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Modern Principles of Economics 3rd edition Tyler Cowen, Alex Tabarrok - Solutions

What is a “price level”? If the “price level” is higher in one country than another, what does that tell us, if anything, about the standard of living in that country?
What are some forces that could cause shocks to v, the velocity of money?
Consider the interaction between inflation and the tax system (assume the inflation is expected). Does high inflation encourage people to save more or discourage saving? If a government wants to raise more tax revenue in the short run, should it push for higher or lower inflation?
Calculate inflation in the following cases:
What does the quantity theory of money predict will happen in the long run in these cases? According to the quantity theory, a rise in the money supply can€™t change v or Y in the long run, so it must affect P. Let€™s use that fact to see how changes in the money supply affect the price
In the long run according to the quantity theory of money, if the money supply doubles, what happens to the price level? What happens to real GDP? In both cases, state the percentage change in either the price level or real GDP.
Much of the economic news we read about can be reinterpreted into our “Mv = PY” framework. Turn each of the following news headlines into a precise statement about M, v, P, or Y. a. “Deposits in U.S. banks fell in 2015.” b. “American businesses are spending faster than ever.” c.
It€™s time to take control of the Federal Reserve (which controls the U.S. money supply). In this chapter, we€™re thinking only about the €œlong run,€ so Y (real GDP) is out of the Fed€™s control, as is v. The Fed€™s only goal is to make
Nobel laureate Milton Friedman often said that “inflation is the cruelest tax.” Who is it a tax on? More than one answer may be correct: a. People who hold currency and coins in their wallet, purse, or at home b. Businesses that hold currency and coins in their cash registers c. People or
In countries with hyperinflation, the government prints money and uses it to pay government workers. How is this similar to counterfeiting? How is it different?
The Fisher effect says that nominal interest rates will equal expected inflation plus the real equilibrium rate of return:i = EÏ€ + rEquilibrium (2)i = Nominal interest rate,EÏ€ = Expected inflation raterEquilibrium = Equilibrium real rate of returnEconomists and Wall Street
If I get more money, does that typically make me richer? If society gets more money, does it make society richer? What’s the contradiction?
Why is it so painful to get rid of inflation? Why can’t the government just stop printing so much money?
Who gets hurt most in the following cases: banks, mortgage holders (i.e., homeowners), or neither?
Let€™s see just how much high expected inflation can hurt incentives to save for the long run. Let€™s assume the government takes about one-third of every extra dollar of nominal interest you earn (a reasonable approximation for recent college graduates in the United States).You
Sort the following shocks into real shocks or aggregate demand shocks. Remember that “shocks” include both good and bad events. A fall in the price of oil A rise in consumer optimism A hurricane that destroys factories in Florida Good weather that creates a bumper crop of California oranges A
Consider the following figure. In this relatively unsuccessful economy, the Solow growth rate is 1% per year:a. Calculate the value of X in this economy.b. If spending growth were 15% in this economy, what would the inflation rate be in the long run, assuming the Solow growth rate stays fixed?
a. The short-run aggregate supply (SRAS) curve is very predictable. When inflation is greater than people expect, SRAS eventually shifts (choose one: up or down?) over the next year or so, and when inflation is less than people expect, SRAS eventually shifts (choose one: up or down?) over the next
When negative real shocks hit, what typically happens to the aggregate demand curve? Does it shift left, shift right, or stay in the same place?
