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304 Econ Sonoma State University Fall 2007 Dr. Robert Eyler Suggested Answers to Homework #3 Please answer the questions fully and draw graphs or use equations when needed. Show all your work and remember that these are practice for the midterm questions, so try your best here. It will pay off later. 1. The financial markets are linked to the macroeconomy in many ways, chiefly through monetary policy and expectations. a. Explain how stock prices may be affected by FED policy briefly. Stock prices are affected by FED policy because the FED, or any central bank, controls interest rates somewhat. Also, there is the issue of expectations. The stock price formula we discussed in class reflects that stock prices move due to two categorical changes. First is a change in the expected cash flows from a stock. If the company is perceived to be more profitable, and may share those profits in the form of dividends, the expected cash flows (ECF) from the stock may rise. Further, if the company is more profitable, investors may be willing to pay more for the stock to take advantage of perceived higher demand in the future for the stock. This enhances the expected growth rate of the stock's price, increasing the price of stock now. If the central bank increases the money supply, this can be a signal that stocks in general will rise due to higher profits as consumer spending rises. Because of the link between GDP and the wages, salaries and profits paid, ECF should also rise in general. Second, as interest rates fall, the expected rate of return for investors falls due to a drop in the alternative rates of return on riskless securities. If the baseline rate of return for any stock is the rate of return on government debt in the United States (or any major, industrialized nation), then the central bank lowering interest rates forces these rates down either directly or indirectly via open market operations for example. As a result, R would fall and stock prices would rise in general. Notice that these changes mirror each other and leave little to no ambiguity. The reverse is true if the FED increased interest rates. b. Explain how bond prices are affected by FED policy, using open market operations as an example. Bond prices are affected by central bank policy, specifically open market operations, in a fundamental way using the time value of money. When the FED buys government debt on the open market from banks, they are trying to lower rates of interest. They do this through increasing their demand for government debt which has the effect of decreasing the effective rate of return on government debt. As a result, banks sell their holding of these securities to the Federal Reserve, and receive cash. What the central bank assumes is that the banks will have an economic incentive to immediately lend out the newly-received cash because other bond prices will be relatively low versus the riskless government debt. As the banks increase their supply of loanable funds, rates fall (or seen another way as banks offer more funds, the "price" of other bonds rise as banks fund larger amounts of debt) as a reaction to other bond markets experiencing higher prices. This inverse relationship between bond rates and prices is a result of the time value of money, assuming the bond's face value (or future value) is known and fixed. c. Explain how the lag structure of policy leads to problems with forming expectations. There are two lags in macroeconomic policy, or any policy for that matter. The first is the inside lag, the time it takes for the policy maker to recognize a need for a policy change and the time of policy initiation. The second lag is the outside lag, the time between policy initiation and the policy's effect on the economy. Concerning expectations formation, households and firms struggle when information comes out during the inside lag to know exactly what the policy makers are likely to do. The formation of expectations during the outside lag is also difficult because the true effects of policy may not happen for some time and households and firms may perceive the effects different from one another. If policy had no outside lag and the effects were predictable, expectations would be formed by policy very well. It is the existence of long inside lags that exacerbate expectations problems. 2. Business Cycles are characterized by booms and recessions. a. Explain how a boom is defined in macroeconomics and why a specific definition such as a certain economic growth rate may be too restrictive. A boom can be defined one of two related ways in macroeconomics. First is an increase in real GDP growth above long-run trend for two consecutive quarters. This is the classic definitions based solely on the rate of change of output. Another definition is an expansion in general economic activity. This can include many macroeconomic statistics including: employment, unemployment, factory orders, building permits, housing starts, interest rates, inflation, etc. Because economists now suggest that booms are better described by an amalgam of statistics, such as leading and coincident economic indicators describing a boom, the growth rate of real GDP is a simple yet archaic measure that is too in its focus on output. b. Describe two types of inflation using the AD-AS model. The two types of inflation are cost-push inflation and demand-pull inflation. Cost-push inflation is analogous to a leftward shift in the supply curve. This reflects an augmentation of costs to businesses which then pass as much of those costs onto the consumer as possible. These costs include the cost of resources rising due to unexpected scarcity, capital destruction or a technological loss, or finally a change in taxes or regulations that augment the cost of doing business unilaterally due to a governmental decision. The first figure below illustrates such a shift, assuming the aggregate supply curve is upward-sloping in the relevant range of GDP and price combinations. The other type of inflation is demand-pull inflation, which is represented by a rightward shift in the aggregate demand curve. This is caused mainly by policy augmenting income (the ability to spend more on consumption) and consumer confidence generally (the idea that consumers see a bright future and spend today believing the resources be will there in the future. The three types of policy are monetary, fiscal and trade where the trade policy should be either exportaugmenting or import-substituting. The second figure below illustrates this point. Cost-Push Inflation P AS2 AS P2 P* AD y2 Demand-Pull Inflation y* y P AS P2 P* AD2 AD y* y2 y 3. Money Demand is linked to financial investment. a. Which motive of money demand is best linked to financial investments like stocks and bonds? Explain. The speculative/savings motive of money demand is best linked to financial investments. This motive for money demand suggests that individuals and firms demand money in a non-interest bearing form because they want to take advantage of speculative opportunities in financial markets, such as the purchase of stocks and bonds. The savings aspect of this motive is to focus on the idea that to purchase securities that represent future consumption (savings) is the same act with cash as is current consumption. b. State and explain the four characteristics of money. The four characteristics of money are as follows: 1. Medium of Exchange: Money is something that eliminates the double coincidence of wants. 