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Unformatted text preview: raises ‘rcent. ent)? rage? i share nt over 1e real Iductiv- re first g true? istribu— ' equals use this roups of :lin ; of hould ICCH t does rmers c HAPT ER 3 National income: Where it Comes From and Where It Goes I77 f. What do your previous answers imply for the price of haircuts relative to the price of food? g. Who benefits from technological progress in farming—farmers or barbers? 6. (This problem requires the use of calculus.) Consider a Cobb—Douglas production function with three inputs. K is capital (the number of machines), L is labor (the number of workers), and H is human capital (the number of college degrees among the workers). The production function is Y: K‘l/SLMHLG. a. Derive an expression for the marginal product of labor. How does an increase in the amount of human capital afiect the marginal product of labor? b. Derive an expression for the marginal product of human capital. How does an increase in the amount of human capital aiTect the marginal product of human capital? c. What is the income share paid to labor? What is the income share paid to human cap— ital? In the national income accounts of this economy, what share of total income do you think workers would appear to receive? (Hint: Consider where the return to human capital shows up.) d. An unskilled worker earns the marginal prodi uct of labor, whereas a skilled worker earns the marginal product of labor plus the marginak product of human capital. Using your answers to parts (a) and (b), find the ratio of the skilled wage to the unskilled wage. How does an increase in the amount of human capital affect this ratio? Explain. e. Some people advocate government funding of college scholarships as a way of creating a more egalitarian society. Others argue that scholarships help oniy those who are able to go to college. Do your answers to the precedm ing questions shed light on this debate? ' 7. The government raises taxes by $100 billion. If the marginal propensity to consume is 0.6, what happens to the following? Do they rise or fall? By what amounts? a. Puhlic saving. b. Private saving. c. National saving. d. Investment. 8. Suppose that an increase in consumer confidence raises consumers' expectations about their future income and thus increases the amount they want to consume today. This might be interpreted as an upward shift in the consumption flinction. How does this shift affect investment and the interest rate? 9. Consider an economy described by the follow— ing equations: Y: C + I + G Y: 5,000 G : 1,000 T = 1,000 C = 250 + 0.75(Y—T) I: 1,000 — 50 r. a. In this economy, compute private saving, public saving, and national saving. b. Find the equilibrium interest rate. c. Now suppose that G rises to 1,250. Compute private saving, public saving, and national saving. (1. Find the new equilibrium interest rate. 10. Suppose that the government increases taxes and govermnent purchases by equal amounts. What happens to the interest rate and investment in response to this balanced—budget change? Does your answer depend on the marginal propensity to consume? 11. When the government subsidizcs investment, such as with an investment tax credit, the subsidy often applies to only some types of investment. This question asks you to consider the effect of such a change. Suppose there are two types of investment in the economy: business investment and residential investment. And suppose that the government institutes an investment tax credit only for business investment. a. How does this policy affect the demand curve for business investment? The demand curve for residential investment? b. Draw the economy’s supply and demand for loanable funds. How does this policy affect the supply and demand for loanablc funds? What happens to the equilibrium interest rate? 78l PA RT 1: Classical Theory: The Economy in the Long Run c. Compare the oid and the new equiiibria. How does this policy affect the total quantity of investment? The quantity of business investment? The quantity of residential investment? 12. If consumption depended on the interest rate, how would that aEect the conclusions reached in this chapter about the effects of fiscal policy? 13. Macroeconomic data do not show a strong cor— relation between investment and interest rates. Let’s examine why this might be so. Use our model in which the interest rate adjusts to equi— librate the supply of loanable funds (which is upward sloping) and the demand for loanable funds (which is downward sloping). a. Suppose the demand for loanahle fimds was stable but the supply fluctuated from year to year. What might cause these fluctuations in supply? In this case, what correlation between investment and interest rates would you find? b. Suppose the supply of loanable funds was stam ble but the demand fluctuated from year to year. What might cause these fluctuations in demand? In this case, what correlation between investment and interest