Econ Exam

What are the advantages to fixing the exchange rate at an undervalued level? What are the disadvantages?

Fixing the exchange rate at an undervalued level will increase exports and decrease imports. This will be an advantage to those who exports goods and a disadvantage to those who import goods.

Why might we want to measure GDP in dollar terms? In output terms? How does the neutrality of money relate to your answer?

GDP is intended to measure production. Calculating GDP in dollar terms is a convenient way to add up the many different goods and services produced in the economy. However, nominal GDP will increase anytime there is inflation—even when the economy is not producing any more goods and services than before. By measuring GDP in real (output) terms, we can focus on growth and actual production. Neutrality of money describes the idea that nominal variables such as prices do not affect real variables such as output.

Foreign investors in a country become worried about the stability of the government due to its rising debt level. What do you expect to happen to the interest rate and the exchange rate value of the country's currency, assuming the country has a floating exchange rate?

Under a floating exchange rate, we would expect the interest rate in the country to increase due to capital outflow, and the exchange rate value of the currency will decrease in value (depreciate) due to an increase in the supply of the country's currency and an increase in the demand for the foreign currency.

What causes a stock market bubble to form?

A stock market bubble forms when stock prices become inflated beyond the point where anyone can explain precisely why the stocks should be so valuable. This tends to happen because the people who buy the stocks develop irrational expectations regarding what will happen to the stock prices in the future. Usually investors are irrationally optimistic in these cases and assume the asset's price will continue to rise.

Your friend claims that a target inflation rate of zero is a good policy because this will keep prices stable. You claim a positive target inflation rate is preferred because the country will be able to better avoid a liquidity trap. Who is right?

A target inflation rate of 2-3% reduces the risk of deflation. If the inflation rate tends to hover around zero percent, and the central bank miscalculates by making monetary policy too contractionary, the result would be deflation, and this can have serious impacts on the economy. If the target inflation rate is 2-3%, then nominal interest rates will be above that level, meaning the Federal Reserve has some room to reduce interest rates before hitting the zero lower bound. A target inflation rate of 2-3% makes it easier for firms to adjust real wages. If prices are stable, reducing the real wage requires employers to reduce the nominal wage; workers may respond to a 1 percent reduction in their nominal pay by reducing their work effort.

As the Federal Reserve responded to the recent housing crisis, how did this affect its balance sheet? Can you think of what caused the balance sheet's size to change so much?

As a result of monetary policy actions taken to fight the effects of the housing crash, the Fed's balance sheet more than doubled in size in just a few months. During this time, the Fed was not only buying U.S. Treasury securities (as it normally does to conduct open market operations), but it was also buying up large quantities of mortgage-backed securities and other financial assets in order to provide liquidity to the financial market.

Suppose a country's currency is a gold coin. One day, speculators find a large gold mine, which doubles the supply of gold coins in the economy. What will happen to output in the short run? What about price levels? What will happen to output in the long run? What about price levels?

Although the process by which the supply of money has increased is different from when the Fed increases the money supply, the effect is the same. The increase in the supply of gold coins (money) will result in lower interest rates, which encourages borrowing and pushes up the consumption and investment components of aggregate demand. Therefore, in the short run, both output and the price level will rise due to a rightward shift of the aggregate demand curve. In the long run, the increase in the demand for labor and other inputs will increase the costs of production. Firms will increase prices, shifting the short-run aggregate supply curve to the left. The price level ends up at a higher level, while output goes back to its long-run level.

Many subprime borrowers entered into "adjustable-rate mortgages" with low teaser rates. These mortgages allowed borrowers to pay a low interest rate for the first two years on their mortgage, before the rate jumped to market levels. But the loan documents sometimes made it difficult for borrowers to understand that the rate would increase. Explain why this practice could lead to a bubble in housing prices.

Anytime borrowers don't understand what they're agreeing to, they run the risk of taking on loans they won't be able to pay back, and this was definitely the case during the recent housing bubble. If borrowers don't understand when interest rates on their loans will rise, or how this will affect their required payments, they may take on too much debt and not be able to make payments when the rate change occurs.

Suppose that in response to a severe recession, a country with an overvalued currency and a fixed exchange rate moves to a floating exchange rate system. Who are the winners and losers in this move?

Because the currency was previously fixed and overvalued, the move to a floating exchange rate will cause the exchange rate to depreciate. Exporters and firms that compete against imports (as well as these firms' workers) are the winners as their products now become cheaper and more competitive against foreign goods.

