Class Notes for The Economics of Macro Issues, 7th Edition

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Online Instructor’s Manual
By
Ninos P. Malek
San Jose State University & De Anza College
For
The Economics of Macro Issues
Seventh Edition
Roger LeRoy Miller
Research Professor of Economics
University of Texas, Arlington
Daniel K. Benjamin
Clemson University, South Carolina
and PERC, Bozeman, Montana

Preface
You don’t have to search far to find macroeconomic issues, and you certainly don’t need to look much
further for help understanding them. This Instructor’s Manual is geared to help you take what is printed in
The Economics of Macro Issues, seventh edition, and to put it to use in the classroom. As Roger LeRoy
Miller and Daniel K. Benjamin have said, macroeconomics comes from a universal, basic knowledge that
can be used in a variety of time-relevant events, debates, and situations. This Instructor’s Manual helps
you tap into this knowledge in an effective and enjoyable manner.
◼ Chapter Overview
This short synopsis tells the overarching points to remember for each chapter. It cuts to the core of the
chapter’s economic issues. This overview can be helpful as you’re deciding where to assign the chapter for
your own unique course. It can be used as a quick refresher before your lecture on a particular topic. By
indicating the most important specific points, this section can help you decide what kinds of test questions
would be the most effective for your course.
◼ Descriptive Analysis
This section goes behind the scenes to the economic analysis upon which the discussion in the text is
based. These descriptions may sometimes go beyond what you would want to include in your class, but
having this in-depth yet concise background will give you what you need to proceed with a well-rounded
discussion of the economic issues for each chapter. While not every angle of an issue can be explored in
this short section, the descriptive analysis should help you as you organize your syllabus, and allow for
your students to dig deeper into the reading.
◼ Teaching Tips
These tips aren’t found in every chapter of the Instructor’s Manual, but where they have been included,
they point out key areas of the text that your students might struggle with. They also provide possible
discussion questions for you to ask the class so that they can work out the answers themselves, helping to
cement the learning process.
◼ Answers to End of Chapter Questions
A section has been included in every chapter to answer the Discussion Questions at the end of each
chapter in the text. These questions may bring about a variety of discussions and answers, and the answers
that are supplied here give you a connection to the work that researchers are doing in the field now. These
answers further develop basic economic analysis and skill sets—as well as introduce new and different
avenues of discussion.
◼ And More. . .
As always, discussion in the classroom doesn’t stop at this Instructor’s Manual. The manual is intended
to help guide you toward a course that is more informative and more enjoyable to the students in your
classroom.

Chapter 1
Rich Nation, Poor Nation
◼ Chapter Overview
Perhaps the most important determinants of a country’s economic growth are the laws and institutions
under which its citizens operate. Stable laws and mechanisms to protect citizens from the government and
each other are necessary for economic growth to be significant and lasting. The rationale behind this is
simple: individuals will not choose to invest if they do not have a reasonable expectation of reaping the
rewards of their investment. This investment, in both physical and human capital, is required for
prolonged economic growth.
◼ Descriptive Analysis
Economic growth requires institutions that protect investment and its proceeds. Two major types of legal
systems are outlined in this chapter: common law and civil law. Common law legal systems grant judges
the authority to decide the law when there is no other authoritative statement of the law. These decisions
are binding for all other cases that are similar until there is another authoritative statement of the law by
a legislature or higher court. This statement of the law announces the “rules of the game” and enables
economic participants to make investment decisions under relative certainty.
Unlike the English-based common law system, civil law has its roots in Roman law. Civil law legal
systems draw on abstract rules that judges must apply to cases before them. Rather than relying on
judicial precedents, judges in civil law nations base their judgments on the provisions of codes and
statutes or the general principles of these codes. This tends to generate incentives for governing bodies in
these countries to pass statutes that deal with specific situations and can lead to preferential treatment of
special interests.
Besides mixtures of common and civil law systems, two general other legal systems exist in the world:
the Islam Fiqh system and legal systems based upon custom.
The importance of the legal system to economic growth is tied to the protection of property rights.
Citizens under the common law system, who can turn to precedents where courts have protected property
rights, are more likely to make long-term investments that can lead to increased human and physical
capital. Civil law nations, where property rights are more easily overturned through new codes, generate a
less secure investment environment and hence generate lower amounts of capital. One study by Mahoney
argues that between 1960 and the 1990s, growth was one-third higher in common law nations relative to
civil law nations.
The type of legal institution developed within a nation has much to do with its history. English colonies
tended to adopt the common law system. However, other factors have influenced the development of
institutions. Tropical colonies tended to be affected by disease more than temperate colonies. As disease

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Chapter 1: Rich Nation, Poor Nation
shortened life expectancy, colonists were more interested in extracting resources rather than establishing
permanent institutions that would lead to long-term growth. Lacking these institutions historically may
explain one reason why growth is much higher in temperate areas of the world.
◼ Teaching Tips
Often students have trouble seeing the importance of institutions, especially if they have not traveled to
other countries. To make this easier, start a discussion by asking a student to imagine a situation where
institutions do less to protect their investment. One simple method is to have students imagine that their
college registrar has the habit of changing graduation requirements every few years. If all registrars acted
this way, how many students would seek to enroll in college? What would happen to the number of
educated adults? What would happen to economic productivity?
◼ Chapter Answers
1. In Country A, where profits are subject to confiscation by the government, few people would
choose to enter mining. While using fewer of their natural resources, the citizens of Country A
also would have less employment, lower incomes, and lower production of goods than Country
B. Thus, in one sense, while the physical endowments are the same between A and B, the ability
to utilize those endowments is considerably lower in A than B.
2. Often, situations like the one asked about in this question arise from a desire for income or wealth
equality. Much of the rationalization for these policies ignores the importance of property rights.
For instance, if we should confiscate miner’s profits so that all in society can benefit, then miners
will choose to reduce the amount of ore mined. The end result is that no mining occurs, no profits
are taxed and no income is generated, which perversely achieves the goal of equity espoused by
the group that wants to redistribute resources.
3. This law would have far-reaching consequences. I will endeavor to outline only a few. A first
reaction might be to think that migration out of the state of college-bound students will occur. To
any extent this happens, this will benefit surrounding states, which will increase their talent pool
in college and future labor markets. Of course, this will decrease the academic talent in the
subject state. The decrease in college applicants may cause in-state universities to lower tuition,
which would attract out-of-state students (who probably wouldn’t stay in state to work upon
graduating) and perhaps induce some in-state students to remain (especially if they were likely to
move out of state upon taking a job). At the same time, hoping to receive the benefits of the
higher tax base, it is likely that non-college-bound citizens will move to this state, which
perversely from the governor’s standpoint would drive down the wages of those not attending
college and, possibly, make the wage gap between education levels larger. Campaign
contributions to the governor are more difficult to predict. Parents of students who have been
driven from local colleges will dislike this policy, as will citizens who support higher education in
that state. On the other hand, those not subject to the tax may think their overall tax burden will
fall and thus be in favor of the governor. These individuals are likely to be disappointed, though,
given that the governor will probably not earn significant tax revenue from this policy because
college graduates are less likely to remain in the state.

