Expansions (periods of. positive economic growth)

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1 Practice Problems IV EC Questions 1. Comparing GDP growth with its trend, what do the deviations from the trend reflect? How is recession informally defined? Periods of positive growth in GDP (above the trend line) are referred to as expansions/booms and periods of negative growth (below the trend line) are referred to as downturns, contractions, or recessions. A recession is informally defined as two consecutive quarters of negative growth in real GDP. Real GDP peak Trend line Time Contractions (periods of negative economic growth) Expansions (periods of positive economic growth) 2. What does it mean to say that an economic fluctuation involves the co-movement of many aggregate macroeconomic variables? Name four variables that exhibit co-movement during an economic expansion. Co-movement of aggregate macroeconomic variables implies that these variables grow or contract together during booms and recessions. Employment and GDP move together with consumption and investment, while unemployment varies inversely with GDP. Thus, during an expansion, consumption, investment, employment and GDP all rise, while unemployment falls. 3. How do wage flexibility and downward wage rigidity affect the extent of unemployment in the economy when the demand for labor shifts to the left? Suppose the labor demand curve shifts to the left when wages are flexible. A new equilibrium will be established at a lower wage (assuming a downward-sloping labor demand

2 curve).although the level of employment will have declined, everyone who wants to work at the new, lower wage will be able to find a job, so there is no unemployment. However, if wages are downwardly rigid, a shift to the left of the labor demand curve has an amplified effect, as shown in Exhibit 12.6(c) in the chapter. The overall level of employment declines more than if wages had been able to adjust. Moreover, the quantity of labor supplied at the rigid wage is now higher than the quantity of labor demanded. Hence, there is now unemployment. 4. What are the major sources of fluctuations identified by each of these three schools of thought real business cycle theory, Keynesian theory, and financial and monetary theories? According to the real business cycle theory, major sources of change come primarily from the technological progress and changing input prices (for example, an increase in oil price). As per the Keynesian theory, changing sentiments or expectations about the future (for example, consumer and business confidence in the future) lead to a change in real GDP. Finally, financial and monetary theories emphasize the monetary policy which affects the price level and real GDP. 5. How did John Maynard Keynes use the concepts of animal spirits and sentiments to explain economic fluctuations? Animal spirits are what Keynes called the psychological factors that lead to changes in the mood of consumers or businesses and affect consumption, investment, and GDP. Animal spirits represent the overall level of optimism or pessimism in the economy and affect expectations of how future events will play out. For example, suppose firms are pessimistic about the future and cut back employment and investment. Households will face a heightened risk of losing their jobs because of the fall in investment and are likely to decrease their consumption and save for a rainy day. This translates into a decline in the current demand for the products of many firms, shifting the labor demand curve at those firms to the left, thereby reducing production and employment. Animal spirits are an example of changing sentiments, which include changes in expectations and changes in the (real or perceived) uncertainty facing firms and households. Changes in sentiments lead to changes in household consumption and firm investment, which affect aggregate expenditure and output. 6. The concept of multipliers was one of the key elements of John Maynard Keynes s theory of fluctuations. What is a multiplier? Explain with an example. The working of a multiplier magnifies a modest negative or positive shock to the economy and generates a cascade of follow-on effects that ultimately causes a larger contraction or expansion, respectively. Multipliers are the economic mechanisms that cause an initial shock to be amplified by follow-on effects. For example, suppose a drop in consumer confidence reduces households willingness to spend. Firms will cut back production and lay off employees. Those newly unemployed workers will be unable to buy goods and services, leading firms that previously sold goods to these consumers to scale back production even more. Such cascades of effects will amplify the impact of the initial shock. 7. What are two important mechanisms that reverse the effects of a recession in a modern economy? In the medium run, two factors tend to reverse the effects of a recession. The labor demand curve shifts back to the right. This can happen for several reasons: Excess inventory has been sold off in the course of the recession; technological advances create new business opportunities that enable firms to expand their activities; or the banking system and other financial intermediaries recuperate, increasing the credit available to finance expanded business operations.