As Figure 32.1 implies, for the United States, the long-run aggregate supply curve has on average been approximately 3% real growth per year. If a negative real shock hits, shifting it by 2 percentage points, what will happen to real growth: Will it be positive or negative? Would you call the
a. What does a negative real shock do to inflation: Does it rise, fall, or remain unchanged? b. What does a negative real shock do to spending growth: Does it rise, fall, or remain unchanged? c. What does a fall in spending growth, that is, a shift inward of the AD curve, do to real growth: Does it
In the following cases, will real growth rise, fall, or remain unchanged according to the New Keynesian model? Expected inflation = 5%, Actual inflation = 7% Expected inflation = 3%, Actual inflation = 1% Expected inflation = 6%, Actual inflation = 6% Expected inflation = 7%, Actual inflation =
a. In the 1970s, the United States had slow growth and high inflation. Which kind of shock best fits these facts? Negative real shock Positive real shock Negative aggregate demand shock Positive aggregate demand shock b. Using the same categories, explain the late 1990s, when the United States
To keep things simple, let€™s put this into a familiar supply and demand story and assume that in the long run, workers offer a fixed supply of labor: In other words, while they may be picky about jobs in the short run, in the long run they€™ll work regardless of the going
a. If newspapers and magazines report a lot of good news about the economy, what is likely to happen to velocity? b. If the Federal Reserve wants to keep aggregate demand (i.e., spending growth) stable, what will it do to the growth rate of the money supply when a lot of good news comes out about
After a monetary shock hits aggregate demand, which curve will shift to bring output growth back to the Solow growth rate: the short-run aggregate supply curve or the aggregate demand curve? (Which curve is more like a micro- economic story about prices adjusting in order to bring supply and demand
What happens when bad aggregate demand shocks hit the economy? Consider the following graph.a. Before we get to the bad aggregate demand shock, let€™s find out what the Solow growth rate is in this economy. Use the quantity theory to find your answer. b. Because of a fall in the growth of
Real-world economies get hit with lots of shocks to aggregate demand and real shocks. Some shocks clearly fit into the first category, some into the second, and some include a generous mix of both. Let’s categorize the following shocks. Only one is a clear case of “both.” Steelworkers go on
Let’s have some practice with the dynamic aggregate demand curve. If you want to draw it in your familiar y = b + mx format, you can think of it this way: Inflation = (Growth in money 1 Growth in velocity) – Real growth a. When you look at a fixed dynamic aggregate demand curve, like in Figure
Here is a puzzle. A country with a relatively small positive aggregate demand shock (a shift outward in the AD curve) may have a substantial economic boom, but sometimes countries that have massive increases in the AD curve (hyperinflation countries like Germany before World War II, e.g.) don’t
Some companies raise their workers’ pay by giving raises, but others prefer to give one-time bonuses instead. Think about two steel mills facing a big two-year drop in steel demand: In one steel mill, workers have received pay raises every year for five years. In the second mill, most of the pay
Reconsider your answer to Facts and Tools question 3. If you wanted to draw the long- run aggregate supply curve accurately, taking into account the idea that very high rates of inflation are likely to reduce real growth, how would you draw the long-run aggregate supply curve? Would you draw a
a. If aggregate demand shocks are the most important drivers of business fluctuations, then should we expect real wages to be procyclical (rising when GDP growth is high) or countercyclical (rising when GDP growth is low)? b. If real shocks are the most important drivers of business fluctuations,
Often, more than one kind of shock hits the economy at once. When this happens, the different shocks could push inflation (or real growth) in different directions in the short run, leaving the final short-run result ambiguous. What is most likely to happen to inflation and real output growth in the
Use Figure 32.11 as a starting point for this problem and consider the initial impact of the following circumstances on the aggregate demand, long-run aggregate supply, and short-run aggregate supply curves.a. A war in the Middle East rapidly increases the price of oil.b. More and more consumers
Continuing from your short run results in the previous problem, what do you think will happen in the long run as these adjustments work their way through the economy?
A significant productivity slowdown occurred during the 1970s and 1980s. A large part of it occurred in industries closely related to the energy crises of the 1970s. (Besides the “Oil Shocks” section in the text, you can read a brief summary of an article by William Nordhaus of Yale University
Following the productivity slowdown discussed in problem 8, the U.S. economy experienced a relatively quick transition to the electronic age of computers and the Internet and many of the outward effects of the 1970s energy crises faded as a result. a. Use the aggregate demand and supply model to
When do you want to study for a test: When your friends are studying for the same test or when they are not? How can this help explain seasonal business fluctuations?
If the long-run aggregate supply curve increased because of a sudden fall in the price of oil, what would happen to inflation? Assume that spending growth (aggregate demand) does not change€”only the LRAS curve shifts. Draw the shift in the following figure. (In the real world, this
Office buildings have a boom-bust cycle every day. At what hours of the weekday do grocery stores have an economic boom? What days of the week do shopping malls have an economic boom?