Suppose the exchange rate was 104 yen per dollar in 2017 and 110 yen per dollar in 2018. Did the dollar appreciate or depreciate? What about the yen?

Because you must now pay more yen in exchange for one dollar, the dollar has increased (appreciated) in value and the yen has decreased (depreciated) in value.

Explain the effect contractionary monetary policy will have on the output gap, inflation, and unemployment if unemployment is currently at the non-accelerating inflation rate of unemployment.

Contractionary policy will reduce the output gap by decreasing spending and lowering employment. This will result in an increase in the unemployment rate, and inflation will decrease.

A country has a fixed exchange rate. If world interest rates rise, what will the country have to do to maintain its fixed exchange rate? Has the fixed exchange rate become relatively more undervalued or overvalued?

If world interest rates rise, the country will have to buy domestic currency and sell foreign currency to maintain the fixed exchange rate because there will be more capital outflow. The fixed exchange rate has become relatively more undervalued.

Your senators now claim that lowering prices would be good for everyone— "Who doesn't like lower prices, after all?" They tell you they plan to lobby for deflation. Explain why falling prices could lead to a bad situation.

Deflation is a very bad idea for an economy. It makes debt harder to pay back because loans are made in nominal terms, yet borrowers will have to give up increasing shares of their real income when they pay them back. This will hurt households' ability to consume. While deflation increases the value of savings in real terms, consumption will remain depressed because people will expect prices to keep on falling and therefore won't want to spend until they come down even more. The economy would find itself in a deflationary trap in which low investment and consumption would lead to even more low investment and consumption. Deflation is definitely not the answer!

Part of the North American Free Trade Agreement (NAFTA) opened the Mexican stock market to U.S. and Canadian investors for the first time. How would this affect direct and portfolio foreign investment in Mexico?

Direct investment is when a foreign company or investor "directly" builds a new factory or store. Portfolio investment is when a foreign investor purchases financial assets in a country. This provision of NAFTA probably wouldn't have any effect on direct investment, but portfolio investment would rise as foreign investors have an increased ability to purchase Mexican financial assets through the Mexican stock market.

During a recession the central bank lowers interest rates. How does this affect the exchange rate and net exports?

During a recession, the central bank lowers interest rates. Under a floating exchange rate system, the value of the currency will depreciate because capital outflow will increase as people move their wealth to other countries where interest rates are relatively higher. Net exports (exports - imports) will increase because when the currency decreases in value, exports become relatively cheaper and imports become relatively more expensive

Why might the velocity of money increase around the holidays? If the Federal Reserve wants to avoid inflation in those times, what should it do?

During the holidays, people increase their spending, which may mean that each dollar of income is spent more times. This is an increase in velocity. To see how inflation could result, consider the quantity equation: MV = PY. If velocity increases while the money supply M and real output Y are constant, inflation will indeed occur. But if the Federal Reserve responds by lowering the money supply, the economy could avoid inflation.

What is the difference between core inflation and headline inflation? Why do economists calculate both types of inflation?

Headline inflation is a measure of inflation that includes all of the goods and services that the average consumer buys. Economists calculate headline inflation to measure changes in the overall price level. Core inflation is a measure of inflation that excludes energy and food from the basket of goods and services purchased by the average consumer. The reason to calculate core inflation is that changes in price levels due to goods with volatile prices might simply reflect shocks to individual product markets rather than any sort of economy wide inflation. In 2018, the price of gasoline dropped 10 percent, while core inflation rose by 2.4 percent.

When does inflation become hyperinflation? What causes hyperinflation?

Hyperinflation occurs when there is an extremely long-lasting and painful increase in the price level. When inflation spirals out of control, it often renders the currency completely useless because people have to hold larger and larger amounts of money to pay for goods and services. Hyperinflation is caused by the printing of too much money or sometimes by expectations that prices will continue to rise. If people expect prices to rise, they demand higher wages, and this then causes firms to increase prices. This can lead to a nasty cycle of rising wages followed by rising prices. When the government prints too much money, and there is no change in velocity or real output, the increase in the money supply is matched by an increase in the price level, as stated by the quantity theory of money.

Why would a company want to make a direct investment in countries where the company's home currency has higher purchasing power?

If a company's home currency has a higher purchasing power in a foreign country, that company should be able to purchase labor, land, and factory equipment more cheaply in the foreign country than at home. Thus it makes sense to expand the company's operations into the foreign country utilizing direct investment.

Foreign investors in a country become worried about the stability of the government due to its rising debt level. How might the IMF help avert a financial crisis in this country?