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Chapter 1: Rich Nation, Poor Nation
4.
2014 Real GDP Per Capita
Common Law Nations Civil Law Nations
Australia 46,600 Brazil 15,200
Canada 44,500 Egypt 11,100
India 5,800 France 40,400
Israel 33,400 Greece 25,800
New Zealand 35,000 Italy 34,500
United Kingdom 37,700 Mexico 17,900
United States 54,800 Sweden 44,700
Note: All figures calculated using PPP. Source: CIA World Factbook.
5. This chapter stresses the importance of property rights. In this light, aid in the form of capital
may have less of a positive impact than the giving nation hopes. Capital that can be transferred or
confiscated may not be used optimally. For instance, when property rights are guaranteed, an
individual given a tractor may be more likely to buy a field and work it. Absent property rights, a
farmer is less likely to buy the field and the tractor becomes less useful. Grants of consumer
goods may reduce incentives for individuals to create their own consumer goods, which in turn
may reduce political pressure to force governments into protecting property rights.
6. In 2014, Louisiana had a GDP per person of $42,287 that ranked it 30th among the 50 states and
DC. In 2013, Quebec had a GDP per person of CAN $44,499 that ranked it 10th among the 13
provinces and territories. Both are below their national GDP per person averages.1
1 Information for Louisiana:
http://www.bea.gov/regional/bearfacts/action.cfm?geoType=3&fips=22000&areatype=22000
Information for Quebec:
https://en.wikipedia.org/wiki/List_of_Canadian_provinces_and_territories_by_gross_domestic_product
(Sources from Wikipedia were based on information provided by Statistics Canada and Canada Revenue Agency.)

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Chapter 2
Innovation and Growth
◼ Chapter Overview
Innovation is necessary to transform prior inventions into something useful for our everyday lives. Profit
is the incentive for businesses to innovate and, when firms are successful, our standard of living increases.
It is the introduction of new products that improves our lives and it is the potential profit for businesses
that leads to new investment, which contribute to economic growth. Property rights to ideas must be
secure and being able to keep the fruits of one’s labor are necessary in order to create the proper
incentives to innovate. Governments need taxes to operate but the unintended consequence of taxing
profits is that there is less incentive for firms to innovate.
◼ Descriptive Analysis
Each of us today benefits from prior inventions and innovations to those inventions. We can communicate
with each other or send pictures to each other from across the world; we are able to obtain information in
a matter of seconds that previously took hours; we can purchase groceries, other essential home products,
and even electronic “toys” that entertain us at much lower prices due to innovation. Innovation either
reduces production costs, which leads to lower prices, or it brings us new goods and services that make
our lives easier or give us more utility (pleasure, satisfaction).
Just because someone invents something does not mean it will automatically reach the masses. In fact,
some inventions in hindsight seem to be useless or have only narrow applications. It is innovation—the
process of transforming the invention—that leads to the increase in the welfare of the masses.
Innovation does not just happen by chance. In fact, inventions and innovation are a function of how much
is spent on research and development (R&D). Large, private firms and government agencies spend
billions of dollars on R&D trying to create new inventions, but only a few actually are created that have
useful applications, and even fewer might be successful commercially. However, not all innovation is
done by large firms or government. Small businesses and individuals invent and innovate, too.
Regardless of whom does the R&D, our standard of living increases when new products are brought to
market and when innovation transforms already made products or lowers production costs, which lead to
lower prices for consumers. These lower prices, in a very real sense, are equivalent to getting a pay raise.
Historically, when the rate of innovation was slow in the United States, the standard of living was low.
However, as the rate of innovation has increased, so has the standard of living for the average American.
It is innovation that is the foundation for economic growth. Innovation does not just happen in any
economic system. The institutions (rules of the game) of a country affect the incentives to innovate. If
there is no stable judicial system that enforces property rights such as patents, then firms and individuals

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Chapter 2: Innovation and Growth
will not have an incentive to invent or innovate. Moreover, if taxes are imposed on the profits of large
firms or small businesses, then the incentive to create a better product or to innovate will be diminished.
The notion that everything important has already been invented ignores the fact that previous inventions
and innovations were built on previous knowledge. So, the fact that we have more inventions and
innovations today than ever before means that there is fertile ground for even more inventions and
innovations that will improve and change our lives.
◼ Teaching Tips
Students might not appreciate how their lives have been impacted by entrepreneurs who had an idea and
made it into the “next big thing.” Our lives today are so much easier and we have so many more products
that entertain us, allow us to communicate more easily and more productively, or even go on dates. You
can use the television show Shark Tank on ABC as an example. Ask your students why they think these
people come on the show? (They will most likely say, “To make money!” and that’s fine. It is this pursuit
of money for themselves that gives others the value-enhancing goods and services.) Students might
underestimate or negatively view the pursuit of profit. Some students might protest that profits are “evil”
and companies take advantage of us. But then ask students if they need their iPhone or Sony
PS4/Microsoft X-Box video game console that is currently in their hand or in their dorm room? Ask them
if Apple or Sony or Microsoft forced them to buy their product? You can also turn the tables by asking
them if they would go to work if they did not receive a paycheck. What you want your students to
understand is that those firms and individuals who invent and innovate respond to incentives just like they
do. This is also a good time to remind students of Adam Smith’s famous quote, “It is not from the
benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to
their own interest.” It is because of their own interest, that we don’t have to produce our own steak, bread,
or beer that we enjoy eating and drinking.
◼ Chapter Answers
1. It is better to live today. If the famous kings and queens of the past or John D. Rockefeller got
sick or suffered from medical problems, they were worse off than the average person today who
can get high-tech medical treatment and medicine. Individuals today can get better relief by just
going to the pharmacy let alone to a physician who has much more human capital and physical
capital to work with today than during the times of the kings and queens or Rockefeller.
As far as homes, cars, communication devices, and entertainment products, the average income-
earner today lives in a safer home, drives a more luxurious and safer car, can communicate both
verbally and visually with anyone across the globe, and can enjoy a beautiful high-definition
picture on their flat television.
2. Human beings are always thinking of new things to create or devising ways of making a better
mousetrap. The problem is that just because someone invents something, it does not necessarily
mean others will benefit from it. First, the invention has to be something that truly has a benefit.
Moreover, in order for it to be commercially successful, it has to benefit many people. This is
why innovation is necessary and not just invention.