3 Government pursues expansionary monetary and fiscal policies to stimulate the economy. Expansionary monetary policy can be used to lower interest rates, stimulating both consumption and investment. Likewise, government spending can be increased, or taxes reduced, as part of expansionary fiscal policy. The inflationary pressures that can result from either of these policies serve to raise the prices for firms products, thus making their operations more profitable at a given wage. This also acts as a stimulus to increased employment. 8. Between 2000 and 2006, housing prices in the United States increased by about 90percent.As detailed in the chapter, this increase abruptly reversed. a. Why is the rise in housing prices between the late 1990s and 2006 characterized as a bubble by some economists? b. How did the fall in housing prices cause the financial system in the United States to freeze up? a. When a large increase in the price of an asset can t be justified by the true economic value of the asset, the price increase is likely to be temporary, and economists refer to this situation as a bubble. b. With the fall in housing prices, many families found that their mortgages were underwater ; they owed more on their home than it was worth. Some households in this situation have a strong incentive to default on their mortgage payments. Home foreclosures rose sharply. Banks were left with outstanding mortgages that they could not recoup as the underlying asset, the house in this case, was worth less than the value of the mortgage. Consequently, banks suffered enormous losses on their portfolios of mortgages and many banks failed, disrupting their ability to extend credit. Even the surviving banks were hesitant to make loans, afraid that these new loans to households and businesses would soon end up in default. In summary, the decline in housing prices (and other asset prices) caused banks to suffer enormous losses, disrupting the banks ability and willingness to make loans to consumers and firms. 9. Suppose that the mythical country of Moricana has a downward rigid wage. Moricana is in a recession; capacity utilization in the economy is at an all-time low, and surveys show that firms do not expect economic conditions to improve in the coming year. a. Firms in the country are cutting back on capital spending and investment. Use a graph to show how this would affect the labor demand curve (ignore the effects of multipliers). b. How would the economy move along the aggregate production function curve? c. Is unemployment in Moricana likely to be classified as voluntary or involuntary? Explain your answer. a. Given the information in the question, wages in Moricana are likely to be rigid. When firms cut back on capital spending and investment, the demand for labor will fall. This shifts the labor demand curve to the left. As shown in the following graph, the economy is initially in equilibrium at point 1, where the level of employment is L. The demand curve for labor shifts from D 1 to D 2. Because wages are rigid and cannot adjust, the economy moves to

4 point 2 on D 2. The level of employment falls from L to L". Had wages been flexible, employment would have only fallen to L'. b. The aggregate production function curve shows the relationship between employment and GDP, holding capital and technology constant. When the level of employment falls from L to L", the level of real GDP also falls from Y to Y". c. When wages are rigid, a left shift of the demand curve leads to involuntary unemployment. At the going wage W in the graph, the number of workers who are willing to work at the going wage exceeds the number of jobs that firms are willing to fill. The number of workers who would like to work at the market wage but can t find a job is equal to the gap between L and L" in the graph from part a. 10. Assuming flexible wages, in which case would the change in total employment be greater during a recession: Scenario 1:Workers do not increase their labor supply very much in response to an increase in the wage; or Scenario 2: Workers increase their labor supply substantially in response to an increase in the wage. Explain your answer fully with a graph.

