Macro: Midterm 2
Using the aggregate demand and aggregate supply model, explain the difference between a one-year drought and permanent climate change. What happens to the price level and output in the short run and in the long run for each type of shock?
A one-year drought raises the price of inputs to the production of food, shifting the SRAS to the left, raising prices, and reducing output. However, when crop yields recover during the next growing season, SRAS will shift back to the right to its original position, bringing the economy back to long-run equilibrium. (If producers anticipate a return to normal crop yields before they actually arrive, the SRAS may actually shift back even earlier.) A permanent change in the growing climate that makes producing food harder will shift LRAS (and SRAS) to the left. Since the LRAS shifts, prices are permanently higher and output is permanently lower.
What happens to a country's levels of frictional, structural, and cyclical unemployment, as well as its labor-force participation rate, as a recession drags on for an extended period of time?
A recession will increase cyclical unemployment and generally have an ambiguous effect on frictional and structural unemployment. As a recession drags on, however, workers who have been unemployed for a long period of time begin to see their skills deteriorate and therefore may move from simply cyclically unemployed to structurally unemployed. Thus, a lengthy recession may have bad long-run effects on the labor market, even once the economy has technically recovered from the recession. In a lengthy recession one should definitely expect the labor-force participation rate to fall as workers who have been unable to find work for a long period of time become discouraged and drop out of the labor market.
If a country's labor and capital grow at the same rate, is this likely to have the same impact on the growth rate of output? Why or why not?
According to the growth accounting equation, the growth rate of output is equal to the growth rate of labor times labor's share of output plus the growth rate of capital times capital's share of output plus the growth rate of technology. Therefore, the impact of labor growth and capital growth on output growth depends on their respective shares of output. For example, suppose both labor and capital grow at 5%, labor's share of output is 60%, and capital's share of output is 40%. The impact on output of the growth in labor is 0.05 × 0.60 = 0.03, or the 5% growth in labor leads to 3% growth in output. The impact of the growth in capital is 0.05 × 0.40 = 0.02, or the 5% growth in capital leads to 2% growth in output.
Measuring the growth in technology directly is almost impossible. How does the growth accounting equation allow economists to calculate an implied growth rate for technology?
According to the growth accounting equation, the growth rate of output is equal to the growth rate of labor times labor's share of output plus the growth rate of capital times capital's share of output plus the growth rate of technology. We can observe or calculate the growth rate of output, the growth rate of labor, the growth rate of capital, labor's share of output, and capital's share of output. Therefore, we can solve for the implied rate of growth in technology. We cannot easily observe or calculate technology directly.
Identify the four components of aggregate demand. Explain the relationship between aggregate demand and the price level.
Aggregate demand is made up of consumption, investment, government spending, and net exports.There is a negative relationship between aggregate demand and the price level because when the price level rises, planned aggregate expenditure will decrease, causing firms to decrease production of goods and services. A rise in the price level reduces the real value of income and wealth, so consumption falls. When the price level rises, the interest rate also tends to rise, so investment spending will fall because it is more expensive to borrow. When the price level rises, domestic goods are more expensive, so exports, and hence net exports, will fall.
What effect does rising business optimism and confidence have on the aggregate demand curve? What effect does falling optimism and confidence in business prospects have on the aggregate demand curve?
Aggregate demand is the sum of the four spending sectors (consumption, investment, government spending, and net exports). When consumers have more confidence (consumption) and when business optimism rises (investment), the aggregate demand curve will shift to the right, representing an increase in aggregate demand. When consumers have less confidence (consumption) and when business optimism falls (investment), the aggregate demand curve will shift to the left, representing a decrease in aggregate demand.
Innovation often requires "creative destruction," in which the new product or technology makes previous products or technologies obsolete. For example, when the personal computer was invented, typewriters became useless; hence, the personal computer "destroyed" the typewriter. This process of creative destruction often results in structural unemployment because workers who knew how to build and maintain the old products have skills that are no longer in demand. Do you think the government has a role in either limiting how often new products are created or in helping those workers who are displaced because of the new product?
Almost certainly the government shouldn't limit how often new products are introduced. Word processors, for example, have clearly made the economy more efficient and made the world a better place for almost everyone─except typewriter manufacturers and repairers. That being said, there is certainly a case to be made to help out those hurt by technological changes, although for the most part this is more of a normative (that is, subjective or opinion-based) response than a positive or objective one.
List several events that could cause a "demand-side" recession (i.e., a recession caused by a fall in aggregate demand).
Anything that causes C, I, G, or NX to fall will result in a demand side recession. These things include, but are not limited to: a collapse in wealth due to a stock market or housing market crash, a fall in consumer or business confidence, a fall in government spending, an increase in taxes, an increase in interest rates, or a collapse in foreign demand for a country's exports.
List several events that could cause a "supply-side" recession (i.e., a recession caused by a fall in aggregate supply).
Anything that reduces L, K, or technology, or increases the prices of inputs can cause a supply side recession. Examples include, but are not limited to, famine, migration, war, large increases in oil or food prices, and significant increases in corporate taxes.