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Chapter 2: Innovation and Growth
3. It depends on who does the spending. One can argue that government expenditures on basic
research are necessary since private firms will not undertake this. On the other hand, government
R&D can be wasteful since they are spending taxpayer dollars and not their own money.
Therefore, the government agencies doing the R&D might not be as good of stewards with their
resources. On the other hand, it can be argued that if our knowledge has increased due to R&D,
even if it isn’t profitable, that knowledge will make us better off and lead to more productive
avenues of R&D. Of course, private firms have the financial incentive to spend time and money
researching and developing products that will make a profit. And if the firm makes a profit, that is
evidence that they did something right (solved a problem, alleviated suffering, created something
pleasurable) since individuals cannot be forced to buy the products of the firms.
4. Economic growth has an impact on individual welfare. Even small percentage changes, due to
compounding, have a large impact. So, while a small change might have a small impact on our
lives in the short-run, in the long-rung our standard of living will be greatly reduced.
There is an easy way to determine the number of years it takes for an economy to double in size.
The formula is equal to 70 divided by the growth rate (the rule of 70). So, using 2.1%, it would
take an economy approximately 33 years to double; however, using .9 %, it would take
approximately 78 years.
5. In Nation A, the after-tax profit will be $83,000 ($100,000 x .17 = $17,000) while in Nation B it
would be $93,000 ($1000, 000 x .07 = $7,000). Therefore, the preferred location is, of course,
Nation B (assuming everything else is equal).
The business is not the only one that will benefit by operating in Nation B—the citizens will also
benefit. First, the business in Nation B will provide a service or product that can be directly sold
to the citizens of Nation B. Second, the business will have to hire workers from among the
citizenry, thereby increasing employment in Nation B. Finally, the business in Nation B will
invest in physical capital and will continue to innovate which will lead to more growth.
6. Answers will vary but most likely students will list the iPhone/Android phone, popular apps like
GPS navigation (Waze) and online banking, social media and dating, websites, improved video
game graphics, picture quality on televisions, online education innovations, and improvements in
medicine.
It is difficult to put a precise dollar value on psychological utility, but students at least could be
asked to estimate how much money they spent on the above items over the last five years.
Students could be asked how much time and money they were able to save by not having to
commute to all of their classes on campus or they could be asked to consider how much money
they would pay to avoid the pain and suffering they would have without their medicine. Finally, if
they met someone online, ask how much that is worth to them.

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Chapter 3
Outsourcing and Economic Growth
◼ Chapter Overview
Broadly defined, underground economic activity consists of transactions not reported or reportable to the
government. Economists estimate that throughout the world, underground economic activities account
for about one-third of all production. However, underground activities are not evenly distributed across
countries. Much underground activity occurs in order to evade taxes. Countries with low marginal tax
rates experience less underground activity because citizens have less incentive to evade taxes.
Regulations on products or labor can also encourage underground activity. This chapter highlights some
of the factors driving underground economics.
◼ Descriptive Analysis
When Americans first think of the underground economy, they almost immediately think of the illegal
drug trade. By definition, the drug trade is underground; buyers and seller purposefully attempt to hide
their activities from the government. However, there are numerous other underground activities that
commonly occur. As evidenced by a number of political scandals involving hiring domestic help,
payments to workers “under the table” constitute a significant proportion of hidden economic activity.
Indeed, in any country where something is banned or taxed there seems to be a black market for that
good.
For obvious reasons, nobody knows exactly the size of the underground economy. Estimates of its size in
the United States range from very little to about 30% with the most reasonable being around ten percent.
The underground economy in Europe is thought to be larger, perhaps as much as 20%, with some
countries like Italy exceeding 30%. Developing countries, especially those with few property rights, are
likely to have a majority of the economies be hidden from the government.
The size of the underground economy between countries varies considerably. The source of this variation
depends upon the marginal tax level, economic regulations, and often the ability for citizens to make
purchases or transport goods to a different jurisdiction. A high marginal tax rate encourages citizens to
hide income generating activities from authorities in hopes of evading taxes. Potentially, this explains the
higher rate of European underground activity (where marginal tax rates tend to be high) relative to
American levels (where tax rates tend to be low). A related issue not to be confused with this argument is
tax avoidance. Tax evasion occurs when citizens illegally avoid paying taxes (i.e. not reporting their
earned income) whereas tax avoidance occurs when citizens use legal loopholes to reduce their tax
burden. A high marginal tax rate increases both tax evasion and tax avoidance.
Market regulations may also induce higher levels of underground activity. Restrictions on firing workers
encourage businesses to hire individuals “under the table” so as to avoid these restrictions. Long-term
unemployment benefits may induce workers to work in the underground economy so as to not lose their

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Chapter 3: Outsourcing and Economic Growth
benefits. Regulations increasing the marginal cost of hiring a worker may also contribute to increased use
of underground labor. For instance, requiring firms to provide health care to employees may induce firms
to illegally contract with employees rather than legally hiring them.
Another form of underground activity is smuggling. Whenever two jurisdictions exist with different
regulations or tax structures, one can imagine smugglers earning a profit by exploiting these differences.
Cigarettes (between low and high tax American states), Cuban cigars, weapons, and drugs are common
examples. There is considerable smuggling of petrol and diesel that occurs between Northern Ireland and
Ireland the flow of which depends upon local tax rates and fluctuations in the value of the Euro and
Pound. The British government estimates it lost 350 million Pounds worth of taxes because of smuggling
cheaper Irish Petrol into Northern Ireland.
Finally, participation in the underground economy is best thought of in terms of opportunity cost and
comparative advantage. When individuals lack mobility or skills to succeed in other areas or sectors of
the economy, they will be more attracted to the underground economy when their economic
circumstances deteriorate. Miller and Benjamin cite Ahmedabad, India as a case in point. When the local
textile industry deteriorated, many workers without the ability to change locations or earn a living in a
different career, turned to the underground economy including street vending, trash collecting, and
recycling. The authors contrast this to residents of Buffalo, New York who, because of the completion of
the St. Lawrence Seaway, has suffered a serious decline in economic activity. Rather than turning to the
underground economy, residents of Buffalo simply departed for jobs in other areas of the country.
Economic mobility allows individuals to substitute out of the underground economy when under pressure.
Finally, it is important to keep in mind that the underground economy is a wealth generating activity in
much the same way that normal, legal economic activity is. In all but extreme cases, the underground
economy relies upon trade that benefits both seller and buyer. As such, the underground economy is
socially beneficial even when it is illegal or frowned upon by governments.
◼ Chapter Answers
1. High marginal tax rates encourage citizens to evade taxes by participating in underground
activities. Consider the extreme case of a 100% marginal tax rate, citizens would have no
incentive to participate in legal work since all of their earnings would be taxed. One would
imagine that in this case, all work done would be hidden from the government so employees
could retain their earnings. On the other hand, a 0% tax rate would not cause any evasion; in this
case citizens would retain all that they earned and have no additional incentive to hide their
production from the government.
2. Laws that discourage employee termination likely increase hiring workers in the underground
economy. These laws likely discourage some overall hiring as the total cost of a worker to a firm
(including termination costs/uncertainty) is greater. However, some hiring does occur in the
underground labor market to counter act this. Interestingly, workers hired in the underground
economy may suffer from these types of laws since they are less well protected by other labor
market safeguards (i.e. safety regulations, workers compensation, etc.).
3. From the individual’s perspective, participating in the underground economy is a voluntary
activity that presumably makes the individual better off—otherwise the individual would not
participate in it. Regardless of the reason why, participating in the underground economy is
illegal and puts the individual in jeopardy of the law. One can imagine the social ramifications
having great differences depending upon the activity undertaken. For instance, hiring a domestic

