中级宏观经济学试题-Chapter18

Solutions to the Problems in the Textbook

Conceptual Problems

1.a. The Keynesian explanation for the Great Depression concentrates on the decline in investment

spending and the reduction in aggregate consumption. The decrease in aggregate demand was reinforced by restrictive fiscal policy as the government tried to balance the budget.

1.b. The monetarist explanation for the Great Depression concentrates on the decline in money supply.

The Fed failed to prevent a large number of bank failures, so consumers lost confidence in the banking system. This led to an enormous increase in the currency-deposit ratio, causing a decrease in the money multiplier. The resulting drastic decline in money supply led to the economic downturn. 1.c.Both explanations given above fit the facts and there is no inherent conflict between them; in fact,

they complement one another. The combination of inept fiscal and monetary policy may have turned what could have been an average recession into a major depression.

1.d. The Great Depression is one of the most drastic economic events in recent history and any theory that

can adequately explain its causes or find remedies to prevent similar occurrences in the future will attract attention. Some economists argue that the Great Depression proves that the economy is inherently unstable and requires a long time to adjust back to full-employment equilibrium. Others argue that it proves that government policy is often misguided and that it may be better to rely on market forces to bring us back to an equilibrium.

2.In the long run no major inflation can persist without rapid money growth, since the inflation

rate is equal to the growth rate of money supply adjusted for the trend in real output and changes in velocity. In the short run, however, changes in output growth and velocity are quite unpredictable and affect the inflation rate. Such short-run fluctuations can be caused by supply shocks or policy changes.

3.a.The key question for governments desiring to reduce inflation is how cheaply (in terms of lost output)

they want to achieve a desired inflation rate. A gradual strategy attempts a slow and steady return to a low inflation rate by reducing monetary growth slowly in an attempt to avoid a significant increase in unemployment. This approach takes a lot longer than the cold-turkey approach that attempts to reduce inflation quickly by immediately and sharply reducing monetary growth. While inflation and inflationary expectations will be reduced faster under the cold-turkey approach, a higher level of unemployment leading to a decrease in the level of output will result in the short run until the economy has time to adjust back to the full-employment level of output. Which strategy policy decision-makers will choose mostly depends on how fast wages and prices are believed to adjust to their equilibrium level.

3.b. If policy makers have a credibility problem, inflationary expectations will not adjust downwards

quickly and it will take a lot longer (and probably a much higher increase in the unemployment rate) to reduce inflation. With a gradual approach, people will be very reluctant to change their inflationary expectations, since they may not be convinced that the central bank will actually stick to its announced policy objective of reducing inflation. A cold-turkey approach may be more attractive since it has a credibility bonus, that is, there is an immediate confirmation that the central bank is committed to reducing inflation. Therefore a new full-employment equilibrium can be reached more

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quickly.

4.People often worry about budget deficits, relating them to their own financial situations and inferring

that nobody, not even the government, can live on borrowed money for a long period of time. The real issues surrounding budget deficits, however, are much more complicated, and most people do not fully comprehend how large budget deficits actually affect the economy and their daily lives.

In the short run, budget deficits caused by expansionary fiscal policy stimulate the economy.

However, the increased need of the government to borrow may drive up interest rates and crowd out private spending, especially investment and net exports. A lower rate of capital accumulation implies less future economic growth and therefore lower living standards. Part of the budget deficit may have been financed from abroad, so foreigners will have to be repaid with interest and this diminishes domestic living standards. Finally, if the Fed is worried about higher interest rates and decides to monetize the debt, a higher rate of inflation results. To avoid inflation, continued high budget deficits eventually require higher taxes or budget-cutting measures to counteract the increased high interest payments on the debt.

As long as the national debt grows more slowly than GDP, financing the national debt does not create

a major problem. But if the debt-income ratio increases, the financing of further budget deficits

creates difficulties. Therefore people should worry less about the size of the deficit or the debt and more about the debt-income ratio, the way in which government deficits are financed, and the possibility of lower future economic growth due to a lower rate of capital accumulation.

5.The further the economy is from the full-employment level of output, the more the Fed should be

willing to monetize the deficit. For one, at a time when unemployment is high, inflationary pressure is probably low, so increasing money supply will not cause rapid price increases. Secondly, a small increase in inflation may be tolerable since a high level of unemployment is costly in terms of lost output. Therefore it may be desirable to return to full employment quickly by increasing money supply. However, when the economy is close to full employment, bottlenecks develop more easily. In this situation, monetizing the deficit will ultimately fail to keep interest rates down or stimulate the economy further. Instead a higher rate of monetary growth will cause inflation to increase sharply, without much increase in real GDP.