What happens to a country's levels of frictional, structural, and cyclical unemployment, as well as its labor-force participation rate, as a country begins to recover from a deep recession?
As a country recovers from a recession, cyclical unemployment will clearly fall and the labor-force participation rate will rise. The effects on frictional and structural unemployment are somewhat ambiguous; however, there is reason to believe that frictional unemployment may actually rise, counter-balancing a portion of the fall in cyclical unemployment. Better job prospects will draw some people from out of the labor force back in. To the extent that not all of the new job searchers will be able to find work, frictional unemployment may rise. The net effect, however, will be a fall in the total unemployment rate.
When policy-makers discuss policies that encourage long-run growth in per capita real GDP, they often mention policies aimed at reducing the growth rate in the population. If effective, why might these policies improve long-run growth? Also, what are the potential costs associated with these policies?
As can be seen in Equation 10-1, real GDP per capita growth rate = Nominal GDP growth rate - Inflation rate - Population growth rate. If one can keep the nominal GDP growth rate and inflation rate the same while simultaneously reducing the population growth rate, then real GDP per capita growth rate will rise. More intuitively, if one can keep the size of the cake growing at the same rate but reduce the number of people among whom you have to divide up the cake, everyone will get bigger and bigger slices. There are two primary costs. First, the policies that reduce population growth may also reduce nominal GDP at the same time. For example, lower population growth will eventually reduce the amount of labor a country can provide or may reduce the rate of technological innovation or capital accumulation. Second, the policies required to reduce population growth may be considered coercive or a violation of human rights. For example, China's "one child" policy is often criticized on human rights grounds.
Suppose the National Bureau of Economic Research (NBER) just came out with a report suggesting that the economy will soon dip into recession. How do you think the levels of frictional, structural, and cyclical unemployment will change as the recession begins? What will happen to the labor-force participation rate?
Certainly, the biggest change is that cyclical unemployment will rise. The effects on frictional and structural unemployment are ambiguous. Frictional unemployment may rise as new graduates or other people losing their jobs for normal "course of life" reasons will find it harder to get new jobs. On the other hand, given a bad job market, people may stay in school or their existing job longer, reducing frictional unemployment. Structural unemployment is not likely to change much over the short run, as recessions do little to change the underlying rate of labor market evolution. The labor-force participation rate is likely to fall. Potential workers facing a bad job market are more likely to stay in school, stay at home, or retire early rather than look for a job.
Southern states in the United States are, on average, poorer than northern states. Southern states also have higher growth rates in real GDP per capita, on average, than northern states. Use these facts to draw a conclusion about whether the theory of convergence is correct. What other factors should be considered?
Convergence theory predicts that different countries or regions will eventually converge to the same growth rate, but not necessarily the same level of income. Countries that start out at a lower income level may grow at a faster rate, but that rate will eventually slow down due to decreasing marginal returns. The level of per capita income in a country is influenced by its savings rate, level of education, and level of technology.
Define the relationship between the expenditure multiplier and the marginal propensity to consume. If the marginal propensity to consume increases, what happens to the expenditure multiplier?
Equilibrium output will increase by more than one million dollars due to the multiplier effect. A multiplier effect occurs because of an increase in consumer spending that occurs when spending by one person causes others to earn more income and therefore spend more too, increasing the impact on the economy of the initial spending. In this case, when firms increase spending by one million dollars, this will increase income by one million dollars and cause consumption spending to rise by some amount that depends on the marginal propensity to consume. This process will repeat itself as firms produce more output in response to the extra spending, and this in turn leads to more consumption spending.
Suppose that an increase in business confidence increases investment expenditure by one million dollars. How do you expect this increase in investment expenditure to affect equilibrium output? Will equilibrium output increase by exactly one million, more than one million, or less than one million?
Equilibrium output will increase by more than one million dollars due to the multiplier effect. A multiplier effect occurs because of an increase in consumer spending that occurs when spending by one person causes others to earn more income and therefore spend more too, increasing the impact on the economy of the initial spending. In this case, when firms increase spending by one million dollars, this will increase income by one million dollars and cause consumption spending to rise by some amount that depends on the marginal propensity to consume. This process will repeat itself as firms produce more output in response to the extra spending, and this in turn leads to more consumption spending.
Why could a free press be important for economic growth? (Think about the connection between the press and government.)
Good governance is an important component of economic growth. A free, independent press serves to promote good government by publicizing government corruption, waste, and fraud. Government officials who run the risk of public exposure are less inclined to engage in behavior detrimental to the economy.
What are government transfer payments? Are they included as part of the government spending component of GDP?
Government transfer payments include payments for unemployment compensation, Social Security benefits, and food assistance. Government transfer payments do not count as part of the government spending component of GDP because they do not directly result in the production of new goods or services. Transfer payments involve the transfer of money from the government to individuals in the economy who are eligible to receive the payment under a specific government policy. The government obtains the funds it needs to make the transfer payments from tax revenue and government borrowing, so technically government transfer payments are transfers of money from one group of people in the economy to another, with the government acting as the middleman. When the individuals receiving the payments spend the income, then there is an impact on GDP. Payments to military personnel or public school teachers count as part of government spending because the government is paying people to provide a new service.