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Chapter 3: Outsourcing and Economic Growth
worker “under the table” and not paying the associated taxes cheats the government out of
revenue but increases the utility for the employer and employee. Selling drugs, on the other hand,
has a negative externality on society and possibly forms or abets an addiction that one party to the
transaction (the buyer) may really want to avoid.
4. A highly corrupt government, defined here as one that does not respect property rights, would
have citizens more likely to participate in the underground economy. In these types of nations, a
corrupt government may take the proceeds or capital of a citizen. In this case, citizens
participating in the underground economy may not rise to the notice of such governments and
therefore may be able to accumulate more wealth than if they were participating in the legal
economy.
5. Yes. One can imagine that being paid “on the books” allows others in society, most notably the
legal system, to recognize your job as legitimate. Legitimate work may be associated with legal
protections such as workers compensation, protection from arbitrary termination, and the ability
to use the job as collateral for loans. Many of these things are expensive for a firm that, in order
to reduce expenses, may desire to pay “off the books.” In an underground economy, these things
may be bargained over. In short, an employee may be willing to receive a wage above the market
rate in exchange for being hired “off the books” and foregoing the benefits that come with being
hired legally.
6. In either case, as long as the hiring (by the employer) and working (by the employee) was
voluntary, then it is hard to imagine an employee systematically ending up worse off by taking
either a “on the books” or “off the books” job. Of course, some jobs turn out badly for an
employee but, presumably, if the employee knew of this in advance she would not have accepted
the job to begin with.

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Chapter 4
Poverty, Capitalism, and Growth
◼ Chapter Overview
While it is easy to see that wealth can be accumulated quickly by a few “lucky ones” in capitalistic
countries, it is more difficult to evaluate how the poor in these countries fare relative to the poor in other
nations. Do the poor in capitalistic countries do better than those in countries following other economic
systems? Does capitalism tend to improve the poor’s standard of living? Does capitalism improve the
opportunities for movement out of poverty? This chapter provides affirmative answers to these questions.
◼ Descriptive Analysis
Since the beginnings of the Industrial Revolution 250 years ago, the ratio of the world’s population living
in abject poverty—that is, on less than $1 per day—has fallen from nine out of ten to one out of seven. As
a matter of fact, fewer people live in abject poverty today than fifty years ago despite the doubling of the
world’s population. In itself, this simple observation really is the most impressive and important
economic fact of the past century. However, a cursory inspection will reveal that these gains have been
uneven. For instance, the extent of poverty in some African nations has changed little over this time,
while poverty has declined dramatically in countries like China and South Korea.
One common thread that explains economic growth is the presence of capitalism. Capitalism allocates
resources more efficiently than other economic systems, which tends to encourage economic growth. At
the same time, capitalism is often viewed as causing a greater income disparity within a country. If some
individuals command a high wage while others cannot, the end result of capitalism may be income
disparity. However, when analyzing cross-country data, this does not appear to be the case. First, when
ranking countries by the degree of market openness, a number of studies, including that of the Fraser
Institute cited by the authors, find that capitalistic countries grow faster than countries utilizing other
systems.
Within the 40 most capitalist countries in the world, the poorest 10% of residents earn about 2.5% of total
income. While there is some variation between nations, when looking across all countries, the poorest
10% of residents receive between 2% and 2.5% of total income. Thus, while the shares may be somewhat
higher for capitalist countries, the big impact on the poor is through the better performing rich countries.
A 2.5% share of U.S. income provides a much better standard of living than a 2.5% share of a communist
country. Further, the higher growth rates experienced by the capitalist countries inevitably aids the poor
in those countries. A 2.5% share in a country that is continuously growing implies a much better long-
term standard of living than a 2.5% share in a country with little or no growth. It appears that a rising tide
(caused by capitalism) lifts all boats.
These differences are reflected in other measures of life quality. Life expectancy is higher in capitalist
countries, while child labor and infant mortality is lower. All three of these increase the standard of living
significantly for the poor. Longer life expectancy allows the poor greater opportunity to accumulate

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Chapter 4: Poverty, Capitalism, and Growth
wealth, while less child labor provides an opportunity for education and growth out of poverty. As a
matter of fact, some economists have argued that reducing poverty requires education, which occurs only
as poverty is reduced. Non-capitalistic countries that grow slowly and do not provide markets that reward
human capital are less likely to see their citizens educating children, and thereby guarantee slow growth
and high poverty rates in the future.
◼ Teaching Tips
Alan Heston and Robert Summers have compiled perhaps the most frequently used data set to examine
economic growth: the Penn World Tables (http://pwt.econ.upenn.edu/). These are an outstanding resource
to instructors wishing to find easy-to-use data that can be shared with students or presented during
lectures. The tables contain data on about 30 variables for about 189 countries over some or all of the
years 1950-2010. The data provide purchasing power parity and national income accounts that are
comparable across nations. The data are easy to access and can be downloaded into an Excel spreadsheet
with relative ease.
◼ Chapter Answers
1. The empirical evidence suggests that noncash benefits are more prevalent in wealthy countries
than poor countries. The reason behind this is simple: Wealthy countries are more able to fund
benefits for the poor than are poor countries. Of course, these types of benefits improve the lives
of the poor in wealthy countries relative to those in poor countries. If non-cash benefits are
higher in rich countries than poor countries, then the data on average income of impoverished
citizens presented in this chapter understate the actual incomes of the poor in rich countries more
relative to those in poor countries.
2. It is easy for political leaders to exploit those with little ability to oppose them. In a nation with a
rule of law, it may continue to be difficult to protect the poor’s interests, but it is easier than in a
nation governed by the whims of the few. In other words, it is relatively less expensive and easy
for the poor to enforce their property rights in a system established on the rule of the law than it is
for the poor to curry the necessary political favor to accomplish their goals in a system without
the rule of law.
3. Certainly strengthening the rule of law is something that could be done to help the poor, as would
be methods governments could use to encourage capitalism’s spread. These are difficult events
for a foreigner to cause to happen, though. Instead, foreigners could focus on the laws and
regulations of their own governments that prevent the poor in other countries from prospering.
Perhaps the domestic laws that have the most impact on the foreign poor are the laws that prevent
a free exchange of goods and services across borders. For instance, a domestic tariff or quota that
prevents foreigners from selling goods in the domestic country has the effect of reducing foreign
demand for labor, which in turn eliminates jobs and reduces wages for all foreigners, including
the poor. By keeping foreigners from enjoying the benefits of trade, there is less reason to fight
for capitalism in the foreign country, as the benefits are not clearly seen. Of course, this can
simply prolong the cycle of poverty in those countries.
4. Many factors make implementing capitalism difficult in countries under other regimes. These
range from the religious, to historical, to protecting the interests of the ruling class from a more
open society. One all too common occurrence is that nations follow a charismatic leader who
consolidates political and economic power and thereby deters capitalism.

