Exam 3

Oil Crises: 1973-81

o Overview: • Egypt and Syria invade Israel in October of 1973 and appear to be winning. After they ultimately lose, OPEC punishes the west with an embargo.

Oil Glut: 1982-8

o Overview: • Industrial countries have time to shift away from oil, non-OPEC countries increase output, and OPEC countries cheat.

94. According to rational expectations, what's the only sort of policy that can lead to a movement away from the long run Phillips Curve? [one word, eight letters-have to work it out yourself]

surprise

78. Explain demand-pull inflation. [102 words]

Caused by excessive demand (too much money chasing too few goods). If D is growing faster than S, then P↑. Output will ↑ as well, as there is a shift along the aggregate supply curve, but because S can't keep up with D P↑ as well. usually occur along with a booming economy. To avoid - try to keep the economy growing at a steady, but not excessive rate.

40. What determines consumption in Keynes' model? [1 word]

income

• The Volcker Recession 1981-1982

o Background • Expansion lasted only a year o Orthodox • Recession necessary to adjust upwardly rising inflationary expectations; it worked and was a great victory for monetarism and the Federal Reserve. o Post Keynesian • The recession was basically an extension of the previous one, extended by the terribly high interest rates.

• Stop-Go Recession 1970

o Background • Long expansion driven by Vietnam War and LBJs Great Society program. o Orthodox: • The tight labor market pushed us to a high point on the Phillips Curve and it was therefore necessary to restrain economic activity in order to move back down. o Post-Keynesian: • A decline in investment almost caused a recession twice already-it finally did.

• The Oil Shock II Recession 1980

o Background • Sluggish recovery but expansionary government programs helped. o Orthodox • Recession necessary to adjust upwardly rising inflationary expectations. o Post Keynesian • Decline in C/GDP and a fall in investment aggravated by historically high interest rates.

• The Oil Shock Recession 1974-1975

o Background • Solid expansion and not clear there was going to be a recession up to the OPEC oil embargo. o Orthodox: • Recession necessary to adjust upwardly rising inflationary expectations. o Post-Keynesian: • Big drop in investment combined with a significant decline in confidence due to oil shock caused recession.

• September 11 Recession 2001

o Background • Ten-year expansion driven by steady investment, helped by computer technology surge. o Orthodox • Recession necessary to adjust upwardly rising inflationary expectations. o Post Keynesian • Due to saturation of demand for investment goods and consumer durables.

• Desert Storm Recession 1990-1991

o Background: • Expansion pretty strong at first and even when it faltered, the massive • Reagan administration deficits kept it going. o Orthodox • Recession necessary to adjust upwardly rising inflationary expectations. o Post Keynesian • Due to saturation of demand for investment goods and consumer durables

• The Great Recession 2008-2009

o Background: • Expansion was the weakest of any since 1950; recession could have started sooner, but consumer spending kept the economy going. o Orthodox •↑ S in gov't budget, CA, and C finally led to ↓. o Post Keynesian • Investment never really recovered and finally collapsed, exacerbated by long-term factors.

Explain classical interest rate theory (aka the loanable funds theory of interest)

o Only households earn income, save and consume...Only firms borrow & invest • I= f®- S = f®+ R is the reward for not consuming • The financial sector pays r on household S and earns r on firms borrowing to I o There exists a full employment level of total spendingY*= C + I Since Y = C + S and Y*= C + S...S = I o Say S0 = I0 corresponds to the full employment level of Y*= C + I ↓ in the desire to invest so there is excess supply of funds, S>I at r0. This causes problems for the financial sector because they're earning less money from firm borrowing but paying the same on household savings. o So they ↓ r to encourage (investment) and discourage (savings). Ultimately this leads to S=I at S1=I1 o Note that since the rise in consumption implied by the move from S0 to S1 is identical to the fall in investment from I0 to I1. Total spending has not changed and we are still at Y*

Camelot: 1960-5

o Overview - Moderate inflation and strong growth

1. Distinguish between validity and cogency. [25 words]

• An argument is valid if the conclusion is supported by the its premises. An argument is cogent if it is valid and the premises are warranted (reasonable).

Speculation: 2003-8

• As stock market slows, speculative money drifts into oil (and other commodity) futures-until the bottom falls out in late 2008.