6.The ability of the government to raise additional tax revenue through the creation of money (and

therefore inflation) is called seigniorage. Inflation acts just like a tax since the government is able to spend more by printing money while people are forced to spend less since part of their income is used to increase their nominal money holdings. Inflation tax revenue is defined as the product of the inflation rate times the real money base.

7.a. During the hyperinflation of 1922-23, the German government financed almost all of its spending

through the creation of money. The excessive monetary expansion caused inflation to skyrocket, reaching an average monthly inflation rate of 322 percent.

7.b.The tax revenue that can be gained through an increase in the inflation rate is defined as:

inflation tax revenue = (inflation rate)*(real money base).

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Figure 18-3 shows that it is possible for the government to increase the inflation tax revenue temporarily as long as money is printed faster than people expect. But excessive monetary growth causes inflation to increase rapidly and people will start to reduce their money holdings in an attempt to avoid the inflation tax. Eventually, the monetary base will decline, and the whole process will break down.

At the end of a hyperinflation, nominal interest rates tend to decline and thus the demand for money balances increases. In this situation, the government is able to increase money supply without creating more inflation—at least for a short while.

8. Russia was burdened with a huge budget deficit and a large external debt as it tried to

transform its centrally planned economy to a free market economy. Real output decreased substantially and all kinds of bottlenecks occurred. Much of the economic activity was on the black market, so collecting tax revenues became difficult. With government spending far outpacing tax revenues, the government budget got totally out of balance and hyperinflation resulted as the central bank created money to allow for more government spending. Inflation peaked at 2,600% in 1993. The ruble totally collapsed in value and the Russian economy became burdened with a huge foreign debt that it was unable to service.

In such a situation, subsidies to loss-making state enterprises had to be cut and tax collections had to be strictly enforced in order to bring the budget back into balance. To bring inflation under control, Russia introduced a new line of ruble notes in January, 1998.

The old 1,000-ruble bills were replaced with new one-ruble notes in an effort to curtail money growth.

9.a. Interest payments on the national debt can be divided into real payments and payments

due to inflation. In other words, we have to distinguish between real and nominal interest rates. During periods of inflation most interest payments are offset by the decrease in the real value of the debt. What we should be concerned about, however, are the interest payments in real terms.9.b. The national debt is a burden on society primarily because of the negative effect it has on the rate of capital accumulation. The increased borrowing needs of the government drive up real interest rates, which then crowd out private spending, especially investment. As a result, future economic growth may be impaired, leading to lower living standards. High interest rates may also crowd out net exports, which may lead to a loss of competitiveness and a decline in the manufacturing sector. In addition, the part of the debt that is held by foreigners will have to be repaid with interest, creating a tax burden on future generations. The part of the debt that is financed domestically does not create the same burden, since future tax increases will be used to pay U.S. citizens holding government securities. It will, however, have redistributive effects, away from mostly lower- and middle-income taxpayers to mostly high-income bondholders.

10. If an amendment to require an annually balanced budget were implemented, the

government would no longer be able to use discretionary fiscal policy as a stabilization tool. In addition, if the amendment called for annually balancing the actual budget, it

could do more harm than good.

Assume that the economy is at full employment and the budget is balanced. If the economy enters a recession, the cyclical component of the budget surplus will become negative and an actual budget deficit will develop. To balance the budget, the government can either increase taxes or decrease spending to create a surplus in the structural component. This fiscal restriction will cause a deeper recession, increasing the cyclical deficit even more. It is doubtful that the government would actually succeed in balancing the budget. For this reason most economists do not favor a balanced budget amendment.

11. It is more important to look at the debt-income ratio than at the absolute value of the

national debt, since the debt-income ratio tells us how much of our current income we would have to give up to pay back the debt. Obviously a $6.2 trillion national debt is much harder to deal with in an economy with a GDP of $5 trillion than in an economy with a GDP of $10 trillion. Similarly, if the economy grows at a higher rate than the debt, we have less reason to worry. However, if the national debt grows faster than GDP over a long time period, we may have to worry about our ability to service the debt.

12.The answer to this question is student specific. There was no easy way to finance the

massive increase in government expenditures that was required to build up the infrastructure in the new Eastern states and to ensure transfer payments to the large numbers of unemployed and retired people. The German government struggled with this question and the transition period has not been easy.

The huge amount of funds required to finance these expenditures could not be raised solely by increasing taxes. Tax increases are not only highly unpopular but may also provide disincentives to work, save and invest and may thus have a significant negative impact on the performance of the economy. Chancellor Kohl initially promised that Germany’s re-unification would not be financed through a tax increase, but when the costs of the re-unification became apparent, he had to break that promise.