rates would you find now? c. Suppose that both supply and demand in this market fluctuated over time. If you were to construct a scatterplot of investment and the interest rate, What would you find? d. Which of the above three cases seems most empirically realistic to you? 114 I PA R T a: Ciassical Theory: The Economy in the Long Run KEY CONCEPTS WM Inflation Central bank Seigniorage Hyperinflation Federal Reserve Nominal and real interest rates Money Openarnarket operations Fisher equation and Fisher eflect Store of value Currency Ex ante and ex post real interest Unit of account Demand deposits rates Medium 0f exchange Quantity equation Shoeleather costs Fiat money Transactions velocity of money Menu COS“ Commodity money Income velocity of money Real and nominal yariabies Gold standard Real money balances Classical dichotomy Money supply Money demand function Monetary neutrality Monetaiy pohcy Quantity theory of money GUESTlONS FQR REVIEW W 1. Describe the functions of money. 8. List all the costs of inflation you can think of, and rank them according to how important you think they are. 9. Explain the roles of monetary and fiscal poiicy in causing and ending hyperinflations. 2. What is fiat money? What is commodity money? 3. Who controls the money supply and how? 4. Write the quantity equation and explain it. 5. What does the assumption of constant veloc1ty 10‘ Define the terms “real variable” and “nominal imply? variable," and give an example of each. 6. Who pays the inflation tax? '7. if inflation rises from 6 to 8 percent, what hapu pens to real and nominal interest rates according to the Fisher efiect? PROBLEMS AN?) APPLICATIONS Wm 1. What are the three functions of money? Which 3. A newspaper article once reported that the U.S. of the functions do the following items satisfy? economy was experiencing a low rate of Which do they not satisfy? inflation. It said that ”low inflation has a down— a. A credit card side: 45 miilion recipients of Social Security and other benefits will see their checks go up by just 2.8 percent next year.” C' A subway token a. Why does inflation aifect the increase in . In the country of Wiknam, the velocity of Social Security and other benefits? money 13 constant. Real GDP grows by 5 b. Is this effect a cost of inflation, as the article percent per year, the money stock grows by 14- suggests? Why or why not? percent per year, and the nominal interest rate 18 11 percent. What is the real interest rate? b. A painting by Rembrandt 4. Suppose a country has a money demand function (MVP)d = kif where k is a constant parameter. @UESTEONS FOR REV!EW 1. What are the net capital outflow and the trade balance? Explain how they are related. 2. Define the nominal exchange rate and the real exchange rate. cm A PTER 5 The Open Economy I151 4. If a small open economy bans the import of Japanese DVD players, what happens to saving, investment, the trade balance, the interest rate, and the exchange rate? 5. If Japan has low inflation and Mexico has high inflation, what will happen to the exchange rate between the Japanese yen and the Mexican peso? 3. If a smafl open economy cuts defense spending, what happens to saving, investment, the trade balance, the interest rate, and the exchange rate? PROBLEMS AND APPLSCATBONS 1. Use the model of the small open economy to predict what would happen to the trade bal— ance, the real exchange rate, and the nominal exchange rate in response to each of the follow~ ing events. Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find. 3. The country ofLeverett is a small open econo— my. Suddenly, a change in world fashions makes a. A fall in consumer confidence about the the exports of Leverett unpopular. future induces consumers to spend less and a. What happens in Leverett to saving, investment, net exports, the interest rate, and the exchange rate? save 1110113. . The introduction of a stylish line of Toyotas makes some consumers prefer foreign cars over domestic cars. . The citizens ofLeverett Eike to travel abroad. How will this change in the exchange rate . The introduction of automatic teller affect them? machines reduces the demand for money. . The fiscal policymakers of Leverett want to adjust taxes to maintain the exchange rate at its previous level. What should they do? If they do this, what are the overall effects on saving, investment, net exports, and the interest rate? 4. In 2005, Federal Reserve Governor Ben Bernanke said in a speech: “Over the past decade a combination of diverse forces has creat— ed a significant increase in the global supply of savingm—a global saving glut—which helps to explain both the increase in the U.S. current account deficit [a broad measure of the trade deficit} and the reiatively low level of iong—term real interest rates in the world today.” Is this statement consistent with the models you have learned? Explain. 