82. What two entries increase by exactly the amount of the loan whenever a loan is made and which is an asset and which a liability? [7 words]

• Assets o Loans increase by the value of the loan • Liabilities o Checking accounts increase by the value of the loan

5. Derive the Classical aggregate supply curve from a labor market. Explain each step carefully. [87 words plus graphs]

• Assume y = f(N) (+) Take a point on the labor market diagram and switch the price and level of output created by that many workers to the supply curve. • ↑P In the labor market, This will ↓ real wages resulting in an excess demand for workers, causing nominal wages to ↑ until NO more excess exists. As we are at the original points, this means the supply curve is vertical

93. What are the policy implications of the accelerationist hypotheses? [32 words]

• Authorities could peg unemployment or stabilize the rate of inflation, not both. • Authorities could choose from among alternative transitional adjustment paths to the desired steady-state rate of inflation.

47. Why would any one in their right mind put down money at a game where they had no idea of the odds and what, at any given moment, determines whether or not US corporations are opening new facilities or laying off workers? [20 words]

• Because our "animal spirits," or exaggerated sense of our chances of winning, make us say, "But it won't happen to me" • the precarious balance between uncertainty and our animal spirits.

98. Know the name of each inflationary and the order they occurred (I'll supply a complete chronology of years). Know, too, the overview of each.

• Camelot:mod inflation and strong growth • Wage-Price Spiral: strong growth • Oil Crises: egypt and syria opec punishes W with embargo • Oil Glut: industrial countries find ways other than oil, non OPEC inc prod, OPEC cheat • Desert Storm: saddam mad at kuait because selling too much oil, UN gets involved • Peacetime Expansion: longest • OPEC Production Cuts: • Speculation: stock market slows money goes into oil until bottom falls

42. In Keynes' model, what maintains the equality of investment and saving? [79 words]

• Changes in income restore the equality of I & S o S=Y-C o C= a+bY o Y=(1/1-b)(a+I) • Whenever I changes, Y will change to compensate and S will follow. • For example: o Example 1: • I=50 • B=0.8 • A=10 • Y=(1/1-b)(a+I) ⇒ 5 * 60 = 300 • C=250 • S=Y-C=300-250=50 • All at equilibrium and full employment o Example 2: • Lower I to 40 • Y= 250 • C= 210 • S=40 • S and I are equal again but at the cost of economic activity

79. Explain the three types of money that have been used.[72 words]

• Commodity money o The item used as money has the same value in use as it does in exchange. • Representative commodity money o The money itself has little or no value, but it can be exchanged for gold or silver equal to its face value. • Credit money o Any money, except representative commodity money, that circulates a value greater than the commodity value of the material from which it is made. o Credit money is the liability of the issuing bank, and is backed by borrowers

Wage-Price Spiral: 1966-72

• Continued strong growth, but, at least by the standards of the day, accelerating inflation-oligopolies and unions?

12. How does New Classicism's Ricardian Equivalence argue that fiscal policy is ineffective? [51 words]

• Government deficits are supposed to inject new income into the macroeconomy that agents then spend, increasing aggregate demand. However, if those agents rationally assume that they will one day be forced to pay higher taxes to repay those deficits, then they will not spend the windfall and aggregate demand is unaffected.

77. Explain Minsky's Financial Instability Hypothesis. [104 words]

• Households, firms and governments in modern capitalist's economies often finance purchases using debt. • That debt is interlocked among the various agents. • Agents determine the safe level of debt by comparing the repayment schedule with expected income. • During expansions, agents become more confident and lower the margin of safety. • Eventually there will be a recession and depending on how much agents have lowered the margin of safety debt default may result, perhaps serious enough to magnify the severity of the recession. • The default and newfound caution will raise margins of safety until the cycle starts again.

4. What determines investment in Keynes' model? Does mec move to meet r, or vice versa? [66 words]

• I=f(mec +,r -) • Where mec is the present value of the expected string of future profits over the lifetime of the project as a percentage of the purchase price. Investment settles at the level where mec=r because firms will undertake projects until they are equal. For example, if mec>r then there is an investment boom that causes ⇓mec due to the rising stock of capital saturation in that market.

14. Draw a labor market diagram with involuntary unemployment. Why is it that, given Keynes' assumptions, there exists no tendency for the involuntary unemployment to disappear (be sure to reference your graph in the explanation)? [89 words plus graph]

• In Keynes' view the involuntary unemployment at W0/P0 is an equilibrium station. He views three groups as being involved o Firms ☺ because on N¬d, & reluctant to lower W because it might lower worker morale and productivity o Workers ☺☺ because they would've worked for W1 o Involuntary unemployed ☹, many willing to work for less. But no one asked them because firms aren't hiring • Though there will be some downward pressure on wages, it is insufficient to create the adjustment described by neoclassicalism

85. If the entire banking system were increasing loan volume then the fed funds market would not be a useful source of reserves, leaving only sales of securities. Why is it likely that the Fed would passively accommodate? [21 words]

• In order to maintain its interest rate target, the Fed must passively supply whatever reserves the banking system demands.

