Brazil has the absolute advantage in both goods because the same amount of resources (1 million acres of land) can produce more of both goods than is possible in Mexico b) The country with the comparative advantage in wheat is the country that produces wheat with the lowest opportunity cost — that is, the country that gives up the least corn for each bushel of wheat produced Brazil must give up 1/3 of a bushel of corn to produce each bushel of wheat Mexico must give up 2/5 of a bushel of corn to produce each bushel of wheat Since 2/5 exceeds 1/3, it is clear that Brazil has a comparative advantage in wheat production Using the same logic we see that Mexico has a comparative advantage in corn production c) It is certainly possible for a country to have an absolute advantage in both goods — this only requires that the country be more efficient than the other country in the production of both goods Here, by “more efficient” we mean less input per unit of output In this case, Brazil is more efficient in both wheat and corn and so it has the absolute advantage in both goods But comparative advantage is based on the idea of opportunity cost — what must be given up in the production of one good to get more of the other good The opportunity cost is revealed by the slope of the production possibilities boundary And if a country has a lower opportunity cost for one good then it must have a higher opportunity cost for the other good Graphically, this simply says that if the PPB is steeper in one country than in another with respect to one axis, then it must be flatter in the first country than in the second with respect to the other axis © 2005 Pearson Education Canada Inc d) See the figure below Note that each country has million acres of land So the most wheat that Brazil could produce is 90 million bushels; the most corn it could produce is 30 million bushels Similarly, Mexico could never produce more than 50 million bushels of wheat or 20 million bushels of corn e) The slope of a country’s production possibilities boundary shows the opportunity cost in that country for each good For example, the slope of Brazil’s PPB in the figure above is (negative) 1/3 (note the different scales on the two axes) This is the opportunity cost of one bushel of wheat in Brazil, meaning that Brazil must forgo 1/3 of a bushel of corn in order to produce an extra bushel of wheat The inverse of the slope is (negative) 3, which is the opportunity cost of one bushel of corn in Brazil Question a) In both markets, the absence of international trade implies that the equilibrium price will be the one that clears the domestic market In the figure below, these prices are denoted pC © 2005 Pearson Education Canada Inc b) Now suppose that Canada is open to world trade, and the world price of each product is denoted pW In the newsprint market, the world price exceeds the domestic Canadian price But the law of one price applies and so only the single world price applies (since Canada is a small player in the much larger world economy) At the high world price, Canadian producers increase their quantity supplied to Q1 and Canadian consumers reduce their quantity demanded to Q2 The balance is exported to the rest of the world c) In the machinery market, the world price is less than the domestic Canadian price But the law of one price applies and so only the single world price applies At the low world price, Canadian producers reduce their quantity supplied to Q2 and Canadian consumers increase their quantity demanded to Q1 The balance is imported from the rest of the world Question a) The damage of Brazil’s coffee crop will lead to an increase in the world price of coffee Coffee is an imported good for Canada, and thus this shock leads to a terms-of-trade deterioration for Canada b) The OPEC output restriction will lead to an increase in the world price of oil Canada produces and exports oil, but it also imports oil However, Canada is a net exporter of oil and so the rise in the price of oil should have a larger effect on Canada’s export price index than on its import price index Thus Canada’s terms of trade should improve c) The development of copper mines in Chile will reduce the world price of copper Canada is a net exporter of copper and so this will lead to a deterioration of Canada’s terms of trade d) The Asian recession leads to a reduction in pork demand and thus to a reduction in the world price of pork Pork is an important Canadian export, so the decline in its price is a terms-of-trade deterioration for Canada © 2005 Pearson Education Canada Inc Chapter 34: Trade Policy Question a) increase; decrease; increase; fall b) domestic producers; the government; domestic consumers; foreign producers c) reduction; deadweight d) increase; fall; increase e) domestic producers; foreign producers; domestic consumers f) reduction; deadweight Question a) See the figure below The demand and supply curves are for Canadian consumers and Canadian producers, respectively The world price, pw, is shown below the price that would exist in Canada if Canada were a closed economy, pc Canada produces Q1 units of steel and consumes Q2 units of steel, importing the difference from abroad b) We assume here that we are talking about one particular grade of steel, so that the foreign steel is identical to the domestic steel With a tariff of t dollars per unit on imported steel, the price in