If foreign investors are worried about a country's ability to repay its debts, then they will be reluctant to make more loans to the country, and they may wish to remove funds from this country. This can cause a financial crisis if the country is unable to repay foreign investors. The IMF can step in and act as a lender of last resort. Additionally, the IMF may require the country to reduce its budget deficit and pursue contractionary monetary policy in order to reduce inflation.

Rating agencies rate countries on the perceived riskiness of investing in their economies. Standard and Poor's, one of the main rating agencies, downgraded the credit rating for U.S. Treasury bonds in 2011. According to this chapter, what impact should the downgrading have had on net capital outflows and interest rates? Why?

If the U.S. is now perceived as riskier, fewer investors will be willing to invest in the U.S. NCO will rise, shifting the I + NCO curve to the right. The equilibrium interest rate will rise.

What could have happened to prices and inflation in the wake of the years during and after 2007-2009 recession if the government and Federal Reserve had not intervened in the economy? How would this have affected the economy?

If the government and Federal Reserve had not intervened, the reductions in consumption and investment would have continued, pushing the aggregate demand curve so far left that we may have seen deflation in addition to below potential output in the short run. Deflation can be hard to eliminate once it becomes established due to people being unwilling to borrow money and increase spending

Discuss what would happen to the real exchange rate between the U.S. and Australia if oil prices fell, which dramatically reduced the cost of transporting goods

If transportation costs between Australia and the U.S. fall, we should expect the real exchange rate between the two countries to converge to 1. When the U.S. dollar price is converted to Australian dollars using the nominal exchange rate, this value should equal the Australian dollar price.

Explain how some analysts might use the short-run and long-run effects on the aggregate demand-aggregate supply model to argue that monetary policy can't affect employment in the long run.

In the short run, expansionary monetary policy shifts the aggregate demand curve rightward, increasing the price level and output. Over time the increase in output will have increased the demand for labor and inputs, and this will increase the costs of production. In response to higher costs of production, firms will increase prices and this will shift short-run aggregate supply to the left. The economy will end up going back to its same level of output with a higher price level. This assumes the economy is at potential output to start with. If the economy is not initially at potential output, monetary policy may have long-term effects on output and employment.

Compare and contrast the effect of increased unemployment on inflation in the short and long run.

In the short run, increased unemployment is associated with decreases in inflation, as captured in the original form of the Phillips curve, but over the long run this relationship tends to disappear as inflation expectations adjust.

In the 1960s, policy based on the simple short-run Phillips curve worked better than similar attempts in the 1970s. How might better information availability have contributed to this result?

Inflation expectations play a key role in the long-run relationship between unemployment and inflation. We expect inflation to continue at its current level, so after a while output stops responding to inflation changes. The result is output going back to its previous level in the long run while inflation stays high. Essentially, policymakers were using the 1960s Phillips curve to make predictions, but by the 1970s the curve had shifted.

Is inflation harmful only when it's unexpected? If yes, why? If no, name two costs that occur with even predictable inflation.

Inflation is harmful even when predictable. Costs involve menu costs (from changing prices on websites, supply sheets, or literal menus), shoe leather costs (related to switching assets from those that pay interest—since predictable inflation is captured in the nominal interest rate—to those that are liquid when we want to spend), and bracket creep, (when increases in nominal but not real income result in being taxed more when our incomes haven't risen in terms of purchasing power at all).

Explain the role that leverage played in the recent housing bubble.

Leverage came into the recent housing bubble in the form of "flipping" houses. With the easy availability of credit, many people bought houses and made minor cosmetic adjustments, counting on prices in the housing market to continue rising so these houses could be quickly resold for a higher price. The resulting increase in demand for houses pushed up housing prices even more, causing more strain on the bubble that would eventually pop.

What is leverage, and how can it make an asset pricing bubble worse?

Leverage refers to using borrowed money to engage in economic investment. In an asset price bubble, irrational exuberance can keep pushing prices higher. These higher prices make it easier for a firm to borrow and therefore to invest via borrowing. However, if the increases in prices are truly caused by a bubble, leverage can worsen the situation by encouraging too much investment, which can go badly if firms cannot repay the loans they've made.

If many factories that once made goods in the United States move to Mexico, what must also happen in order to correct the balance of payments in the United States?

NCO = NX. If U.S. companies are moving factories to Mexico, they are engaging in direct foreign investment, which increases NCO. To balance this out, net exports (NX) must also increase at the same time.

Are deflation and disinflation the same thing? Why or why not?

