Case, Fair and Oster Macroeconomics Chapter 12 Problems -- Aggregate Demand in the Goods and Money Markets

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1 Case, Fair and Oster Macroeconomics Chapter 12 Problems -- Aggregate Demand in the Goods and Money Markets Problem 1. ECB cuts interest rates -- why? Faced with a recession, the European Central Bank cut interest rates -- intending that the cut would lead firms to step up investment and the added investment to have a multiplier effect on GDP. Problem 2. Federal Reserve, interest rates cuts and housing. See next page: graphs require full page. Problem 3. Japanese 1997 tax increase and recession. Why might the tax increase have precipitated a recession? Simple: tax increase on consumers leads to less disposable income, which leads to less consumption spending. The Bank of Japan could have attempted to keep up investment spending by pursuing lower interest rates in response. Problem 4. Animal Spirits and Investment We noted in class that the phrase was from Keynes' General Theory, and that Keynes was not comfortable with what he saw as the excessive emphasis on interest rates as the only factor behind investment. The phrase also appears as the title of the very readable book on the importance of psychology in micro- and macroeconomics by George Akerlof and Robert Shiller, Animal Spirits: How Human Psychology Drives the Economy and Why it Matters for Global Capitalism (2010). If you take the position (neither Keynes, nor Akerlof and Shiller did) that interest rates do not matter at all for investment, the planned investment schedule in text graph 12.1 would be a vertical line, which would shift left or right as animal spirits changed, but would not respond to any change in interest rates. As a result, monetary policy, which works by changing the interest rate, would be ineffective. The graphs for problem 2 (on the next page) suggest that this may have been the case in Problem 5. Fiscal and Monetary Policy Shifts. A. Tight monetary policy will raise interest rates, reduce investment, and hence reduce GDP. Income tax cuts will force the government to borrow more, hence increase interest rates; the tax cut will also increase spending, hence tending to increase GDP. Interest rates certainly increase, but the impact on GDP is uncertain. B. Tax cuts with unchanged monetary policy will definitely increase both interest rates and GDP C. A tax increase will tend to lower both interest rates and GDP; a monetary policy expansion will also lower interest rates, but increase GDP. Interest rates will certainly decrease, but the impact on GDP is uncertain. D. A drop in consumer confidence leading to a drop in consumption will certainly reduce GDP and (since some consumption is paid for with borrowed money) will lead to a drop in interest rates as well. E. Expansionary monetary policy will lower interest rates, but if business pessimism about the future profitability of investment stays unchanged, may not lead to any large increase in investment. See the graphs at the end of the next problem for an illustration of this from the last recession, using the Fed Funds rate and rates on BBB (good quality, but not the best, corporate bonds) and CCC (high-yield or junk bonds.

2 Problem 2. The Federal Reserve, Housing and Interest Rate cuts. In 2007, the Fed cut interest rates to try to offset the drops in investment by firms and housing construction. The lower targets for the Fed Funds rates have been blamed for inflating the housing bubble which led to the recession in late 2007 and (The text question, Did the Fed achieve its goal? has the clear answer: NO ). The Fed response to the recession was to cut Fed Funds rates much more sharply than in The graphs below show two problems: 1. The Fed Funds rate cut did NOT translate into any big impact on mortgage rates. 2. Since banks were reluctant to lend (to people who might lose their jobs in the recession), housing starts fell sharply even though mortgage rates remained the same or fell slightly. The first graph shows FEDFUNDS and MORTG interest rates; the second HOUST (new housing starts) both over the last 5 years ( ): From problem 2, note that expansionary monetary policy may also not work well in increasing investment.

3 E. Expansionary monetary policy will lower interest rates, but if business pessimism about the future profitability of investment stays unchanged, may not lead to any large increase in investment. See the graphs at the end of the next problem for an illustration of this from the last recession, using the Fed Funds rate and rates on BBB (good quality, but not the best, corporate bonds) and CCC (high-yield or junk bonds. Note especially the increase in the interest rate spreads between good quality and less good quality corporate bonds: Investment may respond to the interest rate -- but Fed policy cannot easily control the interest rates easily, and in face of the massive uncertainty of 2008, interest rates rose very steeply (to 45 percent on CCC bonds!) despite Fed cuts to the Federal Funds rate.

4 Problem 6. FOMC interest rate targeting This problem assumes the FOMC will keep the interest rate constant. It would therefore: A. React to an increase in investment (which would be graphed as a shift in the investment curve) by expanding the money supply to keep the interest rate from rising. This would result in a movement down the investment curve, increasing investment by more than a simple shift would have, and so a greater increase in investment and GDP than would otherwise have taken place. As a result of the increase in GDP, consumption, savings, and money demand will all also increase. This last will lead to some increase in the interest rate, which may require the Fed to expand the money supply still more. B. A bank failure causes an increase in the demand for money -- that is, savings accounts are cashed in. This can be read as an increase in k in our money demand equation Md = k * PY / r Absent a change in PY, or in Ms, r must increase. The Fed can try to make the change in r unnecessary by expanding the money supply. Problem 7. Paranoia and Penguins Paranoia experiences a sharp decline in investment spending, due to fear of a penguin attack. A. With no policy response, the fall in GPDI will lead to a sharp drop in GDP (multiplier effect). The drop in GDP will mean a drop in disposable income, and hence in both consumption and savings. Interest rates will fall, since firms will not be seeking loans to finance investment, though this may be offset by the drop in savings (which would tend to raise interest rates). The quantity of money demanded would increase if the fall in interest were the only consideration; but money demand will also decline due to the fall in GDP, and the final impact on money demand is uncertain. B. Possible policy offsets, ranked from most to least expansionary: 1. Balanced budget increase in government spending, matched by an increase in taxes. The balanced budget multiplier with lump-sum taxes is only one. 2. Increase in government spending financed by borrowing: the increase in interest rates due to government borrowing will crowd out some private investment; the multiplier will be greater than one, but will be less than the simple Keynesian model predicts. 3. Increase in government spending financed by printing money: the tendency of the government borrowing to raise interest rates will be countered by the expansion of the money supply, which will keep interest rates lower unless the monetary expansion leads to fears of inflation and hence (through the Fisher effect), an increase in nominal interest rates.

5 Problem 8. Investment -- Not responding to interest rates? A. During a recession, the normal impact of lower interest rates (more investment) may be offset by: 1. Worsening expectations of the profitability of investment. 2. Credit rationing by banks which want to protect their own position. B. During a boom, the normal impact of higher interest rates (less investment) may be offset by: 1. Improving expectations of future profitability. 2. Increased readiness to lend by banks which share those expectations, and think that there will be little danger of default. Problem 9. Explaining the slope of the Aggregate Demand Curve. Higher price levels cause movements ALONG, not a SHIFT IN, AD. They do so not because people cannot afford to buy GDP (wages rise with prices in the long run), and not because people substitute other goods (there are no other goods aside from GDP), but because of: A. the interest rate effect: Higher prices increase the demand for money, hence raising interest rates. Investment and some interest-sensitive consumption will be reduced. B. the real wealth or real balance effect: Higher prices reduces the value of money in savings accounts or of bonds promising to repay a given amount of money. With less real wealth (or real money balances), consumption will be reduced.