5 In Scenario 1, workers do not increase their quantity of labor supplied much for a given increase in the wage. This implies that the labor supply curve is quite steep. This is illustrated by labor supply curve Labor Supply 1 in the following graph. Scenario 2, reflected by curve Labor Supply 2, involves the opposite situation: Workers increase their quantity of labor supplied substantially for a given increase in the wage, which implies that the labor supply curve is flatter, meaning that the quantity of labor supplied is more responsive to a change in wages. We can see the effects of these two labor supply curves in the graph, which shows the two labor supply curves superimposed on each other, along with a labor demand curve. Suppose we start at equilibrium E 0.At wage w 0, the quantity of labor demanded and supplied is L 0.Now, consider what happens due to a decrease in labor demand, as would be the case in a recession. As the labor demand curve shifts to the left, the equilibrium wage will decrease, as will the equilibrium level of employment. However, the decrease in the equilibrium wage is greater the steeper the labor supply curve is. Correspondingly, the decrease in employment is smaller given a steeper labor supply curve. This can be seen on the graph: For the steeper labor supply curve, the wage declines from w 0 to w I, but the level of employment only declines from L 0 to L I. For the flatter labor supply curve, the wage only decreases from w 0 to w E, but the level of employment decreases from L 0 all the way to L E. 11. Assume that labor supply and labor demand are described by the following equations: Labor Supply: Labor Demand: L S = 5 w L D = w Where w = wage expressed in dollars per hour, and L S and L D are expressed in millions of workers. a. Find the equilibrium wage and the equilibrium level of employment. b. Assume that there is a shock to the economy, such that the labor demand curve is now described by the equation: L D = w. If wages are flexible, what will be the new equilibrium wage and level of employment? Show your work. c. Now assume that wages are rigid at the level you found in part (a).what will employment be at this wage? How many workers will be unemployed? a. L S = 5w L D = w

6 In equilibrium: L S = L D 5 w = w Solving for the equilibrium wage, w*: 5.5 w = 110 w* = 20 Plug in w* to find L* using either L S or L D : L S = 5w* = 5 20= 100 = L* L D = w = = 100 b. L S = L D = L* 5 w = w Solving for the equilibrium wage, w*, assuming the wage is flexible: 5.5 w = 55 w* = 10 Plug in w* to find L* using either L S or L D : L S = 5 w* = 5 10 = 50 = L* L D = w = = 50 = L* c. From part (a), we already know that the wage will be 20, and L S at 20 = 100.However, labor demand at the previous wage of w = 20 will be: L D = = = 45 Given that L S = 100, unemployment will be: L S L D = = The Internet boom of the 1990s has changed all of our lives and transformed the way business is conducted. During the late 1990s, the economy was described as the best of all possible worlds with quite high employment (and low unemployment).explain this phenomenon using the real business cycle approach. Recall from the chapter that the real business cycle approach stresses the role of technology in economic fluctuations. Technological innovation leads to increases in productivity, which in turn increases the marginal product of labor and therefore labor demand. The labor demand curve shifts to the right, raising employment along with wages. Both of these occurred during the late 1990s.

7 13. Suppose that the central bank uses expansionary monetary policy to increase employment. However, employment only increases in the short run, and returns to its initial level in the long run. Use a graph to explain this result. Assume that the wage is flexible. Initially the economy is at point 1. Lower interest rates stimulate firm investment and household consumption. Firms would produce more and the labor demand curve shifts to the right. The labor market equilibrium is at point 2. The expansionary monetary policy also leads to inflation. Given the nominal wages at point 2, as price increases, real wages fall. Firms then hire more workers to produce more. The labor demand curve further shifts to the right. For workers, the real wages fall, so the labor supply shifts to the left. As shown in the figure below, the new labor market equilibrium is at point 3 at which the employment level is same as the initial level. The higher nominal wage reflects the rise in price level. 14. The Evidence-Based Economics feature in the chapter identifies three key factors that caused the recession of a. How would Keynes concept of animal spirits explain the creation of a housing bubble? b. What does the national income identity show? Explain how the recession of affected the consumption and investment components of the national income identity. a. According to Keynes, animal spirits is a psychological phenomenon. It represents the overall level of optimism or pessimism in the economy. In the book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, George Akerlof and Robert J. Shiller explain that the idea that everyone should own a house and that a house is a worthwhile investment played a part in creating a bubble. This belief, which gained momentum in the 1990s and the early 2000s, pushed housing prices up and also led many to ignore the possibility of a decline in housing prices. The housing bubble showed that animal spirits in an economy can fluctuate sharply even as the underlying fundamental features of the economy change relatively little.

