Exam 2 Answers EC 302 Intermediate Macroeconomics Prof. Michael McElroy Spring 2017

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1 Exam 2 Answers EC 302 Intermediate Macroeconomics Prof. Michael McElroy Spring 2017 Brief answers to the 6 questions on Exam 2. Each is either an explicit application of IS-LM, AD/AS or based on one of the It depends discussions about fiscal policy impact and sustainability. Below I just outline the answers I was looking for. I leave it to you to draw the graphs, shift the curves, and confirm the outcomes. 1. Now that the economy has finally returned to full employment, suppose consumers, remembering the long recession and uncertain about what events and policies may lie ahead, decide to cut back (autonomous) consumption spending to increase their savings for the future. Use the full macro model to answer the questions below. a. What short and long run impacts would you expect this increased saving to have on the macroeconomy, specifically on y, P, r, i, x, and b? Use the model and explain. Starting at y* in the twin graphs, the drop in c 0 means a - z 0 so both the IS and AD curves shift to the left to a short run equilibrium with - y, - r (as IS slides down LM), P=0 (by our definition of the short run). The increased saving and reduced consumption spending contracts the economy. Those changes also bring + i, + x, and + b in the short run (explain through underlying equations). The long run is about flexible prices and market-clearing as P drops and we slide down AD to its intersection with AS*. The long run outcome is y=0, - P, -- r (since the fall in P shifts LM out and it slides down the IS curve), + i, + x, and b=0. b. In the long run, where did the resources no longer needed to produce so many consumer goods and services end up going? In other words, are they unemployed or reallocated and, if so, where? Be specific and use the model to explain your reasoning. As can be seen in part a), this increased saving through reduced consumption leaves some resources (labor, capital etc.) unemployed in the short run. In the long run, we return to y* and full employment. Where have the inputs no longer needed for consumption gone? They have moved into private investment and net exports, i.e., - c has moved to + (i+x). Put another way, our increased savings has gotten channeled, due to - P and r, into domestic investment and net foreign investment in response to our decision to become bigger savers. c. The President asks you whether there are policy changes that he could make at the outset to offset or minimize any adverse impacts of this decline in consumer spending. What, if any, policy changes would you recommend? Explain your reasoning and use the model. President and Congress control fiscal policy. A straightforward response would be to respond quickly to the c 0 with some combination of + g 0 and - t 0. Either policy change offsets the initial leftward shift in IS and AD if done in a timely fashion and with a measured response that stops at y*. Trying to offset unwanted drops in AD rather than going through a recession to finally get a long run return to y* is the goal of macro stabilization policy. 2. Suppose that in the next election voters across the spectrum agree that our taxes and the government s budget deficit are both unacceptably high. They elect a President who makes reducing taxes and budget deficits her top economic priority. a. Using the full model to guide your explanation, what fiscal policy action, if any, could accomplish both these goals and what would be its short and long run implications for y, P, r, c, i, and x? Be specific and explain. The government budget constraint shows that g = t + b. To cut both taxes and current borrowing is possible only by cutting current spending. This is what I discussed as a true tax cut (- t & - g) as opposed to a tax postponement (- t & + b). [Supply siders assert, without evidence, that the - t will cause such a large supply side + AS* and + y* that the cut in tax rates will be self-financing because of the higher tax rate. Though politically popular, it falls in the smoke and mirrors category among macroeconomists.] The outcome of this contractionary fiscal policy is a leftward shift in IS and AD with the usual short and long run consequences, like part a) above, which you needed to show and explain.