No. Deflation is a decrease in overall prices and is very unhealthy for a nation. Disinflation is a decrease in the rate of inflation (a decrease in the rate of increase of overall prices) and can be quite healthy for a nation, especially when it's the result of contractionary policy meant to cool down the economy.

Identify the main reasons why people convert one currency into another currency

People convert currency to buy goods and services from another country. They also sometimes engage in speculation and buy currency if they think it will increase in value. Foreign investors need to convert their home currency into the local currency to engage in direct foreign investment or portfolio investment.

What is quantitative easing, and when might it be used?

Quantitative easing occurs when a nation's central bank targets monetary policy directly at the money supply instead of attempting to affect it indirectly via interest rates (the usual method). This can be effective when the government is at or near the zero lower bound on interest rates and cannot take them further downward; it was used with some success after the housing market bubble burst in2007. Quantitative easing involves the purchase of long-term government bonds or other financial assets by the Federal Reserve, as opposed to its more typical policy of purchasing short-term government securities.

History suggests that all stock market bubbles will eventually pop and cause severe financial loss for many of those who purchased stock. Given this history, do you think that stock market bubbles will continue to occur? Why or why not?

Stock market bubbles are likely to continue to occur despite the fact that the bubble always bursts, causing stock prices to fall back to normal levels. Bubbles occur because people have irrational expectations and assume prices will continue to increase. Investors may know the bubble will eventually burst, but they may irrationally assume they can purchase the stock at a low price and then sell before the bubble bursts.

What is the "zero lower bound" that must be considered in monetary policy, and how can it cause problems in enacting such policy?

The "zero lower bound" refers to interest rates hitting zero—after all, if interest rates are already at zero, how can the Federal Reserve enact expansionary monetary policy by lowering them? Hitting the lower bound can cripple monetary policy, as was the case in Japan over the 1990s.

What is the difference between the Consumer Price Index and the inflation rate?

The Consumer Price Index (CPI) is a number that measures the cost of a market basket of goods and services in a given year relative to the cost of the same market basket of goods and services in the base year. For example, if the basket of goods cost $80 in the base year and $120 in 2018, the CPI in 2018 would have a value of ($120/$80) × 100, or 150. This means prices are 50% higher in 2018 than in the base year. The inflation rate measures the percentage change in the CPI from year to year. If the CPI in 2018 was 150 and in 2019 it was 155, then the inflation rate is equal to (155 - 150)/150 × 100 or 3.33%.

Imagine what would have happened if the Federal Reserve was not in place to act as a lender of last resort during the financial crisis. Absent government involvement, what would be the likely effect on aggregate supply? Why? What would be the likely effect on aggregate demand? Why?

The Fed's "lender of last resort" function means that it stands ready to provide loans to banks that need liquidity. If the Fed didn't fulfill this function, it would not buy up bad assets or provide reserves to banks that needed them, further decreasing the availability of credit. So aggregate demand would likely decrease even further as borrowing to invest becomes less possible. Eventually, lack of investment would also reduce aggregate supply, as businesses wouldn't be able to invest in new technology and productive assets, which would hurt their ability to produce goods and services. Therefore, both AD and AS would shift leftward by a larger amount during a financial crisis if the Fed did not act as a lender of last resort.

What happens to the U.S. balance of trade as oil prices rise?

The U.S. is a large net importer of oil. In fact, about one-third of our usual trade deficit is net oil imports. If oil prices rise faster than the quantity demanded of oil falls due to its higher price (in other words, if oil is inelastically demanded), then an increase in oil prices will cause an increase in the dollar value of imported oil. The U.S. balance of trade will fall.

How did the recent housing crisis affect the aggregate demand curve?

The aggregate demand curve shifted leftward mostly because of decreases in investment and consumption spending. Investment spending fell as credit became less available, and the types of consumption that require borrowing were similarly affected. Moreover, households felt less wealthy than before as the value of their homes decreased, further depressing spending. Their need to make payments on loans pushed consumption down even further by reducing the amount of money households could spend on goods and services.

Use the quantity theory of money to explain how expansionary monetary policy can be inflationary.

The quantity theory of money (MV = PY) can written in growth rate terms:% Change in M + % Change in V = % Change in P + % Change in Y.If we assume that velocity and real output Y are unchanging (in other words, their percentage change is zero), then any change in the money supply M must be matched by an equal change in the price level P.

List three policies that a government could engage in that would reduce interest rates. (Hint: Look back to Figures 18-6 through 18-8.)

