MACRO MIDTERM

multiplier for investment

1/MPS 1/(1-MPC)

Stabilizing effects

FED RULE IS A STABILIZER ex. If G goes up, Y up, C up, then Y up, then C up, then r up, I down, Y down, C down, Y down net effect = Y increases but by less than predicted

Should the illegal production of drugs be counted in GDP?

Illegal production of drugs should be counted in GDP because it is a final good produced by the factors of production, but it is difficult to measure using official statistics.

Why are transfer payments like social security payments not counted in GDP?

Payments from Social Security are pure transfers and do not represent any current production of goods or services and so are not counted in GDP.

What is the key assumption behind the Phillip's curve?

The key assumption is that AS stays constant. When in the 1970s, the curve "broke down" it was because the AS curve AND the AD curve were moving so there was no longer a correlation between Unemployment and Inflation

Explain why if planned aggregate expenditure > output, the economy is not in equilibrium.

if AE > Y, then there is not enough investment inventory to meet demands so firms will increase output to reach equilibrium if AE < Y, then there is too much investment inventory for current demands so firms will decrease output to reach equilibrium

IS curve

shows relationship between interest rate and Y

What is the discount rate?

the rate banks borrow money from the fed

balanced budget multiplier

∆Y/∆G = 1

What can a bank do to increase reserves?

(1) Attract more deposits (thereby increasing both deposits and reserves by the same amount) from new or existing clients. (2) Borrow money from the Fed or the interbank market. (3) Recall loans (thereby increasing reserves and decreasing loans by the same amount without affecting deposits).

From the Board of Governors website, the 10 year nominal rate of interest is 1.56 percent and the 10 year real (inflation indexed) rate of interest is 0.09 percent. What is the implicit 10 year expected rate of inflation at an annual rate? Why should borrowers and lenders be more concerned about real interest rates than about nominal interest rates?

(1+nominal interest rate) = (1+real interest rate)*(1+ expected inflation) [Or Nominal interest rate - inflation ≈ real interest rate] Expected inflation = 1.47% Borrowers and lenders care about real interest rates because they represent the true value of what they are getting paid back, or paying back in terms of the goods and services they can buy. If the price level is going up at 10%, and I am getting paid back 5% on my loans, then I am worse off in real terms, even though I am getting a nominal rate of 5%. The real interest rate adjusts for the price level, and so borrowers and lenders will care more about that.

Suppose government spending is made endogenous. (Government spending = total tax revenue collected). Does this increase or decrease the effectiveness of investment as a tool to stimulate the economy?

(This means that you are putting all tax rev. collected right back into the economy) This INCREASES the effectiveness of investment because when I^, Y^, then C^, then the multiplier causes Y^ and C^ again

When does I not depend on r?

- When b=0 in the equation I = a +br - This means the Fed rule no longer matters because the Fed influences AD thru r -

AS curve

- decrease: caused by an incr. in cost of production or a supply decrease - sticky wages on horizontal - max output on vertical

3 costs of inflation

1. Distribution of Income 2. Administrative costs 3. Uncertainty Anticipated versus unanticipated inflation. Unanticipated is more costly.

Economist disagree about the effectiveness of government spending to increase aggregate income Y. Explain two different reasons.

1. If the supply curve is vertical line, any increase in AD (result of G^) is purely inflationary so ineffective 2. The multiplier is very small

What are some of the limitations of GDP per capita as a measure of social welfare.

1. distribution of wealth 2. composition of output (think govt spending vs. universal healthcare) 3. currencies

3 kinds of unemployment

1. frictional—normal working of labor market 2. structural—little that macro policies can do about this 3. cyclical—the main macro concern; maybe macro policies can help

Traditional 3 tools used by Fed to increase interest rate

1. open market operations 2. reserve requirement ratio 3. discount rate

If Apple issues debentures to finance the building of a factory, what will be included in GDP?

1. value of the factory 2. commissions made by bankers/lenders etc. involved in transaction

Why does a decrease in G shift the IS curve to the left?