In India, the economy grows faster when there’s a lot of rain and grows more slowly when there is a drought. This creates big fluctuations in the economy. If the government wrote laws to smooth out these fluctuations by paying people to work more in the dry years and by taxing people so that they
a. According to Figure 32.10, about how long does it take for an oil price shock to have its biggest impact on the economy? How long does it take before the oil shock’s effects completely go away? b. What might be happening in the labor market that might explain why it takes so long for an oil
How is marriage like a decision to build a new factory? Which decision is easier to reverse?
a. Who would you be more likely to hire at your company: someone who has stayed in the same career for years, or someone who tries an entirely new career every time he or she becomes unhappy with their job? b. How does this help explain why workers are reluctant to quickly move on to a new career
People sometimes use the expression, “Kicking the can down the road.” It refers to putting a big decision off until later—it’s almost (but not quite!) a synonym for procrastinating, and it’s usually used in a negative sense. “Fred graduated and decided to spend a year waiting tables in
As we note in the chapter, an oil price shock will probably increase the size of an oil-centered city like Houston, Texas. During the time that people are moving to Houston, looking for jobs, and switching jobs to find the best job possible, do you think GDP will be lower than usual or higher than
Can you think of some reasons why the following examples of time bunching and intertemporal substitution might be true? (Yes, you’ll notice that there’s a blurry line between the two.) a. People who work outside work more when the weather is good. b. People work when others are also working. c.
Consider the following economic events. Which of them will have the effect of amplifying a negative real shock and which are intended to offset a shock? a. Several large financial institutions become insolvent as a housing bubble bursts and subprime mortgages begin to default in large numbers. b.
In 1971, Intel invented the first computer microprocessor. In early 1993, the National Center for Supercomputing Applications released the first Web browser, Mosaic (which later became Netscape). Both inventions seem like good news, and both inventions created great uncertainty about which business
For the sake of the economy, should the government ban Christmas, and instead encourage people to give gifts throughout the year? Why or why not?
How the previous question is similar to this question: Should the government encourage people to move from the East and West coasts to the Midwest and Rocky Mountain states, where the population is less crowded?
Do workers choose to work more because wages are temporarily high and do workers choose to work less because wages are temporarily low? This is key to the €œintertemporal substitution€ story of this chapter. The following chart shows how much wages change in the short run:
a. If long-run aggregate supply rate shocks do largely explain business fluctuation while the aggregate demand curve mostly stays fixed, then should prices be higher than usual or lower than usual during a recession?b. The following chart portrays historical U.S. data on the relationship between
In the context of this chapter, identify what each of the following scenarios has in common and explain how they will affect an economy suffering from a recession. a. Joe and Julie married, saved, and bought a modest home several years ago when housing prices were rising. They love their home and
Let’s find out what counts as money. In this chapter, we used a typical definition of money: “a widely accepted means of payment.” Under this definition, are people using “money” in the following transactions? If not, why not? a. Lucy sells her Saab to Karen for $1,000 in cash. b. Lucy
Define the following: a. The monetary base, MB b. M1 c. M2
a. Suppose that banks have decided they need to keep a reserve ratio of 10%—this guarantees that they’ll have enough cash in ATM machines to keep depositors happy, and enough electronic deposits at the Federal Reserve so that they can redeem checks presented by other banks. What is the money
If the Federal Reserve wants to lower interest rates via open market operations, should it buy bonds or should it sell bonds?