The government either needs to shift the I + NCO curve left or shift the savings curve (S) right. They can shift S right by encouraging savings (e.g., subsidizing savings through IRA or 401(k) plans or lowering tax rates on interest, dividends, or capital gains) or discouraging consumption (e.g., raising consumption taxes). The government can also directly increase S itself by reducing budget deficits or increasing budget surpluses. It can shift I + NCO left by discouraging investment (which would lower interest rates but be bad for long-term growth) or by engaging in plans that decrease NCO by convincing domestic savers to keep their savings in the country or encouraging foreign investors to bring money to the country (e.g., engaging in actions that make investors feel safe at home, reducing barriers for foreigners to invest, or raising barriers for domestic citizens to invest abroad).

How did government policies and asymmetric information problems make the recent housing bubble worse?

The government played a role in the recent housing bubble by promoting loans to low-income individuals, some of which were probably not creditworthy. On the monetary side, the Federal Reserve kept interest rates quite low, encouraging more borrowing to buy houses and for business growth. Investment banks bought loans assuming that commercial banks did their due diligence in researching borrowers and learning as much about them and their likelihood of repayment as possible, but many of those banks were more focused on the fees they could get from making loans than on the kind of information that would imply whether the loan would be repaid in full.

Would you expect nominal interest rates to be higher in countries that have higher target inflation rates? Why or why not

The nominal interest rate will be higher in countries that have higher target inflation rates. Given the target inflation rate is higher, actual inflation rates are likely to be higher as well. Higher inflation rates lead to higher nominal interest rates in order to maintain a reasonable real interest rate. The real interest rate is equal to the nominal interest rate minus the inflation rate, so higher inflation rates will reduce the real interest rate, all else the same. As a result, nominal interest rates will rise.

The interest rate on 10-year U.S. Treasury bonds just before Standard and Poor's downgraded the U.S. credit rating was 2.47 percent. One year later, the interest rate on these bonds had fallen to 1.60 percent. How can one explain this result that seems to contradict the findings of this chapter?

There are two potential explanations here. First, we could have had a violation of the "all other things equal" or ceteris paribus condition. For example, while a downgrade of U.S. debt alone would shift I + NCO right, if Standard and Poor's simultaneously downgraded many other foreign countries by even more, the net effect might be a leftward shift of NCO + I. Alternatively, a large fall in the demand for investment funds in the U.S. would shift I + NCO left, counteracting the initial rightward shift in I + NCO. Finally, a large increase in savings would shift S right, which, if large enough, could more than counteract the rightward shift in NCO + I. The second explanation might be that no one put any faith in Standard and Poor's judgment about the risk of U.S. debt and simply ignored its downgrade. This might be a reasonable explanation considering S&P had rated mortgage-backed securities with its highest possible grade only months before the housing meltdown made many of these financial instruments worthless.

Critics of NAFTA argued that opening our borders to free trade with Mexico would result in U.S. firms moving all of their factories to Mexico and the United States running large trade deficits with Mexico. Comment on the concerns of these critics using your knowledge of international trade and net capital flows.

This criticism should not be a concern. If domestic firms increase their direct investment in Mexico, NCO rises—meaning that net exports must also rise to keep the economy in equilibrium. The U.S. would be running trade surpluses, not trade deficits. If the U.S. begins running large trade deficits with Mexico, NCO must fall in order to keep the economy in equilibrium. Thus, under this scenario Mexican firms and individuals would be investing in the U.S. Either one of the critics' fears may come true, but they both can't be true at the same time.

A country doubles its rate of saving. How is this likely to affect the equilibrium interest rate and net capital outflow? What is the impact on the trade balance?

This is likely to decrease the equilibrium interest rate as the supply of saving curve shifts to the right. This will increase net capital outflow as people seek higher rates of return in other countries. The value of the country's currency will decrease under a floating exchange rate system because the demand for the local currency will decline. The trade balance (exports - imports) will increase because the decrease in the value of the country's currency will increase exports and decrease imports.

Suppose a presidential candidate criticizes his opponent by saying his opponent's economic policies have made the dollar weaker and cost U.S factory workers their jobs. What would be your response?

This presidential candidate is making no sense. A weak dollar makes our factory exports cheaper for foreigners to buy and makes imports that compete with our domestic factories more expensive. Thus, a weak dollar helps factory workers keep their jobs.

Explain why it's possible for tranching to make investing in a mortgage-backed security more risky than investing in a single subprime loan.

