ECON 1150 Honors Macroeconomics v. 2A posted November 24 th 2013 Fall 2013

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1 ECON 1150 Honors Macroeconomics v. 2A posted November 24 th 2013 Fall 2013 Review Sheet for Quiz 5 Monday November 25 th, please review before lecture Thursday, a few questions for Chapter 21 to follow, in reading chapter 21 focus on fiscal policy and the multiplier, the money supply/interest rate discussion is a little out of date. The first 2-3 are QFRs from Chapter 20, page 458. them carefully, ordering the effects in terms of strength in the United States, keep these strong movers along in mind for LDQ Previewing the LDQ-21 questions will be especially helpful for Monday s Quiz. This is most of the material covered on Quiz 5. Please ask about any of this material before Monday s quiz. There is a practice quiz for Chaper 21, and some short answer questions below, There are also few MC questions for Chapter 20 below. s to all of these questions are below as well. s to the practice quiz for Chapter 21 are below as well. Turnitin.com: Typed answers in the standard format for LDQ 20-3, 21-1 and 21-2 can be turned in for HW credit by end of day Tuesday, on turnitin.com, particularly if you need HW points. Part I: Lecture and discussion question (related to lecture notes). LDQ 20-1 and QFR 20-3: List and explain the three reasons the AD (aggregate demand) curve slopes down. Order these three effects in terms of their strength in the United States LDQ 20-2 and QFR 20-5 A) List and explain the three effects of a higher price level that make the shortrun aggregate-supply curve is upward sloping. Order these three effects in terms of their strength in the United States. B) Briefly, explain why the long-run aggregate-supply curve is vertical at full employment (more or less). LDQ 20-3 Below in description of Figure 1 is the Mankiw Chapter 20 story of a loss of confidence recession story. From full employment point A, AD shifts left causing prices to fall, with the economy coming to rest in a recession at point B. Then with time prices fall further and economy moves alone the AD curve as the SRAS curve shifts to the right, ending the recession. (a) What is the main mover or movers of the economy down the AD curve (see the reasons the AD slopes down ). Why did these three movers fail to work post 2008 (or did they/). (b) Did falling prices help Greece and Spain exit their depression? Have they exited? Have their prices fallen (are their Lattes the cheapest in Europe?) LDQ 21-1 Keynesians (as in PK) do not see recessions as bouts of deflation followed by more deflation, are therefore much more likely to jump to step iv as soon as a recession officially begins, as discussed toward the end of Mankiw Chapter 21 and Chapter 2 of Krugman, (a) Why did members of the Capitol Hill Baby Sitting Co-op stop going out on weekends? Distinguish this liquidity crisis from the liquidity preference theory of money discussed in Chapter 21. They are related no? But why might higher interest rates (a tax on unused tickets) not solve the going out problem? What was the solution to babysitting crisis? (b) Were the Co-op couples insolvent or just illiquid? (How do you know? see Blinder, 2013 on liquidity vs. solvency crises 1 page ) Was the solution to the babysitting crisis analogous to a helicopter money drop or exercise of the Bagehot principal, or was it more like quantitative easing (Careful, what matters here is not your answer, but how you justify it what happens when someone leaves the club?) 1 Blinder, 2013, Liquidity crisis See also Bailouts AIG, 135 Bagehot principal, 94, 97, 104 Bear Stearns, danger of, 104 Fed initial actions, insolvency versus illiquidity, preventing, regulatory needs, , , 308 Blinder, Alan S. (2013). After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead Penguin Group US.

