Final Exam Study Guide
Financing constraints
A limit on the quantity of funds a firm can raise—such as through borrowing— in order to buy capital.
Financial crisis
A major disruption in the financial system that impedes the economy's ability to intermediate between those who want to save and those who want to borrow and invest.
IS-LM model
A model of aggregate demand that shows what determines aggregate income for a given price level by analyzing the interaction between the goods market and the money market. (Cf. IS curve, LM curve.)
1. How does recession occur? What is a business cycle?
A recession is primarily caused when there is a fall in aggregate demand. There are many factors that can lead to a recession, but the primary one is inflation. The higher the rate of inflation, the smaller the percentage of goods and services that can be purchased with the same amount of money as before. In an inflationary environment, people tend to cut out leisure spending, reduce overall spending and begin to save more. As individuals and businesses curtail expenditures in an effort to trim costs, GDP declines and unemployment rates rise because companies lay off workers to reduce costs. A business cycle is the rise and fall in production output of goods and services in an economy.
Borrowing constraint
A restriction on the amount a person can borrow from financial institutions, limiting that person's ability to spend his or her future income today; also called a liquidity constraint.
Keynesian cross
A simple model of income determination, based on the ideas in Keynes's General Theory, which shows how changes in spending can have a multiplied effect on aggregate income.
Theory of liquidity prefer- ence
A simple model of the interest rate, based on the ideas in Keynes's General Theory, which says that the interest rate adjusts to equilibrate the supply and demand for real money balances.
Liquidity crisis
A situation in which a solvent bank does not have sufficient cash on hand to satisfy the withdrawal demands of depositors.
Liquidity trap
A situation in which the nominal interest rate has fallen to its lower bound of zero, calling into question the efficacy of monetary policy to further stimulate the economy.
Debt-deflation theory
A theory according to which an unexpected fall in the price level redistributes real wealth from debtors to creditors and, there- fore, reduces total spending in the economy.
Shocks
An exogenous change in an economic relationship, such as the aggregate demand or aggregate supply curve.
Leading Indicators
Economic variables that fluctuate in advance of the economy's output and thus signal the direction of economic fluctuations.
9. "A fire-sale can make illiquid institutions insolvent." Explain how.
In a crisis, when there is a fall in the prices of assets, financial markets start quickly selling their assets, which leads to further decline in prices. This is known as a fire-sale. An illiquid institution that has more assets than liability, but lacks immediate funds for promised payments, will see a steep decline in their value of assets if they go for fire-sale and may become insolvent as its total liability becomes more than its assets.
Financial intermediaries
Institutions that facilitate the matching of savers and borrowers, such as banks.
8. Give at least two reasons why a decline in stock prices might lead to a slowdown in economic activity. Be sure to connect your reasons to economic models.
Possible explanations include: (1) the decline in stock prices via Tobin's q reflects an expected decline in the present and future profitability of capital resulting in a decline in investment spending at every interest rate, which would reduce aggregate demand and reduce the equilibrium level of output; and (2) the decline in stock prices reduces household wealth, which is a determinant of consumption according to the life-cycle model. The decline in consumption spending reduces aggregate demand and leads to lower output.
Stabilization policy
Public policy aimed at reducing the severity of short-run economic fluctuations.
10. Why was the recession of 2008-2009 sometimes also referred as the subprime crisis?
Subprime lending is giving loans to borrowers with risky credit profiles. Subprime lending was one of the major contributors to the recession of 2008-2009. The money was lent to buy a house with a very small down payment and over-priced assets as collateral. When the speculative bubble burst, the price of collateral fell and institutions were left with low-value assets that did not support their liabilities.
Precautionary saving
The extra saving that results from uncertainty regarding, for example, longevity or future income.
Marginal propensity to consume
The increase in consumption resulting from a one-dollar increase in disposable income.
Monetary transmission mechanism
The process by which changes in the money supply influence the amount that households and firms wish to spend on goods and services.
Tobin's q
The ratio of the market value of installed capital to its replacement cost.
Financial system
The set of institutions through which the resources of those who want to save are allocated to those who want to borrow.
Permanent-income hypothesis
The theory of consumption according to which people choose consumption based on their permanent income and use saving and borrowing to smooth consumption in response to transitory variations in income.
Efficient markets hypothesis
The theory that asset prices reflect all publicly available information about the value of an asset.