A decrease in G, government spending, lowers income directly and as a result, lowers consumption spending, which further lowers income and spending because of the multiplier in the economy. This results in a lower level of total spending for any given interest rate, and so the IS curve, which describes the total quantity of spending at each interest rate, shifts left.

Why does an increase in oil prices shift the AS curve to the left? We are now seeing an increase in oil prices. In the model so far (i.e., the AS/AD model) is an increase in oil prices bad for the economy? Why or why not?

An increase in oil prices increases the marginal costs of many producers, who use oil as an input to their production processes (either directly as in manufacturing, or indirectly through costs of energy or transportation, which themselves use oil as an input). This increase in marginal costs raises the price at which any level of output can be produced, and so increases the price level that firms can profitably charge at any level of output. Based on the AS/AD model learned in class so far, the increase in oil prices shifts AS curve to the left, which results in lower output and a higher price level. This is bad for the overall economy. Nonetheless, some sectors of the economy like the oil industry may reap increased profits from now having to sell their products at a higher price. Moreover, the stock prices of the oil companies are likely to increase, which may increase their shareholders' wealth and consumption depending on their investment portfolios.

One-year bond yields stayed the same but two-year bond yields increased. What best explains this. State all assumptions.

Assume: risk neutral, you can roll over 1 yr = (1+r1) 2yr = (1+r1)(1+f1) = (1+r2)^2 If the 2yrs has increased then the forward rate must have increased.

Does the unemployment rate, conventionally measured, overestimate or underestimate unemployment?

BOTH over - some people are offered jobs but hold out for better wages under - discouraged worker effect (typ. bigger)

Explain why inflation calculated using current year quantities as weights would produce a lower inflation figure than using previous year weights.

Because of the substitution effect. When P^ you substitute and buy more of another good. Using previous year quantities tends to overweight inflation

If U is below NAIRU.... If U is above NAIRU....

Below Nairu: (positive) prices increase at an increasing rate of inflation Above Nairu: (negative) prices increase at a decreasing rate of inflation

What happens when Z in the Fed Rule goes down?

Consumer Confidence r down, I up, Y up, C up, then Y up, C up net effect = AD will increase, NE on prices and output depends on AS curve

What is the theory behind the proposition that the demand for money depends negatively on the interest rate?

Defining money as M1, suppose that the decision is to hold M1 or deposit money into an interest bearing instrument. The higher the interest rate on that instrument, the higher the opportunity cost (more interest foregone) from holding M1 and the less M1 people will want to hold.

When does deflation occur?

Deflation occurs when CPI decreases over some period.

What is meant by double counting in the calculation of GDP?

Double counting occurs when certain transactions like intermediate consumption are counted multiple times due to, for example, simply adding up all sales of goods and services in the economy rather than adding up just the final sales or adding up all values of output rather than just the value added for each product produced. Ex. car industry

Explain carefully the difference between an endogenous variable, an exogenous variable, and a parameter or coefficient. Give an example of each as used in class.

Endogenous: if it is explained within the model in which it appears. It is the variable that economists want to explain. Consumption and output are endogenous variables in the multiplier model of the goods market. Exogenous: if it comes from outside the model and is not explained by the model. Transfer payments, investment and government spending have been treated as exogenous variables in the goods market model. Parameters or coefficients are non-economic variables that describe the relationship between economic variables in our model. Examples: marginal propensity to consume b, which describes the relationship between income and consumption, or the technology parameters that describe a production function. These coefficients cannot be measured directly but have to be estimated using econometric techniques like least squares.

How is the Fed's ability to control the money supply affected if commercial banks hold excess reserves?