2. Macroeconomic equilibrium occurs when firms' expectation of sales is not disappointed. In terms of Keynes Z-D diagram, what does this mean? Explain why none of the other points can be an equilibrium and where full employment is. [94 words and two graphs]

• In overestimate graph, firms thought they could sell Py1, so they hired N1 workers. However, N, workers only generated Py2 sales. Firms will lay off workers until they reach N0 • In underestimate graph, firms expected to sell Py2 so they hired N1. However, N1 workers generated Py1 sales. Firms will add workers until they reach N0. Full employment may be at, but is probably to the right of, the intersection of Z and D.

4. Draw a labor market diagram with involuntary unemployment. Why is it that, given the Orthodox assumptions, the involuntary unemployment must disappear? [graph plus 64 words]

• In the Orthodox view, unemployment at W0/P0 is a disequilbrium situation. They view two groups as being involved: o FIRMS: Happy because on Nd. o WILLING TO WORK: Sad, because some will not get jobs. They will therefore compete among themselves for positions by offering to work for less. • This process of competing wage down will continue until # willing = # employed at W1/P0 and N2

75. According to Post Keynesians, in what way does inflation redistribute income? [61 words]

• Inflation is always and everywhere a non-arbitrary redistribution of income. In a closed system, ↑P must mean that someone is earning ↑ incomes. They gain at the expense of others. Demand pull winners = those selling the products in ↑ demand -cost-push=those with market power.

43. How are interest rates determined in the General Theory? [107 words]

• Interest determines how you save, not how much. It is the price of parting with liquidity rather than the reward for abstaining from consumption. Three reasons for liquidity preference: o transactions motive: the need of cash for the current transaction of personal and business exchanges (varies positively with Y). o precautionary motive: the desire for security as to the future cash equivalent of a certain proportion of total resources (varies positively with Y). o speculative motive: the object of securing profit from knowing better than the market what the future will bring forth (varies negatively with r). • When compared to the supply of money, this gives the rate of interest.

11. What is the policy ineffectiveness critique that represents one of the distinguishing features between Monetarist and New Classical economics? [59 words]

• It says that because they are armed with rational expectations, economic agents will correctly anticipate the effect of the monetary policy that changes price levels. This means that, so long as the government does not manipulate the money supply in secret, economic agents will never suffer from the money illusion that causes fluctuations in employment in the Monetarist model.

Peacetime Expansion: 1992-8

• Longest peacetime expansion in US history, but no inflation?

1. What assumptions are made regarding M, V, P, and y in the "money growth ==>inflation" view? [123 words]

• M o That which is money is easily defined and identified and only the central bank can affect it's supply, which it can do with autonomy and precision. • V o The velocity of money is related to people's habits and the structure of the financial system. It is, therefore, relatively constant. • P o Neither firms nor workers can control prices due to competition. Solely changed by changes in supply and demand • Y o Economy tends to be at full-employment, so Y tends to be at maximum output. Relatively constant (although it does increase over time)

6. Derive the Classical aggregate demand curve from the Quantity Theory of Money. [97 words plus chart and graph]

• MV=PY • V is assumed constant over the short run as it is a function of habits of institutions. (things that don't change quickly)

88. What are the four factors Post Keynesians say actually do cause inflation? Explain each in a sentence.

• Market power o Firms with higher market power can interrupt markets by artificially adjusting the supply, and thus altering the price of their product. • Demand pull o Demand rises more proportionally than supply, prices rise and inflation occurs. • Asset Market Boom o When speculation bids up prices for a commodity, an incentive is created to withhold supply today so they can sell it in the future (when prices will presumably be higher). • Supply Shock o If there is a shock in supply (hurricane, fire, other natural disasters/interruptions in production) inflation will occur.

13. Show how unemployment can occur if coordination problems occur on the labor market diagram. What kind of unemployment is it? [73 words plus graph]

• Nd is notional demand curve; Nd* is effective demand curve, the vertical portion of which is a function of how much firms think they can sell (N1). In fact, firms could have employed up to N0 folks and sold everything, but they didn't know this. The effective demand curve shown will definitely leave employment less than N0. Wages are left undetermined, but at very one except W0/P0 there will be involuntary unemployment.