During the 1960s societal norms regarding working women were changing, and many women who had been housewives began working outside the home. How would you expect this new norm to change the labor-force participation rate? What about the unemployment rate?
Growing opportunities for women to work outside the home increased the labor-force participation rate as women either found jobs or spent time looking for jobs. Determining whether an increase in the number of women in the labor force changes the unemployment rate takes a bit more care. If one assumes there are a fixed number of jobs in the economy, every job taken by a woman (or immigrant or minority or any other group) would take a job away from someone else. Thus, unemployment would rise because more people would be searching for the same number of jobs. However, the assumption that the number of jobs in an economy is fixed is typically incorrect and often referred to as the "lump of labor fallacy." An increase in the number of women in the workforce tends to lead to an increase in the equilibrium number of jobs, increasing the employment/population ratio and having little effect on the unemployment rate in the long run. Empirically, the labor-force participation rate averaged 59.2 percent in the 1960's and 66.7 percent in the 1990's. The employment/population ratio rose from 56.4 percent to 62.9 percent between the two decades. Unemployment was relatively unchanged across this time period, averaging 4.9 percent in the 1960's and 5.8 percent in the 1990's, even though the 1990's number was biased upward by cyclical unemployment caused by a recession in the early part of the decade. In the short run more women entering the labor force might lead to an increase in the unemployment rate, especially if women find they are lacking skills and education. The natural rate of unemployment was in fact higher in the 1970's and 1980's before falling in the 1990's.
Many believe that technology is very costly to create, but cheap to transfer. For example, think of the personal computer: The technology underpinning the personal computer took a generation of time and a ton of money to create. However, now that the personal computer has been created, it is easy for others to purchase and reap the benefits. Given this insight, what do you believe will be the growth implications for the United States (traditionally more apt to create new technology) and China (traditionally more apt to adopt technologies created elsewhere)?
Growth should be slower in a country that has to engage in the creation of new technologies and faster in countries that get to deploy technologies that have already been created elsewhere. Thus, China should grow faster than the U.S. The idea of technology transfer is one reason why economists believe that convergence may be likely to occur between rich and poor countries.
In the late 1990s, the United States experienced very high GDP growth, record low unemployment rates, and virtually nonexistent inflation. Based on the conclusions of the AD/AS model, what could explain this combination of good economic results?
High GDP growth and low unemployment must mean that AD or AS was shifting to the right. However, if AD were shifting right, there should be upward pressure on prices, but instead the late 90s experienced almost no inflation. A shift right in either SRAS or LRAS, on the other hand, would cause output to rise while putting downward pressure on prices. So, the boom of the late 90s must have been the result of a rightward shift in SRAS or LRAS. While lots of things can cause a shift in AS, the most likely culprit in the late 90s was an increase in technology as the Internet spread throughout the economy.
How might low rates of saving in the United States limit the accumulation of physical capital?
If a country must rely primarily on domestic sources of savings in order to provide funds for investment, a low savings rate will result in a low rate of physical capital accumulation. Domestic savings comes from individuals and firms deciding to save more and spend less, or from the government deciding to increase taxes to pay for government investment spending. It is also possible for a country to use the savings of foreigners to pay for physical capital accumulation.
Suppose planned aggregate expenditure is greater than actual aggregate expenditure. In this case, what do you think will happen to output over time?
If actual aggregate expenditure is less than planned aggregate expenditure, then actual investment is less than planned investment. In this case, firms must be adding less output to inventory than was planned, meaning they are selling more than they expected. Firms will have an incentive to increase output.
What effect does an increase in current income have on current consumption? What effect does an increase in expected future income have on current consumption?
If current income increases, then current consumption will also increase. People are likely to spend part of the extra income on consumption and save the rest. If expected future income increases, then current consumption will increase. People are likely to spend a little bit more of their current income and save a little bit less due to the expectation of higher income in the future.
How does a change in expected profitability affect aggregate investment? How does a change in business taxes affect aggregate investment?
If firms expect profit to increase in the future, they are likely to increase aggregate investment by choosing to replace or upgrade existing equipment or expand productive capacity. If business taxes increase, then this is likely to decrease aggregate investment. Higher taxes will reduce profitability and therefore make purchases of new equipment and buildings less attractive.
What effect does an increase in the interest rate have on current consumption? What effect does an increase in wealth have on current consumption?
If interest rates increase, then it becomes more expensive to borrow. Consumers are likely to spend less on big purchases that require borrowing such as new cars and new houses. Additionally, consumers may be inclined to save a little bit more due to the higher interest earned on saving. If wealth increases, then consumers are likely to spend a little bit more and save a little bit less out of their current income. This is because they have a larger stock of wealth (in the form of financial assets or real estate) that they can draw on for retirement or other expenses, and therefore they feel less of a need to add to that stock of wealth by saving a greater amount of current income.
You read in the paper that the dollar has strengthened in value relative to the euro. How is this change in the exchange rate value of the dollar likely to affect exports to Europe and imports from Europe?