2 LDQ 21-2 a) Discuss what makes the fiscal multiplier large or small (start with formula) making reference to crowding in and crowding out? Is the fiscal multiplier likely to large or small in the U.S. and EU right now? B) (hard) Use the general formula for the multiplier Y = x* G where x the fiscal multiplier with G financed entirely by new government debt ( D = G) to discuss whether fiscal stimulus will increase or decrease debt to GDP (D/Y). C) (harder, almost impossible until you see it in lecture). Why does an increase in government spending financed entirely by new income taxes still stimulate the economy (is greater than 1). What is this multiplier called? Part II: Short s from Chapter 21 (see answers at the end of this review sheet, SAQ Suppose that the government spending increases to build a new ship (the LPD SSS New York, for example, made with 6 tons of steel from the WTC) or the new 2 nd Avenue subway (Q trains) or extension of the air train at JFK. A) What does this do to aggregate demand? How is your answer affected by the presence of the multiplier, crowding-out or crowding in, high unemployment, taxes, and investment-accelerator effects (see part B before you answer)? B) Why does the opportunity real cost of public works or defense spending fall when unemployment is high? Assuming both types of projects take many years to complete, why is it better to start them during a recession or period of high unemployment (low inflation) SAQ: Suppose that there are no crowding-out effects and the MPC is.9. By how much must the government increase expenditures to shift the aggregate demand curve right by $10 billion? SAQ Suppose government expenditures increase by $150 billion while increasing taxes by $150 billion. Suppose that the MPC is.80 and that there are no crowding out or accelerator effects. What is the combined effects of these changes? Why is the combined change not equal to zero? SAQ Suppose that consumers become pessimistic about the future value of there assets (stocks, bonds and houses). A) What will happen to aggregate demand and to output? What might the president and Congress have to do to keep output stable? B) Relate this to what happened in the Washington Babysitting Co-op, why did people stop going out? What was done to restore their confidence and get them going out again? Was this a permanent transfer? Was it like a helicopter money drop? (yes and no, explain). SA Explain how unemployment insurance acts as an automatic stabilizer, especially if the government extends benefits during a period of high unemployment. B) Is unemployment insurance welfare (a transfer from the government?). Why is this particular transfer (extended benefits) well targeted to deal with recessions (or jobless recoveries)? What is the disadvantage of extending benefits during a recession?

3 Part II. Short quiz review answers AQ-21-8 : The increase in expenditures means that government spending rises. The aggregate demand curve shifts to the right. Aggregate demand shifts farther if there is a multiplier effect or an investment accelerator and shifts less if there is crowding out or if taxes are raised to increase government expenditures. B) High unemployment reduces the opportunity cost of ships and public works, because unemployment is high and factories may have extra capacity (and construction workers are unemployed). Also interest rates are low (nominal and real) so the cost of financing the construction of ships or subways falls. On the other hand, these projects take a long time to set up and complete, so the recession may be over by the time this large projects come on line. Also government my place a high priority on these projects, so it cannot wait for a recession to build them. The fiscal stimulus spending in required projects to already be DIF: 2 REF: Chapter 21-2, Analytic, Monetary and fiscal policy Multiplier effect Crowding out Investment ANS 21-9 : An MPC of.9 means the multiplier = 1/(1 -.9) = 10. The increase in aggregate demand equals the multiplier times the change in government expenditures. So to increase aggregate demand by $10 billion, the government would have to increase expenditures by $1 billion. DIF: 2 REF: Chapter 11-2 Analytic Monetary and fiscal policy, Multiplier effect, Analytical SAQ-20-10: The multiplier is 1/(1-MPC) = 1/(1-.8) = 1/.2 = 5. The increase of $150 in government expenditures leads to a shift of $150 billion x 5 = $750 billion in aggregate demand. The increase in taxes decreases income by $150 and so initially decreases consumption by $150 billion x MPC = $150 billion x.8 = $120 billion. This change in consumption will create a multiplier effect of $120 billion x 5 = $600. The net change is $750 billion - $600 billion = $150 billion. The changes don t cancel each other out because a tax increase decreases consumption by less than the tax increase, this is because households always save part of a tax cut, whereas the government spends it all (even the part of tax cut consumers would have saved). DIF: 3 Chapter21-3 Analytic Monetary and fiscal policy, Multiplier effect, Taxes SAQ-20-11: : As consumers become pessimistic about the future of the economy, they cut their expenditures so that aggregate demand shifts left and output falls. The president and Congress could adjust fiscal policy to increase aggregate demand. They could either increase government spending, or cut taxes, or both. See Krugman, 2013 Chapter SA As income falls, unemployment rises. More people will apply for unemployment compensation from the government which raises government spending. An increase in government spending tends to increase aggregate demand, output, and income thereby lessening the effects of the recession. Normally unemployment insurance is self-financing, it is just what it says insurance. But during a recession the government can convert it into a transfer, by extending benefits. Chapter: 21-3 Analytic Monetary and fiscal policy Topic: Automatic stabilizers