Ex. Banks want to reduce money supply by $10 If banks hold no excess reserves, the multiplier effect implies that money supply is reduced by the amount: (1 / RRR) × $10 = (1 / 0.2) × $10 = $50 If banks have excess reserves, before the trans- action the money supply was M1= currency + deposits = $70 + $100 = $170. After the transaction we have M1 = $70 + $90 = 160. Therefore the money supply has been reduced by 10, that is one fifth of the reduction we would have had in the case in which the bank had no excess reserves. The reason is that when banks hold no excess reserves, they don't need to adjust loans and deposits after every transaction in order to meet the Federal Reserve required reserve ratio, so that the multiplier effect is weaker and monetary policy is less effective.

What is government deficit?

Government Deficit=𝐺 + 𝑇𝑅 − 𝑡𝑌

Suppose I = d + e*Y. Discuss the implications.

I is a function of only income -- no longer of r this means... 1. fed rule doesn't matter 2. AD doesn't depend on P anymore 3. Previously only C multiplier, now there is another (??)

What is the effect of an increase in the propensity to save on the effectiveness of fiscal policy effected by increasing government spending?

If people are looking to save this means people will spend less which makes fiscal policy less effective. note: govt spending muliplier = 1/MPS so a bigger MPS means a smaller fraction, and a smaller multiplier effect

What happens regarding the effects of fiscal policy and monetary policy in the AS/AD model if planned investment (I) does not depend on the interest rate?

If planned investment (I) does not depend on the interest rate in the AS/AD model, this means that (if the interest rate also does not have other effects), the IS curve which relates interest rates and output, becomes vertical. If this is the case, shifts in monetary policy, which move the Fed rule curve up or down, have no effect on output and only change the interest rate. The aggregate demand curve becomes vertical and is no longer moved at all by shifts in the interest rate, so monetary policy also has no effect on the price level. Fiscal policy shifts the IS curve right or left (depending on whether it involves increasing or decreasing government spending, or lowering or raising taxes, respectively). A shift right in the IS curve moves along the Fed rule curve, resulting in a rise in interest rates, but this rise in rates does not reduce investment and so the increase in spending is greater than it would have been in the case that this change in interest rates reduced spending. The AD curve shifts right in response to this expansionary fiscal policy, which results in a move along the AS curve, resulting in an increase in the price level. Overall, this change results in a larger response of output, a larger response of interest rates, and a larger response of the price level to a given change in fiscal policy, while it leads to a zero response of output and inflation and a larger response of interest rates to a change in monetary policy.

If someone wins a $100 million lottery in the form of $10 million a year for 10 years, he or she can cash out and get all the money at once, but the amount is much less than $100 million. Why? Why does the decision of whether to cash out or not depend on the size of the interest rate?

If someone wins $10 million a year for 10 years, the net present value of the award would be less than $100 million because the winner would only be able to start receiving interest immediately on the first $10 million. He/she would have to wait to receive interest on the future tranches of $10 million as he/she receives them. Therefore, the equivalent (in terms of net present value) of receiving $10 million a year for 10 years would be receiving less than $100 million right away. A higher interest rate would increase the net present value of receiving the entire amount immediately (because it could all be invested right away), relative to the net present value of receiving $10 million a year for 10 years (because it could not all be invested right away). Therefore, a higher interest rate would increase the incentives for the winner to cash out right away. Note that the present value of receiving $10 million a year for 10 years can be derived as: 𝑃𝑉 = $10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 + $10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛/(1+r)+ $10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛/(1+r)^2+ ⋯ + $10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛/(1+r)^9 We can also see from this formula that the present value of the $10 million tranches decreases from most recent tranche to most distant tranche. The reason is that future money streams need to be discounted by the interest rate.

**Suppose the government increases the tax rate. What is the effect on Investment and the government deficit?**

If tax rate increases, C as a function of Yd decreases, and Y decreases, so C decreases again (multiplier effect) This triggers the Fed rule. R decreases, so I increases, Y increases, C increases (2nd multiplier effect). So, Y decreases, C decreases, and I increases. The result effect on the government deficit is AMBIGUOUS because t went up simultaneously with Y going down. note: the Fed rule can never fully offset #1 because they care about P and Y

What would the shape of the AD curve be if the Fed cared much more about output than about the price level? Explain carefully. How would the effects on output of a change in the price of imports PM differ in this case versus the case in which the Fed cared much more about the price level than about output? Show graphically.

