ANSWERS TO END-OF-CHAPTER QUESTIONS

Transcription

1 CHAPTER 5 ANSWERS TO QUESTIONS 24 CHAPTER 5 ANSWERS TO END-OF-CHAPTER QUESTIONS 2. "The Federal deficit for next year is expected to be in excess of $300 billion, and that doesn't include the additional promises incurred through the various entitlement programs. What clearer evidence could there be of continued fiscal irresponsibility on the part of our political leaders?" Evaluate this statement fully, considering both the measurement issues underlying the government deficit and the short- and long-term consequences of this deficit for the economy. Fiscal responsibility is used in many different ways, most of them quite fuzzy or even distorted. To many people, any deficit is irresponsible because it's a deficit. They are trapped in the semantic inconsistencies with which we distinguish identical actions depending upon whether they occur in the public sector (deficit) or private sector (borrowing). This is not only poor logic but it can lead to damaging policy responses. So, to answer this we must first come up with a sensible definition of fiscal responsibility and irresponsibility. For example, we could say that a fiscal policy of deficit financing is irresponsible if it (1) is not sustainable and therefore falls into the consumption-draining category and/or (2) results in continued increases in aggregate demand in a fully-employed economy that merely drive prices higher and higher without altering output or employment. Students need to learn to explain these situations precisely, including the specific conditions under which a deficit would result in one or both of these events. They should also be able to explain the conditions under which we could run continued deficits from now to kingdom come without causing impoverishment (consumption-draining) or inflation. 3. a. Explain, in your own words, why current inflation reduces the nation's net indebtedness. This comes from the erosion in the real value of outstanding government bonds. It is also important for students to see that expected inflation is likely to have been built into interest rates in advance, so that it is really unanticipated increases in inflation that reduce the real value of the Treasury's outstanding debt. b. Under current accounting procedures, Social Security payments are counted in the budget only as they are made. Explain the logic for including a change in future obligations to make Social Security payments as part of the government's current deficit. Social Security payments to the government are used either to make payments to current recipients or are used to purchase government bonds that become assets of the Social Security Trust Fund. Since these bonds are issued by one part of the government (the Treasury) and held by another (Social Security Administration), we can say that the additional liabilities are offset by the additional assets of the government so that there is no impact on the overall net worth of the government sector. This is the thinking that underlies current practice which does not count bonds purchased by the Social Security Trust Fund as net debt of the government. But critics argue that since all the bond holdings of the Social Security Trust Fund represent obligations to make future payments to retirees, these are not really assets of the government. They argue that the amount of government debt held in the Social Security Trust Fund should be counted as a net obligation of the government. In our framework, this simply says that while the Social Security holdings of bonds do cancel out the obligation of the U.S. Treasury, the future obligation to make Social Security payments is a "hidden liability" of the government and should be included in any meaningful and

2 CHAPTER 5 ANSWERS TO QUESTIONS 25 complete measure of our future commitments of tax money. 4. a. "Deficits cause recessions." This statement would be true only if the deficit in question is a decreasing structural deficit that would shift IS and AD inwards. b. "Recessions cause deficits." This statement would be true only if the deficit in question is a cyclical rather than a structural deficit. 5. Explain in common-sense terms why the ratio of national debt to total output is a better indicator of whether we're borrowing too much than is the actual level of national debt. The easiest way to think about this is to note that, in the private sector, it is obviously not true that people or firms with larger indebtedness are necessarily worse off than people with smaller debts. The whole point is to look at the ratio of your debt to your ability to repay debt. People or firms with large incomes can handle more debt than those with small incomes. Similarly, a nation with a large total income has a larger tax base than one with a much smaller income and can thereby "handle" larger amounts of debt without having to raise tax rates or cut government spending in the future. 6. "The issue of a burden to the debt is in good part an issue of how far-sighted we are in our consumption decisions." Evaluate, incorporating the notion of "tax-discounting" into your answer. If people were full tax-discounters they would make no distinction between an increase in their taxes and an increase in the government's deficit. They would know that every dollar of deficit must necessarily come out of future taxes, and they would take that into account in how much they consume and save now. Therefore, an increased deficit (+)b) would have the same impact on them as a tax increase (+)t). It would call for a cut in consumption (increase in saving) that will set aside the needed purchasing power to pay the future taxes represented by current deficits. There could be no consumption-draining behavior in a world of tax-discounters. 7. Evaluate the economic content of each of the statements below. Be sure to read each statement carefully and explain your reasoning. a. "Deficits are a means for living high now at the expense of those who have to pay them off later." Answer is "It depends." You need to show why it depends on whether the deficits are cyclical or structural and whether they're self-financing or consumption-draining. b."a large national debt is sufficient evidence to conclude that past generations have left a net burden on the current generation through their expenditure and tax policies." Again, it falls in the "it depends" category. We need to know how the borrowed funds were used. c. "You can't spend your way to prosperity. When a recession comes, we must tighten our belts, spend less and pray more." Spending less when a recession hits only contracts aggregate demand further and keeps the economy mired in recession longer. d. "A continued unbalanced budget, by an individual, business or government, is not sustainable