Canada of imported steel will now be pw+t But the law of one price says that identical products will sell for the same price, so the price of domestic steel will also rise by t dollars per unit (the price in the rest of the world will not be affected by the Canadian tariff since Canada is a small country) The Canadian price rises to pw+t The quantity supplied domestically rises to Q3 while the quantity demanded domestically falls to Q4 Imports therefore fall from Q1Q2 to Q3Q4 © 2005 Pearson Education Canada Inc c) Domestic consumers clearly lose since they consume less steel and pay a higher price per unit The loss of consumer surplus is shown by areas plus plus plus Canadian steel producers (and their workers) gain from the tariff since it raises the price and allows them to increase sales The gain in producer surplus is shown by area The taxpayers benefit by the amount shown in area 3, since this is the revenue raised by the tariff Thus, area is simply a redistribution away from consumers toward producers, and area is a redistribution away from consumers toward taxpayers We are left with areas and as a net loss to society — this is the deadweight loss of the tariff Question a) At the world price of pw, Canadian consumers demand Q2 units of shoes, Q1Q2 of which must come from imports If the government restricts the quantity of imports to Q3Q4, there will be an excess demand for shoes in Canada at the price pw This excess demand forces up the Canadian price The equilibrium is reached when at the new price the demand for imported shoes just equals Q3Q4 units (Note that as the Canadian price rises, two things reduce the quantity of imports demanded — an increase in domestic production and a reduction in domestic consumption.) From the diagram it is clear that this new price must be exactly equal to pw+t Note also that the law of one price is not violated here, although it may appear to be The high price in Canada is caused by the import quota There is no way that arbitrageurs could buy shoes at the low world price and then sell them at the high Canadian price because such arbitrage would violate the import quota and thus be illegal So it is the obstacle to arbitrage that permits the price differential to exist b) With a tariff, area C would be the tariff revenue But with an import quota equal to Q3Q4 units, there is no tariff revenue It is the foreign producers who now earn area C — they earn a higher price on their Q3Q4 exports to Canada than they earn on their other units Having the right to sell in the import-restricted market is valuable! c) The effect on consumers is the same with a tariff or a quota — consumers face a higher price and their consumption falls in both cases It is also the same for Canadian producers — they produce and sell more and also benefit from a higher price The only difference is area C With a tariff, this area is the tariff revenue for Canadian taxpayers With a quota, this area is revenue for foreign producers For Canada overall, therefore, the tariff is preferable to the import quota Question Note that these data are for trade in goods, but not services a) In 2002, Canada’s exports of goods to the United States equalled $346.9 billion Canada exported $22.7 billion of goods to the European Union b) In 2002, Canada’s imports of goods from the United States were $254.9 billion From the EU, Canada imported $36.1 billion in goods © 2005 Pearson Education Canada Inc c) The volume of trade between Canada and the United States was $601.8 billion in 2002, up from $453.9 billion in 1997 This is an increase of 33 percent In contrast, national income (in nominal terms) increased by 29.5 percent from 1997 to 2002 (from $882 billion to $1142 billion) Therefore the volume of trade has grown slightly faster than national income over this period © 2005 Pearson Education Canada Inc Chapter 35: Exchange Rates and the Balance of Payments Question a) more; rise; fewer; fall b) 1/0.784 = 1.27; 1.27 c) demand; supply; supply; demand; fall; appreciate d) increase; appreciate (the exchange rate will fall) Question a) Tess’s trade balance is the value of her “exports” minus her “imports.” Her exports are the income that she earns by selling goods and services to the world — the $2500 from babysitting and the $3500 from her newspaper route Her imports are the expenditures she makes on goods and services — the $1000 on coffee and pastry and the $3500 on tuition Thus Tess’s trade balance is $6000 – $4500 = $1500 This is a trade surplus b) Tess’s current account balance is her trade balance plus her capital-service balance, the latter being the net interest earnings (or payments) on assets (or debts) plus the unilateral transfers Tess’s capital-service balance is therefore the $150 she earns in interest plus the $1000 gift from her grandparents Thus her overall current account balance is the $1500 surplus on the trade account plus the $1150 surplus on her capital-service account — she has a current account surplus of $2650 c) Tess’s capital account balance shows the change in her holding of assets She purchased mutual funds of $1200 and she increased her bank account by $1450 Thus she has a capital account deficit (since her purchases of assets exceeded her sale of assets) of $2650 d) Tess’s bank balance at the end of the year is not needed for computing her balance of payments This bank balance is part of Tess’s stock of wealth; the