If the Fed cared much more about output than about the price level, then in the equation for the Fed rule we would have β < α. This means that the central bank will react to price changes only if these changes are substantial, to avoid negative effects on output due to the increase in the interest rate. This implies that the Fed is willing to accept high changes in P to keep output stable. This clearly implies that the AD has a very steep slope. If there is an increase in the price of imports, the aggregate level of prices goes up. If the Fed cares more about output, then its response will be mild: it will increase the interest rate by few basis points. If instead the Fed cares more about price stability than production, then the response will be stronger and it will increase the interest rate a lot to keep prices stable, at the cost of reducing investment and thus output. You can see the opposite situation (a decline in the price of imports) graphically below, where again, price declines less and so the output impact is greater.

If there is a zero interest rate lower bound, is fiscal policy more or less effective than otherwise? Explain carefully using the AS/AD model.

If there is a zero interest rate lower bound, the AD curve is a vertical line: if there is a change in prices, r does not change (since is set to zero) and thus also investment and output don't change. If there is an expansionary fiscal policy (an increase in spending G), the AD curve shifts to the right, but the absence of crowding out effects (an increase in the interest rate that causes I to go down) makes this policy even more effective than in the standard case of r > 0.

If the Fed raises the interest rate in December, trace through in the AS/AD model the effect this would have on consumption and taxes. What would be the effect on the government deficit?

In this case, let us assume that the interest rate is exogenous. The increase in the interest rate lowers Investment. The decrease in Investment lowers Y directly. The decrease in Y lowers Consumption, which in turn further reduces Y through the multiplier effect. All of this leads to a decrease in AD. The cumulative effect on output depends on which portion of the AS curve the economy is operating in. [1] If the economy is on the vertical part of the AS curve and remains on it after the decrease in AD, the decrease in AD leads to a reduction in aggregate price but no change in Y. [2] If the economy is on the upward sloping part of the AS or moves from the vertical to the upward sloping part following the decrease in AD, the decrease in AD reduces both aggregate price P and Y. Taxes = tax rate* Y If Y decrease, then Taxes decreases. Government deficit = Transfer Payments + Government Expenditure - Taxes Government deficit increases if tax collected decrease.

Suppose that the government wants to increase AD. It can either increase TR by x units or G by x units but not both. What would you recommend that the government do?

Increase G. (Assuming you are on an upward sloping AS curve) Increasing G is more effective because it increases Y directly & through the multiplier effect. TR only increases through the multiplier effect. Because G will lead to higher taxable revenue, ty will increase and lower the Government Deficit

Suppose the government taxes income at the rate t%. (Investment, Government expenditure and transfer payments are exogenous). What is the effect of increasing the tax rate on the effectiveness of government spending to stimulate the economy?

Increasing the tax rate DECREASES the effectiveness of government spending. This is because a higher tax rate means lower disposable income which makes the multiplier smaller.

Is it true that at the non-accelerating rate of inflation, there is no change in the price level?

Inflation rate stays the same but if the inflation rate is positive you could still have a change in prices

If parameters are chosen by the procedure of least squares, what does this mean? What if least absolute deviations was used instead?

Least squares means that we choose the parameters that minimize the squared deviations between the fitted values provided by the model and the values observed in the data. Absolute deviations allow us to choose the model parameters that optimize for the minimum absolute value of the difference between the fitted and observed values. One difference: least squared deviations rely on the squared terms, which gives greater emphasis to large differentials between the fitted and observed data points in determining model parameters.

What is the marginal propensity to save? How is the multiplier affected by it?

MPS = the proportion of each additional dollar of income that is saved by consumers. MPC = the direct opposite Thus, the MPS + MPC = 1, and MPS = 1 - MPC. Multiplier = 1/MPS So a higher MPS leads to a lower multiplier.

