Econ 104 Final Exam

What are we are referring to when we talk about "The Fed." Who are the main decision makers at the Fed?

"The Fed" is the Federal Reserve. The Federal Open Market Committee and Janet Yellen is the head of this committee and decides the federal funds rate.

In 2017, the U.S. Congress passed and Trump signed into law a major tax-cutting measure. Opinions range as to the impact this new tax structure is likely to have on the U.S. economy. Consider at least one perspective as to what the impacts are likely to be. Will it lead to increased federal deficits and debt? If so, will those be cyclical or structural deficit increases? Will there be any broader impacts on the economy?

- SHORT TERM: when taxes are cut there will be a deficit. -LONG TERM: cutting taxes will put more money in businesses pockets and allow them to expand and hire more people. Therefore, unemployment will decrease and the number of people paying taxes will increase. Because more people are paying lower taxes, the tax revenue will stay the same or go up, so it will not lead to increased deficits and debt.

The main justification for cyclical deficits comes from the "functional finance" approach. What function are the deficits serving? Are the deficits being put to good use?

-"Functional Finance": the role of government to stave off inflation and unemployment by controlling consumer spending through raising and lowering taxes. This prevents recession. -It considers the national income identity, saying that consumption depends on national income.

In 2007 - 09, the U.S. and global economy experienced the most severe financial bubble, collapse, and crisis in 70 years. Be clear on the basic dynamics driving a financial bubble. Why can financial bubbles be self-reinforcing? Why do they collapse?

-Bubbles are a result of borrowing too much in pursuit of new profit opportunities. "Over leveraging" -As an example, in 2001 banks started to bundle up mortgages and sell them in the form of mortgage backed securities. Banks would be more willing to own mortgages because they were "less risky." Real estate prices went up because banks are giving out more mortgages, so more money is available in the real estate market. But, once people become unable to pay back their debt, bubble deflates. -These bubbles are self-reinforcing, because you believe there is a big profit opportunity, prices go up that make people borrow even more. We can easily stop the bubble by putting a ceiling on how much debt you can bring into the market.

Understand the role of exchange rate issues with respect to China and the US, and more generally. How does having a "cheap" currency help a country export? How could China continue to help keep its currency value low?

-By having a cheap currency, it's cheaper for other countries to buy products from them which increases their exports around the world. -If currency rises that means it would be more expensive to buy goods, which decreases demand.

If we consider the cases of South Korea and China, is it accurate to say that their successful growth experiences have been tied to the idea of comparative advantage? Distinguish between "static" and "dynamic" comparative advantage.

-China's strength is low-cost labor and Korea's is technology and capital. As China's economy grows they now have enough capital to invest in its economy. -Dynamic is -Static is

Cyclical vs. Structural Deficits

-Cyclical: gov borrowing money to counteract recession. It is the balanced budget over a full cycle. -Structural: gov borrowing money to improve the structure of the economy. It is the deficit over a full cycle.

During the COVID lockdown, the combined bailout operations of the U.S. Treasury and Federal Reserve reached unprecedented levels. This included federal government deficit spending and Federal Reserve asset purchases. Be able to describe the main features of these interventions. Were these interventions necessary? Are other policy measures more effective/fair?

-Deficit spending was necessary because without the government intervention and injecting money into the market, the economy would have collapsed. These measures helped the economy to stay afloat. -The federal reserve asset purchases were 25% of the GDP. This was necessary because the bailout needed was much higher than anything we've ever experienced.

Deficits vs. Accumulated Debt

-Deficit: what the government borrows in one year. -Accumulated debt: accounts for all of the money owed overall, while deficit is just an annual difference.

Differences between rich, poor and middle-income countries: what does the average person in each country expect in terms of life expectancy and average income?

-GDP per capita and life expectancy are good indicators for quality of life. US>Haiti US: additional 15 years life expectancy over Haiti, GDP of 60,000 Haiti: GDP of 2,000

Consider the 1970s. What could explain the relationship between unemployment and inflation that we observe then for the U.S. economy, relative to the relationship for the 50s and 60s?

-In the 1970s, there was an oil problem which caused prices of goods and service to go up which increased unemployment. Therefore, there was a positive relationship between inflation and unemployment. -However, the relationship in the 1960s and 1950s was supported by the Phillips Curve (which said they have an inverse relationship)

It is a widely held view that immigrants in the U.S. labor market hurt job prospects for native U.S. workers. Why?

-They think immigrants take up jobs in the market. However, immigrants create jobs by creating businesses, and are an integral part of our workforce. -They increase supply of jobs by increasing the demand for goods and services -Alternative perspective: Miami has a lot of immigrants, Philly doesn't, yet there isn't a difference in their economy.

What is the law of comparative advantage? Why would any given country seek to specialize in producing one or two products and importing everything else they need, rather than diversifying?