balance of payments accounts are all about flows, not stocks We include by how much Tess changes her stock of wealth (by purchasing assets) but not the stock itself Question a) To fix (or peg) the exchange rate at e1, the Bank of Canada must be prepared to buy or sell any amount of foreign exchange at that price Since e1 is above the free-market equilibrium exchange rate, we know that there will be an excess supply of foreign exchange Thus the Bank must purchase that excess supply of foreign exchange with Canadian dollars But as soon as those “new” Canadian dollars leave the Bank, they are in circulation and are part of the money supply Thus the fixing of the exchange rate at e1 © 2005 Pearson Education Canada Inc requires the Bank of Canada to increase the Canadian money supply in every period that such an excess supply of foreign exchange exists b) By purchasing foreign exchange, the Bank of Canada is acquiring an asset Thus there is a negative balance on the official financing account Aside from any statistical discrepancy, it follows that the current and capital accounts sum to a surplus c) To fix (or peg) the exchange rate at e2, the Bank of Canada must be prepared to buy or sell any amount of foreign exchange at that price Since e2 is below the free-market equilibrium exchange rate, we know that there will be an excess demand for foreign exchange Thus the Bank must satisfy that excess demand for foreign exchange by selling its foreign-exchange reserves in return for Canadian dollars But as soon as those Canadian dollars enter the Bank, they are no longer in circulation and are no longer part of the Canadian money supply Thus the fixing of the exchange rate at e2 requires the Bank of Canada to decrease the Canadian money supply in every period that such an excess demand for foreign exchange exists d) By selling its foreign-exchange reserves, the Bank of Canada is selling an asset Thus there is a positive balance on the official financing account Aside from any statistical discrepancy, it follows that the current and capital accounts sum to a deficit Question a) See the table below Since the exchange rate provided is the number of units of domestic currency required to purchase one U.S dollar, the U.S.-dollar price of the Big Mac in each country is equal to the domestic-currency price divided by the exchange rate Country U.S dollar price of the Big Mac Canada Australia U.S.A Japan France U.K $2.75/1.52 = $1.81 (U.S.) $3.50/1.85 = $1.89 (U.S.) $2.25/1.00 = $2.25 (U.S.) Yen 375/125 = $3.00 (U.S.) Euros 3.6/1.15 = $3.13 (U.S.) Pounds 1.50/0.80 = $1.88 (U.S.) b) Using The Economist’s logic, the Canadian and Australian dollars are undervalued, as is the British pound sterling The Japanese yen and the Euro are overvalued c) Big Macs are not traded goods You could not buy one in one country and ship it to another country and sell it (Actually you could, but if you’ve ever tasted even a one-hourold Big Mac, you wouldn’t want to!) But non-traded goods not satisfy the law of one price and so there is no reason why the prices should be equal across countries d) What you want to use for this sort of price comparison is a traded good that has a very low per-unit transportation cost (relative to the price of the product) In other words, you © 2005 Pearson Education Canada Inc want to choose a product that has a very high value-to-bulk ratio Of the products listed, diamonds would work best, but computer RAM chips would also work well Cement and fresh fruit would be poor choices © 2005 Pearson Education Canada Inc Chapter 36W: Challenges Facing the Developing Countries Question When you get to the Social Indicators home page, click on “Income and Economic Activity.” a) The most recent data for the levels of per capita GDP (in 1997 U.S $) are: Albania: Bangladesh: Czech Rep.: Iceland: Rwanda: 732 286 052 27 181 170 Angola: Canada: Guatemala: India: 663 20 082 691 402 b) The listed country with the highest per capita GDP is Luxembourg with a per capita GDP of $37 785 c) The listed country with the lowest per capita GDP is the Democratic Republic of the Congo with a per capita GDP of $52 Question a) The agricultural values added per worker in 1995 dollars (as an average for the 1996– 98 period) are: Australia: $30 904 Dom Rep.: $ 599 Netherlands: $21 663 Botswana: Haiti: Niger: $676 $396 $195 Chile: India: Paraguay: $5 039 $ 406 $3 448 b) The greater productivity in the developed countries probably comes mostly from greater accumulated capital, both physical and human There are obviously more highly developed methods of irrigation, pest control, fertilization, and so on in the developed countries than in the developing countries Further, there is a great deal more formal education and accumulated knowledge about crops © 2005 Pearson Education Canada Inc ... revenue is equal to total revenue divided by quantity So note that average revenue is simply equal to price The completed table is shown below Price ($) Quantity Total Revenue ($) Average Revenue... are given in the following table: Change in Consumption 0th to 1st 1st to 2nd 2nd to 3rd 3rd to 4th 4th to 5th 5th to 6th 6th to 7th 7th to 8th Marginal Utility 100 85 60 40 30 20 10 c) The graph... the park it would not generate total benefits to cover the total costs b) If the park costs only $20 000 to build, then the town should it because the total value to the residents is $32 000 Thus