The required reserve ratio is 10%. A bank has deposits=$100, loans=$50 and reserves=$50. An additional $100 is deposited. Your friend from Harvard claims that money supply will increase by $1000 as a result, assuming no leakages from the system. Is he correct?

NO. Currently, the bank has $40 in excess reserves when they only need $10 so an increase of deposits of $100 will not convince the bank to increase loans. There must be something else in the economy that makes the bank not want to loan

Suppose that the Fed suspended the Fed Rule. Does government spending still have a crowding out effect?

NO. The crowding out effect occurs when the Fed Rule (step 2) is triggered. So if its taken out, there is no crowding out effect. (1) G^, Y^, C^, Y^ (2) then r^, I decr.

Some argue that services performed in the home by stay-at-home spouses should be counted in GDP. What is the argument for this?

Nonmarket activities like the home services provided by the stay-home-spouses also produce economic values and constitute a significant part of our economic activities.

What happens to the economy if actual investment is greater than planned investment?

Planned investment = amount of investment firms plan to undertake during a year. Actual investment = amount of investment actually undertaken during a year. If actual investment is GREATER than planned investment, then inventories INCREASE, since inventories are part of capital. This increase in inventories may lead firms to reduce output.

Why are stock purchases like buying shares of Google stock not counted in GDP?

Purchase of stock does not itself represent any current production. Nonetheless, any fees paid to a broker for the purchase represent a current service and are counted in GDP.

equation for real interest rate

Real interest rate (r)—not directly observed Nominal interest rate (i)—observed Rate of inflation (p ̇)—observed r ≡ i − p ̇

When the Fed finally begins to raise the interest rate, how is it likely to do this?

Since excess reserves today are over $2.5 trillion, the Fed cannot use the traditional tools of open market operations, reserve requirement ratio, and discount rate. Rather, when the Fed begins to raise the interest rate, it will likely do so by increasing the rate it pays to banks on their reserves. This would induce banks to try to sell their relatively less attractive securities and substitute towards holding more reserves, thereby increasing to a supply of those securities without a change in demand, which would ultimately lead to a decrease in the price of the securities. This would in turn cause the interest rate to rise.

Why might stock prices fall if the Fed raises the interest rate?

Since interest rates are in the denominator of the stock price equation, an increase in the interest rates would reduce the price. The intuition is that the future stream of cash flows would be discounted more than would have been the case with a lower interest rate.

Can you give some intuition as to why the inflation rate is higher when using one set of weights than when using the other?

Since the price change of each good is weighted differently, the inflation rates will be different depending on the base year used. Using the first year quantities will miss how quantities change based on price substitution effects (i.e. consuming more when the price decreases and less when the price increases) and will tend to overstate inflation as a result.

AD curve

Slopes downward because P and Y are negatively related P down, r down, I up, Y up, C up, then multiplier, Y up, C up SHAPE: influenced by the Fed - based on what it cares about - steep AD curve -- more sensitive to output - flat AD curve -- more sensitive to price *fiscal policy effect is applified

Use the AS/AD model to explain how stagflation can occur.

Stagflation is a period of simultaneous inflation, or increase in the price level, and stagnation or recession, or decline in total output. With a downward sloping aggregate demand curve (as explained in 2.) and an upward sloping aggregate supply curve (as explained in 1), an increase in prices and a decrease in output can occur via a movement up and left along the aggregate demand curve, which can occur due to a shift up of the aggregate supply curve. This may occur, for example, due to a sudden increase in oil prices, which shifts up the aggregate supply curve, raising prices and thereby causing a movement along the aggregate demand curve as the rise in prices leads the monetary authority to raise interest rates and thereby contract spending.

"The Phillips Curve broke down in the 1970's." What does this mean and why is it perhaps a misleading statement? Explain the "breakdown" using the AS/AD model.