If the dollar has strengthened in value, then this is like the exchange rate changing from $1.10 per euro to $1.06 per euro. In this case, people pay fewer dollars for a euro, so the euro has lost value relative to the dollar, meaning the dollar has gained value relative to the euro. When the dollar becomes stronger in value, this will decrease exports to Europe and increase imports from Europe. When the value of the dollar is stronger, Europeans receive fewer dollars per euro ($1.06 vs. $1.10), so U.S. goods are relatively more expensive. When the dollar is stronger, people in the U.S. can buy euros for fewer dollars, so European goods are relatively cheaper.
Suppose the economy is experiencing a recessionary output gap. What has happened to planned aggregate expenditure? What might have caused this change?
If the economy is in a recessionary gap, then the current level of equilibrium output is below potential output. In this case, the planned aggregate expenditure line shifted down due to a change in some nonincome determinant such as an increase in interest rates, a drop in consumer or firm optimism, an increase in taxes, or a decrease in government spending.
The investment category of GDP measures three different types of expenditures. What are they? Why is planned investment sometimes different from actual investment?
Investment measures spending by firms on new goods and services, and includes spending on new capital, new houses, and inventory accumulation. Purchases of stocks and bonds are a type of financial investment, and this does not count in the investment spending category of GDP. When firms or people purchase stocks, they are converting one type of asset (money) to another type (stock), and this does not count as new production. Unexpected changes in demand will cause planned investment to differ from actual investment. For example, suppose a firm produces 10 units, plans to sell 8, and plans to put the extra 2 in inventory. If this all happens, then planned investment equals actual investment (the value of the 2 extra units). If they only sell 7, then they will add 3 to inventory and actual investment (the value of the 3 units) is greater than planned investment (the value of the 2 units).
Which components of aggregate expenditure do not directly depend on current income?
Investment: Investment includes spending on new capital, new houses, and inventory accumulation. The determinants of investment are the factors that change the benefits and costs of adding new physical capital—expected profitability, the interest rate, and business taxes. Government spending: Government spending is determined by Congress and the president based on what they think citizens need. Consumption: Consumption depends directly on income—when people have more income, they spend more. Net exports: Net exports depend directly on income because some of the extra consumption spending will be spent on imports.
Unemployment is often called a lagging or trailing indicator because unemployment tends to rise sometime after the economy begins to slow down, and unemployment begins to fall again after the economy begins to rebound. In other words, unemployment trails GDP. Why do you think this might be the case?
It is expensive and unpleasant for firms to fire or lay off workers. Thus, firms will avoid getting rid of employees at the first sign of an economic downturn and will often wait until a recession is firmly in place before they start getting rid of workers. Thus, the rise in unemployment trails the fall in GDP. Likewise, it is expensive to recruit and train new employees, so firms typically wait until a recovery is well underway before they start hiring again. Again, the fall in unemployment trails the rise in GDP.
Why is long-run economic growth generally positive rather than negative?
Long-run changes in output are driven by changes in the LRAS. The primary components of LRAS are L, K, and technology. While all three of these can either rise or fall, at least with technology, this component tends to go only one direction. Once something is discovered or invented, it is rarely forgotten, so technology causes economic output to steadily grow. Of course, it is possible for technology to go backwards. The dark ages represented a long period of time in Europe where, for a variety of reasons, things were forgotten. Thus, economic growth stagnated and potentially even reversed for many centuries. More recently, in Cambodia in the late 1970s, the Khmer Rouge dictatorship actively destroyed the country's existing modern technology, significantly reducing GDP (as well as resulting in the deaths of roughly 2 million citizens.)
In France, labor laws typically made it very difficult or even illegal for firms to fire workers during economic downturns. How would these laws affect cyclical unemployment as well as frictional and structural unemployment? (Hint: Think about how these laws affect firms' decisions to hire workers in the first place.)
Making it difficult to fire employees during economic downturns will reduce cyclical unemployment. That's the obvious part of the question. These laws, however, make it far riskier to hire workers in the first place, since firms will be unable to fire them in the case of a recession. Since firms are more reluctant to hire in the first place, frictional and structural unemployment is likely to be higher. The net effect on unemployment is ambiguous, but overall, one should expect a higher natural rate of unemployment in France but lower peaks of unemployment during recessions. Laws like this make it very hard to find work in the first place, but also make the jobs that workers do have more secure.
What happens to the level of net exports in an economy when income in that economy increases? What happens to the level of net exports in an economy when income in other economies increases?
Net exports is equal to the value of exports minus the value of imports. When income in the economy increases, the level of net exports will decrease. With higher levels of income, consumption spending is higher and some of this spending represents imports. Higher import spending reduces net exports. When income in other economies increases, the level of net exports will increase. When foreigners have more income, they spend more, and some of this is on our exports.
The traditional goal of a government is to maximize its citizens' welfare. Given this goal, would you suggest getting rid of unemployment insurance? How would your answer change if the goal of the government is to maximize employment?