8 b. The national income identity shows that output is a function of consumption, investment, government spending, and net exports: Y = C + I + G + NX. The Great Recession primarily affected the C and I components of the national income identity. The fall in housing prices reduced consumers wealth and led to a drop in consumption. Because falling prices made new construction unprofitable, construction of new houses dropped, which reduced I. The decline in housing prices also led to millions of mortgage defaults. These mortgage defaults led to bank failures. Bank lending fell sharply, causing further reductions in C and I. Based on: What are the tools used by the government and the central bank in their conduct of fiscal and monetary policies? Tools of fiscal policy include changing government expenditure and taxes. Tools of monetary policy include open market operations, changing the reserve requirement, changing the interest rate paid on reserves, quantitative easing and lending from the discount window. 16. How do expansionary policies differ from contractionary policies? During a recession, expansionary policy aims to reduce the severity of the downturn by shifting labor demand to the right and expanding economic activity. Contractionary policy, on the other hand, shifts the labor demand curve to the left and sometimes is used to reduce the rate of inflation or slow down the economy when it grows too fast or overheats. 17. Briefly explain how expansionary monetary policy shifts the labor demand curve to the right. Expansionary monetary policy lowers short-run interest rates and increases access to credit in order to stimulate economic activity. The fall in short-run interest rates usually causes the longterm expected real interest rate to fall. A fall in the long-term expected real interest rate encourages households and firms to make more investments (such as building new homes and factories) because a lower real interest rate implies that the cost of a loan has fallen. Lower interest rates also stimulate consumption spending, especially on durable goods, because loans to finance those purchases cost consumers less. To satisfy an increase in demand for investment and consumption goods, firms seek to hire more workers, shifting the labor demand curve to the right. 18. What is quantitative easing? Why do central banks undertake quantitative easing programs? Quantitative easing involves primarily a change in the way that the Fed conducts open market operations. Rather than buying just short-term Treasury bonds, which is the usual way that the Fed increases bank reserves in a standard open market operation, the Fed buys other assets as well, including long-term bonds and mortgage-backed securities. This pushes up the price on the long-term bonds and thereby drives down long-term interest rates. Such purchases also increase the quantity of bank reserves, with the goal of increasing bank lending, and ultimately, stimulating the economy. Quantitative easing is one of the major factors behind the significant increase in bank reserves that occurred from 2008 to What do countercyclical policies mean? During an economic boom, what countercyclical fiscal and monetary policies are used? Countercyclical fiscal and monetary policies aim to reduce economic fluctuations. For example, in the case of an economic boom, contractionary fiscal policy (such as lowering government

9 expenditure or raising taxes) would shift the labor demand curve to the left and contractionary monetary policy (such as raising interest rates) can be used to slow down the economy by manipulating bank reserves and interest rates. 20. How does the zero lower bound on interest rates affect the working of monetary policy? The zero lower bound is a barrier that nominal interest rates cannot cross; when nominal interest rates have been lowered to zero, the central bank cannot lower rates any further. When the rate of inflation is low or negative, the zero lower bound is a problem for the working of monetary policy. When the nominal interest rate is stuck at or above zero and the inflation rate is negative, the real interest rate will be positive. If the inflation rate keeps falling, the real interest rate will rise, reducing investment and shifting the labor demand curve to the left. 21. How can expansionary expenditure-based fiscal policy lead to crowding out in the economy? Expansionary expenditure-based fiscal policy is implemented by increasing government spending or by cutting taxes. Both government expenditure and tax cuts can partially or even fully displace expenditures by households and firms. This is called crowding out of private consumption and private investment. Crowding out occurs because the government borrows from credit markets to fund its increased expenditure. As the government borrows to pay its bills, the interest rate in the credit market rises. At higher interest rates, private consumption and investment will fall. Private savings will now be lent to the government and will not be used in funding private consumption and investment. In effect, the private expenditure is crowded out by the government borrowing.

