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ANSWERS, SOLUTIONS, AND EXERCISES
PROBLEM SET
1. a. An increase in labor demand will shift the labor demand curve from LD1 to LD2,
raising the real hourly wage from W1 to W2. Given the stock of capital and the
b. An increase in labor supply will shift the labor supply curve from LS1 to LS2,
lowering the real hourly wage from W1 to W2. Other things equal, this will move
215
Q′ Q2 Q1 Funds
Interest Rate
D2 = I + G2 - T
Total Supply of Funds
r1
r2
D1 = I + G1 - T
c
a
b
216 Instructor’s Manual for Economics: Principles and Applications, 6e
2. a. The distance marked “a” represents the decrease in government purchases.
3. a. “Crowding in” is the increase in one sector’s spending caused by a decrease in
some other sector’s spending. If the crowding in is “complete,” then there is a
b. This statement is true. To see this, look at the graph shown in the answer to
Problem #2, above. As a result of the decrease in government purchases, both
4. a. Net taxes = total tax revenue – transfer payments = $2.5 million - $0.5 million =
$2 million.
b. There is a budget deficit of $1 million (assuming that government spending refers
T
$2 trillion
S
$2 trillion
IP
$1 trillion
G
$3 trillion
$10 trillion $10 trillion
C $6 trillion C $6 trillion
G
$3 trillion
IP
$1 trillion
=
Total Output Total Income Total Spending
Leakages
Injections
Chapter 20 The Classical Long-Run Model 217
5.
As consumption rises with no change in net taxes, saving will begin to fall. This will
218 Instructor’s Manual for Economics: Principles and Applications, 6e
6. a) Government budget deficit would increase.
c) Increased Social Security payments would increase household disposable income
8. a. If the government ran a deficit, the interest rate would rise. This would cause total
investment spending to decrease, and saving to rise. All of the other variables in
Chapter 20 The Classical Long-Run Model 219
b.
9. a. When the government is running a budget surplus, the supply of funds curve is the
b. Define the surplus as T – G. This surplus will be part of the supply of funds in the
loanable funds market. The interest rate will adjust until the supply of funds equals
I2Funds
Interest
Rate
r2∆G
SF2
r1
SF1
I1
IP (Demand for Funds)
220 Instructor’s Manual for Economics: Principles and Applications, 6e
c.
The total supply of loanable funds (saving plus the budget surplus) will decrease
(shown as the leftward shift from SF1 to SF2), causing the interest rate to rise (from
r1 to r2), which will decrease planned investment from I1 to I2. Saving first falls by
d. Yes, crowding out is still complete. As a result of the increase in government
spending, both consumption and planned investment fall. As before, each dollar of
MORE CHALLENGING
10. a. Initially, the loanable funds market is in equilibrium at point A with an (arbitrarily
chosen) interest rate of 5%. As a result of the tax cut, the government’s budget
deficit increases (by the amount of the tax cut), shifting the demand for funds
S1
B
A
5%
Trillions of Dollars
per Year
Interest Rate
D1
S2
D2
Chapter 20 The Classical Long-Run Model 221
b. As is evident from the diagram, the result is an increase in the volume of loanable
c. When the tax cut is entirely saved, both the supply of funds curve and the demand
for funds curve shift to the right (as seen on graph) and the interest rate does not
11. a. The condition for loanable funds market equilibrium in a closed economy is S = Ip
+ (G – T). With the government’s budget balanced (G = T), this simplifies to S =
b. The equilibrium condition in an open economy is S + (IM – X) = Ip + (G – T). If
trade is balanced and the government’s budget is balanced, this simplifies to S = Ip,
c. With the government’s budget balanced, the equilibrium condition is S + (IM – X)
Trillions of
Dollars
Interest Rate
A
S
[IP + (G – T) + (X – IM)]
222 Instructor’s Manual for Economics: Principles and Applications, 6e
12. a.
b. See the diagram in part (a) above.
EXPERIENTIAL EXERCISE
Use The Wall Street Journal to find a recent article about fiscal policy that mentions both the
interest rate and the rate of economic growth. Once you have found such an article, try to
