Econ Solutions 116b Final 2005 Part I. 1. False. A higher MPI lowers the government multiplier because of increased spending (i.e. consumption) leakages to imports. So, if the US has the higher MPI, fiscal policy here would be less effective than in Germany. 2. False / Uncertain. Monetary policy does have a shorter implementation lag than fiscal policy, but the implementation lag is not the only (and probably not the best) indicator of effectiveness. First, despite having the higher implementation lag, fiscal policy has a much shorter response lag from the moment of implementation. Second, the relative effectiveness of fiscal and monetary policy depends on the slopes of the IM and LS curves. 3. False. Consumption per worker is lower for savings rates beyond the golden rule rate of savings. 4. True. Monetary policy has no effect with fixed exchange rates, so monetary policy under flexible exchange rates must be more effective by definition. 5. False. Unlike the case of bond prices, stock prices depend on more than just the interest rate stock prices could have decreased in this case due to lower future expected dividends on the stock. 6. True. Relative to a model with trade and no feedback, the feedback effect improves the effect of government spending. This occurs through a virtuous loop where the increase in the trade partner's export earnings and output leads them to increase their imports, in turn increasing the first country's exports, and thus further increasing its output. 7. False. The life cycle theory is based on the premise that consumers seek to smooth consumption over time so consumption should be steady no matter if the consumer is young (a net borrower), in his or her middle productive years (a net saver), or old (a net dissaver). 8. False. The unemployment rate can be expressed as u = U/[E+U], where [E+U]=L is the number of individuals actively seeking work (i.e. the labor force) and E is the number of the employed, and U, the unemployed. Similarly, the employment rate is e = E/[E+U]. Hence, e + u = U/[E+U] + E/[E+U] = 1, and so it is not possible for the unemployment and the employment rates to increase simultaneously. (The level of unemployment and employment can increase simultaneously, indicating a growth of the labour force.) 9. False. The Fed can intervene in the foreign exchange market directly by changing the US money supply. If the Fed does not wish to alter the money supply or interest rates (thus disturbing the domestic equilibrium) it could also intervene with a process known as currency sterilization. This strategy would entail the Fed buying foreign currency with US bonds, or, alternatively, buying foreign currency with USD and simultaneously selling an equivalent amount in US Treasury bonds on the domestic market, thereby avoiding any change in the domestic money supply.
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Part II. 1. The J-Curve Effect: CA = PX*EX PM*IM and PM = 1/e *PXF Currency depreciation: e EX and IM, both have a positive affect on trade balance. PM and so has a negative effect on the trade balance (due to currency depreciation). PX changes when the US price level (P) changes. i. The initial effect of depreciation on the domestic price level is not large, and the price of exports will typically lag behind that of imports. So the change in export revenue does not outweigh the change in input costs in the short-run, which means the depreciation may in the short term have the perverse effect of actually increasing the trade deficit (or decreasing the trade surplus). ii. In time, the shock to import prices works its way through the economy [PM, AS shifts left, P], and PX increases, thereby increasing export revenues and offsetting the initial increase in import costs. As a result CA will eventually improve. 2. A number of variables affect a firm's demand for labor and capital, including the following: Technology used by firm depending on wage rate and cost of capital. Expectations (animal spirits, accelerator effect) Excess labour and capital. Desired/optimal level of inventories (storage costs vs. lose of sales). Current amount of inventories Interest rates Recall from the lecture notes (LN 14) that: K = K(from last period) + I Depreciation, I = function of r, w, Ye, [(actual desired)K(from last period)], J = function of r, w, Ye, [(actual desired)J(from last period)]. 3. The Phillips curve describes the relationship between inflation and unemployment. During most of the 60s, the economy was hit by mostly large demand shocks and relatively smaller supply shocks, thus shifting the AD curve, while keeping the AS supply curve mostly constant. This produced a positive relationship between the price level and output and thus a negative relationship between the price level and unemployment (since output and unemployment are negatively correlated). During the 70s, due mostly to large oil shocks, the AS curve shifted around quite a bit and because the AD curve also shifted (since the government was trying to counter these supply shocks), the negative relationship between inflation and unemployment broke down. For most of the 90's, both inflation and unemployment were relatively low because of large rightward shifts in the AS curve due to the productivity gains stemming from the information technology revolution. Part III. 1. 2