3 CHAPTER 5 ANSWERS TO QUESTIONS 26 and must eventually have adverse consequences." Again, "it depends"; basically, the same issue as in 7b. 8. Suppose a balanced budget law is politically inevitable, but the debate centers on which budget to balance -- cash flow (b=0), structural cash flow (b str =0, so b=t 1 (y * -y)), government capital account (b k =0, so b=g i ), or a combined structural-capital account (b str/k =0, so b=t 1 (y * -y)+g i ). Discuss the costs and benefits associated with each. This question covers a lot of territory. It centers around an explanation of two key facts: (1) balancing a structural (cyclically-adjusted) budget is not destabilizing, but balancing an "actual" budget (structural plus cyclical as both b=0 or b k =0) is; (2) a continuing cash-flow deficit may or may not be sustainable, but a continuing capital account deficit definitely is not. 9. It is 2006 and the after-math of the failed Balanced-Budget Amendment has brought a gradual but real end to decades of agonizing over the government deficit. For better and for worse, the federal government has finally reached a balanced cyclically-adjusted, cash-flow budget. But the president decides that she wants to do something about the accumulated deficits of the past -- namely, eliminate the $8 trillion national debt. a. She asks you for an economic evaluation of the basic macroeconomic consequences (short- and long-run impacts on y, P, and r) and related costs and benefits of the following three proposals for ending the national debt. For each proposal, explain your reasoning. I. Pay it off by a combination of higher taxes and lower public spending, gradually, over the next thirty years. II. Require the Federal Reserve to use its monetary powers to buy up outstanding U.S. Treasury obligations, gradually, over the next thirty years. III. Simply declare a one-time national moratorium on government debt in which all existing U.S. Treasury obligations, for the economic good of our great nation, are declared null and void. Without going through all the messy details, paying off the existing national debt requires that the government run surpluses (b=g-t<0) each year. In Proposal I this is done by a combination of +)t and -)g, both of which are contractionary fiscal policies and would shift IS and AD to the left. But if you're thinking that this means an ongoing contractionary policy each year that they run a surplus, remember that it is the change in the (structural) deficit that matters, not its level. So, if they go from a balanced budget to a large surplus the first year, this would be a definite contractionary fiscal policy initiating the usual short- and long-run impacts. But if government spending and tax rates are kept at these levels, so that the deficit remains constant at this same level each year, then fiscal policy will remain "neutral" for all the remaining years until the debt has been repaid. In Proposal II there is no change in public spending or tax rates, and the only thing that happens