OPEC Production Cuts: 1999-2002

• OPEC misses the old days and introduces a series of production cuts.

99. Know the Post Keynesian, Monetarist, and Neoclassical Keynesian explanations and evidence for inflation.

• Post Keynesian: o Cost Push. Look for CPI to accelerate when oil prices rise and productivity falls. • Monetarist: o MV=Py. Look for CPI to accelerate when money grows faster than real GDP (in fact, excess growth should equal inflation). • Neoclassical Keynesian: o Demand Pull and the Phillip's Curve. Look for inflation to accelerate when GDP accelerates, unemployment falls, and cap utility rises.

74. Know the Post Keynesian, Monetarist, and Neoclassical Keynesian explanations and evidence for the business cycle.

• Post Keynesian: saturation of investment demand. Look for positive investment growth to cause falling unemployment and vice versa. • Monetarist: unexpected inflation (caused by money growth) leads to a fall in unemployment. Look for lower unemployment when money growth accelerates and vice versa. • Neoclassical Keynesian: monetary and fiscal policy cause fluctuations in employment. Look for rising fiscal impulse and falling interest rates to cause falling unemployment.

76. How do Post Keynesians argue that in the real world, ΔP causes ΔM and not the other way around? [54 words]

• Production takes time in the sense that there is a lag between hiring inputs and selling output. Firms often borrow short term to cover production costs and then repay when goods are sold. If costs are ↑ for firms, they borrow more, and via money endogeneity the MS ↑. Thus ΔP causes ΔM.

81. Why don't banks like to keep reserves and how much are they required to keep?[14 words]

• Reserves earn zero interest income • Reserve requirement is 10%

92. What were the three innovations that led to the expectations-augmented version of the Phillips Curve? [35 words]

• Respecification of the excess D variable as the gap between the natural and actual rates of unemployment • Introduction of P anticipations • Incorporation of an expectations-generating mechanism

Desert Storm: 1989-91

• Saddam Hussein says Kuwait is selling too much oil and they should cut back-or else. Or else happens and UN intervenes.

2. Explain Say's Law (both pro and con). [94 words]

• Say's Law argues that the economy always tends toward maximum growth in full employment • Pro's o Demand can never fall short of total supply since our desire for goods and services is insatiable. Unused resources we already afford to employ are a waste so we will put them to work even doing trivial tasks rather than leave them idle. • Anti- o Demand may be insatiable, but when the future is uncertain part of demand is a desire for a stockpile of purchasing power to meet unforeseen circumstances. Income diverted into this stockpile does not create employment.

10. Know the name of each recession and the order they occurred (I'll supply a complete chronology of years). Know, too, the summary versions of each (cause, Orthodox, and Post Keynesian).

• Stop-Go Recession 1970 • The Oil Shock Recession 1974-1975 • The Oil Shock II Recession 1980 • The Volcker Recession 1981-1982 • Desert Storm Recession 1990-1991 • September 11 Recession 2001 • The Great Recession 2008-2009

96. What is a stop-go policy and upon what concept is it based? [62 words]

• Stop-go policies meant the use of fiscal and monetary policy to "go," or stimulate the economy, during periods of low GDP growth/recession and rising unemployment and "stop," or implement contractionary policies when the go part of the cycle had succeeded in lowering unemployment and raising growth, but brought with it inflation and trade deficit. It is based on the Phillips curve tradeoffs.

91. Briefly explain the pessimistic Phillips Curve and the "Cruel Dilemma." Please illustrate with a graph. [19 words plus graph-have to work out yourself]

• The cruel dilemma refers to certain pessimistic situations where none of the available combinations on the menu of policy choices is acceptable to the majority of a country's voters.

87. The Post Keynesian view argues that since V and y can and do vary in the real world, there is no reason to believe that changes in P can necessarily be linked directly to changes in y. However, the real nail in the coffin of the "money growth==>inflation" is what? Explain it briefly. [136 words]

• The fed can't affect Δ in the $ supply without a conscious and voluntary cooperation of the private sector. • The fed has no mechanism to alter $ supply otherwise. Their options are Fed purchases of government debt from the public, Fed loans to banks through the discount window, or Fed adjustment of reserve requirements so that banks can make more loans from the same volume of deposits. • Fed can't force anyone to sell treasury bills in exchange for cash, can't force a private bank to accept a loan, and private banks can't force their customers to accept loans. • Can't S $, unless corresponding D exists

97. What is the wage-price spiral? [27 words]

• The phenomenon in which prices for goods and services rise, which causes employees to demand higher wages. This added expense on business causes higher prices, which leads to still higher wages, and so forth.