i. Long term interest rates are an average of current short term rates and expected future short term rates. In theory, short term rates and long-term rates move in parallel, in practice however, while the Fed has very tight control over the short-term rates, long term rates (especially very long-term rates) are less well correlated with the Fed's policies. ii. A real 10 year interest rate is the nominal ten year interest rate adjusted by the expected rate of inflation for the relevant period (Nominal inflation = real). 2. The main argument against joining the Euro currency union is the loss of monetary policy. The interest rate would now be set by the European Central Bank and the Bank of England wouldn't have control over it. Thus it wouldn't be able to use monetary policy to control inflation or to stimulate the economy. Another related disadvantage that some economists have put forth is that the UK's business cycles are not correlated with the rest of the EU countries. Therefore if there is an economic downturn in the UK, the rest of the countries in the EU may be booming and vice versa. In that case the European Central Bank will not lower or increase the interest rates to accommodate the UK, but will set the interest rates to according to what's best for all the other countries. A third argument is the limited labor mobility in Europe. Unlike the US where workers often move from one state to another if they have to, in Europe language and cultural barriers prevent them from going from one country to another. Since labor mobility is a way to smooth shocks across countries, its absence is another reason against the currency union. A fourth and final argument is the limited size of the EU budget. In the US instance, for if there is a shock to one of the states (e.g. like the hurricane in New Orleans), there will be a large transfer of federal funds to it and will help its economy recover. In the Euro zone however, the EU budget is tiny, so it is not the case that if the UK is in a recession, funds from Germany, France or other countries are going to be transferred over to help out the situation. 3. a. The are a few possible explanations here, but the most obvious is that the Fed is continuing to tighten the monetary policy because it is afraid of inflation. It could be, for example, that the Fed believes that the increased government spending due to the war effort could create inflationary pressures. Alternatively, the Fed may have been trying to respond to or anticipate an inflationary cost shock (though in this case, the more likely story is that the Fed is trying to nip inflation in the bud in the anticipation of a more expansionary fiscal policy). b. If the Fed had increased the interest rate beyond the level that was anticipated in the market, we would expect the dollar to become more attractive to foreign investors, and with this increasing demand for dollars we would expect the dollar to appreciate over other currencies (including the euro and the yen). c. The output growth was worse than it looked if there was a substantial unanticipated increase in inventories. The inventory increase indicates that planned aggregate expenditures for the period were below the level of output and, therefore, suggest that, all other things being held equal,
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economic growth will be lower in the next period as the inventories from the current period are consumed. Part IV. 1. a. Multiplier decreases. Previously we had G , Y . Taking the money market and the relationship between r and I into account we would have G , Y, Md , r , I, Y (so Y increases less than otherwise due to crowding out, i.e. lower multiplier). b. Multiplier decreases. When the AS curve is introduced we now need to take the price level into account. As G , AD shifts to the right and we get a higher Y and higher price level. The higher price level leads to Md , so r , I , Y (in sum, Y increases less than it would otherwise due to crowding out). c. Multiplier decreases. With excess capital and labor, when G and Y , Y increases