Practice with money multipliers. Think of the “money supply” (MS) as equal to either M1 or M2. a. RR = 5%, Change in reserves = $10 billion. MM = ?; Change in MS = ? b. RR = ?, Change in reserves = 2$1,000. MM = 5; Change in MS = ? c. RR = 100%, Change in reserves = $10 billion. MM = ?; Change
In the previous question, one example assumed that banks kept a 100% reserve ratio. Some economists have recommended that all banks be required by law to keep 100% of their deposits in the bank vault, at the Federal Reserve, or invested in ultra safe investments such as short-term U.S. Treasury
The main interest rate that the Federal Reserve tries to control is the Federal Funds rate, the interest rate that banks charge on short-term (usually overnight) loans to other banks. Let’s see how much interest a bank can earn if it lends money at the Federal Funds rate. Virginia Community Bank
Let’s use the model of the supply and demand for bank reserves to explain how the Federal Reserve can change aggregate demand in the short run. Remember that the Federal Reserve controls the supply of bank reserves, but private banks create demand for bank reserves. a. After a meeting, the
Whether an asset is “liquid” often depends on what situation you are in. For each of the following pairs of assets, which is more liquid in the particular setting? You want to buy a sofa: A savings account or currency You want to trade for a bologna sandwich in elementary school: A peanut
a. Who is more likely to take bigger risks: a trapeze artist with a safety net underneath or a trapeze artist without a safety net? b. Who is more likely to take bigger risks with his deposits: a bank CEO in a country where there is a lender of last resort or a bank CEO in a country where there is
a. In the short run, if the Fed wants to cut short-term, nominal interest rates, what does it do: Does it increase the growth rate of money or decrease the growth rate of money? Why? Will this tend to lower the real rate or will it tend to lower inflation? b. In the long run, if the Fed wants to
Let’s watch a bank create money. Last Wednesday, the Bank of Numenor opened for business. The first customer, Edith, walked in the door with 100 silver coins called Thalers to deposit in a new checking account. The second customer, Max, walks in the door a few minutes later, asking to borrow 50
You are a bank regulator working for the Federal Reserve. It is your job to see whether banks are solvent or insolvent, liquid or illiquid. Fit each of the following banks into one of the following four categories: 1. Liquid and solvent (best) 2. Illiquid but solvent (probably needs short-term
We mentioned that banks are reluctant to borrow from the Fed’s discount window because it’s looked down on by other banks: Other banks think that if a bank needs to use the discount window, it’s probably not very healthy. So where you get your loans is a signal about what kind of bank you
We mentioned how difficult it can be for the Federal Reserve to actually control aggregate demand: Its control over the broader money supply (M1 and M2) is weak and indirect, plus it can’t control velocity very much at all. Let’s translate the following bullet points from the chapter into an
In the past, the Federal Reserve didn’t pay interest on reserves kept in Federal Reserve banks: For an ordinary U.S. bank, money kept at the Fed earned zero interest, just like money stored in a vault or in an ATM machine. In 2008, the Fed started paying interest on deposits kept at the Fed. a.
Economist Bennett McCallum says that in order to push interest rates down in the long run, the central bank needs to raise interest rates in the short run. How can this be true?
This chapter is concerned mostly with how monetary policy might be able to return an economy quickly to the potential growth rate after a shock. But as we saw in Chapter 31's discussion of the quantity theory, a market economy has a correction mechanism to return itself slowly to the potential
We€™ve just reviewed the quantity theory, which is a theory that shows how the economy fixed itself in the long run. But as economist John Maynard Keynes famously said, €œIn the long run we are all dead.€ Let€™s bring SRAS back into the model, and play the role of a central banker
Let€™s look at the Federal Reserve€™s dilemma when there€™s a positive shock to the long-run aggregate supply curve. We€™ll consider the reverse of Figures 35.3 and 35.4.a. In the following figure, illustrate the effect of this positive potential growth shock, ignoring the possible
All of the following are called “rules.” Which of the following so-called rules are actually like “rules” and which are more like “discretion”? How can you tell the difference? a. Congress passes a law providing automatic cost of living increases to Social Security every year. b.
Let€™s consider a case that has some similarities to Figure 35.2. We mentioned that it€™s difficult for the Fed to know what€™s really happening to the economy in real time. This is similar to the well-known €œfog of war,€ where wartime news accounts often turn out to be
When talking about the economy, people often make a distinction between policies that work “only in theory” compared to those that work “in practice.” In theory, a fall in money growth slows down the economy in the short run. In the six episodes since World War II when, as discussed, the
A monetary policy is said to be credible if the central bank will have an incentive to do tomorrow what it says today that it will do tomorrow. Other policies may be credible or noncredible. Which of the following policies are credible? a. A student promises to study for the final after going to
a. When a financial bubble collapses, is that more like a fall in aggregate demand or a fall in the Solow growth rate? b. When a financial bubble collapses, what is more likely to happen as a result:a fall in inflation or a rise in inflation?