An increase in expenditures that is debt financed leads to higher interest rates, crowding out some private spending (investment and net export). In addition, it leads to a capital inflow that strengthens the value of the domestic currency. In Germany, this process created a problem since exchange rates among countries of the EC were fixed within a relatively small range. The European currency crisis of 1992 was caused by the increase in the German budget deficit that was largely debt financed. The subsequent inflow of funds from other EC-countries required massive government intervention to keep exchange rates within their assigned range and caused problems for other European countries. Eventually these countries had to devalue their currencies. In addition, Germany experienced a current account deficit because of the high value of the D-Mark relative to the currencies of non-EC countries. Thus, the situation in Germany in the early 1990s strongly resembled the situation in the U.S. in the early 1980s, with its high interest rates due to large government borrowing and fairly tight monetary policy and subsequent trade imbalance.

Financing large increases in government expenditures through money creation would serve to keep interest rates low, which would not only reduce interest payments on the

national debt but also help to keep the value of the D-Mark from rising. However, money creation would also lead to increased inflation. The Bundesbank, Germany’s central bank at the time, which was known for its independence and its aversion to inflation, chose to let money supply grow only to a small degree. As a result, German interest rates rose substantially, leading to an inflow of funds but a weaker performance of the economy.

13.a. The pay-as-you-go financing of the Social Security system results in a transfer of income

from the young to the old. This is possible for three reasons. First, a growing population will make financing public pension systems easier. Second, a high growth in income due to higher productivity will allow retirement benefits to be higher than past contributions.

Finally, since older people are more likely to vote than younger people they can enforce this intergenerational transfer through the political system.

13.b. The pay-as-you-go financing of Social Security causes a savings replacement effect, that

is, the government does not save Social Security contributions but uses them immediately to pay for the benefits of those currently retired. This decrease in national saving reduces the rate of capital accumulation and negatively affects future living standards.

13.c.P roposals for Social Security reform include the following suggestions: first, allow people

to invest at least part of their funds in private retirement accounts to ensure that they are productively invested; second, increase payroll taxes, tax retirement benefits, and increase the retirement age to make financing the system easier. If Social Security contributions are put into individual retirement accounts or in a trust fund, there is no savings replacement effect and therefore the rate of capital accumulation is not negatively affected.

However, private retirement accounts are not necessarily indexed against inflation while Social Security benefits are. Similarly, funds that are invested in the stock market bear a significant risk.

Technical Problems

1.a.Period % change in real GNP

1929 - 1930 (285.2 - 314.7)/314.7 = - 9.37%

1930 - 1931 (263.3 - 285.2)/285.2 = - 7.68%

1929 - 1931 (263.3 - 314.7)/314.7 = - 16.33%

1.b.Period % change in real GDP

1990 - 1991 (6,079.0 - 6,138.7)/6,138.7 = - 0.97%

The numbers of the real GDP in 1990 and 1991 are taken from the Economic Report of the President, February, 1997. Table 18-1 lists output in terms of GNP, used at that time, and not GDP, which is used now as a measure of total output.

1.c. There is no official distinction between a depression and a severe recession and it is

obvious that if the real GNP had stopped decreasing in 1931 rather than in 1933, the depression would have been much less severe. From Table 18-1, we see that real GNP continued to decline to $222.1 billion in 1933, an overall decline of 29.42% (almost double the rate calculated in 1.a.) and that it took until 1939 to return to the 1929 level of real GNP.

While it is always hard to guess "what would have happened if...," it seems accurate to say that if the government had taken immediate steps to stimulate economic growth through expansionary fiscal and monetary policies, the severity of the Great Depression could have been greatly reduced. In this respect, the first sentence of Question 1 is correct.

However, it should be revised to say: "The severity of the Great Depression could have been greatly reduced if active expansionary government policies had been employed sooner."

2. The actual government surpluses from 1929-33 were +1.0%, -0.3%, -

3.8%, -3.1%, and

-2.5% of GNP. However, the full-employment budget surplus (a concept that had not as yet been developed at the time) in each of those year was - 0.8%, -1.4%, -3.1%, -0.9%, and +1.6% of potential GNP. The large size of the actual budget deficits may have led to the incorrect conclusion that fiscal policy had been too expansionary, when in actuality the size of the budget deficits was due to the decline in GNP. The existence of a full-employment budget surplus in 1933 indicates that fiscal policy was too restrictive, and this greatly contributed to the severity of the depression. The full-employment budget surplus rather than the actual budget surplus provides a much better indication of whether fiscal policy is expansionary or restrictive.