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Chapter 5
The Threat to Growth
◼ Chapter Overview
As discussed in Chapters 1 through 4, components to successful long-run economic growth include secure
property rights in a system that allows individuals to freely participate in market activities. One possible
barrier to free trade between individuals is government involvement in economic decisions. Whether
directly through regulation or indirectly through taxation, government involvement in economic decisions
may lower social welfare and has the potential for reducing economic growth. Given the recent large
budget deficit run by the U.S. government, this chapter argues that a big threat to U.S. growth is a future
increase in taxes.
◼ Descriptive Analysis
Over the past decade, the U.S. government has represented an increasing share of the economy. Federal
government spending represents one-quarter of gross domestic product (GDP). Combined with
increasing shares of state and local government spending, all governments in the U.S. account for almost
one-half of GDP. The reasons for this expansion are many including war, recession, expansion of
entitlement programs, and subsidies. What is obvious from this experience is that taxes have not risen to
meet increased government spending resulting in growing budget deficits and debt.
Regardless of changing the amount of government spending, the economy’s budget constraint remains
unchanged. In other words, U.S. output is dictated by the amount of labor, capital, entrepreneurship,
innovation, and human capital available at any given time. As the government expands, the production
created by these inputs are redirected from consumers, investors, and foreigners to the government. This
occurs regardless of if the government pays for goods using tax revenues or by using borrowed funds. In
short, increased government spending is paid for by citizens either immediately through taxes or over
time through increased taxes used to repay borrowed money.
At first glance, it may appear that increased government spending has no impact on economic growth.
After all, if the government spends taxed money something is being purchased and, presumably, the
citizen who was taxed is not spending. This is much like robbing Peter to pay Paul; Peter (the citizen)
does not spend but Paul (the government) does. However, this analogy is not correct. The act of taxing
Peter may influence Peter’s decisions in such a way as to reduce Peter’s future economic productivity.
Because the U.S. government is in debt, it will need to repay that debt through increased future taxes.
Higher taxes reduces the incentives for citizens to work, innovate, and invest. In short, increased tax rates
reduce the after-tax profits individuals earn on their economic activities and thus discourage the pursuit of
those activities. The end result is that higher government spending today coupled with increased deficits
produces higher future taxes and lower economic growth rates.

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Chapter 5: The Threat to Growth
The link between higher taxes and reduced economic growth is straightforward to understand. First,
consider a potential investor choosing between investing in a project that will create some future returns
and spending on a consumable good today. An increase in taxes reduces the after-tax returns on the
investment and makes that investment less desirable relative to consumption. The end result is a
reduction in investment demand and, in equilibrium, less capital created. Less capital means fewer inputs
to production to create future GDP.
The same occurs in labor supply decisions. Individuals choosing between working and an alternative
(leisure, school, etc.) weigh the benefits and costs of each. Increased taxes reduce the benefits of work
and make supplying labor less attractive. Individuals who were deciding between working and not
working will be less likely to work; those deciding between working overtime and not may be less likely
to work overtime. In short, higher taxes reduce labor supply and again, reduce inputs to production.
While lower economic growth in and of itself is a poor outcome, one should remember that this is the
result of increased government purchases. If those purchases benefited society more than the decreased
future growth, then the government spending may be economically efficient.
◼ Teaching Tips
The connection between tax rates and labor supply is easy to demonstrate in a class if you are willing to
pay out a small amount of cash to a student. One way to do so is to create an auction for student labor to
do a menial task during every remaining class in the semester (clean the chalkboard, etc.). Start with a
high price ($5) and ask how many students would be willing to receive that price in exchange for
completing the menial task. Reduce the price and count how many students supply labor. Repeat this
exercise and graph the labor supply curve. Finally, repeat the entire exercise after imposing a 25%
income tax. Graphing both resulting labor supply curves demonstrates a decrease in the effective labor
supply curve under an income tax. It is easy to generate discussions involving the equilibrium effects of
an income tax (lower employment, raise the hiring cost of labor) and you get somebody to clean your
blackboards for you.
◼ Chapter Answers
1. Higher debt implies that future taxes will be higher, though the extent of this increase is unclear.
If the government can perpetually borrow to make payments on its current debt, then the timing
of higher taxes can be postponed, perhaps indefinitely if the government’s ability to borrow
remains unimpeded. For instance, if the economy grows quickly, individuals may have both the
ability and desire to make additional loans to the government. However, for most countries,
including currently Greece, Spain and Italy, eventually investors are unwilling to lend to
governments and these governments respond by raising taxes and by reducing expenditures. The
end result seems to be that more debt today leads to higher future taxes.
2. Any tax reduces the incentives for individuals to pursue the thing being taxed. A wealth tax will
reduce the incentive to accumulate wealth, or at least cause individuals to try to avoid the tax
(either legally or illegally). One possible response would be for individuals to reduce their net
worth by borrowing against paid-for assets. Another, which appears to be happening in some
European countries, is for the very wealthy to renounce citizenship and leave the country.
Ultimately, a wealth tax will have long-run consequences on citizen’s work effort and holdings of
things considered wealth by the taxing authorities.