5. Under what condition does a liquidity trap occur?
When nominal interest rates are already really low, nominal interest rates cannot fall below zero: rather than making a loan at a negative nominal interest rate, a person would just hold cash. In this environment, expan- sionary monetary policy increases the supply of money, making the public's asset portfolio more liquid, but because interest rates can't fall any farther, the extra liquidity might not have any effect. Aggregate demand, production, and employment may be "trapped" at low levels.
3. Consider the economy of Hicksonia. (a) The consumption function is given by The investment function is C = 300 + 0.6(Y − T ). (2) I = 700 − 80r. (3) Government purchases and taxes are both 500. For this economy, graph the IS curve for r ranging from 0 to 8. 2 (b) The money demand function in Hicksonia is (M/P)d =Y −200r. (4) The money supply M is 3,000 and the price level P is 3. Graph the LM curve for r ranging from 0 to 8. (c) Find the equilibrium interest rate r and the equilibrium level of income Y. (d) Suppose that government purchases are increased from 500 to 700. How does the IS curve shift? What are the new equilibrium interest rate and level of income? (e) Suppose instead that the money supply is increased from 3,000 to 4,500. How does the LM curve shift? What are the new equilibrium interest rate and level of income? (f) With the initial values for monetary and fiscal policy, suppose that the price level rises from 3 to 5. What happens? What are the new equilibrium interest rate and level of income? (g) For the initial value of monetary and fiscal policy, derive and graph an equation for the aggregate demand curve. What happens to this aggregate demand curve if fiscal or monetary policy changes, as in parts (d) and (e)?
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Albert and Franco both follow the life-cycle hypothesis: they smooth consumption as much as possible. They each live for five periods, the last two of which are retirement. Here are their incomes earned during each period: Period Albert Franco 1 100,000 40,000 2 100,000 100,000 3 100,000 160,000 4 0 0 5 0 0 They both die at the beginning of period six. To keep things simple, assume that the interest rate is zero for both saving and borrowing and that the life span is perfectly predictable. (a) For each individual, compute consumption and saving in each period of life. (b) Compute their wealth (that is, their accumulated saving) at the beginning of each period, including period six. (c) Graph consumption, income, and wealth for each of them, with the period on the horizontal axis. Compare your graph to Figure 16-12. (d) Suppose now that consumers cannot borrow, so wealth cannot be negative. How does that change your answers above? Draw a new graph for part (c) if necessary.
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In the Keynesian cross model, assume that the consumption function is given by C = 120 + 0.8(Y − T ). (1) Planned investment is 200; government purchases and taxes are both 400. (a) Graph planned expenditure as a function of income. (b) What is the equilibrium level of income? (c) If government purchases increase to 420, what is the new equilibrium income? What is the multiplier for government purchases? (d) What level of government purchases is needed to achieve an income of 2,400? (Taxes remain at 400.) (e) What level of taxes is needed to achieve an income of 2,400? (Government purchases remain at 400.)
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The IS-LM model developed in Chapter 11 and Chapter 12 assumes that investment depends only on the interest rate. Yet our theories of investment suggest that investment might also depend on national income: higher income might induce firms to invest more. (a) Explain why investment might depend on national income. (b) Suppose that investment is determined by I = I ̄+ aY, (5) where a is a parameter between zero and one, which measures the influence of national income on investment. With investment set this way, what are the fiscal-policy multipliers in the Keynesian- cross model? Explain. 3 (c) Suppose that investment depends on both income and the interest rate. That is, the investment function is I = I ̄ + aY − br, (6) where a is a parameter between zero and one that measures the influence of national income on investment and b is a parameter greater than zero that measures the influence of the interest rate on investment. Use the IS-LM model to consider the short-run impact of an increase in government purchases on national income Y, the interest rate r, consumption C, and investment I. How might this investment function alter the conclusions implied by the basic IS-LM model?
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Nation A has a well-developed financial system, where resources flow to the capital investments with the highest marginal product. Nation B has a less-developed financial system from which some would-be investors are excluded. (a) Which nation would you expect to have a higher level of total factor productivity? Explain. (Hint: See the appendix to Chapter 9 for the definition of total factor productivity.) (b) Suppose that the two nations have the same saving rate, depreciation rate, and rate of techno- logical progress. According to the Solow growth model, how does output per worker, capital per worker, and the capital-output ratio compare in the two countries? (c) Assume the production function is Cobb-Douglas. Compare the real wage and the real rental price of capital in the two countries. (d) Who benefits from having a better-developed financial system?
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