less than it would otherwise because fewer new workers are hired (instead existing workers work more intensely), and so there is less of a increase in C due to increased consumption, corresponding to a smaller multiplier for G. d. Multiplier decreases. The inventory investment story is added. Inventory investment has the same effect as the excess labor story above. When G goes up, Y may increase less as the inventories from the preceding period are utilized. e. Multiplier decreases. Automatic stabilizers will decrease the multiplier. If G , Y , T , the higher taxes lead to Y . The overall result leads to a lower increase in Y than would have occurred otherwise. f. Multiplier decreases. If investment is very sensitive to the interest rate, then, the decrease in investment, I, due to the increase in r, is greater )compared to the case where I is less sensitive to r), and the amount of crowding out is greater (Recall: G , Y, Md , r , I, Y ). g. Multiplier decreases. If the change in government spending is perceived to be temporary, MPC out of the increase in Y (generated by the increase in G) would be very low, leading to a lower multiplier. h. Multiplier increases. Under the interest rate rule the interest rate is chosen by the Fed and the money supply is endogenous. If the Fed chooses to keep the interest rate flat, and G increases, we will have the following effects: G , Y , Md , Ms adjusts so that r stays the same, and so no crowding out of investment occurs. Without the crowding out of private investment, the multiplier will be higher. Note: The "interest rate rule" can be understood two ways. One interpretation (the one assumed and probably intended above) is that the Fed will set the interest rate (in this case, keeping it steady). The other interpretation, however, is that the interest rate rules means that the Fed will lean "against the wind" in response to increases and decreases in economic output. This interpretation would lead to a different result: as G , Y (creating inflationary pressure), the Fed 4
would increase interest rates to keep the economy from overheating, so r , I , Y. Under this interpretation, the interest rate rule would decrease the multiplier. i. Multiplier decreases. Several potential effects here. One interpretation is that if gov't interest payments increase as r , the increase in G would lead to higher interest payments, and therefore a higher government deficit. The government is likely to respond to the increasing debt burden by decreasing G or increasing T (both effects tending to decrease Y), so in this scenario an increase in G would (in the long term) have a smaller effect on Y. 2. Numerical problem. IS: Y = C + I + G + EX IM Y = .75 (Y T) + (150-10r) + 50 + 10 - .1Y = .75 (Y + 20 - .2Y) - .1Y + 150 + 50 + 10 10r = .75 (.8) Y - .1Y + 225 10r Y (1-.75(.8) +.1) = 225 10r .5 Y = 225 10r Y = 450 20r LM: Ms = Md 250 = 200 + Y 20r Y = 20r + 50 IS = LM Y = 450 20r Y = 20r + 50 2Y = 500 Y = 250 T = -20 + .2(250) = 30 r = 200/20 = 10 Y-T = 250 30 = 220 C = .75 (220) = 165 NX = EX IM = 10 - .1(250) = - 15 Deficit = G T = 50 30 = 20 I = 150 10*10 = 50 Savings: Private Savings = (Y T) C = 250 30 165 = 55 Public Savings = T G = -20 Foreign Savings = (-NX) = - (EX IM) = 15 Total Savings = (Private + Public + Foreign) Savings = 55 20 + 15 = 50 = I If we want Y to be 300 with G at 50, we would need to change the interest rate. 5
300 = 450 20r 20r = 150 r = 7.5% With r at 7.5, we get the following results: Y* = 300 I = 75 T = 40 C = 195 Y-T = 260 NX = 10 - .1(300) = - 20 G T = 50 40 = 10 If the Fed fixes the rate at 10% and G increases to 75, we have I = 150 10*10 = 50, and the new equilibrium will be: IS: Y = 450 20r + 50 (note, multiplier on G is 2 (i.e. 1/.5), so if G goes up by 25, Y will increase by 50). Y = 450 20*10 + 50 = 300 T = 40 C = .75 (300-40) = 195 I = 50 (note, no crowding out since the upward pressure in r by the increase in G is counteracted by increase in money supply). NX = -20 Deficit = G T = 75 40 = 35 (deficit is higher b/c G increased). How would the Fed insure that the interest rate remained at 10%? LM: Md = Ms = 200 + Y + 20 * 10 = Y The Fed would need to set Ms = Y (in this case, Ms would need to equal 300) If transfers decline from 20 to 12, T will now equal T = -12 + .2Y. With the balanced budget amendment in place, G-T=0, so that G=T = -12 +.2Y. Recalculating with these assumptions, we get: Y = C + I + G + EX IM = .75 (Y + 12 - .2Y) + (150 10r) + (-12 + .2Y) + 10 - .1Y = .75(.8)Y + 9 + (150-10*10) 12 + .1Y + 10 Y - .6Y - .1Y = 57 .3Y = 57 Y = 190 r = 10% T = G = -12 + .2 (190) = 26 I = 150 100 = 50 6
C = 123 Y T = 164 NX = 10 190*.1= -9 D=GT=0
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