4 CHAPTER 5 ANSWERS TO QUESTIONS 27 is that the Federal Reserve buys up the Treasury bonds by printing new money. Although it is just trading one kind of paper for another, the new kind is "money" and has the usual expansionary impact on the economy. "Monetizing the debt" constitutes an expansionary monetary policy that shifts LM out and has the usual short- and long-run consequences. It essentially pays off the debt by stealing the purchasing power of all who use dollars -- the socalled inflation tax. Proposal III. This is just like raising taxes to pay off the entire amount in one year. The colossal loss of net worth by all the individuals and firms and financial institutions holding these now worthless assets could lead to an immense contraction, a series of bankruptcies, and that would be the most devastating way to have paid off this debt. b. Suppose one of these is chosen and implemented and the national debt is entirely eliminated. In terms of macroeconomic performance, present and future, in what ways do you think this economy is better off and/or worse off now that this huge public debt has been repaid? Be specific and explain your reasoning. Whichever method is chosen, the outstanding IOU's of the Treasury/taxpayers have been eliminated. Those claims against our future purchasing power are gone because they have been pre-paid, i.e., converted into claims against current purchasing power through either higher conventional taxes, a higher inflation tax, or by default that taxes the bond holders. The gain is that there is nothing left to have to pay back later; the loss is that costs that were scheduled to be paid off over many years have been paid off early. To the extent that this outstanding debt represented expenditures on public capital that will continue to yield benefits in the years to come, this means a transfer from the present to the future -- a "nice" thing to do but not something that any logic could tell us is unambiguously good or bad. To the extent it involves pre-paying for public capital, it essentially becomes a "burden" on the current generation. 10. Perhaps the most confusing thing about all the discussion of the government deficit is that people mean different things by the word "deficit." a. "Some kinds of deficit are clearly more dangerous than others. Forbidding all government borrowing may, contrary to most people's expectations, impose more costs than benefits on the economy." Describe circumstances in which the preceding sentence would be true, explaining the costs and benefits carefully. A complete answer requires the student to make all the important distinctions between cyclical, structural, cash-flow, and capital account concepts of the deficit. Zero borrowing (balancing the actual cash-flow budget) would be destabilizing in a recession and requires "prepayment" for government capital expenditures, i.e., the coercion is now, even though the benefits will not accrue until later. b. "Although a law that requires surplus or balance in the government's capital account budget (b k #0) may have some immediate appeal, the problem is that it leaves the cash flow deficit (b) in deficit which just means continued and unending growth in our total national debt. We might get away with this for a while, but it obviously can't go on forever." Do you agree or disagree? Explain. This requires an explanation of "sustainability." As long as the capital account budget

5 CHAPTER 5 ANSWERS TO QUESTIONS 28 is not in deficit, the borrowing falls in the "self-financing" category. Since this involves spending beyond our current income but not spending beyond our "means" (current plus expected future income), it is sustainable. The resulting cash-flow deficit can go on forever. c. "Deficit spending can have some real benefits in certain circumstances. But even so we must be aware of the costs, particularly the drain on the economy from the resulting huge interest payments. This wouldn't be so bad if our national debt were all internally held. But with 12% of it held by foreign investors, this continued leakage of purchasing power can only result in a lower standard of living for us." Evaluate and explain. Here it is important to see that the issue is how we use borrowed funds, not whom we borrow them from. Assuming we get the lowest rate of interest available and use them for investment spending, the nationality issue is irrelevant. 11. "A look through history will show that there is no basic relationship between government deficits and macroeconomic performance. Sometimes the economy prospers in spite of large deficits. Other times, the deficit seems to grab onto the economy and strangle it into a recession. The only thing we can say for certain is that the relationship between deficits and economic prosperity is not the simple one that most people think. In fact there's no clear relationship at all." Evaluate this statement and explain your reasoning. This statement is true if we say "there's no clear relationship between measured (or actual) deficits and economic prosperity." But what you need to show is that this statement makes it look like we know much less than we really do because of its failure to distinguish between "structural" and "cyclical" deficits. Once that distinction is made, the answer is much like the answer to question 4 on page Virtually everyone has a strong opinion about the government debt and deficit situation. Two such views are captured in the following quotes, which are identical except for the first word. Do you agree with either, both, or neither? "Unless we do something about this huge government debt the economy will be devastated." "If we do something about this huge government debt the economy will be devastated." Another question in which confusion is caused by the failure to use a careful definition of the deficit. Students should explain why the first statement would be true if and only if we're talking about a situation in which there is a continuing capital account deficit. The second statement could be true if we made a large decrease in the cash flow deficit in the misguided belief that a cash flow deficit has the same consequences as a capital account deficit.