Obviously this question is a normative one, so there is no one right answer. That being said, most people benefit from having a safety net that protects them from economic variations that are beyond their control. Unemployment insurance helps people just during the time that they need help the most, so it can easily be argued that the unemployment insurance safety net improves citizens' welfare on average. On the other hand, it is clear that unemployment insurance reduces workers' incentives to find new jobs when they lose their old ones, which decreases employment. Whether unemployment insurance is a "good" thing clearly depends on what government is trying to maximize.
Explain why inflation reduces the real value of nominal GDP per capita.
Real GDP per capita is the amount of goods and services produced per person. Nominal GDP per capita is the number of dollars produced per person. Since inflation increases the number of dollars required to purchase goods and services, if a country's nominal GDP is fixed, inflation will reduce the amount of goods and services that the fixed amount of nominal GDP can purchase.
Explain why many rich countries are able to continuously grow, even though they already have very high levels of physical and human capital.
Rich countries with high levels of physical and human capital are able to continuously grow if they can continuously increase any of the components that lead to productivity growth. First, it is possible that even countries with high levels of physical and human capital can continue to accumulate even higher levels of these factors of production. Second, countries with lots of physical and human capital are well equipped to engage in technological innovation, another component of productivity growth.
Explain the difference between sticky wages and sticky prices. How do these two ideas explain the upward slope of the short-run aggregate supply curve? Why don't sticky wages or sticky prices affect the long-run aggregate supply curve?
Sticky wages are contracts that keep wages fixed between businesses and workers, while sticky prices are contracts that keep prices fixed between businesses and their suppliers. The SRAS is upward-sloping because as prices of a firm's products rise, it is willing to supply more if its input costs are not rising at the same time. Thus, in the presence of sticky wages and prices, the SRAS is upward-sloping. Sticky wages and prices don't affect the LRAS because eventually every contract expires and firms, workers, and consumers renegotiate prices. Thus, prices and wages are only sticky in the short run, not in the long run. In the long run, prices and wages will adjust and output will be equal to potential output, so the LRAS is vertical.
Everything else equal, which will have a larger effect on aggregate demand and GDP: a $100 million reduction in taxes or a $100 million increase in government spending? Is everything else equal in practice? Why or why not?
The $100 million increase in government spending will have a larger effect because planned aggregate expenditure will initially rise by the full $100 million. When taxes are cut by $100 million, this will cause disposable income to rise by $100 million and consumption will rise by less than $100 million because the MPC is less than 1. For example, if the MPC is 0.9, then the $100 million tax cut will increase consumption spending (and therefore planned aggregate expenditure) by an initial amount of $90 million.
At a young age, would you rather have a large level of savings or a pool of savings that was increasing at a faster rate?
The answer depends on the relative size of the two starting amounts, and on the two growth rates. As a general rule, it is possible that the smaller initial amount of savings growing at a faster rate will end up larger after some long period of time. For example, if you start with $5,000 and the growth rate is 11% per year, then you end up with $114,461.48 after 30 years. If you start with $50,000 (a much larger level) and the growth rate is 2% per year, then you end up with $90,568.08. If the growth rate on the $5,000 is only 9%, then after 30 years you would end up with $66,338.39.
How is it possible that Switzerland, a landlocked country with almost no natural resources, is one of the richest countries in the world while the Democratic Republic of the Congo, a huge country with vast deposits of many strategically important minerals, is one of the poorest?
The case of Switzerland vs. the Democratic Republic of the Congo clearly highlights that natural resources are only one component of productivity. All things equal, it is probably better to have more natural resources than less, but when comparing a country with lots of physical capital, human capital, technology, and good governance but few resources (Switzerland) and a country with lots of resources but little human or physical capital, low levels of technology, and a long history of corrupt governance (Democratic Republic of the Congo), we see that natural resources alone generally can't make up for all of the advantages that the other components of productivity growth bring.
The demand curves for individual goods are typically downward-sloping, due both to the substitution effect as well as to the income effect. Why does the substitution effect not affect the aggregate demand curve?
The demand curve for an individual good is downward-sloping because an increase in the price of the good will reduce the amount of the good purchased, assuming the prices of all other goods remain the same. When the price of the good rises, other goods become relatively cheaper and people have an incentive to substitute towards another similar good.The aggregate demand curve is downward-sloping because an increase in the price level (or the price index) will reduce the real value of income and wealth, and people will reduce the quantity of goods and services purchased. In this case there is no substitution effect because the overall price level is rising, so we are thinking about the effect of a change in overall purchasing power, and not the effect of a change in relative prices that causes people to substitute away from one good and towards another.
In a Keynesian equilibrium will the economy always be producing at its level of potential output? Why or why not?
The economy does not always produce at its level of potential output. Firms do not choose to produce the most they can at a given price. Instead, they produce what they can sell at a given price. When demand is weak and prices do not immediately fall, firms end up producing only what is demanded. Firms will choose to reduce output in response to weak demand to avoid unwanted inventory accumulation.
Suppose the economy is in a recession and the president wants to stimulate production and create jobs. To do this, he has decided to increase government spending. Some of his economic advisors are suggesting the marginal propensity to consume (MPC) has a value of 0.9 and others are suggesting the value is 0.8. How will this difference in the value of the MPC affect the president's decision regarding the dollar amount of the increase in government spending?