Now, let’s reenact the Volcker disinflation in an alternate universe where wages are more flexible and workers are much more willing to accept slower growing wages when the inflation rate falls. This will make the SRAS steeper, as we saw in our original discussion of short-run aggregate
The Fed plays an important role in maintaining market confidence. As former Chairman Alan Greenspan put it in a 1997 address: “In [financial crises] the Federal Reserve stands ready to provide liquidity, if necessary. . . . The objectives of the central bank in crisis management are to . . .
We discussed how hard it is to keep AD stable or put it back "where it belongs" after a shock. Alan Blinder, a former vice chairman of the Federal Reserve, noticed that this was a major problem. In his book Central Banking in Theory and Practice, he argued that this was a good reason for the Fed to
Milton Friedman and Anna Schwartz argued in the last chapter of their Monetary History of the United States that a shift in money growth will usually cause velocity to shift in the same direction: So higher money growth causes optimism, and slower growth causes pessimism. They believed that
One argument for giving discretion to central bankers is that sometimes emergencies come along that a simple rule can’t solve. Suppose there’s a massive, permanent negative shock to velocity. Naturally, if the central bank has discretion, it will immediately respond by boosting money growth.
In response to the housing bust and its fallout discussed at the end of this chapter, the U.S. economy entered into recession in December of 2007. That recession officially ended in June of 2009, but more than two years later at the end of 2011, many people still felt that the “recession” was
We explained how a central bank has an important role in maintaining confidence: “High confidence” keeps velocity growth and the money multiplier from falling. But as we’ve seen, sometimes one has to be cruel to be kind. President Franklin Roosevelt followed this “tough love” approach
Central bankers often believe that their hands are tied by the public. Arthur Burns, the Fed chairman under President Nixon, reportedly said in the November 1970 Federal Reserve board meeting that “he did not believe the country was willing to accept for any long period an unemployment rate in
Central bankers are reluctant to try to pop alleged bubbles. Which topics covered in this chapter might explain why they are reluctant to do so?
We mentioned Milton Friedman’s advice that central bankers should follow a “fixed money growth rule,” where the broad money supply (M1 or M2) grows at the same rate every year. Other economists have instead recommended that central bankers follow “nominal GDP targeting,” which is similar
The previous question assumed that the central bank can really control money growth and velocity growth within a reasonable period of time. Instead, let€™s work with the more realistic assumption that it takes about a year for a change in monetary policy to actually influence money
a. Central bankers must manage expectations. Suppose that inflation is running at 10% and the central banker would like to lower inflation to 2% without reducing real growth. What should the central banker tell the public? And at what level should the central banker set money growth? Assume that
a. Consider Table 36.3. We can use these data to find out what percentage of federal taxes is paid from the €œtop down€ by the top 40%, top 60%, or top 80% of income earners. Likewise, we can count from the €œbottom up€ by the bottom 40%, 60%, or 80% of
In 2013, corporate income taxes were about 9.9% of total federal revenue. Use Figure 36.6 to help estimate what fraction of GDP represents corporate income taxes.
a. Let€™s explore the difference between the average income tax rate and the marginal income tax rate. In the simple land of Rabushka, there is only one tax rate, 20%, but workers don€™t have to pay tax on the first $10,000 of their income. For every dollar they earn above $10,000, they pay
Based on the information in this chapter, let’s see who gets a better deal, a greater net benefit, from Social Security. In each pairing, choose one, or write “unclear.” Women or men? Married couples or singles? People born in 1910 or people born in 1965? High-income earners or low-income
There are a lot of ways to slice up the U.S. budget. With this in mind, which of the following statements are true, according to Figure 36.4? i. Most of the federal budget is spent on welfare and foreign aid. ii. About half of the federal budget goes toward Medicare, Medicaid, and Social Security
Pundits and commentators often state (correctly) that entitlement spending (spending on Medicare, Medicaid, and Social Security) is going to explode in the future. But by lumping all three together, we obscure the source of the explosion. a. Which of the three really won’t be “exploding” all
By U.S. law, your employer pays half of the payroll tax and you, the worker, pay the other half. We mentioned that according to the basics of supply and demand, the part of the tax paid by the employer is likely to cut the worker€™s take-home pay. Let€™s see why.
It€™s easy to confuse the €œfederal deficit€ with the €œfederal debt.€ We€™ll work out an example to make the differences clear. To keep the math simple, we€™ll falsely assume that in this land of Barrovia, the government can

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