90. What factors probably contributed to the attractiveness of the Phillips Curve? [41 words]

• The remarkable temporal stability of the relationship. • Ability to accommodate a wide variety of inflation theories. • Appeal to policymakers because it provides a convincing rationale for their apparent failure to achieve full employment with price stability-twin goals that were thought to be mutually compatible before Phillips' analysis.

15. Why is it that Keynes argues that wage flexibility should not even be a goal in terms of finding means to lower unemployment?

• Too many payments in a modern capitalist economy are contracted in nominal terms. Lowering nominal wages will leave people unable to pay mortgages, car loans, etc. and lead to financial distress for buyer and seller • The livelihood of the worker is the reason for being of the economy. All other prices should adjust to wages and not the other way around. • Wages are an important part of aggregate demand. Lowering them may plunge the economy into further recession and make unemployment worse. • Most fundamentally a rise in wages is not the cause of economic downturns, decreases in aggregate demand are. The latter should be raised rather than the former lowered

89. According to Neoclassicism, what are the costs of inflation (just the first two)? [106 words]

• Uncertainty o If inflation keeps varying, then firms may be reluctant to invest in new plant and equipment as they may be unsure of what the government will do in the future. People also may be uncertain and reluctant to spend. Both of these factors could reduce the long-term level of economic growth • Income redistribution o Many people have to live off fixed incomes, particularly those on pensions. The higher the level of inflation the less their income will be worth. This effect can also happen among people who are working, as their incomes go up either faster or slower than inflation. These effects can arbitrarily redistribute income.

83. After a loan is made and the immediate adjustment to assets and liabilities is made, what other asset entry will banks need to make sure they adjust (although by how much may vary) and how long do they have to make that adjustment? [14 words]

• after a loan is made, reserves must be adjusted to meet requirement • banks have 14 days to average meeting their reserve requirement

3. Show that the Classical labor demand function is actually a representation of the profit maximizing condition (MC=MR) in N and W/P space. What assumptions must be made to make the transformation? [18 words]

• assume perfect competition: MR = P • assume fixed capital: MC = W/MPN • substitute MC=MR • W/MPN = P • Rearrange: MPN = W/P

84. What are the two means shown in the article for a bank to adjust its reserves? [11 words]

• borrow from the federal funds market • sell treasury bills

86. Banks are always willing to make loans to what kind of customers (meaning that they are never constrained by a lack of saving)? [one word; HINT: 12 letters]

• creditworthy

8. Show how unemployment can occur if there is a minimum wage on the labor market diagram. What kind of unemployment is it? [47 words plus graph]

• if the minimum wage is set so that the associated real wage is above the intersection on the labor market diagram. Then involuntary unemployment will result. The excess supply is placing downward pressure on wages (W) but it is socially unacceptable to allow that to occur.

80. It is in what act that banks create money? [4 words]

• lending money to customers

8. Keynes' Chapter Twelve: What does Keynes mean by speculation? By enterprise? [24 words]

• speculation: o the activity of forecasting the psychology of the market • enterprise: o the activity of forecasting the prospective yield of assets over their whole life

9. Show how unemployment can occur if workers suffer from money illusion on the labor market diagram. What kind of unemployment is it? [graph, schematic, and 16 words]

• voluntary unemployment

9. Keynes' Chapter Twelve: What does Keynes think could be accomplished by his half sarcastic, half serious, suggestion that we should make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause? [17 words]

• would force the investor to direct his mind to the long-term prospects and to those only.

1. Draw Keynes' aggregate supply curve (Z). Explain carefully the relationship it represents. From what is it derived? Would the classicals object to the Z curve? [72 words and a graph]

• z is the profit maximizing condition written in Py and N space. • Derived: o W/P = MPN o Rearrange: W/MPN = P o Multiply by y: W/MPN *y = Py o Multiply left by N/N: W/MPN *N/N *y=Py o Rearrange: W/MPN * y/n * N = Py o Note that y/n= average product of labor o W/MPN * APN * N = Py o W * APN/MPN * N=Py • The z curve shows the level of nominal sales (Py), firms must expect to make hiring N workers a profit maximizing proposition. Since MPN falls faster than APN, Py increases at an increasing rate as N rises. • Classicals would have no problem with Z as it's basically Nd