The expenditure multiplier is equal to 1/(1 - MPC). If the MPC has a value of 0.9, then the expenditure multiplier is equal to 10. If the MPC has a value of 0.8, then the expenditure multiplier is equal to 5. If the president believes the MPC has a value of 0.9, then he will choose to increase government spending by less than the amount he would choose if he believed the MPC had a value of 0.8. With an MPC of 0.9, any given increase in government spending will increase output (GDP) by a factor of 10, as opposed to a factor of 5 with an MPC of 0.8. Therefore, the change in government spending does not need to be as large.
Suppose a country is in the midst of an economic boom and is running large budget surpluses. The president suggests that due to the good economic conditions, the time is ripe for a large tax cut. What are the arguments for and against this position?
The fact that the country is experiencing a boom should lead one to believe that the economy is at or above its usual long-run equilibrium. The president is suggesting that the country now further stimulate the economy by cutting taxes. This will push AD to the right and increase output even further. However, this higher level of output is above LRAS, so it is not sustainable. SRAS will eventually shift left bringing the economy back to its original level of output but with much higher prices. Cutting taxes in an economic boom can't produce a long-run increase in output and will only serve to overheat an already booming economy. While the president's suggestion might sound right, this is actually poor macroeconomic policy.
Suppose a country is in the midst of a serious recession, with high unemployment and large government deficits. The president suggests that in times like this the government has the obligation to "tighten its belt" and cut spending, since so many families around the country have to do the same thing. Do you agree with the president? Why or why not?
The fact that the country is experiencing a recession should lead one to believe that the economy is below its usual long-run equilibrium. The president is suggesting that the country now further restrain the economy by raising taxes and cutting spending. This will push AD to the left and decrease output even further. While the president's suggestion might sound right, this is actually poor macroeconomic policy.
Why does the government have a harder time counteracting shifts in AS than in AD?
The main problem is that leftward shifts in AS both raise prices and reduce output. Standard policies can only cure one of these two problems at a time. If the government raises spending or cuts taxes, output can be restored, but at the cost of even more upward pressure on prices. If the government cuts spending or raises taxes, prices can be restored to their previous levels, but output falls even further.
Using the growth rates for countries found in Figure 10-3, is there evidence that poorer countries in Africa and Asia are converging to the level of income found in Western Europe? Why or why not?
The map shows that over the past 20 years countries in Africa and Asia have grown faster than countries in Western Europe. This suggests that some level of convergence has taken place.
Give two reasons why it may be rational for a firm to offer wages above the minimum wage.
The old adage is "you get what you pay for." Paying higher wages is likely to attract higher-quality workers, who will be more productive. Paying higher wages also induces higher effort from employees, since highly paid workers have more to lose if they lose their jobs. Finally, highly paid workers are less likely to leave their jobs, and since recruiting and training employees is expensive, reducing job turnover is valuable to firms.
What causes a movement along the planned aggregate expenditure curve? What causes the planned aggregate expenditure curve to shift?
The planned aggregate expenditure line illustrates the relationship between planned aggregate expenditure (on the vertical axis) and output/income (on the horizontal axis). When income rises, so does expenditure and output, and this leads to an upward movement along the planned expenditure line. Changes in nonincome determinants of aggregate expenditure such as government spending, interest rates, and business optimism cause the planned aggregate expenditure line to shift. For example, if businesses are more optimistic, then they will increase investment spending and this will lead to an increase in planned aggregate expenditure at the given level of output—the PAE line will shift upwards.
Does the rule of 70 predict greater increases in the amount of income for richer or poorer countries when both have the same growth rate? Why?
The rule of 70 predicts that the amount of time it will take a country's income to double is dependent only on its growth rate, not on its initial level of income. However, the size of the increase certainly depends on its starting point. For example, two countries with a 7% real per capita growth rate will both have their incomes double in 10 years (70/7 = 10). If one country started with a GDP of $1,000/capita and the other started with a GDP of $10,000/capita, the poor country would have experienced an increase in income from $1,000 to $2,000 per person in 10 years, an increase of $1,000 per person. The rich country would have experienced an increase in income from $10,000 to $20,000 per person in 10 years, an increase of $10,000 per person.
Suppose the president of a country comes to you to ask your advice. The country is currently at 8 percent unemployment, and the president wishes to reduce unemployment in the country to 3 percent. As an economist, you determine that the country's natural rate of unemployment is 5 percent. What advice would you give the president?
There are several potential things you could tell the president. First, since the current unemployment rate is 8 percent and the natural rate is 5 percent, the country must be suffering from cyclical unemployment. Anything the president can do to stimulate the economy is likely to reduce the unemployment rate closer to 5 percent. However, the president should also pick a different target. The natural rate of unemployment is "the minimum level of unemployment that is unavoidable in a dynamic economy," and in general, any attempts to reduce unemployment below this number are likely to result in a lot of effort for little gain. So, economic recovery should bring the unemployment rate down closer to 5 percent, but there is no reason to believe the economy can get all of the way to 3 percent. There are ways to reduce the natural rate of unemployment (although probably not to 3 percent, at least in the U.S.). The government can provide retraining for those with structural unemployment issues. Lowering unemployment compensation and eliminating the minimum wage are also likely to reduce the natural rate of unemployment.