Tranching is dividing a large loan into several smaller parts with different characteristics in terms of risk and return; it allows loans to be made that would not have been made otherwise due to borrower uncreditworthiness, but it may result in overextension of credit (loans may be made to borrowers who are simply uncreditworthy). When this occurs, a mortgage-backed security can actually be riskier than a single subprime loan, despite the fact that tranching was created to reduce risk.

Explain how a mortgage-backed security can increase loan availability to those with little credit or bad credit.

When a bank makes a traditional loan, it takes on the risk of that loan; if the borrower defaults, the bank will suffer significantly. Mortgage-backed securities bundle many mortgages together, with the idea that while one or a few home borrowers may default on their mortgages, the chance of all of them doing so is much less. Spreading out risk in this fashion can make banks more willing to provide credit to those it would not otherwise lend to, increasing loan availability to those with little or bad credit—though, as seen throughout the chapter, sometimes this can go too far.

Imagine you own an ice cream store in New York City. Write a brief note to your senators explaining two ways in which unpredictable inflation hurts your business.

When inflation is unpredictable, it is harder for the business to make plans. The business may set its plan under one set of assumptions about prices, and then have to change its plan if there are unpredictable changes in prices. When inflation is higher than expected, this will reduce the real value of savings. When inflation is lower than expected, the real interest rate will rise and firms will have to make higher real interest payments. Shoe leather costs and menu costs occur with predictable inflation

A country operates under a flexible exchange rate system. When the central bank lowers the interest rate during a recession, how does this affect investment and net exports, and ultimately aggregate demand? What if the exchange rate was fixed instead?

When the central bank lowers the interest rate during a recession, investment spending will increase because it is cheaper for firms to borrow, the exchange rate value of the currency will decrease because there is more capital outflow, and net exports will increase because of the change in the exchange rate. The aggregate demand curve will shift to the right because spending is higher. If the exchange rate was fixed instead, then the central bank would not be able to use monetary policy to change the interest rate because any change in the interest rate would move the exchange rate away from its fixed value.

Suppose the exchange rate value of the dollar depreciates. Who wins and who loses?

When the dollar depreciates, our goods become relatively cheaper so this will benefit people who travel to our country, firms that export our goods, and people who want to buy our assets. Anyone who wants to buy foreign goods will not benefit, such as domestic residents who want to travel to foreign countries and domestic residents who want to buy imported goods or financial assets from other countries.

When we have a negative output gap, what is the proper monetary policy response in the short run? What are its intended effects on interest rates and employment?

When we have a negative output gap, we are producing below our potential output, so expansionary monetary policy would be the best response to bring actual GDP closer to potential levels. The intent would be to lower interest rates to boost borrowing and spending and increase production and therefore employment.

Is it ever possible for a country's nominal exchange rate to be depreciating while its real exchange rate is appreciating? Explain.

Yes, it is possible for a country's nominal exchange rate to be depreciating while its real exchange rate is appreciating. EXr = EX × (Ph /Pf). If the nominal exchange rate is depreciating this means EX is falling. EXr could still be rising as long as (Ph /Pf) is rising faster than EX is falling.

Your best friend comes to you for financial investment advice. She is wondering whether she should invest in (a) a sector of the economy that has been performing extremely well in the last five years relative to historical levels or (b) one that has been performing extremely poorly in the last five years relative to historical levels. What would you advise? How might irrational expectations affect your recommendations?

You might advise your friend to invest in the sector that's been performing poorly on the assumption that what goes down must eventually go back up, or you might advise her to invest in the sector that's been performing well on the assumption that what's done well will continue to do well. Either way, irrational expectations can affect your answer via the recency effect, in which investors pay too much attention to recent events and not enough attention to the big picture.

Your uncle comes to you with an investment idea. He tells you that the nominal GDP of Paradisia quadrupled over the past year and suggests that you invest there. Unemployment is at 20 percent, and inflation over the last year was 500 percent. Do you think it's a good idea to invest? Draw on the neutrality theory of money to explain why or why not.

lthough nominal GDP has quadrupled (risen by 400%), this does not mean the value of real GDP has increased. Nominal GDP is measured by multiplying current prices times current output, so the growth rate of nominal GDP is equal to the growth rate of prices + the growth rate of output. Therefore, the growth rate of real output is equal to the growth rate of nominal output minus the inflation rate, or -100%. Given the decline in real GDP and the high unemployment rate, Paradisia is not a good place to invest. The neutrality of money defines the idea that, in the long run, changes in the money supply affect nominal variables, such as prices and wages, but do not affect real outcomes in the economy.