1. $27,000 (anything from 20,000 to 40,000 will do)

2. 3%

3. 24 years

4. situation in which it is not possible to change to make someone better off without making someone else worse off

5. real interest rate (plus one) is relative price of current goods in terms of future goods (or inflation-adjusted interest rate)

6. i=r+ inflation

7.

8. (2 points) holders of money lose from inflation & government gains from inflation

(2 points) debtors gain and creditors lose from unexpected inflation

(3 points for both)

9. 3 million unemployed

If unemplyment is 10 million, and 1/10 find jobs each month while 300,000 new people become unemployed, then unemployment falls by 700,000 in the first month, and continues to fall until it reaches 3 million.

10. Because the price they charge exceeds the marginal cost of production, so they raise their profit by selling more as long as other cartel members restrict output to keep the price high.

11. Because the monopoly loses money when it reduces its price to cause another firm to lose money. (The monopoly is also likely to sell more units than the smaller firm that is the victim of predatory pricing, so the monopoly takes a larger loss -- e.g. the same per-unit loss on more units sold.)

12.

13. Anything that raises inflation must either raise the growth rate of the money supply, raise the growth rate of velocity, or reduce the growth rate of real GDP. A change in the relative price of a good differs from a change in the overall price level, which is an average of the nominal prices of the economy's goods and services. While relative prices are determined by the supplies and demands for particular goods and services, the economy's price level is determined by the supply and demand for money.

An increase in the price of any particular good or service does not cause inflation (unless it raises the growth rate of money or the growth rate of velocity, or reduces the growth rate of real GDP). Suppose demand for a good causes a rise in its relative price. If people decide to eat more vegetables and less meat, then the demand for vegetables rises and the demand for meat falls. This raises the relative price of vegetables and reduces the relative price of meat. It does not change the price level because the money supply, velocity, and real GDP do not change. Because the price level does not change, the nominal price of vegetables rises to create a rise in the relative price of vegetables. Similarly, the nominal price of meat falls to create a fall in the relative price of meat. The change in demand causes a change in both relative prices, but does not affect the price level.

Now suppose a change in supply caused the relative price change. The price level may change if the price of vegetables rises due to a fall in the supply. The result depends on why the supply fell. If farmers grow fewer vegetables and raise more chickens instead, then the supply of vegetables falls but the supply of chickens rises. This raises the price of vegetables but reduces the price of chicken, but it is unlikely to affect the price level. Suppose, however, that the supply of vegetables falls because of a bad harvest (perhaps due to bad weather). This may reduce the economy's real GDP, raising the price level. The effect is likely to be small -- if vegetables constitute one percent of GDP, GDP would fall by only one-half of one percent even if the quantity of vegetables sold fell in half, so the price level would rise by one-half of one percent. (The price of vegetables might triple, but the size of the change in the price of vegetables is affected by the supply and demand for vegetables, while the change in the price level is affected by the supply and demand for money.)

Inflation occurs as the price level rises, but this inflation is temporary. A permanent fall in real GDP causes a permanent rise in the price level, but only a temporary inflation. Once the price level reaches its higher level, it stops rising.

14. Greed for high profits does not cause inflation. There are two fallacies in the reasoning that says greed causes inflation. First, sellers almost always want more profits. If sellers could increase their profits by raising their prices, they would already have done so. While greed might make prices high, it does not cause prices to increase over time. Inflations do not occur because sellers suddenly became greedy -- they have always been greedy. Nor did hyperinflations end because sellers became less greedy. Greed has nothing to do with inflation.

The second fallacy in the claim that greed causes inflation is that it ignores equilibrium between the quantity of money demanded and the quantity supplied. If the nominal money supply, velocity, and real GDP do not change, then the equilibrium price level does not change.

Suppose sellers increased prices without any changes in the nominal supply of money, velocity, or real GDP. The increase in the price level would raise the quantity of money demanded, kPy, making the quantity demanded larger than the quantity of money supplied. People would hold less money than they want, so they would add to their holdings of money by spending less. The fall in spending would reduce prices. The price level would fall, reducing the nominal quantity of money demanded, until the nominal quantity of money demanded equals the nominal quantity supplied. So if sellers tried to raise prices when the nominal money supply, velocity, and real GDP do not change, they would create a situation in which nominal prices would tend to fall and bring the price level back to its equilibrium level.

15. Consumption falls,

savings rises,

the real interest rate falls,

and investment rises.

16. Majority view:

Demand for loans by the government

falls. The real interest rate falls.

(People pay the higher tax at least

partly out of money they would have

spent, so if the supply curve shifts

to the left at all, it shifts by less than

the demand curve shifts, so the real

interest rate falls.)

Minority view:

People pay the higher taxes out of money

they would have saved, so the supply of

loans shifts to the left by the same amount

as the demand curve shifts left, and the

real interest rate remains unchanged.

17. (a) 5 people fish

(b) 3 people (or 2 people)

(c) owner would charge $100 per person for fishing rights;

3 people would fish, and the owner would earn $300 profit

18. (a) 5 gallons at $11 each (4 gallons at $12 each is also okay answer)

(b) $20 profit

(c) $4+$3+$2+$1=$10 consumer surplus ($3 + $2 + $1 = $6 is also okay answer)

(d) $6 (because the total gain from trade falls from $36 = $8+7+6+5+4+3+2+1,

to $30 = profit plus consumer surplus)

19. (I) If court rules in favor of writer, then dentist spends $600 to sound-proof walls.

If court rules in favor of dentist, then writer pays dentist $600 to sound-proof her walls.

(Ii) If court rules in favor of writer, then dentist spends $600 to sound-proof walls.

If court rules in favor of dentist, then the dentist loses $800 per year in income.

20. Fixed quantities of inputs may create diminishing returns to other inputs, so output will rise more slowly over time even if the economy accumulates capital (and technology grows)just as fast as ever. On the other hand, human ingenuity may lead to creation of new ways to substitute for fixed resources and resources that become exhausted over time, effectively preventing diminshing returns from occurring.

NOTE TO GRADERS -- ANY OTHER REASONABLE ARGUMENTS ARE ALSO ACCEPTABLE. NOTE THAT THIS PROBLEM WAS NOT ASSIGNED (THOUGH IT IS IN THE BOOK AT THE END OF CHAPTER 6), AND NOTHING LIKE IT WAS DISCUSSED IN CLASS, SO IT’S ON HERE JUST TO SEE HOW WELL THEY CAN DO.