4 Quiz Review Section III. The following is largely from the instructor s manual, sorry for the typos. i. Recession and Recovery Example: Starting with full employment at point A, suppose pessimism causes household spending and investment to decline, causing the AD (aggregatedemand) curve to shift to the left. In the short run, both output and the price level fall. This drop in output means that the economy is in a recession, stuck at point B. ii. In the long run, the economy will move back to the natural rate of output. a. People will correct the misperceptions, sticky wages, and sticky prices that cause the aggregate-supply curve to be upward sloping in the short run. b. The expected price level will fall, shifting the short-run aggregate-supply curve to the right returning the economy to full employment, point C, eventually. FIGURE 1 B A C iii) In the long run, the decrease in aggregate demand can be seen solely by the drop in the equilibrium price level from A to C. Thus, the long-run effect of a change in aggregate demand is a nominal change (in the price level) but not a real change (output is the same). iv) Instead of waiting for the economy to adjust on its own, policymakers may want to eliminate the recession by boosting government spending or increasing the money supply. Either way, these policies could shift the aggregate demand curve back to the right.

5 Part IV: s for Review Chapter 20 MC From 2007 to 2008 there was a dramatic fall in the price of houses. If this fall made people feel less wealthy, then it would have shifted a. aggregate demand right. b. aggregate demand left. c. aggregate supply right. d. aggregate supply left. MC When taxes decrease, consumption a. increases, so aggregate demand shifts right. b. increases, so aggregate supply shifts right. c. decreases, so aggregate demand shifts left. d. decreases, so aggregate supply shifts left. MC In 2009 Congress passed legislation providing states with funds to build roads and bridges. It also insti-tuted tax cuts. Which of these shifts aggregate demand right? a. only the increased funding for states b. only the tax cuts c. both the increased funding for states and the tax cuts d. neither the increased funding for states nor the tax cuts MC At the end of World War II many European countries were rebuilding and so were eager to buy capital goods and had rising incomes. We would expect that the rebuilding increased aggregate demand in a. both the United States and Europe. b. the United States but not Europe. c. Europe, but not the United States. d. neither the United States, nor Europe. MC The long-run aggregate supply curve shifts right if a. immigration from abroad increases. b. the capital stock increases. c. technology advances. d. All of the above are correct. MC-20-9.The long-run aggregate supply curve shifts left if a. the capital stock increases. b. there is a natural disaster. c. the government removes some environmental regulations that limit production methods. d. None of the above is correct. MC The long-run aggregate supply curve shifts right if a. immigration from abroad increases. b. the capital stock increases. c. technology advances. d. All of the above are correct. MC-20-9.The long-run aggregate supply curve shifts left if a. the capital stock increases. b. there is a natural disaster. c. the government removes some environmental regulations that limit production methods. d. None of the above is correct.

6 MC An innovation that makes accessible large reserves of previously-unrecoverable natural gas in the U.S. would shift a.the long-run aggregate-supply curve to the right. b.the long-run aggregate-supply curve to the left. c.the aggregate-demand curve to the left. d.none of the above is correct. MC Since the end of World War II, the U.S. has almost always had rising prices and an upward trend in real GDP. To explain this a. it is only necessary that long-run aggregate supply shifts right over time. b. it is only necessary that aggregate demand shifts right over time. c. both aggregate demand and long-run aggregate supply must be shifting right and aggregate demand must be shifting farther. d. None of the above cases would produce rising prices and growing real GDP over time. MC Sticky nominal wages can result in a. lower profits for firms when the price level is lower than expected. b. a decrease in real wages when the price level is lower than expected. c. a short-run aggregate-supply curve that is vertical. d. a long-run aggregate-supply curve that is upward-sloping. -MC LATA Wages tend to be sticky because of a.labor contracts and social norms. b.efficiency wage considerations, it is very hard to supervise employees every minute c.notions of fairness and loyalty of employers to their employees d. Workers may reduce effort or look for another job if their nominal wage falls. e. As long as there is some inflation, real wage costs fall even if employers leave wages unchanged, so why demoralize workers by lowering nominal wages -MC A Recession in China or India would cause a.a rise in the U.S. price level and real GDP and fall in the U.S. RER. b.a fall in the the U.S. price level and NX (real GDP) and the U.S. RER to appreciate. c.the U.S. price level to rise and real GDP to fall. d.the U.S. price level to fall and real GDP to rise. MC In the first few years of the Great Depression, unemployment rose to about a. 10 percent, and prices rose about 14 percent. b. 15 percent, and prices rose about 22 percent. c. 20 percent, and prices fell about 14 percent. d. 25 percent, and prices fell about 22 percent. MC Which of the following by itself is consistent with the directions that the price level and real GDP changed at the onset of the Great Depression? a.aggregate demand shifted right b.aggregate demand shifted left c.aggregate supply shifted right d.aggregate supply shifted left MC Suppose that during the Great Depression long-run aggregate supply shifted left. To be consistent with what happened to the price level and output, what would have had to happen to aggregate demand? a.it would have to have shifted left by less than aggregate supply. b.it would have to have shifted left by more than aggregate supply.