2. Store of Value: Money itself is an asset and can earn income. 3. Standard of Value: Goods are priced in terms of the local currency or what is accepted as money. 4. Standard of Deferred Payment: Debts are priced in terms of the local currency or what is accepted as money. c. Explain how utility maximization is linked to money demand. Utility maximization is linked to money demand because one can think of deriving utility directly from holding money. For example, the household's utility function could have both consumption and money within, if some satisfaction is drawn from holding money balances greater than zero at the end of the current period. There are two ways to see this idea. The first is that money itself provides satisfaction, perhaps because having cash is a sign of wealth and provides some psychological gratification from its possession. Second, and more important to economists, money represents future consumption in a non-interest bearing form. For that reason, money also represents the purchase of other assets. The key is that avoiding a liquidity cost may itself bring satisfaction to the household or individual. d. Suppose money demand, cash held that does not pay interest, is defined as: Md = 500 + 0.2y 1000r, where r is the real rate of interest, and y is real GDP P or real output. i. If P = 100, y = 1000, and r = 0.1, find real money demand, nominal money demand and velocity. This is pure plug and chug: Multiply both sides by P and solve for nominal money demand: 100 * [500 + 0.2*1000 1000 * 0.1] = 100 * [500 + 200 100] = 100 * 600 = $60,000. Real money demand is Md x 100 = $60,000 (remember, P = 100 is the base year!) P V = Y/M, where M is money supply. Assuming money demand is equal to money supply: V = 100,000/60,000 = 5/3 = 1.67. ii. Suppose the price doubles. Redo 3d.i. above. If prices double, the value of money would be cut in half, but velocity would remain the same since there was no real growth of the economy. Nominal money demand: 200 * [500 + 0.2*1000 1000 * 0.1] = 200 * [500 + 200 100] = 200 * 600 = $120,000. Md Real money demand is x 100 = $60,000 (price growth only, real remains unchanged) P V = Y/M, where M is money supply. Assuming money demand is equal to money supply: V = 100,000/60,000 = 5/3 = 1.67. 4. The IS-LM model is a short-run model of the macroeconomy a. State and explain the IS Curve and its relationship to the Keynesian multiplier. The IS curve is the locus of real interest rate and equilibrium real income combinations in the short run macroeconomic model representing goods market equilibrium at every point. The IS curve is downward sloping which reflects both the inverse relationship between interest rates and investment and the similar relationship between interest rates and money. The slope of the IS curve is related to the Keynesian multiplier; in its simplest form = 1 1 = . As interest 1 - mpc mps rates change, and investment reacts, how much new GDP is created depends on how consumption reacts in the multiplier effects. If the reaction is small, the multiplier is relatively small and the IS curve is relatively steep. The reverse is true for economies where consumption reacts in large ways because of interest rate changes. b. State and explain the LM Curve and its relationship to the money supply curve. The LM curve is the locus of equilibrium real interest rate and real income combinations in the short run macroeconomic model representing money market equilibrium at every point. The LM curve is upward sloping which reflects both the positive or direct relationship between the interest rate and savings and the same relationship between interest rates and the quantity of money supplied. For this reason, the LM curve is very much related to the money supply curve. c. State and explain the assumptions of the short and medium runs in the Keynesian model. The assumptions are as follows: 1. The economy is not at full employment. There is excess capacity in the macroeconomy due to market frictions that exist: monopoly power, government intervention in markets, net externalities, etc. 2. Prices are sticky downward: Prices are held artificially at levels that are not a reflection of perfect competition. Further, because of scarcity, aggregate prices are not likely to fall as growth takes place, and if they fall, they fall slowly as compared to the speed at which they rise. The medium run AS curve reflects that stickiness in its convex shape. 3. Expectations are adaptive: Because some parties in transactions own more information than others, forming expectations involves uncertainties that lead individuals and firms to make mistakes in their behavior vis- -vis these expectations. d. Find the equilibrium interest rate and income level in the short run with the following IS and LM curves: IS: r = f(y) = 0.25 0.00001y LM: r = f(y) = 0.2 + 0.000005y This is a simple algebra problem. Set the two equations equal to each other and solve for y*, then plug into either equation and solve for r*: 0.25 0.00001y = 0.2 + 0.000005y 0.05 = 0.000015y* y* = 3333.33 r* = 21.67%
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Path: JMU >> ECON >> 201 Fall, 2007
Description: ...
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Path: JMU >> ECON >> 201 Fall, 2007
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Path: JMU >> ECON >> 201 Fall, 2007
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Path: JMU >> ECON >> 201 Fall, 2007
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Path: JMU >> ECON >> 201 Fall, 2007
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Path: UCSB >> ECON >> 01 Summer, 2007
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Path: JMU >> ECON >> 201 Fall, 2007
Description: Answers to Problems 1. For the demand curve shown, the slope is 1 so (1/slope) is also 1. The absolute value of the price elasticity of demand at any point on this demand curve is thus the ratio (P/Q) at that point. A B C D E P 100 75 50 25 A B C D E...
Ch 5 answers
Path: JMU >> ECON >> 201 Fall, 2007
Description: Answers to Problems 1. Because willingness to pay for food quality is likely to be an increasing function of income, we expect patrons of the gourmet restaurant to have higher incomes, on average, than the patron of the diner. And since willingness t...
PQuiz10
Path: Wisconsin >> ECON >> 101 Spring, 2007
Description: Econ 101: Principles of Economics Korinna K. Hansen NAME: Disc. Section: Practice Quiz 10 Use clear graphs to answer the questions below. Be brief, but clear and neat. Make sure that you label all your axes and curves. 1). (4 points). True or False...
Ch 8 (partal) Answers to Problems
Path: JMU >> ECON >> 201 Fall, 2007
Description: Ch 8 Answers to Problems 1 a. False: the maxim tells us that there are no unexploited economic opportunities when the market is in long-run equilibrium. b. False: firms in long-run equilibrium have to make an accounting profit in order to cover the o...