6 CHAPTER 6 ANSWERS TO QUESTIONS 29 CHAPTER 6 ANSWERS TO END-OF-CHAPTER QUESTIONS 2. Suppose a critic of monetary policy argues that the Federal Reserve should reverse recent policy and expand the money supply at a faster rate. In so doing, he contends, they will be able to lower interest rates, stimulate investment and net exports, and increase output, all at the same time. These benefits would more than outweigh, in his opinion, the relatively small cost of a little inflation. Evaluate this argument and explain your reasoning in terms of the basic macro model. This is the kind of statement that we hear often about what the Federal Reserve ought to be doing. It seems to make sense, at least on the surface, and it seems to offer many wonderful things -- lower interest rates, more investment, lower trade deficit, and a higher standard of living. All this at the cost of just a little more inflation. Sounds like a good deal. Our instincts should tell us that the costs are being understated or the benefits overstated. Working through the analytics with the AD/AS framework reveals that the benefits will, at best, be temporary. As explained in section 6.6, the lasting impact on the economy of faster money growth will be a faster rise in the price level (+%)P) and an increase in the money rate of interest (+)R) due to the rise in the underlying rate of actual and expected inflation (+)A & )A e ). The short-run impact on real output, the real rate of interest, investment, and net exports cannot be sustained. 3. "Money is the root of all evil." Evaluate this adage in light of the material in this chapter. Do you think the elimination of money from the economy would eliminate the alleged "evil"? The point here is a reminder that "money" is just a commodity that reduces the costs of making transactions and thereby raises our individual and economy-wide efficiency. A well-functioning "money" is often identified with the goods and services for which it can be traded. But it is actually these goods and services that we are after -- all the convenience and excitement and wellbeing and power that they embody. The goods and services are the trophies we get for our ceaseless battle with scarcity. Eliminating the commodity called "money" would make it even more difficult and expensive to wage this battle and probably intensify the underlying economic struggle that many lament when they say things like "Money is the root of all evil." 4. Suppose a careful statistical study shows that the real rate of interest does not influence money demand at all. a. How would this change the LM equation, the LM curve, and the AD curve? Explain. b. Would this new information alter our conclusions about the impact of fiscal and monetary policy on aggregate demand? Explain. See the answers to questions 5 and 8 at the end of Chapter Four. (a) We now end up with a vertical LM curve since its equation is y=[(m 0 /P 0 )-j 0 ]/j 1 when j 2 =0, which is what it means to say that money demand does not vary with the real rate of interest (dl/p/dr=j 2 =0). (b) The implications of this model are now much closer to those of our original classical model where the velocity of money was presumed to be constant and thereby rendering "fiscal policy powerless."