7 c.it would have to have shifted right by less than aggregate supply. d.it would have to have shifted right by more than aggregate supply. MC During World War II, a. government purchases of goods and services increased fivefold. b. the economy's production increased about 25 percent. c. unemployment fell to about 5%. d. All of the above are correct. MC During World War II, the economy's production increased about a. 25 percent and prices rose about 5 percent. b. 50 percent and prices rose about 10 pernt. c. 75 percent and prices rose about 15 percent. d. 100 percent and prices rose about 20 percent.

8 Part IV Chapter 20 s s MC ANS: A PTS: 1 DIF: 1 REF: 20-3 TOP: Aggregate demand shifts Housing prices MSC: Applicative MC ANS: A PTS: 1 DIF: 2 REF: 20-3 NAT: Analytic LOC: Monetary and fiscal policy TOP: Aggregate demand shifts Fiscal policy MSC: Applicative MC ANS: C PTS: 1 DIF: 2 REF: 20-2 TOP: Aggregate demand shifts Fiscal policy MSC: Applicative MC ANS: A PTS: 1 DIF: 2 REF: 20-3 TOP: Aggregate demand shifts Investment Net exports MSC: Applicative MC-20-8 ANS: D PTS: 1 DIF: 1 REF: 20-4 TOP: Long-run aggregate supply shifts MSC: Applicative MC-20-9 ANS: B PTS: 1 DIF: 1 REF: 20-4 TOP: Long-run aggregate supply shifts MSC: Applicative * MC ANS: A PTS: 1 DIF: 2 REF: 20-4 TOP: Long-run aggregate supply shifts MSC: Interpretive MC ANS: C PTS: 1 DIF: 3 REF: 20-4 TOP: Growth and inflation MSC: Applicative MC ANS: A PTS: 1 DIF: 2 REF: 20-4 TOP: Sticky-wage theory MSC: Interpretive MC ANS: B DIF: 1 REF: 20-5 NAT: Analytic LOC: Aggregate demand and aggregate supply TOP: Aggregate demand shifts Net exports MSC: Applicative

9 MC ANS: D DIF: 1 REF: 20-5 NAT: Analytic LOC: Aggregate demand and aggregate supply TOP: Great Depression MSC: Definitional MC ANS: B DIF: 2 REF: 20-5 NAT: Analytic LOC: Aggregate demand and aggregate supply TOP: Great Depression MC ANS: B DIF: 3 REF: 20-5 NAT: Analytic LOC: Aggregate demand and aggregate supply TOP: Great Depression MSC: Applicative MC ANS: A DIF: 2 REF: 20-5 NAT: Analytic LOC: Aggregate demand and aggregate supply TOP: World War II MSC: Definitional MC ANS: D DIF: 2 REF: 20-5 NAT: Analytic LOC: Aggregate demand and aggregate supply TOP: World War II MSC: Definitional If you can volunteer or bring a dish, please Elvia at address below (mention Fordham). The location is a few blocks from Fordham, near the Armory and Lehman College, at 2757 Morris Ave, Bronx NY