The Phillips Curve illustrates the inverse relationship between the inflation rate and the rate of unemployment: when unemployment is high, inflation is low, and vice versa. This relationship held very strongly in the 1950s and 1960s. But for much of the 1970s both inflation and unemployment moved in the same direction, rising and falling together. This is what is meant by "the Phillips Curve broke down." This statement might be misleading for two reasons. First, by the end of the 1970s the rate of inflation fell as unemployment rose, so the relationship may not have broken down entirely. Even if the graphical representation of the Phillips relationship became messy, the underlying association between inflation and employment could remain. Second, it might be misleading because it attributes a sense of historical accuracy to the Phillips Curve that may be undeserved. The mid-century stability of the AS curve allowed fluctuations of the AD curve to trace-out a robust and inverse relationship of the unemployment rate and the rate of inflation: when inflation declined, unemployment rose; when unemployment declined, inflation rose. As price shocks hit the economy in the 1970s, the AS curve began to shift at the same time the AD curve shifted, distorting the Phillips relationship. The Phillips curve holds for a given AS curve, and so it represents a short-run trade-off that can vary over time as fundamentals change.

Why does the AD curve slope down? What role does the Fed rule play in this derivation? What is the theory behind the Fed rule?

The aggregate demand curve describes the relationship between the price level and total spending in the economy. It slopes down because the monetary policy authority responds to changes in the price level by adjusting the interest rate according to a monetary policy rule, which dictates that the Fed raise the interest rate when inflation is high and so the price level is increasing, and lower the interest rate when inflation is low and so the price level is decreasing (or not increasing as much). Because an increase in the interest rate lowers planned investment (and a decrease raises it), the Fed response of raising the interest rate in response to higher prices results in reduced investment spending, which in turn lowers income and so also reduces consumption spending via the multiplier effect. In this way, price level increases reduce aggregate spending and decreases increase it. It is important to note that AD curve is not a market demand curve. This means that one cannot simply employ the logic of substitution and income effects to explain the negative slope of the AD curve. Unlike the market demand curve which plots quantity demanded of a good for different possible prices holding prices of all other goods fixed, the AD curve plots the economy's aggregate output for different possible overall price levels, which allows prices of different goods to vary simultaneously. Instead, as explained above, the negative slope of AD curve must be explained using the Fed behavior and investment function: when price level rises, Fed raises the interest rate, which then lowers planned investment and hence aggregate output.

Why does the AS curve slope up, at least in the short run? Some argue that the AS curve is always vertical. What is this argument?

The aggregate supply curve describes the relationship between the price level and the total quantity of output produced by firms. 1. Because firms have market power (as in monopolistic competition) they may raise output and prices in response to an increase in demand for their products. When aggregate demand rises, price level rises but wages tend be sticky, moving only gradually in response to price level changes so that the marginal cost curve does not shift up along with prices. Because price rises faster than marginal costs, firms find it profitable to increase production. As a result, an increase in prices is accompanied by an increase in firm output, that is, the aggregate supply curve slopes up, at least in the short run. This increase in output may be only temporary because nominal wages gradually adjust, raising marginal costs and returning supply to a long-run level consistent with full employment. Some economists who dismiss the idea of sticky wages believe that the AS curve is always vertical, arguing that wages adjust proportionally as prices adjust. Furthermore, there is likely to be an output level beyond which the economy no longer has an excess capacity to produce so that any increase in aggregate demand will be met with price increase (and proportional wage increase) rather than with output increase. Hence, beyond this maximum output capacity level, the AS curve is likely to be vertical.

Explain logically why total output and total income in an economy are the same. What is it in the construction of the data that insures that this is the case?

The expenditure approach = the income approach When money is spent for a good or service, this is also income which is received by the firm. This, in turn, goes towards paying wages or other expenses such as interest or taxes, and what remains is corporate profit.

Assume that for some reason the 1-year interest rate expected to exist two years from now increased. How will this affect the current 1-year rate? The current 5-year rate? Explain carefully.