7 CHAPTER 6 ANSWERS TO QUESTIONS 30 The vertical LM means that any shifts of the IS curve alter the real interest rate but not the level of aggregate demand (y). Therefore, changes in fiscal policy can no longer shift aggregate demand. Monetary policy still changes the intercept of LM, shifting the curve along the IS curve and changing both the real interest rate and the demand for output and shifting aggregate demand as before. 5. A potential presidential candidate believes that a neglected and important long-run economic goal should be lower interest rates. As her expert economic adviser, you must answer the following questions and explain your reasoning. a. "Do you agree with me that lower interest rates are an important ingredient in bringing about a more prosperous and secure economic future? It is true that lower real interest rates cause us to allocate more of our current production to investment, thereby increasing the capital stock and increasing economic growth. But don't forget the point in Chapter 1 that we can't get something for nothing, so changing the composition of output toward more investment (representing consumption in the future) must leave less consumption now. It's the inevitable tension between "now" or "later." b. "I heard some economist say that high interest rates were the result of too much money supply, not too little. Does that make any sense?" This statement represents the common confusion between nominal (money) interest rates (R) and real interest rates (r). Real interest rates represent the cost of borrowing (or the return to lending) after we adjust for changes in the unit of measurement caused by inflation. They represent how many more goods and services we'll have tomorrow when we loan out some of them today. Common sense and empirical evidence says that real interest rates are what matter to decision-makers. Getting back to the statement in the question, it is true if we're talking about money interest rates (R=r+A e ), since "too much money" means higher inflation and hence higher R. c. "Suppose I had total control over both monetary and fiscal policy. What combination of policies should I run to get mortgage rates down from 9% to 5% where they belong?" There are a number of possibilities here and no single "right" answer. But there are definitely some wrong answers. Perhaps the most appealing solution is a simultaneous contractionary fiscal policy (shifting IS to the left and lowering r) and an expansionary monetary policy (shifting LM to the right so as to offset the leftward shift in AD due to the contractionary fiscal policy). (Note that this is just the reverse of the policy that was run in the U.S. in the 1980s.) The presumption here is that it is the real rate of interest that matters, not the nominal rate. If it were just the nominal rate that we wanted to reduce, that could be done with contractionary monetary policy alone. d. "Would there be any unpleasant side effects from these policies?" Here you need to address the problems of timing and the impact of these policies on the other variables in our model. 6. Though the use of money goes back many millennia, David Hume, the eighteenth-century Scottish philosopher, was among the first persons to give careful thought to its implications for the overall economy. His conclusion was that "It is of no manner of consequence, with regard

8 CHAPTER 6 ANSWERS TO QUESTIONS 31 to the domestic happiness of a state, whether money be in a greater or less quantity." (1742) Put this into modern terms and explain what it implies for the use of monetary policy. Do you agree with it? Explain. In modern terms, it is a statement about the "long-run neutrality of money." In terms of our model, it comes down to the fact that a vertical aggregate supply curve says that doubling the supply of money (other things the same) will double the price level and leave real output and everything else unchanged. Other ways to say what Hume said include "Money is a veil." or "We can't "print" our way to prosperity." As obvious as it seems, it's remarkable how often this message is neglected by governments and central banks willing to blame high inflation on everything but their own continued rapid increases of the money supply. 7. When asked whether she expects a monetary expansion to result in lower or higher interest rates, an economist replies "Yes." Explain why this cryptic remark, implying that both may happen, is not just an idle witticism. This is another question about the crucial distinction between real and nominal interest rates. Other things the same, faster monetary growth is likely to lower interest rates on short-term instruments (since they are more sensitive to )r than to )A e ). For long-term bonds, the opposite is true; so, faster monetary growth is likely to raise the nominal rate because of the dominant role of A e. 8. "The conclusion that monetary policy can have no lasting impact on the real rate of interest is true under certain conditions, but these conditions are so restrictive that the conclusion is of little real significance. If the economy is initially below full employment, an increase in the money supply will cause a lasting drop in the real rate of interest and therefore provide a real and lasting stimulus to the macroeconomy through investment and net exports." Evaluate this statement. This statement is mostly true, but we need to be careful what conclusions we draw from it. It is certainly correct to say that if we are initially below full employment in the AD/AS model, a rightward shift in LM and AD can return us to full employment and, in the process, lower the real rate of interest. But there are two particularly important qualifications that need to be made to this conclusion that expansionary monetary policy causes a permanent drop in the real rate of interest. (1) The real rate of interest will end up no different with this expansionary policy than without it, since market clearing will have exactly the same outcome with respect to everything except P and R. (2) In the business cycle (as in comedy), timing is everything.. The problems posed by various response lags (and our limited knowledge of them) make it impossible to approximate anything like fine tuning of the macroeconomy. 9.a. "Expansionary monetary policy is ultimately inflationary, so when an aggregate demand stimulus is needed, it's preferable to use fiscal policy." While it's true (as will be documented later) that virtually all inflations come from too-rapid monetary growth, this only reflects the fact that over-expansionary monetary policy is politically much easier to run (and, hence, more common) than any other sources of continued rapid growth in aggregate demand. But that doesn't mean what this quote says. Any expansionary demand-side policy will shift AD to the right and, if there is no comparable growth in supply, will have its long-run impact on the price level rather than real output. b. "Expansionary fiscal policy raises the real rate of interest, whereas expansionary monetary