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Chapter 5: The Threat to Growth
3. Marginal tax rates are the rates paid on the next dollar of income. When making a decision to
earn an additional dollar, an individual weighs the benefits and costs of that dollar. The benefits
are the things that dollar purchases. Among other things, the cost of earning the dollar is the time
spent working. A higher income tax rate would cause these costs to increase (one has to work
more time to earn a dollar if the marginal tax rate is high). Thus, the decision to work is based
upon the marginal tax rate and not the average tax rate or the overall amount of taxes paid.
4. Higher marginal tax rates are associated with increased tax avoidance (the legal reduction of tax
bills through things like legal loopholes) and tax evasion (the illegal reduction of tax bills). When
marginal tax rates are high, individuals are willing to spend considerable effort avoiding taxes
and may be more willing to risk legal action by tax evasion. Individuals fail to save significant
amounts of taxes through avoidance and evasion when marginal rates are low, hence less of these
activities occur as rates fall.
5. Individuals who realize that future taxes will rise can protect themselves in a number of ways.
Individuals can increase their current work effort in order to generate savings so they can reduce
their work effort under the future higher tax regime. Some individuals will move out of high tax
jurisdictions in favor of lower tax jurisdictions. Others can avoid some future higher taxes by
investing in tax-exempt or tax-deferred vehicles. After tax rates have increased, people will
substitute out of activities that are taxed into non-taxed or lower-taxed activities. It is commonly
believed that responses to increases in taxes will grow over time; in other words the size of the
response will be larger as time passes and individuals have more opportunity to find ways of
shielding themselves from higher taxes.
6. In Country A where a 20% tax rate exists on all income, an individual earning $40,000 per year
will pay $8,000 and an individual earning $100,000 will pay $20,000. In Country B where the
tax rate is 10% on the first $40,000 and 40% thereafter, an individual earning $40,000 will pay
$4,000 and an individual earning $100,000 will pay $28,000. The lower income individual is
better off living in Country B whereas the higher income individual is better off living in Country
A. Without barriers to moving across borders, one would imagine lower income earners to move
to Country B and higher income individuals to move to Country A. As this occurs, one would
expect labor markets in each country to adjust. As individuals willing to work low income jobs in
Country A become scarce, one would imagine their wages being bid up. Simultaneously, as high
income individuals become relatively more common in Country A, their wages will be lowered.
These effects become smaller if it is more difficult to move between countries.

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Chapter 6
What Should GDP Include?
◼ Chapter Overview
Gross Domestic Product (GDP) is one of the key statistics that policymakers use to help them analyze the
macroeconomy. GDP is the total market value of all final goods and services produced within a country
annually. However, official GDP is understated because not all goods produced or services rendered are
included. Home production and certain underground activities, both legal and illegal, are not reported to
the government.
◼ Descriptive Analysis
GDP measures the quantities of final goods and services produced and their prices in a given year. The
Bureau of Economic Analysis, a subdivision of the Department of Commerce, measures GDP. Only final
goods are counted and not intermediate goods, or inputs in the final good. A product can be a final good
or intermediate good based on whom does the buying. For example, if an individual buys a tomato at a
grocery store to make a salad, the purchase of the tomato would count in GDP; however, if Subway buys
tomatoes to put in their sandwiches (the final product), the tomatoes would be considered an intermediate
good and would not count in GDP calculations.
When GDP is higher in one year compared to another, it could be because more goods were produced,
prices were higher due to inflation, or a combination of both increased production and inflation. This is
why there is a distinction between nominal GDP and real GDP. Just because GDP goes up in one year, it
does not necessarily mean there was economic growth. Nominal GDP is just a current figure (nominal
GDP is expressed in current dollars) while real GDP has been adjusted for inflation (real GDP is
expressed in constant dollars).
Not all goods and services that are produced are included in the official GDP calculation. Income earned
from prostitution, illegal drug sales, and illegal gambling is obviously not reported to the government.
Therefore, the reported GDP is actually understated. Ironically, government expenditures on the War on
Drugs and personal expenditures on items that are complementary to drug use do get counted.
Not all underground activities are illegal. Many services provided each year such as landscaping, home
repairs, and selling home-cooked foods are not reported to the government because individuals want to
avoid having their income taxed. Moreover, the goods and services produced in the home are not
included in GDP because there is no market transaction to record. For example, the contributions that a
stay-at-home parent provides each day to his or her family are not counted in GDP. However, if that
parent goes back to work and now the child is put in a legal daycare, GDP will increase because that
parent is now receiving a salary and because the daycare facility is getting paid. Therefore, actual GDP is
higher than the official statistic.

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Chapter 6: What Should GDP Include?
One way to measure GDP is to add consumption (C), investment (I), government spending (G), and net
exports (NX). This is known as the expenditures approach. Investment in economics does not mean what
people usually mean when using that term. Investment is mainly business spending on capital (factories,
tools, machines). But there is also artistic investment, such as authors and songwriters who spend
valuable time creating their product. Until recently, R&D has been considered an intermediate good and,
therefore, not counted. However, the BEA now includes R&D as an investment component in GDP. The
artistic investment is an estimate but nevertheless tries to capture this productive process. As a result, our
official GDP numbers have increased approximately by 3.6%.
Economists are sometimes criticized for focusing only on money. While GDP is a number reflecting
dollar value, it cannot accurately measure happiness. Researchers in other social sciences have attempted
to measure personal life satisfaction. Of course, one has to be careful about these data because actions
speak louder than words. When one buys a good or service, they are demonstrating their true preference.
However, it is very easy to simply check a box on a “happiness” survey.
GDP does not include the value people place upon leisure or happiness. Economists Stevenson and
Wolfers found that real GDP per capita (GDP per person that has been adjusted for inflation) and
happiness are positively related. Perhaps more income makes people happier but it can also be that the
institutions that lead to higher GDP per capita also contribute to well-being and happiness in life.
◼ Teaching Tips
Have students look up and read “Yes, Lady Gaga’s Songs Contribute to GDP,” Wall Street Journal, May
27, 2013 to help understand how spending time developing music is now considered investment by the
BEA.
Also, students need to know that someone’s expenditure is another person’s income. You can simply
demonstrate to students by giving them a dollar for something currently in their hand (i.e., pen, pencil).
Your expenditure of a dollar is income received by the student. This is a simple way to demonstrate that
the expenditures approach and income approach are two sides of the same coin.
In order to help students understand the distinction between intermediate good and final goods, you can
buy various inputs for chocolate chip cookies—flour, sugar, salt, baking powder, butter, eggs, and
chocolate chips (make sure that there are two sets of everything). Then assign one student to represent a
baker who runs his or her own business and assign the other student as an amateur baker who plans on
baking cookies to enjoy at home. Then give each student the same amount of money to buy these inputs
from you (the grocery store).
Ask the students if the ingredients purchased are considered final goods or intermediate goods? They
should be able to conclude that the business baker’s purchases are intermediate goods going into the final
product that will be sold in the marketplace and that the amateur, home baker’s purchases are considered
final goods because the products are purchased for exclusive home use and the cookies will not be sold in
the marketplace.
Finally, to help students understand the difference between nominal and real numbers, you can tell them
that nominal numbers are the current “sticker price.” So, for example, you can have students quickly
research on their smartphone or laptop which movie is the number one grossing movie of all-time in
nominal terms (Avatar ) and then ask them which is the highest grossing movie in real terms (Gone with
the Wind ). If they are confused, you tell them that even though Gone with the Wind grossed less total