2.. Consider an economy described by the follow— ing equations: Y = C + I + G + NX, Y = 5,000, G = 1,000, T = 1,000, C: 250 + 0.75(Y— T), I : 1,000 M 50r, NX= 500 — 5006, r z r* = 5. a. In this economy, solve for national saving, investment, the trade balance, and the equilib— rium exchange rate. . Suppose now that G rises to 1,250. Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find. ‘. Now suppose that the world interest rate rises from 5 to 10 percent. (G is again 1,000.) 5. What will happen to the trade balance and the real exchange rate of a small open economy when government purchases increase, such as during a war? Does your answer depend on whether this is a local war or a world war? 6. A case study in this chapter concludes that if poor nations offered better production efficiency and iegal protections, the trade balance in rich nations such as the United States would move toward surplus. Let’s consider why this might be the case. a. if the world’s poor nations offer better production efficiency and legal protection, what would happen to the investment demand function in those countries? in. How would the change you describe in part (a) affect the demand for ioanable funds in world financial markets? c. How would the change you describe in part (b) affect the world interest rate? d. How would the change you describe in part (c) affect the trade balance in rich nations? . The president is considering placing a tariff on the import of Japanese luxury cars. Discuss the economics and politics of such a policy. In par— ticular, how would the policy afiect the US. trade deficit? How would it affect the exchange rate? Who would be hurt by such a policy? Who would benefit? . Suppose China exports TVs and uses the yuan as its currency, whereas Russia exports vodka and uses the ruble. China has a stable money supply and slow, steady technological progress in TV production, while Russia has very rapid growth in the money supply and no technologi— cal progress in vodka production. Based on this information, what would you predict for the reai exchange rate (measured as bottles of vodka per TV) and the nominal exchange rate (measured as rubles per yuan)? Explain your reasoning. (Him: For the real exchange rate, think about the link between scarcity and relative prices.) 152! PA R T 1: Classical Theory: The Economy in the Long Run 9. Suppose that some foreign countries begin to subsidize investment by instituting an investment tax credit. a. What happens to world investment demand as a function of the worid interest rate? b. What happens to the world interest rate? c. What happens to investment in our small open economy? d. What happens to our trade balance? e. What happens to our real exchange rate? 10. “Traveling in Mexico is much cheaper now than it was ten years ago,” says a friend. “Ten years ago, a dollar bought 10 pesos; this year, a dollar buys 15 pesos.” Is your friend right or wrong? Given that total inflation over this period was 25 percent in the United States and 100 percent in Mexico, has it become more or less expensive to travel in Mexico? Write your answer using a concrete exampie—such as an American hot dog versus a Mexican taco-—that will convince your friend. 11.You read in a newspaper that the nominal interest rate is 12 percent per year in Canada and 8 percent per year in the United States. Suppose that the real interest rates are equalized in the two countries and that purchasing—power parity holds. a. Using the Fisher equation (discussed in Chap— ter 4), what can you infer about expected inflation in Canada and in the United States? b. What can you infer about the expected change in the exchange rate between the Canadian dollar and the US. dollar? c. A friend proposes a getwrich—quick scheme: borrow from a US. bank at 8 percent, deposit the money in a Canadian bank at 12 percent, and make a 4 percent profit. What’s wrong with this scheme? c H A p T E R 30 Aggregate Demand I: Building the ISWLM Model I 309 triece KEY CONCEPTS tomists - ' —_"—""""—'——"'“‘_——‘—“—— t n S on IS—LM model Keynesian cross Tax muitipiier IS cuwe Governmentipurchases multiplier Theory of liquidity preference LM curve QUESTJONS FGR REViEW mm kes _ 1. Use the Keynesian cross to expiain why fiscal interest rate. What does this explanation assume flat . policy has a multiplied effect on national about the price level? [uals ' income. 3. Why does the IS curve slope downward? 2. Use the theory of liquidity preference to explain . 4. Why does the LM curve slope upward? why an increase 1n the money supply lowers the ant, pROBLEMS AND APPLiCATEQNS . .—__.__.._—__.._____—__“___ K"? 