3. With real output remaining constant, the additional tax revenue gained from inflation is:

inflation tax revenue = (inflation rate)*(real money base).

If the real money base is 10% of GDP and the inflation rate increases from 0% to 10%, we should expect an increase in government tax revenues of 1%, as long as the real money base remains constant. However, as inflation increases, people reduce their money holdings and banks reduce their excess reserves since it becomes more costly to hold money. In countries that have sophisticated banking systems, money holdings (and therefore the inflation tax revenue) decrease to a much larger extent than in countries where there are fewer alternatives to cash holdings. But if the real money base decreases, so does the inflation tax revenue.

4.The inflation-adjusted budget deficit can be calculated in the following way:

inflation-adjusted deficit = total deficit - (inflation rate)*(national debt)

= 4% - (7%)(30%) = 4% - 2.1% = 1.9%,

that is, the inflation-adjusted deficit is 1.9% of GDP.

5. From the equation MV = PY ==> %?M + %?V = %?P + %?Y ==> %?P = %?M

- %?Y + %?V

==> π = m - y + v.

In other words, the rate of inflation (π) is equal to the difference between M2 growth (m) and economic growth (y) adjusted for changes in the income velocity of M2 (v). If we subtract the second column (output growth) from the first column (money growth) in Table 18-11, we get the inflation rate minus the change in the velocity. In other words, Column 3 (the inflation rate) would only be equal to the difference of the first two columns if velocity remained constant. The numbers in this table imply that the changes in velocity varied from - 6.3% in 1880-1889 to + 3.1% in 1920 - 1929. From 1960 to 1989 the changes in velocity were very close to 0%. Therefore in these three decades, the rate of inflation can be explained very well by the difference between M2 growth and economic growth. From 1990-1999, the change velocity again differed significantly from 0%.

6.a. According to Table 18-8, total government outlays were 18.8% of GDP in the 1960s,

20.7% of GDP in the 1990s, and 18.8% of GDP in 2000-02. Thus there was an increase of

roughly 10% from 1960 to 1999, which we can calculate in the following way:

(20.7 - 18.8)/18.8 = 0.101064 = 10.1%

The latest number for 2000-2002 actually shows total outlays of 18.8%, which is exactly what it was (percentage-wise) in the 1960s. However, these two years most likely will not be representative for the whole first decade of the new millennium.

6.b.National defense decreased from 8.6% of GDP in the 1960s to 4.1% of GDP in the 1990s,

and 3.5% in 2000-2002. However, over the same time period, entitlements and other mandatory spending increased from 6.2% to 11.2% of GDP. In 2000-2002, they accounted for 11.0% of GDP. This is now the largest component of government outlays. 6.c. Besides the increase in entitlements, which almost doubled over the last three decades,

interest payments on the national debt more than doubled from 1.3% in the 1960s to 3.0% in the 1990s. In 2000-2002, they decreased to 2.0%.

7.a. According to Table 18-9, total federal revenues were 17.8% of GDP in the 1960s and

18.6% of GDP in the 1990s. This constitutes an increase of almost 4%, which we can

calculate in the following way:

(18.6 - 17.9)/17.9 = 0.03911 = 3.9%

However, total revenues increased to 19.5% in 2000-2002, an increase of almost 5% over

the 18.6% in the 1990s.

7.b. In the 1960s, the corporate income tax was the second largest component of federal

revenues with 3.8%. It decreased to 1.9% in the 1990s, and was 1.7% in 2000-2002.

Social insurance taxes and contributions increased from 3.5% to 6.6% from the 1960s to the 1990s and were 6.8% in 2000-2002. They are now the second largest component of federal revenues, only slightly behind the 8.4%, in the 1990s and 9.5% in 2000-2002 that came from the individual income tax.

7.c.Since the corporate income tax and other revenues decreased, the increase in tax revenues

from the 1960s to the 1990s came primarily from social insurance taxes and contributions and the individual income tax.

8.From Tables 18-8 and 18-9 we can calculate the budget deficit (defined as government

outlays minus government revenues) as a percentage of GDP in the following way:

1960s: 18.8% - 17.8% = 1.0%

1970s: 20.0% - 17.9% = 2.1%

1980s: 22.2% - 18.2% = 4.0%

1990s: 20.7% - 18.6% = 2.1%

As we can see, federal budget deficits as a percentage of GDP more than quadrupled from the 1960s to the 1980s, but then started to decline in the 1990s to a bit more than double the percentage in the 1960s. For the years 2000-2002, we get 18.8% - 19.5% = -0.7%. In other words, we had budget surpluses during these years.