The term structure equation is: 1+𝑟5^5 = (1+𝑟1) (1+𝑟1+1)(1+𝑟1+2 )(1+r1+3)(1+𝑟1+4 ) If the 1-year interest rate expected to exist two years from now (𝑟1+2) increases, then the current 1-year rate (r1) will not change, but the current 5-year rate (r5) will increase.

Which is bigger, govt. spending multiplier or transfer payment multiplier?

The transfer payment multiplier is less than the government spending multiplier. The change in transfer enters spending decisions through C and C is dependent on the MPC. Assuming MPC < 1, a dollar increase in transfer payments results in an increase in spending of less than one dollar. In contrast, G affects spending decisions directly, making a higher multiplier. Government spending is an injection into the economy that does not have to work through some indirect source before having an effect on the economy.

Explain why it is possible for both employment and the unemployment rate to increase at the same time.

The unemployment rate is the fraction of people who are in the labor force but do not have a job. However, if you do not have a job, to be counted in the labor force you must be actively looking for a job. So, if the number of employed people increases and the number of people looking for a job substantially increases, then it is possible for the unemployment rate to increase.

Some people argue that the actual unemployment rate is higher than the government estimates it to be. What is this argument?

The unemployment rate would be higher if it included discouraged workers. Discouraged workers stopped looking for a job because they could not find a job but they still want to work. These people are not officially unemployed because they are not counted as in the labor force, though arguably they truly are.

Say you bought a 10 year government bond last year that yielded 3.0 percent per year. Assume that since that time the 10-year government bond rate has fallen to 2.0 percent. Are you better off or worse off after this fall? Explain carefully. How is this related to Professor Serebryakov?

There are two ways to think about this. 1) If you assume that the 3% yield is promised per year to you, you have an instrument that pays you 3% per annum at a time when the outside interest rate is 2%. On the other hand, you can assume that the interest on your bond has also fallen to 2%. You are better off. The reason is that (given the coupon structure of the bond you bought) when yields fall prices increase. This fact derives just from the fact that bond prices equal the present value of future cash flows. Then you have realized a capital gain on the government bond and you are better off. In the play Professor Serebryakov thought that it was a good idea to sell an estate earning a 2% return in order to buy a security that earns a 5% return. He didn't realize that the he would never enjoy a 3% profit from this operation, as the sale price of the estate would have to be low enough to compensate the buyer for not buying the 5% return security. Professor Serebryakov should have discounted profits from the estate by using the 5% discount rate that the market offers and not the 2% rate that its own estate earns. In the same way, future cash flows of a security should be discounted at the appropriate rate (that is the best opportunity currently available, often the interest rate).

Why would a balanced budget amendment increase the size of the government spending multiplier?

This is a TRICK question. Under the balanced budget amendment, government spending becomes an endogenous variable. There is thus NO government spending multiplier.

How do you find nominal GDP for a year?

To find nominal GDP for a given year, multiply the price of each good times the quantity produced, and sum across goods:

How do you find the price level in a given year using 2016 weights?

To find the price level in a given year using 2016 quantity weights, multiply the price of each good in that year times the quantity purchased in 2016, and sum across goods:

In 2013, a curious thing happened. The US faced a government shutdown and one major credit rating agency downgraded the US. Credit downgrades usually result in rising interest costs. But the implied interest on US bonds fell and the prices of stock fell as well. How can you explain this?

When it is risky (credit downgrade) people go to safety (bonds) and price for bonds goes up and implied interest fell.

1. Why might there be unemployment if wages are sticky downward? Why might wages be sticky downward? Give at least four reasons.

With sticky wages, if labor demand decreases but wages do not decrease, then the supply of labor will exceed the demand. This excess supply would persist because so long as wages don't adjust downward, and there would be unemployment. There are many reasons why wages might be sticky downward. Implicit/social contracts prevent firms from cutting wages because it hurts morale and therefore productivity. Explicit contracts may keep wages fixed at the agreed-upon level. Minimum wage laws will fix wages for a fraction of workers. Firms may have imperfect information and not react to changes in the economy right away so that it takes time for wages to adjust. Finally, employers may keep wages higher than the market-clearing rate to provide incentives to employees to work harder (efficiency wages theory).