1. Use the Keynesian cross to predict the impact where Tand t are parameters of the tax Code, on equilibrium GDP Of The parameter t is the marginal tax rate: if LtiOl’l ' a. An increase in government purchases. income rises by $1: {”35 rise by 5 X 551- b. An increase in taxes. a. How does this tax system change the way ' . . . t' nd t h ' GDP? Le c. Equal—Sized increases 1n both government consump ion respo S O C anges in t purchases and taxes. b. In the Keynesian cross, how does this tax system alter the government—purchases 2.. In the Keynesian cross, assume that the consumption fiinction is given by ,hip C = 200 + 075 (Y— T). c. In the IS—LM’ model, how does this tax sys— multipher? . , tern alter the 310 e of the IS curve? e5 Planned investment 15 100; government p purchases and taxes are both 100‘ 4. Consider the impact of an increase in ‘e . _ thriftiness in the Ke nesian cross. Su ose a. Graph planned expenditure as a function of V pp _ the consumption function is income. 11d CZE-FdY—T), b. What is the equilibrium levei of income? m . where C is a parameter called autonomous c. If government purchases increase to 125, consumption and c is the marginal propensity to i _ what is the new equilibrium income? consume. i z _ d. What level of government purchases is need— a. What happens to equilibrium income when r, 1 ' ed to achieve an income of1,600? the society becomes more thrifty, as i 3. Although our development of the Keynesian represented by a decline in E? i cross in this chapter assumes that taxes are a b, What happens to equilibrium saving? ‘ fixed amount, in many countries (including the United States) taxes depend on income. Let’s represent the tax system by writing tax c. Why do you suppose this result is called the paradox cf thrfli‘? revenue as (1. Does this paradox arise in the classical model i T T + tY of Chapter 3? Why or why not? 310i PA 12 T IV Business Cycle Theory: The Economy in the Short Run 5. Suppose that the money demand function is b. What is the equilibrium interest rate? (M/P)d = 1,000 * 10015 C. Assume that the price ievel is fixed. What where r is the interest rate in percent. The happens to the equilibrium interest rate if the money supply M is 1,000 and the price level P supply of money is raised from 1,000 to is 2. 1,200? 9.. Graph the supply and demand for real money d. If the Fed wishes to raise the interest rate to 7 balances. percent, What money supply should it set? 336! PA R T :V Business Cycle Theory: The Economy in the Short Run 4. Expansionary fiscal policy—en increase in government purchases or a decrease in taxesfishifts the IS curve to the right. This shift in the IS curve increases the interest rate and income. The increase in income represents a rightward shift in the aggregate demand curve. Similarly, contractionary fis— cai policy shifts the IS curve to the left, lowers the interest rate and income, and shifts the aggregate demand curve to the left. 5. Expansionary monetary policy shifts the LM curve downward. This shift in the LM curve lowers the interest rate and raises income. The increase in income represents a rightward shift of the aggregate demand curve. Similarly, contractionary monetary policy shifts the LM curve upward, rais— es the interest rate, lowers income, and shifts the aggregate demand curve to the left. KEY CONCEPTS Monetary transmission Pigou eEect Debt—deflation theory mechanism QUEQTEONS FOR REVEEW ________________________.___...._—_.——-—-————-——--——- 3. What is the impact of a decrease in the money supply on the interest rate, income, consumption, and investment? 1. Explain why the aggregate demand curve siopes downward. 2. What is the impact of an increase in taxes on the interest rate, income, consumption, and investment? 4. Describe the possibie effects of falling prices on equfiibrium income. PROBLEMS ANS} APPLICATJON$ 1. According to the ISWLM model, What happens in the short run to the interest rate, income, consumption, and investment under the follow— ing circumstances? a. The central bank increases the money supply. b. The government increases government purchases. C. Th6 gOVCIDIHCIlt increases taxes. (1. The government increases government purchases and taxes by equal amounts. 2. Use the IS—LM model to predict the effects of each of the following shocks on income, the interest rate, consumption, and investment. In each case, explain what the Fed should do to keep income at its initial level. a. After the invention of a new high—speed computer chip, many firms decide to upgrade their computer systems. b. A wave of credit—card fraud increases the fre— quency with which people make transactions in cash. . A best-seller titled Retire Rich convinces the public to increase the percentage of their income devoted to saying. 3. Consider the economy of Hicksonia. a. The consumption fianction is given by C = 200 + O.75(Y— T). erc ;s a fis— )me, ift se rais— rve )ney BS 011 pgrade 1e fre— ictions .3 the air c H A P T E R 11 Aggregate Demand ll: Applying the IS—LM Model I 337 The investment function is I = 200 — 25r. Government purchases and taxes are both 100. For this economy, graph the IS curve for r ranging from 0 to 8. b. The money demand function in Hicksonia is (iii/P)d = Y — 100x The money supply M is 1,000 and the price level P is 2. For this economy, graph the LM curve for r ranging from 0 to 8. c. Find the equilibrium interest rate r a...
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