10 Multiple Choice: 21-1: Which of the following is likely more... Which of the following is likely more important for explaining the slope of the aggregate-demand curve of a small economy than it is for the United States? the interest-rate effect the wealth effect the exchange-rate effect the real-wage effect Multiple Choice: 21-2 Monetary Policy: Monetary policy must Monetary policy must Correct Feedback any or all of the above target interest-rates. Target the supply of money (M1 or M2) Target an inflation rate. Think about the evolution of U.S. monetary pollicy over the past 40 years. Incorrect Feedback 3. Multiple Choice: 21-3: 21-2 Think about the evolution of U.S. monetary pollicy over the past 40 years The theory of liquidity preference is most helpful in understanding the interest rate effect on the demand for money. the wealth rate effect on the demand for money. the exchangre rate effect on the demand for money. the effect of misperceptions regarding relative prices on the demand for money 4. Multiple Choice: 21-4 Liquidity: The liquidity preference theory of The liquidity preference theory of money demand (due to Keynes) says people will hold less money if, 5. the interest rate rises, which causes the opportunity cost of holding money to rise. the interest rate falls, which causes the opportunity cost of holding money to rise. the interest rate rises, which causes the opportunity cost of holding money to fall. the interest rate falls, which causes the opportunity cost of holding money to fall.

11 Multiple Choice: 21-5: According to the theory of liquidity A situation in which the Fed s target interest rate has fallen as far as it can fall is sometimes scribed as a a liquidity trap the preference for liquidity deflation or disinflation 21-5 According to the theory of liquidity preference, the interet rate adjusts to balance the supply and demand for money make the quanitity of loanable funds supplied (savings) equal the demand for I and NCO reflect the real interest rate plus the expected inflation rate make investment which depends on r equal savings which depends on real GDP (the IS curve) 21-6 Paul Samuelson, the first American Economist to win the Nobel prize in 1970, uncle of Larry Summers,* once said that, (*why don't they have the same name?) Correct Feedback Incorrect Feedback Correct Feedback Incorrect Feedback the stock markt has predicted nine out of the past five recessions. the bond market has predicted zero out of the past nine recessions. the stock market has predicted zero out of the past nine recessions. the bond market has predicted nine out of the past five recessions. The same can be said of Dr. Doom, ask Warren Buffet The same can be said of "Dr. Doom", ask Warren Buffet 21-7 The multiplier relating changes in government spending to changes in GDP is calculated as 1/MPC 1/MPS (1-MPC)/MPC 1/(1-MPC) What makes the fiscal multiplier greater or less than one? If the change in G is financed with new Government debt, what happens to the debt to GDP ratio when the fiscal multiplier is greater than one (or less than one)? See lecture notes. What makes the fiscal multiplier greater or less than one? If the change in G is financed with new Government debt, what happens to the debt to GDP ratio when the fiscal multiplier is greater than one (or less than one)? See lecture notes.

12 Correct Feedback Incorrect Feedback 21-8 LATA The government builds a new walk way along the Hudson. The owner of the company that builds the plant pays her workers. The workers spend their pay on lunch, but do not have time to go far from the job. The vendors that sell food to the workers buy another food truck to park near the river and hire more workers. This sequence of events illustrates the crowding out effect of higher government spending. the multiplier effect of government spending the Fisher effect as food price inflation increases the potential "crowding in" impact of fiscal stimulus, especially when unemployment is high. When is crowding in more likely than crowding out? When is crowding in more likely than crowding out? 21-9 Which of the following illustrates how the investment accelerator works? Correct Feedback Incorrect Feedback An increase in government expenditures increases aggregate spending so that the In and Out sign and entry way. An increase in government expenditures increases the interest rate so that In and Out burgers de An increase in government expenditures increases the interest rate so that the demand for stock An increase in government expenditures decreases the interest rate so that In and Out burgers The investment accelerator can raise the fiscal multiplier and make crowding out less likely (in fac driving to one late at night). Tourists from Europe on the SFO shuttle rave about their food (wha The investment accelerator can raise the fiscal multiplier and make crowding out less likely (in fac driving to one late at night). Tourists from Europe on the SFO shuttle rave about their food (wha The most important automatic stabilizer is income and sales taxes unless governments balance their budgets. open-market operations. unemployment compensation, the EITC and food stamps welfare and WIC benefits. Other things the same, automatic stabilizers tend to raise expenditures during recessions and lower expenditures during expansions. raise expenditures during expansions and recessions. lower expenditures during expansions and recessions. raise expenditures during expansions and lower expenditures during recessions It is likely that a constitutional amendment that requires the Federal government alwa its balanced budget would eliminate the economy s automatic stabilizers, making booms longer and recessions deeper. contribute to a more stable level of output over the business cycle. mitigate crowding-out but not the crowding in effect. all of the above

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