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Chapter 6: What Should GDP Include?
money, the amount back then (1939) is worth more than what Avatar made (2009) because inflation
reduces the value of money.
◼ Chapter Answers
1. A purchase made by an individual would be considered a final good while a purchase made by a
business would be considered an intermediate good. For example, if someone buys a tire at
Goodyear to replace a worn out tire on their car, then that tire is considered a final good.
However, when Ford purchases tires from Goodyear to put on their brand new cars, those tires are
considered intermediate goods because they will be sold as part of the new cars. The car price
will reflect all the intermediate goods that are part of the final product.
2. GDP or nominal (unadjusted for inflation) GDP needs to be distinguished from real (adjusted for
inflation) GDP because economic growth occurs when the economy actually produces more
goods and services. When GDP is reported as higher, people might mistakenly think the economy
is doing better, but in reality it’s just that inflation has overstated the value of production. This is
why we must deflate the “hot air” of inflation using the GDP Deflator to get an accurate
measurement of real production of goods and services.
3. a. Intermediate good (assuming that the spare tire is the original provided by auto manufacturer)
b. Consumption (spending on a current service)
c. Consumption (spending on a current service)
d. Consumption, if purchased by someone for just immediate pleasure and he or she has no plans
on being a professional singer; investment, if this is something that is undertaken in order to
produce final products (songs) which will be sold
e. Consumption (an individual is spending their money for immediate educational consumption).
While it is an investment in one’s human capital, the BEA would classify expenditures on
education as consumption.
4. As more women have entered into the labor force, GDP has gone up because the value of the
services they provide (as measured by their salaries and wages using the income approach) is
counted in GDP. Moreover, if these women have hired legal house cleaning and childcare
services that report their income to the government, then this too will have had a positive impact
on GDP. Of course, if the labor hired is paid “under the table,” then that cannot be counted in
GDP.
5. It is difficult to measure “happiness” in an objective manner. However, ceteris paribus, it is
probably the case that people living in a clean environment will feel happier than people living in
a highly polluted environment. As far as GDP is concerned, when firms pollute, the “bad” does
not get deducted from GDP. However, if there is an oil spill, the expenditures by the private
sector and the government get counted in GDP and, therefore, GDP would go up. Of course, we
do not want to conclude that the economy did better because of that.
6. Nations with large underground economies typically have lower measured levels of real GDP per
capita because the institutions in these countries are such that are there is little or no protection of
private property, no consistent rule of law, high rates of taxation, and extensive command and

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Chapter 7
What’s in a Word? Plenty, When It’s the “R” Word
◼ Chapter Overview
Defining recessions is a common topic to cover in an introductory course. It is important for political
reasons as well as for the national psyche. It is also a very difficult term to define. As pointed out in this
chapter, there is no concrete definition of a recession nor is there a governmental agency that declares
when one exists. This chapter explores these issues with an eye to giving students an idea of the difficulty
in evaluation of overall economic performance.
◼ Descriptive Analysis
The National Bureau of Economic Research (NBER) is the nation’s leading nonprofit economic research
organization and has historically proclaimed the beginning and end of recessions. The NBER’s recession-
dating committee defines a recession as “a significant decline in activity spread across the economy,
lasting more than a few months, visible in industrial production, employment, real income less transfers,
and wholesale-retail sales.” Since these four economic concepts may be measured with various statistics
monthly, the NBER is able to construct a fairly accurate, real-time picture of the economy that it uses to
determine when a recession begins and ends.
Because measures of industrial production, employment, income, and sales undergo considerable month-
to-month variation, the NBER does not define a recession simply when these measures decline. Rather, a
recession is deep, of lasting duration, and dispersed across the economy. These descriptors are all qualitative
and open to argument as to what they precisely mean, but a deep change is one that requires a significant
and meaningful fall in the measures of economic activity. Duration refers to the fact that this fall must last
longer than what would be expected to occur given traditional historical variation in the measures. And
this fall in activity must be dispersed across the economy both spatially and across industries.
The NBER does not determine the presence of a recession using real GDP for a number of reasons. First,
real GDP is measured only quarterly, which does not allow for precise dating of a recession. Second, real
GDP is measured imprecisely and often subject to a number of large revisions that occur over a period of
years. After a new revision occurs, it may be found that a period that was thought of as a recession was
really not (or vice versa).
An argument can be made that defining a recession as a decrease in economic activity actually may hide
periods of lowering living standards. For instance, if an economy’s potential output grows at 3% but
actual economic activity grows at 2%, one might argue that the economy is underperforming (even though
it is growing). This issue becomes more transparent if one considers the primary reason why potential
growth may grow at 3%: because of a 3% increase in inputs to production. For instance, if population
grows at 3% per year, one would expect potential output to also grow at that rate since there is a large
labor force to draw upon. On the other hand, if output grows at 2% per year, then it is clear that on a per

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Chapter 7: What’s in a Word? Plenty, When It’s the “R” Word
capita basis, citizens are worse off. Yet, with output growing at 2% per year, no recession would be
declared.
◼ Teaching Tips
Defining recessions is often overdone. Many textbooks attempt to precisely define recessions. Rather than
stressing a technical definition, the goal of labeling a period as a recession is to indicate that, on average,
a nation’s output is falling. Help students keep in mind that the differences in growth rates of income or
GDP over a short period of time are rather insignificant relative to the long-run average of GDP growth.
Also stress that the definition of a recession is much less important than understanding what causes GDP
to change from period to period. Finally, point out that even in periods of expansion, it is possible that a
nation’s standard of living per capita may be falling. Thus, the technical definition of recession may be
less important than many students believe.
Students are often interested to know when recessions have occurred. On the next page is a table
produced by the NBER that defines U.S. recessions. Note the relative infrequency and shorter duration of
recent recessions compared to earlier ones.