-Law of comparative advantage is that each country would thrive if it was specialized in a certain aspect of trading. Focusing on producing one high quality product is more efficient than multiple low quality products. Allows countries to benefit by trading with each other. -Both Belgium and Pakistan produce textiles and chocolate, but Belgium is more productive and efficient and producing more chocolate. Shows us that Belgium should specialize in producing chocolate and Pakistan should specialize in textiles. Then they can benefit by trading with each other, they will have more money and more resources.

It is a widely held view that immigrants living in the U.S. are absorbing a significant share of the economy's available public services, without paying a proportional share of taxes to support these services. Why?

-Legal immigrants still pay a great amount of taxes. They work in many American companies and make their own businesses. -They attract foreign investment which brings more money into the US -Undocumented workers are contributing to social security trust funds because they are taxed at jobs. -They also pay sales tax on anything that they purchase but do not receive health care benefits.

How did the government try to get out of the crisis using monetary policy, fiscal policy, and financial regulatory policies?

-Monetary Policy: the fed created more money supply to be available to the public. -Fiscal Policy: keeping interest rates low. The government bailed out banks that were too big and the fed bought $1.25 trillion in market backed securities so the banks could get back on their feet. -Financial Regulatory Policies: the government enacted the Dodd-Frank which regulated banks so a crisis like the recession would never happen again.

To what extent can we attribute the current rise in inflation to wage increases? What might be some other factors contributing to the current inflation spike?

-Overall inflation is at 8.5%, the highest since the late 1980s. Wage increases are about 4% -Current inflation is not the result of wage increases -Inflation spiked because: 1. The rise in energy: (gas price increase by about 50% during covid), caused the production of fuels to decline because there was no demand. when demand rose after lockdown, the prices went up. 2. Used cars: there was a supply chain breakdown during covid, so demand went up because supply of new cars went down bc of the lack of technology to produce the cars

The Fed introduced a new policy tool during the 2007 recession, which has come to be known as "quantitative easing." What are the basics of quantitative easing policy? How does it differ from the two policy tools mentioned above? What was the basis for the Fed introducing this new policy tool?

-Quantitative easing means that the federal reserve intervenes, not just to influence the federal funds rate, but to directly influence the interest rate of assets. -They did this during that crisis because dropping the interest rate to 0 didn't get them out of the recession because the long term rates were staying high. -Quantitative easing directly lowered the cooperate bond rate through policy

What are the main differences between the "functional" and "sound" finance approaches? Consider with respect to cyclical and structural deficits.

-Sound finance argues that deficits should always be balanced, except during wartime. It believes that politicians should not be trusted with money, and that government spending inhibits private sector growth. Big deficits during recession will cause high inflation, high interest rates, and debt burden. -Functional finance believes that a fall in the economy requires government deficit and that the critical issue in that moment is that the economy could collapse.

As a share of U.S. GDP, the federal government's fiscal deficit reached its highest level since World War II between 2009-12, then again over 2020 - 2021. What is the explanation for deficits reaching these unprecedented levels?

-The Great Recession was the reason for the first deficit, as the government was forced to significantly increase spending to try and aid the economy in recovering from the recession. The government had to spend money on food stamps, bailouts, and a stimulus package, while taking a hit in tax revenue. -Covid left the government with high fiscal deficits because they needed to keep the economy running during lockdown, give unemployment benefits, extensions, etc.

Inflation/unemployment trade-off: is it accurate to say that there is always a trade-off between unemployment and inflation?

-The Phillips Curve SHORT TERM: tracks the relationship between inflation and unemployment. it is an inverse relationship. inflation rises when unemployment goes down and vice versa. Gives businesses the idea to raise prices. -Oil LONG TERM: when price of oil and energy increases, inflation rises and makes it difficult for the economy to operate, so they lay off workers and drives unemployment .-Yes there is trade-off inflation, but it is not accurate to say that there is always a trade-off and it depends on the decade because of alternative sources

What was the logic of the Fed pushing the Federal Funds rate down to near zero during the 2007-09 crisis, and then again during the COVID? What would be the logic of the Fed ending this policy now?

-The fed pushed federal funds rate to 0 to stimulate the economy to counteract the recession. Interest rate went to 0 for covid, but we learned it wasn't sufficient because they said the big danger is inflation. -So they raised the interest rate in order to slow down the economy so unemployment rises and weakens inflation.

The Fed's mandate is to maximize employment in a manner consistent with price stability. Their main policy tools are to: 1) lower or raise the Federal Funds interest rate 2) lender of last resort policies. Be clear on what both of these policies are and how they differ.

-The federal funds rate is the interest rate that private banks borrow and lend money in hopes to stimulate business investment. The fed changes their interest rates by intervening in that market and buying or selling bonds to the banks. Raising this will worsen inflation. -Lender of last resorts (aka bailout) is when financial institutions are in distress and the fed has the power to put money back into the economy to keep it functioning. (done during covid)

What would be the reasons for the Fed to be raising the Federal Funds rate now? Is there a relationship between their most recent actions, and their understanding of the concept of the "natural rate of unemployment?"