2 b. Drawing on relevant material from class or readings, address the question of taxes in the US being too high. Although typically viewed as simply a matter of opinion, what is the economic substance behind the logic and facts of the level of taxes? Be specific, complete, and explain. The article by Bruce Bartlett addressed this directly. You might also refer to some of the readings on how supply-side enthusiasts have asserted that taxes are so high that they reduce tax revenues. Another point that could be made here, but not required, is that our taxes, now or merely postponed, always equal our level of spending since g = t + b. We re never talking about tax cuts with everything else the same, i.e., a free lunch. It s always either cut taxes and reduce government spending and the income that provides or cut taxes and postpone them by issuing bonds (promises to tax later). Overall, US taxes per person, as Bartlett shows, are quite low compared to other industrial nations. That means so is government spending per person. c. Most people believe continuing US budget deficits are undesirably large and inconsistent with a responsible, far-sighted fiscal policy. Such views are often just asserted rather than built around a solid notion of how we can know when a budget deficit is or isn t too high. Again, bring some economic substance into the topic by discussing the logic and facts behind whether or not deficit financing is short-sighted and damaging to our future. Be specific and explain. This is our it depends Question 4. I wanted you to explain the reasoning underlying the depends on how the borrowed funds are used and show that b > 0 may or may or may not be sustainable but b k = b - g i >0 is not. As far as the underlying facts as to whether our current national debt is selffinancing (rather than consumption-draining), there is no official, reliable measure of government investment spending and therefore no b k to turn to. As discussed in Chapter 5 and in class, this is where the role of the key ratios (b/y, nd/y, etc.) come into play. When borrowing gets into the spending beyond our means category, these ratios will increase at an exponential rate as we continue to add more to future liabilities than to current productive capacity. 3. Suppose the economy is in a lingering recession and it s an election year. Three leading candidates emerge a macro policy Activist, a macro policy Non-Activist, and a Protectionist. a. What specific proposal for economic recovery might the Activist propose for economic recovery? Using the full model, what impact would you expect this policy to have on y, P, r, x, and b? Use the model and explain your reasoning. We start below full employment so the initial point on the graphs is at y < y*. Rather than wait for market-clearing, the Activist approach is to use macro policy stimulus (fiscal and/or monetary) to shift AD out and end the recession more quickly. Regardless of the policy it will increase y (restore y*) without raising P. The other variables will depend on whether you use fiscal (+ r, - x,? b) or monetary (- r,? x, - b) policy to expand AD. b. What policy proposal for economic recovery would the Non-Activist advocate? Using the full model, what impact would you expect this to have on y, P, r, x, and b? Use the model and explain your reasoning. In macroeconomics, a Non-Activist is someone who prefers the slower marketclearing path to recovery to overt intervention by fiscal or monetary policymakers. For some this reflects their fear of concentrated economic power. Others think our policy tools and the people making the decisions are as likely to end up responding too late or overshooting. Still others think that policy has little ability to alter AD. You didn t need to discuss this. You just needed to explain that for an economy initially below y*, market-clearing brings long run + y, - P, - r,? x, and - b. c. What policy proposal for economic recovery would the protectionist propose? Using the full model, what impact would you expect it to have on y, P, r, x, and b? Use the model and explain your reasoning. A protectionist wants to reduce imports and, as discussed so well in The Choice, supposedly make the national economy stronger. Starting below y*, suppose we put high tariffs on imports and consumers switch to domestically-produced goods and services. The drop in imports shows up initially as + x 0 so + z 0 and rightward shifts in IS and AD as we move toward y*. It looks like this really will put America back to work again. But two additional factors must be included. First, if our trading partners retaliate with tariffs on our exports (trying to convince us this was a bad policy move) then this brings - x0, offsetting our initial + IS and + AD. In other words, they can simply neutralize our protectionist policy by