9 CHAPTER 6 ANSWERS TO QUESTIONS 32 policy lowers it. This needs to be considered in choosing between them." It's true that in a fullyemployed economy expansionary monetary policy initially lowers the real interest rate, while expansionary fiscal policy increases it. The lasting impact, however, is a rise in the real interest rate from expansionary fiscal policy and no change from monetary policy. This does need to be considered in choosing between them, but don't fall too easily into the "higher interest rates are terrible" trap. High real interest rates hurt borrowers, but help lenders. 10. a. "To illustrate how irrational capital markets can be, when the Federal Reserve chairman announced a goal of immediately lower interest rates for the economy, there was an immediate increase in interest rates on bonds, mortgages, and other long-term obligations." b. "To further illustrate how irrational capital markets can be, when the Federal Reserve chairman announced a long-term goal of lowering interest rates in the economy, the immediate impact was rising interest rates. It just doesn't make sense." This is another way to ask the same question as question 7 above. 11. When diplomacy fails and warfare begins, we most often think of it in military terms. Destruction of capital and lives imposes obvious costs on society that show up in our model as negative supply-shocks. They are typically accompanied by sizable demand increases to finance the war effort, and the result is both falling output and rising prices. These ends can also be accomplished by economic warfare, most commonly through embargoes and boycotts, but sometimes through massive counterfeiting of the enemy's currency. Using the AD/AS framework, evaluate and explain the destructive power of these economic weapons. This is a slightly different angle on some basics. It is worth emphasizing the fact that when inflation becomes so large and erratic people actively avoid the currency, demonetization begins and leads to negative supplyshocks as less efficient ways of making transactions become necessary. 12. The reunification process in Germany has created a huge and growing cash-flow deficit for the nation. At the same time, the German Central Bank has been running a relatively contractionary policy through open market operations and through its control of the German discount rate. Predict the short- and long-run impacts of this policy package on y, P, r, R, i, and x in Germany. This is the identical policy that the U.S. ran during the Reagan years -- fiscal expansion and monetary contraction and the result was to push real interest rates higher and so on. 13. The Federal Reserve has great power over the nominal value of money, but it has no long-run control over the real value of the money supply. Do you agree or disagree? Explain. This statement is generally correct. It says that while the central bank is given monopoly power over the nominal supply of money (M), the value of the real supply of money (M/P) depends on all the forces that come together to determine the price level, including the influence of changes in the money supply. What our AD/AS framework shows is that in the long run there is a proportional relationship between changes in the numerator (M) and changes in the denominator (P). Although the monetary authority can double the money supply, our understanding of macroeconomic interactions tells us that this will end up approximately doubling (other things the same) the price

10 CHAPTER 6 ANSWERS TO QUESTIONS 33 level, leaving M/P and hence the intercept of the LM curve unchanged. 14. The analysis in this chapter has assumed a zero-growth economy. But suppose there is steady growth in the full employment level of output, showing up as a continued rightward shift in AS *. What are the relationships among monetary policy, real interest rates, and real output under these circumstances? How do they differ from those of a zero-growth economy? The continued growth of aggregate supply, other things the same, puts downward pressure on the price level, and the real rate of interest as AS * shifts to the right, and the economy "slides down" its AD and IS curves. Ignoring the issue of time lags, the Central Bank could steadily increase the nominal money supply at approximately the rate of growth of real output, shifting AD at the same rate as AS * and maintaining price stability but still experiencing a declining real rate of interest.