-The goal of raising federal funds rates is to increase the cost of credit in the economy (making loans more expensive) -We are currently not at a point where the inflation is increasing, but Janet Yellen says we are close. -The "natural rate of unemployment" is the point where unemployment rates are as low as possible without an increase in inflation.

The Financial Times reported that the "Fed reaches for its 'hatchet" to attack galloping inflation." What is the Financial Times referring to as "the hatchet?" When has "the hatchet" been deployed in the past?

-When the government needs to control inflation, they raise the federal funds interest rates so that the economy will slow down and inflation will decrease -In 1980s, inflation was deflated by a big hatchet, because they raised interest rates to about 18%. -When interest rates are raised, unemployment increases bc businesses have a lower incentive to borrow money and produce more.

Two factors have contributed to making this most recent financial bubble bigger than previous ones: 1) Rising inequality in the U.S. economy 2) Deregulation of U.S. financial markets. How have these factors contributed to the crisis?

1.) Rising inequality gives too much power to the rich to support financial speculation and gives too little money to promote market demand and business expansion. The more money the rich has, the more money they will put in the speculative market which raises speculation and instability. 2.) Financial deregulation is an effort by democrats and republicans to overlook the lessons of the past

The debates on the recent macroeconomic crises and on solutions for getting out of them involve both philosophical positions and technical debates on policy tools. How would you distinguish between the philosophical viewpoints and the technical debates on policy approaches?

Adam Smith is a great example. The philosophical argument for a capitalist market would be: do we let people be greedy and let the free market operate? -The technical argument would be if you let the capitalist market run during a crisis, the costs are so extreme that we need to use tools to bailout and prevent these financial issues from having a great harm on society. -The philosophical argument for this would entail that we don't truly believe in free markets all of the time.. only when it benefits the economy.

While the fiscal deficit over 2009-12 and 2020-21 reached historic highs, government interest payments as a share of GDP have remained historically low. How is this possible and why did it happened? Why is the disparity between the two patterns—high fiscal deficits but low government interest payments—significant?

Even during deficit, it is possible for government to have low interest rates because the fed is keeping interest rates low. The government debt was increasing but the interest rates were so low, so the burden was less.

China's successful growth experience has been tied to its achievements as an exporter, with the US being the largest purchaser of Chinese products. What have been the main factors behind China's success in exports?

Factors: -To improve productivity, they improved technology by investing in infrastructure. -Exchange Rate Policy: China is a currency manipulator because they have maintained low currency levels to keep price of exports low in other foreign markets. -Wage Repression: having cheap labor and producing goods that people want to buy at mass quantity at low costs.

Karl Marx argued that the operation of a capitalist economy requires a "reserve army of labor"—or mass unemployment—in order for the system to continue functioning. Why did Marx think that capitalism could not operate if full employment is achieved and sustained?

Karl Marx believes that capitalism needs competition to work, and unemployment is some of that competition. With full unemployment, workers would have too much bargains power and drive up wages, making business profits lower. This would create an unsustainable capitalist market.

Be clear on where the U.S. stands in the global economy. How big is the U.S. economy as a share of the global economy? How important is the U.S. in terms of population and addressing climate change?

The U.S. is only a small part of the world, but they have 23% of the worlds GDP. The US population is 4% of the worlds population. This shows that the standard of living in the US is about 4 times higher than the global average. The U.S. is the second largest influencer in climate change with 16% of CO2 emissions coming from the US in the past 60 years.

The official unemployment rate for the U.S. today is 3.6%. What does that statistic measure? How does that measure take account of people who are "underemployed" or "discouraged" from trying to find a job?

This statistic is measuring those who are able to work and are actively looking for work. It does not measure those who are underemployed or discouraged from trying to find a job.

Government Deficit Spending

When the government spends more than it receives in income.

Within the context of functional finance, what is the justification for the government running deficits during recessions, such as the one we experienced over 2007-09 and 2020-21?

When times are good, the government cuts back on spending, but in recession, the government increases spending and cuts back taxes. This causes government deficit to go up, but it is necessary when the economy is in bad shape in order to kickstart the economy

Has the rise of China as an export powerhouse been detrimental in any way to working people in the U.S.?

Yes, it gives businesses more power over workers. If workers start wanting higher wages and unions, a company can threaten them by moving to China.

Be prepared to give reasoned views as to what we do today and give your thoughts on aspects of the current policy situation and debates. -Is the federal government deficit too large, and if so, why? Should the Fed be focused on slowing down the economy to prevent a rise in inflation?

yes the deficit is too large because the larger the debt the more we have to pay interest in the future. if the fed slows down the economy then unemployment will go up and GDP will worsen, but