9.The debt-income ratio is defined as the national debt divided by GDP. Therefore if the

national debt grows by 5% a year, but GDP grows by only 4%, the debt-income ratio will increase.

Empirical Problems

1. Defense expenditures were not a very important component of government expenditures

in Australia. At the beginning of the 1970s, the Australian government spent only roughly 10% of its total expenditures on defense. By 2002, the share of defense expenditures in total government expenses fell to just above 7%.

2. In the last 25 years or so, Australian NGDP increased about 10 times. However, in the

same period government spending on social security and welfare in Australia increased more than 20 times. Thus, transfer payments are a bigger share of GDP today than they were 25 years ago.

Additional

Problems

1. In the early 1930s, interest rates were extremely low and the supply of money fell

sharply. Does this mean that the Fed used expansionary or restrictive monetary policy? Explain your answer.

The low interest rates in the 1930s resulted from a low demand for credit due to the sharp decline in aggregate demand, rather than from expansionary monetary policy. The decrease in money supply was the result of a huge decline in the size of the money multiplier as a result of many bank failures and not the result of restrictive policy by the Fed. The money multiplier fell sharply, since consumers lost confidence in the banking system and started to hold much more currency, increasing the currency-deposit ratio.

Surviving banks became much more careful and increased their excess reserve holdings, decreasing the money multiplier even more.

2. "The Great Depression was a direct result of the Fed's inept monetary policy."

Comment on this statement and indicate whether you think that the Fed has learned from past mistakes.

The Keynesian explanation of what caused the Great Depression concentrates on the collapse of investment, the reduction in consumption, and the decrease in aggregate demand that was further exacerbated by poor fiscal policy. Monetarists concentrate on the behavior of money, asserting that the Fed failed to prevent the collapse of the banking system, which led to a sharp decline in the money multiplier. They see the resulting decline in money supply as the primary cause of the Great Depression. Both explanations seem to fit the facts and there is no inherent conflict between them. While the Great Depression was not caused by government actions, its severity could have been greatly reduced if the government had employed active expansionary policies much sooner.

It can be assumed that the Fed has learned from its mistake. For example, after the stock market crash of October, 1987, when stock values dropped by more than 24%, the Fed, conscious of what had happened in 1929, immediately assured financial markets that it would provide the liquidity needed to prevent a financial collapse. The Fed also undertook open market purchases in an effort to drive interest rates down.

The recession in 1981/82 serves as another good example. Although the downturn seems to have been caused by the Fed's overly restrictive monetary policy, the Fed reversed its course and implemented expansionary policies as soon as the size of the downturn became clear.

3. Do you think that a downturn in the economy as large as the one the U.S.

experienced during the Great Depression could happen again?

The answer to this question is student specific, even though most economists would agree that it could not. The introduction of the FDIC and other regulatory agencies and programs such as the Social Security system and unemployment insurance have brought institutional changes that have increased automatic stability and limited the impact of even large disturbances. It also can be assumed that policy makers have learned from past mistakes. In other words, recent history has shown that the government does not sit still if

the economy experiences a large disturbance. The recession of 1981/82 serves a good example. With an unemployment rate of almost 11%, it was the most severe recession since the Great Depression. It lasted a relatively short time, however, since expansionary policies were implemented almost immediately after the magnitude of the downturn became clear.

4. What are the factors that would make an anti-inflation policy less costly in terms of

increased unemployment and subsequent loss of output?

A more gradual approach to reducing inflation is generally less costly than other options

because it causes less unemployment. Such an approach can only be successful, however, if it has a high degree of credibility. In other words, past records should indicate that policy makers are willing to adhere to an announced policy change. The greater the relative importance of the expected future rate of inflation in determining the current rate of inflation is, and the more wage and price flexibility there is, the more successful the anti-inflation policy would be.

5. “Higher monetary growth is generally followed by higher wage demands.”

Comment.

The equation %?P = %?M - %?Y + %?V implies that in the long run the rate of inflation (%?P) is determined by the growth rate of money supply (%?M) adjusted for the growth rate of income (%?Y) and changes in velocity (%?V). In addition, from the equation w = W/P, that is, real wages equal nominal wages divided by the price level, we can calculate that (%?w) = (%?W) - (%?P). This can be reformulated into the equation (%?P) = (%?W) - (%?MPN), assuming that w = MPN, that is, the real wage rate is equal to the marginal product of labor in a competitive labor market. Thus we can see that inflation increases if nominal wages increase more than labor productivity. Since workers base their wage demands on their inflationary expectations which are largely based on the growth rate of money supply, we can see that increases in money supply are likely to be followed by demand for higher nominal wages.