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Chapter 7: What’s in a Word? Plenty, When It’s the “R” Word
NBER-Defined Peak NBER-Defined Trough
Contraction
Peak to Trough
(Months)
Expansion
Trough to
Peak
(Months)
Trough from
Previous
Trough
(Months)
Peak from
Previous
Peak
(Months)
June 1857(II) December 1858 (IV) 18 30 48 —
October 1860(III) June 1861 (III) 8 22 30 40
April 1865(I) December 1867 (I) 32 46 78 54
June 1869(II) December 1870 (IV) 18 18 36 50
October 1873(III) March 1879 (I) 65 34 99 52
March 1882(I) May 1885 (II) 38 36 74 101
March 1887(II) April 1888 (I) 13 22 35 60
July 1890(III) May 1891 (II) 10 27 37 40
January 1893(I) June 1894 (II) 17 20 37 30
December 1895(IV) June 1897 (II) 18 18 36 35
June 1899(III) December 1900 (IV) 18 24 42 42
September 1902(IV) August 1904 (III) 23 21 44 39
May 1907(II) June 1908 (II) 13 33 46 56
January 1910(I) January 1912 (IV) 24 19 43 32
January 1913(I) December 1914 (IV) 23 12 35 36
August 1918(III) March 1919 (I) 7 44 51 67
January 1920(I) July 1921 (III) 18 10 28 17
May 1923(II) July 1924 (III) 14 22 36 40
October 1926(III) November 1927 (IV) 13 27 40 41
August 1929(III) March 1933 (I) 43 21 64 34
May 1937(II) June 1938 (II) 13 50 63 93
February 1945(I) October 1945 (IV) 8 80 88 93
November 1948(IV) October 1949 (IV) 11 37 48 45
July 1953(II) May 1954 (II) 10 45 55 56
August 1957(III) April 1958 (II) 8 39 47 49
April 1960(II) February 1961 (I) 10 24 34 32
December 1969(IV) November 1970 (IV) 11 106 117 116
November 1973(IV) March 1975 (I) 16 36 52 47
January 1980(I) July 1980 (III) 6 58 64 74
July 1981(III) November 1982 (IV) 16 12 28 18
July 1990 (III) March 1991 (I) 8 92 100 108
March 2001(I) November 2001 (IV) 8 120 128 128
December 2007 (IV) June 2009 (II) 18 73 91 81
Source: NBER
◼ Chapter Answers
1. The NBER relies upon the perception of being unbiased arbiters of recessions. If the NBER
redefines a recession, especially if the redefinition occurs at a time when it may benefit a political
party, then it will lose its credibility and lack any following to which to declare recessions.

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Chapter 7: What’s in a Word? Plenty, When It’s the “R” Word
2. My guess is that people care more about their individual circumstances and those of their
immediate acquaintances than the proclamations of officials regarding the national economy. Of
course, when the national economy is undergoing a recession, the situation of individuals is likely
to be worse, so some value is placed upon these declarations.
In the competitive world of politics, politicians will use whatever tools are available to gain an
advantage. Poor economic performance can always be attributed (correctly or not) to incumbent
politicians. The declaration of a recession by an apolitical body like the NBER can be powerful
ammunition to use against one’s political foes.
3. According to the NBER, the durations of the last 6 recessions, in months, were:
November 1973 (IV) March 1975 (I) 16
January 1980 (I) July 1980 (III) 6
July 1981 (III) November 1982 (IV) 16
July 1990 (III) March 1991 (I) 8
March 2001(I) November 2001 (IV) 8
December 2007 (IV) June 2009 (II) 18
Compared to long-term U.S. experience, these were very short recessions.
Severity is more difficult to determine. One could measure this by the unemployment rate. Using
this measure, the July 1981−November 1982 recession would be the most severe (10.8%
unemployment in Nov. 1982) followed closely by the 2007-2009 recession (10.1%
unemployment in Oct. 2008). Unfortunately, the unemployment rate usually lags recessions and it
is not a good measure for what happens to the average employee. A second option would be to
measure the percent decline in real income from previous peak to the trough of the recession.
Since personal income is measured monthly, this data could correspond with the officially
declared recession dates. A third option would be to measure the percent change in real GDP or
the percent deviation of actual GDP from potential GDP (this third option requires one to
estimate potential GDP). As one can see, it is easy to think of different ways to determine the
severity of a recession, which, of course, can engender discussions and arguments over which is
best.
4. When comparing unemployment rates, the peak unemployment rate of the “great recession” does
not match that of the 1981-1982 recession. Nor is the “great recession” substantially longer than
the recessions encountered in 1973-1975 or 1981-1982. However total employment fell 6
percentage points from the prior economic peak, the largest postwar decline. Further, total output
in the economy fell by 4.8% between 2007-2009; the largest previous postwar decline was 3.2%
in 1973-1974.
5. In looking at U.S. Civilian Unemployment rate and economic recession data between 1948 and
2011 from the FRED, it is apparent that the unemployment rate begins rising at the onset of a
recession and peaks near or shortly after a recession ends. Because the unemployment rate
appears to follow recessions, it is said to be a lagging indicator.
6. In looking at year-to-year percent change in the S&P 500 index plotted against U.S. recessions
between 1957 and 2011 from the FRED, it appears that the S&P 500 index falls (or trends
downward) preceding a recession and then rebounds at the end of a recession. Since it appears
that the S&P 500 index precedes events, it is referred to as a leading indicator.

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Chapter 8
Capital, Wealth, and Inequality
◼ Chapter Overview
Karl Marx argued that capitalism exploits workers by extracting what he called “surplus value”—the full
value of their service. Marx believed that the rich would get richer and the poor would get poorer.
However, since Marx wrote his famous book Das Kapital in 1867, the average standard of living for all
groups has gone up, especially in capitalist, market-based countries. The critics of capitalism, who focus
on income inequality, use data incorrectly to portray a situation that is truly not the case. The main focus
should be on the sources of income inequality.
◼ Descriptive Analysis
French economist Thomas Piketty argues that the top marginal tax rate should be 80 percent. His concern
is that wealth is becoming concentrated among fewer individuals at the top. The problem with this
proposed solution is that people respond to incentives. A marginal tax rate that high will discourage
productive activity, which harms everyone, not just the rich. The Laffer curve illustrates this principle.
Piketty points out the well-known fact that the rate of return on individual capital assets exceeds the
overall growth rate of the economy; however, because people save over their lifetime and because of
existing inheritance taxes (“death taxes”), there is little change in income inequality. Piketty also focuses
on the last thirty years to prove his case. Using a different thirty year time period we get different results.
Wars, depressions, and shocks change outcomes unevenly and unpredictably.
Piketty also ignores that many low-income and middle-income individuals receive government transfer
payments and have lower average tax burdens. He claims that the elderly are among the poorest in society
but he ignores the fact that the elderly receive Medicare benefits and Social Security checks.
The Congressional Budget Office (CBO) has analyzed the last 35 years of income distribution and found
two important facts. First, everyone has seen their incomes rise. For every single quintile, real (adjusted
for inflation) incomes have risen and after tax incomes for those in the bottom quantile have risen the
fastest. The second key finding is that incomes increased more for the top quintiles than for the bottom
ones. However, while the rich are getting the richer, so are the poor, even though not at the same rate.
This is what bothers Piketty.
People move up and down the income ladder over time so we should not focus on only one time period.
People exhibit a life-cycle pattern of earnings, meaning incomes are low for young people, peak around
the mid-50s, and then diminish in retirement age (but the income is higher at the end than at the
beginning).

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