3 doing the same thing to us that we tried to do to them. The second factor is the reduction of comparative advantage as both countries put more resources into products that someone else can produce relatively cheaper. As we saw earlier, trade restrictions reduce our overall productivity and bring - inst and, thereby - AS* and - y*. From an economic standpoint, the notion that trade policy can be used to create jobs is misleading and dangerous. Reducing trade restrictions brings better jobs and an overall growth in y*. 4. Your Uncle Henry, hearing that you re studying macroeconomics, shares his concerns about current fiscal policy. I understand that government budget deficits are a useful stimulus when the economy is in recession. But once we ve returned to full employment, those continued deficits not only become inflationary but also keep increasing the national debt and pushing the cost of government into the future. That s nice for now but it s a short-sighted and irresponsible thing to do to our economic future. a. Evaluate the economic logic behind his statement that budget deficits are a useful stimulus when we re in recession but inflationary at full employment. Do you agree or disagree? Be specific and explain your reasoning. For many it seems intuitively obvious that budget deficits are expansionary and surpluses contractionary. Hence Uncle Henry s widely-shared view that deficits are a useful stimulus in recession but inflationary at full employment. As explained in the discussion of Question 3, it depends. There is absolutely nothing inherently expansionary or contractionary in a given level of b = g - t. I wanted you to explain how it depends on the source (type) and other factors. Is it b cyc or b str? If it s b str >0 is bstr positive, negative or zero? To be expansionary it must be an increasing, structural deficit resulting from either an increase in government spending or a decrease in taxes. b. Now evaluate the economic logic behind his support for a balanced government budget at full employment. What are the likely costs and benefits of such a policy? Be specific and explain your reasoning. I discussed this in class in terms of the costs and benefits of a Balanced Budget Amendment (to the US Constitution) that requires b = 0, i.e., zero borrowing by the federal government. It s also covered in Chapter 5. Once we get to y* would this be economically beneficial? The economic costs far outweigh the potential benefits. I wanted you to note that paying for all g out of current t forces us to prepay for the future benefits derived from current public investment (g i ). This puts a burden on current generations and, in practice, is likely to mean a substantial drop in g i since its cost can t be spread over a future that is receiving its benefits. It s like having to pay cash for a house and not being able to get a mortgage that spreads the cost over the time when you re getting the housing services. Put another way, it prohibits the win/win outcome that financial markets provide (willing lenders/borrowers) when it comes to government spending. In addition, a policy that requires b = 0, making no distinction between cyclical and structural borrowing, is destabilizing to fiscal policy. When an economic decline begins (- y, from any source) it causes a loss of tax revenues. If we can t borrow then we either have to raise tax rates or cut government spending, either of which adds further contraction to a contracting economy. c. Suppose that consumers increasingly become tax discounters in their perceptions of deficitfinanced government spending. Will this make the existence of a large national debt more or less dangerous to our economic future? Be specific and explain your reasoning. I wanted you to explain what tax discounting meant and then think about it in the context of the national debt. We already saw that more tax discounting would weaken the power of fiscal policy changes to shift IS and AD. But this asks something a bit different. Is a national debt in a world of tax discounters more dangerous than one in a world with no tax discounters? Because tax discounters treat current borrowing just like taxes and set aside saving (decrease consumption) accordingly, they are well-prepared for paying it off in the future. There will be no consumption-draining since they ve already saved and invested the money they will need to pay off the bonds in the future. Without tax-discounting, consumers are essentially living a lie, thinking that tax postponements are actually true tax cuts. Their consumption will need to drop by the amount of the borrowing plus interest when the time comes to repay. Tax discounting, then, makes a national debt more sustainable and less dangerous.