Realizing that poor countries must solve many problems at once has shifted donors away from the idea of giving multiple small payments to the idea of a "Big Push." This Big Push entails giving a very large sum of money that could be used to fix multiple problems at once. In fact, the amount of money required might be so large that other countries might be the only ones who could afford the donation. What are the trade-offs associated with this idea?
There are tradeoffs faced by both the donor country and the recipient country. From the donor country's perspective, a large donation to a developing nation could have great humanitarian benefits, including reducing poverty and encouraging sustainable growth in that country. However, this money could have been used for other purposes within the donor country. Here in the United States, it is a frequent source of contention that the U.S. donates "so much" money to other countries instead of rebuilding our own cities. (Of course, we don't actually donate a large portion of our GDP.) So, the tradeoff is between improving the lives and welfare of foreigners with the opportunity cost of the money. From the recipient's perspective, the benefits of a large donation could be quite dramatic—again, reducing poverty and encouraging sustainable growth. However, receiving a sudden large donation might simultaneously undermine that country's nascent set of institutions. Corruption, for example, might arise, as local officials try to siphon off some of the incoming funds. Also, the developing country might begin pushing for policies that it thinks will attract more foreign funds, rather than pushing for policies that are actually in the country's best interests.
Whenever AD or AS shifts, putting the economy out of long-run equilibrium, AS has a natural tendency to shift in such a way as to bring the economy back into long-run equilibrium. If the economy always eventually comes back to long-run equilibrium, why would the government ever try to implement policies to bring the economy into equilibrium through government means?
There are two reasons. First, when AD shifts the economy experiences a short-run change in output and both a short-run and long-run change in prices. The appropriate government response can eliminate the long-run shift in prices. Second, negative shifts in AS or AD cause a reduction in output and a corresponding increase in unemployment. The natural return to full unemployment may take a long time and government action can speed up the process reducing suffering.
Does the amount of government spending in an economy respond directly to changes in aggregate income, wealth, or interest rates? Does it respond indirectly to changes in these variables?
There is no direct relationship between government spending and aggregate income, wealth, or interest rates, meaning a change in one of these variables does not automatically change government spending. The U.S. Congress and the president determine government spending each year as part of the budget process. A change in one of these variables may have an indirect effect on government spending. If changes in income, wealth, or interest rates are linked to a severe recession, then the government may feel compelled to change government spending and enact a specific policy to stimulate economic activity.
"People who earn more income tend to have higher levels of consumption spending, so the value of their marginal propensity to consume must be greater than that of lower income people." Do you think this is a true statement? Why or why not?
This statement is false because the marginal propensity to consume is a proportion of additional income spent. The average propensity to consume is the proportion of income spent. The average propensity to consume is likely lower for those with higher incomes.
A government official observes that there has been a short-run increase in the price level. Is it possible for her to determine whether this was caused by a demand shock or a supply shock? Why or why not?
This was caused by a positive demand shock or a negative supply shock. A positive demand shock will increase aggregate demand—the aggregate demand curve will shift to the right, causing firms to increase production and the price level. A negative supply shock will decrease short-run aggregate supply; the short-run aggregate supply curve will shift to the left as firms increase prices and production falls. A negative demand shock would shift the aggregate demand curve to the left and the price level would fall. A positive supply shock would shift the short-run aggregate supply curve to the right and the price level would fall.
A government official observes that there has been a long-run increase in the price level but no change in the level of potential output. Is it possible for her to determine whether this was caused by a demand shock or a supply shock? Why or why not?
This was caused by a positive demand shock. A positive demand shock will increase aggregate demand; the aggregate demand curve will shift to the right, causing firms to increase production and the price level. In the long run, the prices of inputs and the wages of workers will increase, causing the short-run aggregate supply curve to shift to the left. The price level will increase further and output will return to potential. A negative supply shock will decrease short-run aggregate supply; the short-run aggregate supply curve will shift to the left as firms increase prices and production falls. Assuming this is a temporary supply shock, in the long run, the short-run aggregate supply curve will shift back to the right, causing the price level and output to return to their initial long-run levels. A negative demand shock would shift the aggregate demand curve to the left and the price level would fall. In the long run, the prices of inputs and the wages of workers will decrease, causing the short-run aggregate supply curve to shift to the right. The price level will decrease further and output will return to potential. A positive supply shock will increase short-run aggregate supply; the short-run aggregate supply curve will shift to the right as firms decrease prices and production rises. Assuming this is a temporary supply shock, in the long run, the short-run aggregate supply curve will shift back to the left, causing the price level and output to return to their initial long-run levels.
List at least five types of people who do not have paid jobs but would nevertheless not be considered unemployed.
To be unemployed, one needs to not have a job but be actively searching for one. Anyone without a job but not actively searching would be neither employed nor unemployed. Examples include students, retirees, many disabled persons, persons institutionalized or incarcerated, homemakers, full-time volunteers, and discouraged workers who do not have a job but have given up looking for work.