10 22. To reduce the hardships that the unemployed workers suffer, a government decides to improve unemployment benefits, such as extending eligibility for unemployment insurance. Would you say it is a good or a bad policy, and why? Explain your answer with the aid of a labor market graph. More generous offers to unemployed workers would create a disincentive for them to find employment, thereby shifting the labor supply curve to the left. As shown in the graph, the new equilibrium is at point 1 where the employment and real GDP are lower than their initial levels at point 0. However, increasing the incomes of unemployed workers would encourage consumption, thereby shifting the labor demand curve to the right. If the magnitude of the rightward shift in labor demand curve is less than that of the leftward shift in labor supply curve, the new equilibrium is at point 2. The employment L 2 at this point is lower than L 0. Along the aggregate production function, lower employment leads to lower real GDP. Thus, the policy results in lower employment and lower real GDP. Alternatively, if the magnitude of the rightward shift in labor demand curve is greater than that of the leftward shift in labor supply curve, the new equilibrium will be at point 3. The employment L 3 at this point is higher than L 0. Along the aggregate production function, higher employment leads to higher real GDP. As improvement in unemployment benefits results in higher employment and higher real GDP, this is a good policy. 23. Two economists estimate the government expenditure multiplier and come up with different results.one estimates the multiplier at 0.75, while the other comes up with an estimate of a. What do these different estimates imply about the consequences of government expenditure? b. If the current value of GDP is $13.28 trillion and the government is planning to increase spending by $800 billion, what is the percentage increase in GDP for each of the two estimates for the multiplier? Assume the increase in spending occurs all in one year. a. The economist who estimates the multiplier at 1.25 is likely to be assuming that the increased government spending will lead to an increase in consumption. The increase in government spending can stimulate business activity, which will increase the income of workers and hence consumption spending in the economy. The other economist is likely to be assuming that the increase in government spending will lead to more government

11 borrowing, which will divert resources away from consumption and investment. The resulting higher interest rates dampen consumption and investment spending. According to the economist who estimates the multiplier at 0.75, a $1 increase in government spending will not even generate a $1 increase in equilibrium GDP. b percent, 7.53 percent If the multiplier is 0.75, an $800 billion increase in government spending will result in an increase in GDP of 0.75 $800 billion = $600 billion. GDP would increase from $13.28 trillion to $13.88 trillion, an increase of 4.52 percent. If the multiplier is 1.25, then an $800 billion increase in government spending will result in a 1.25 $800 billion = $1,000 billion increase in GDP. GDP would increase from $13.28 trillion to $14.28 trillion, which is an increase of 7.53 percent. 24. In 2005, $320 million of the federal government s budget was allocated toward building a bridge to nowhere in Alaska that connected two small towns. In 2006, $500,000 was allocated toward a teapot museum in North Carolina, $1 million toward a water-free urinal initiative in Michigan, and $4.5 million toward a museum and park at an abandoned mine in Maine. These projects were requested byspecific legislators in order to boost their popularity in their constituencies. a. What is this type of expenditure called? b. Since government spending increases employment by shifting the labor demand curve to the right, is it always a good idea for the government to increase expenditure? Explain your answer. a. Public spending that politicians value because it increases their popularity is called pork barrel spending. Pork barrel spending is seen as an inefficient use of government funds; most people who benefit from these projects pay a very small fraction of its cost but enjoy all of its benefits. b. The effectiveness of additional government expenditure would depend on whether the economy is operating at full capacity or whether it is contracting. When the economy is already working at full capacity, it is likely that additional government expenditure will substantially crowd out other kinds of economic activity. Most economists believe that the government expenditure multiplier is close to zero when the economy is already booming. When the economy is contracting, however, factories are likely to be running below capacity and there are likely to be a significant number of unemployed workers. The government expenditure multiplier is likely to be above 1because additional government expenditure will not crowd out private consumption or investment. In this situation, additional government expenditures encourage the utilization of some of the idle capacity and unemployed workers.