4 5. Balance the budget! Fiscal responsibility! It seems obvious to most that such balance is essential and that continued budget imbalances are dangerous and, ultimately, irresponsible policies. But when we think more carefully about what the definition does and doesn t tell us, the issue of fiscal responsibility looks a bit different. a. Explain why and how the standard view of government deficits and the national debt is incomplete and potentially misleading. Explain clearly and without jargon so that someone with no background in economics could understand just when continued borrowing is and isn t dangerous. Be specific and complete. I wanted you to explain that the standard cash flow measure of the deficit only tells us how much we re borrowing and tells us nothing about why or how the borrowed funds are used. Are continued deficits harmful? Are they inflationary? Maybe, maybe not. We need to know if the deficits reflect a cyclical downturn or if they re built into the structure of current spending and tax rate levels. If the latter, are they increasing, decreasing or constant. Are they a burden on our future economic well-being? Explain that it depends how the borrowed funds are used and perhaps make a comparison to private borrowing that is used to finance education or other productive uses. Bottom line: fiscal responsibility, in any meaningful sense, wouldn t involve zero borrowing no matter what. A more reasonable one is what the state of North Carolina and others use balance the capital account budget so that all current benefits are paid out of current taxes and borrowing can only be used for capital investment that is expected to yield a return, directly or indirectly, that at least covers the cost of borrowing. b. Under what specific circumstances could a policy goal of a balanced federal budget turn out to be a serious self-inflicted wound to economic stability and full employment? Explain clearly. This is just another way to ask the question in 4 b) above. c. Sometimes it is argued that two major economic threats to our future are the twin deficits simultaneous and ongoing budget deficits along with trade deficits. What is the difference between these two deficit concepts and under what specific circumstances might both be considered positive steps toward a healthy economic future? Be specific and explain. A budget deficit (b>0) means that part of current government spending is financed with borrowed funds. A trade deficit (x<0) means that our imports of goods and services exceed our export of goods and services. As we saw, this means that we re exporting more securities (stocks, bonds, etc.) that we re importing from abroad. In other words, foreigners are sending us more saving to buy our assets than we re sending to them. It s a net saving or capital inflow to the economy. Both are about borrowing and whether they end well or badly depends, for both, on how they inflow of funds are used. If they re consumed (benefits now) they leave liabilities but not benefits for the future. If they re invested they can be a productive way to spread costs and benefits across time and increase economic growth. 6. Suppose our European Union trade partners, sensing increased hostility toward trade from the US, decide to initiate a 25% across-the-board tariff on US exports. They argue that this is not anything against the US but only reflects their own need to stimulate their economies which, for the most part, have been stagnant and struggling for several years. a. Use the full model and evaluate the likely impact of this new EU policy on the US economy. That is, what will happen to y, P, r, i, and b in the US in both the short and long run as a result of this loss of export markets? Be specific and explain. In the model, this loss of exports shows up as - x 0 which brings - z 0, shifting IS and AD to the left. Working it through the graphs, we see a short run - y, - r, P=0, + i, and + b. In the long run, y returns to y* and we see P, -- r, + i and b=0. b. As an adviser to President Trump, you are asked to evaluate the likely short and long run costs and benefits to the US economy if we respond with a 50% across-the-board tariff on goods and services coming from the EU? Again, use the model and explain your reasoning. This retaliation on our trading partners by imposing an even larger tariff on their products would bring a large drop in our imports and so a + x 0 larger than the decline in part a). So IS and AD would shift back to

5 the right beyond their original positions. It looks, at first, like this is an excellent jobs policy and like it puts America back to work and all the rest. We looked at this carefully in The Choice and it s discussed in the answer to question 3 c) above. It continues a lose/lose trade war that pushes all participants away from the roundabout way to wealth and brings negative supply shocks to more self-reliant economies. It s the most damaging and costly way to respond to the actions of our trading partners. c. President Trump then says he wants your candid advice. It seems to me that the best way to respond to the EU attack is to fight fire with fire. If they take a shot at us we ll take two shots at them. We need to protect our industries and our jobs from their attacks on us. But let s suppose you were in my job and the goal was to make the American economy great again. Is there any other policy response that might work better? Be specific and explain your reasoning. Using our analytical framework, there are several ways to offset the initial AD from their tariffs against US exports. Fight fire with common sense run an expansionary fiscal policy and/or monetary policy to counteract the decline in AD.

Economics 102 Summer 2014 Answers to Homework #5 Due June 21, 2017

Economics 102 Summer 2014 Answers to Homework #5 Due June 21, 2017 Directions: The homework will be collected in a box before the lecture. Please place your name, TA name and section number on top of the