Does inflation have distributionary consequences?

Yes. High inflation with a fixed nominal interest rate makes lenders worse off and buyers better off. Distribution effects only matter if the inflation is unexpected

Why are the following not included in GDP: (a) Jacket sold in the USA but produced in Canada (b) retirement benefits (c) commission-free sale of stock of Apple?

a) GDP is about domestic production b) transfer payment 3) stock is already created, so not a new good, effectively a TR

What is the effect on the money supply if [a] the Fed buys U.S. treasury securities from banks [b] increases the discount rate?

a) Gives banks $, which increases reserves, so banks increase loans, which increases money supply new excess res./reserve ratio = increase in $ supply b) Increase discount rate, banks borrow less, and then they have less excess reserves, then they loan less, then there is less $ supply

Assume that a bank has on its asset side reserves of 500 and loans of 3000 and on its liability side deposits of 3500. Assume that the required reserve ratio is 10 percent. (a) How much is the bank required to hold as reserves given its deposits of 3500? (b) How much are its excess reserves? (c) By how much can the bank increase its loans? (d) Suppose a depositor comes to the bank and withdraws 400 in cash. Show the bank's new balance sheet, assuming the bank obtains the cash by drawing down its reserves. Does the bank now hold excess reserves? Is it meeting the required reserve ratio? If not, what can it do?

a) Required Reserves = Required Reserve Ratio X Deposits Required Reserves = 0.1*3500= 350 b)Excess Reserves = Actual Reserves - Required Reserves = 500 - 350 = 150 c) TWO OPTIONS since excess reserves are positive, the bank can increase lending by... 1. INCREASE in deposits: issue new loans through raising new deposits, The bank has 500 of reserves so it can raise up to 500/0.1 = 5000 in deposits. If 5000 of deposits are raised, the bank is then able to issue total loans for an amount equal to the difference between deposits and reserves, which is: 5000 − 500 = 4500. (so 1500 additional loans) 2. DECREASE in reserves: run down reserves and use its reserves surplus to issue loans. Reserves can be run down exactly of the amount of excess reserves, that is 300. In this case the bank would increase loans by 150 d) The bank no longer holds excess reserves: Excess Reserves = 100 - (0.10 × 3100) = -210 The bank is also not meeting the required reserve ratio of 10%: Actual Reserve Ratio = Reserves / Deposits Actual Reserve Ratio = 100 / 3100 Actual Reserve Ratio = 3.23%

Equilibrium between Y and AE

if Y>AE, that means the actual investment > planned investment and there is too much inventory if Y<AE, that means actual investment < planned investment and there is too little inventory

Suppose alpha = 0, beta > 0. Suppose PM increases. What is the effect on the government deficit? How would the result change if instead of alpha, beta = 0, alpha > 0?

if a = o, the fed cares ONLY about P (not Y) This causes AS to decrease, AD stays the same (set horizontal line) and Y to decrease. As Y decreases, government deficit increases. if b = 0, the fed ONLY cares about Y (not P) This means the AD curve would be a vertical and a shift in AS would result in a large increase in P and no increase in Y.

If wages were not sticky but adjusted immediately, what would be the shape of the short run aggregate supply curve?

if wages aren't sticky the SR AS curve will be a vertical line

effect of an increase in r

r up, I down, Y down, C down, then second level multiplier, Y down, C down

When is the real interest rate negative?

real = nominal - inflation real is negative when inflation > nominal

In an econometric regression, what is the reason for preferring absolute deviations over squared deviations as the method for calculating the "best fit" line?

squared deviations -- outliers have a bigger effect absolute deviations -- outliers have less of an effect, more accurate