Which typically can change faster: the components of aggregate demand or the components of aggregate supply? Explain.
Typically, the components of AD can change faster than the components of AS. A person can make a quick decision about whether to buy a new car (C). A business can make a quick decision about whether to build a new plant (I). The government can make a quick decision about whether to spend more money. Increasing the number of workers, the amount of capital, or the level of technology in a country, all of which affect AS, takes a long time to occur. The only component of AS that can change somewhat quickly is price expectations, but even this can be somewhat slow due to wage and price stickiness.
"During a recession more people qualify for unemployment insurance. This will increase the government spending category of GDP and help reduce the severity of the recession." Do you agree with this statement? Why or why not?
Unemployment insurance is a government program that provides cash benefits to eligible workers who have lost their jobs. The purpose of the program is to reduce the severity of recessions. When people lose their jobs during a recession, their income falls and this causes consumption to fall. The cash benefits from the government act as temporary income and this causes consumption to rise. Note the cash benefit is typically not more than 50% of the worker's lost salary and the benefits can only be collected for 26 weeks during normal times. The cash benefits are government transfer payments and, therefore, they do not count as part of the government spending category.
"When one country in the world falls into a recession, this tends to cause other countries to also fall into a recession." Do you agree with this statement? Why or why not?
When a country falls into recession, the levels of output and income will decrease. Because firms are producing fewer goods, they need fewer workers and unemployment will increase. The reduction in income will reduce consumption spending. People will spend less on domestically produced goods and on imported goods, so imports will fall. When imports fall, net exports will increase because net exports is equal to exports minus imports. Given imports to the country in recession have fallen, exports from the trade partners will fall. This will reduce the level of production and income in the trade partners' countries. When one country in the world fall into a recession, this tends to cause other countries to also fall into a recession, given the importance of global trade.
Explain the mechanism through which the economy adjusts in the short run and the long run when consumer confidence falls.
When consumer confidence falls, in the short run, aggregate demand will shift to the left, reducing equilibrium GDP and the price level. In the long run, the lower price level resulting from reduced aggregate demand will lower costs, increasing the aggregate supply curve and shifting it to the right.
How does a change in the interest rate affect aggregate investment? What if firms prefer to pay for investment spending out of retained earnings? Does a change in the interest rate still affect aggregate investment?
When firms take out loans to pay for capital improvements, any increase in the interest rate will decrease aggregate investment because it is more costly to borrow. When firms prefer to pay for investment spending out of retained earnings, any increase in the interest rate will decrease aggregate investment. This is because the retained earnings are likely to be accumulated in a bank account that pays interest. Therefore, when the interest rate goes up, the opportunity cost of spending the accumulated funds also goes up, and investment spending is likely to fall.
Do you think there is a predictable relationship between the business cycle and aggregate investment spending? Why or why not?
When the economy is in a recession, spending on goods and services falls, so firms will reduce production. Because firms are producing less output, they don't need to hire as many workers and this causes unemployment to rise. Rising unemployment leads to a reduction in income. Firms will be less likely to purchase new equipment and expand their productive capacity because planned aggregate expenditure has fallen. During a recession, aggregate investment spending falls. During an expansion, aggregate investment spending rises.
What is the relationship between the equilibrium level of aggregate expenditure in an economy and the aggregate demand curve? According to the aggregate expenditure equilibrium model, why does the aggregate demand curve slope downward?
When the price level rises, the planned aggregate expenditure line shifts downwards because the higher price level reduces the real value of income and wealth so there is less consumption spending. Our exports are also more expensive, so there is less net export spending. The decrease in planned aggregate expenditure causes firms to decrease production of goods and services. This explains why the aggregate demand curve slopes downwards.
In the United States during regular economic times, the maximum length of time a worker can collect unemployment insurance is 26 weeks. During recessions, however, Congress often increases the length of time in which workers can collect benefits. During the recent financial crisis, workers could collect benefits for up to 99 weeks in some states. Comment on the advantages and disadvantages of this system.
With a 26-week limit on unemployment insurance, workers have a strong incentive to search diligently for work since their benefits last only a short period of time. In normal times, this amount of time should be sufficient for a worker to find a new job, so unemployed workers are provided with an adequate safety net while also given appropriate incentives to find work. In a recession, however, there will be more unemployed workers and fewer firms hiring, so 26 weeks may not be sufficient for the typical person to find a new job. Raising the length of time a worker can receive benefits keeps the safety net in place while acknowledging the additional difficulty in finding work in a bad economy. Of course, raising the length of time an unemployed individual is eligible for benefits will generally prolong the amount of time a person stays out of work.
Compare two countries, one that has unlimited unemployment insurance and one in which workers are eligible for 26 weeks of unemployment insurance. Explain one reason why the country with more unemployment insurance may have a higher equilibrium unemployment rate.
Workers in the country with unlimited unemployment benefits have less incentive to search diligently for work since they will receive benefits for an unlimited period of time even if they don't find work. Thus, they are more likely to remain unemployed than workers in a country with benefits limited to 26 weeks, who have a very strong incentive to find a new job within the 26 weeks before they lose their benefits.
