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dynamic macroeconomics

Macroeconomics Principles And Policy 12th International Edition William J. Baumol, Alan S. Blinder - Solutions

2. The following table provides data on nominal gross domestic product and the money supply (M1 definition)in recent selected years. Compute velocity for each year.Do you see any trend? How does it compare with the trend that prevailed from 1975 to 1995?
1. How much money by the M1 definition (cash plus checking account balances) do you typically have at any particular moment? Divide this amount into your total income over the past 12 months to obtain your own personal velocity. Are you typical of the nation as a whole?
7. (More difficult) In March 2008, the Fed helped prevent the bankruptcy of Bear Stearns. However, in September 2008, the Fed and the Treasury let Lehman Brothers go bankrupt. What accounts for the different decisions?(Note: You may want to discuss this question with your instructor and/or do some
6. Explain the basic idea behind the TARP legislation. Was that idea carried out in practice?
5. Explain how a collapse of the economy’s credit-granting mechanisms might lead to a recession.
4. Explain how a collapse in house prices might lead to a recession.
3. Explain why a mortgage-backed security becomes riskier when the values of the underlying houses decline.What, as a result, happens to the price of the mortgagebacked security?
2. What factors do you think bankers normally use to distinguish“prime” borrowers from “subprime” borrowers?
1. If you were watching house prices rise during the years 2000–2006, how might you have decided whether or not you were witnessing a “bubble”?
4. During the financial crisis and recovery, stock market prices first fell by about 55 percent and then rose by about 65 percent. Did investors therefore come out ahead? Explain why not.
3. Why do we say that deposits are “liabilities” of banks?
2. Create your own numerical example to illustrate how leverage magnifies returns both on the upside and on the downside.
1. If the expected default rate on a particular mortgagebacked security is 4 percent per year, and the corresponding Treasury security carries a 3 percent annual interest rate, what should be the interest rate on the mortgage-backed security? What happens if the expected default rate rises to 8
. From 2003 to 2011, the federal government’s budget deficit rose sharply because of tax cuts and increased spending.If the Federal Reserve wanted to maintain the same level of aggregate demand in the face of large increases in the budget deficit, what should it have done? What would you expect
6. Explain why both business investments and purchases of new homes rise when interest rates decline.
5. Once the federal funds rate reached (approximately)zero, which happened in December 2008, what options were still open to the Fed. What did it actually do?(Note: This may be a good question to discuss with your instructor.)
4. From September 2007 through December 2008, the Fed believed that interest rates needed to fall and took steps to reduce them, eventually cutting the federal funds rate from 5.25 percent to nearly zero. How did the Fed reduce the federal funds rate? Illustrate your answer on a diagram.
3. Explain why the quantity of bank reserves supplied normally is higher and the quantity of bank reserves demanded normally is lower at higher interest rates.
. What are some reasons behind the worldwide trend toward greater central bank independence? Are there arguments on the other side?
1. Why does a modern industrial economy need a central bank?
8. (More difficult) Consider an economy in which government purchases, taxes, and net exports are all zero. The consumption function is C = 300 + 0.75Y and investment spending (I) depends on the rate of interest (r) in the following way:I = 1,000 – 100r Find the equilibrium GDP if the Fed makes
7. Explain how your answers to Test Yourself Question 5 would differ if banks decided to hold onto the $5 billion in new reserves as excess reserves.
. Explain how your answers to Test Yourself Question 5 would differ if each of the assumptions changed.Specifically, what sorts of changes in the assumptions would weaken the effects of monetary policy?
5. Explain what a $5 billion increase in bank reserves will do to real GDP under the following assumptions:a. Each $1 billion increase in bank reserves reduces the rate of interest by 0.5 percentage point.b. Each 1 percentage point decline in interest rates stimulates $30 billion worth of new
4. Treasury bills have a fixed face value (say, $1,000) and pay interest by selling at a discount. For example, if a one-year bill with a $1,000 face value sells today for $950, it will pay $1,000 – $950 = $50 in interest over its life. The interest rate on the bill is therefore $50/$950 =
3. Suppose the Fed purchases $5 billion worth of government bonds from Bill Gates, who banks at the Bank of America in San Francisco. Show the effects on the balance sheets of the Fed, the Bank of America, and Gates. (Hint: Where will the Fed get the $5 billion to pay Gates?) Does it make any
2. Show the balance sheet changes that would take place if the Federal Reserve Bank of New York purchased an office building from Citigroup for a price of $100 million.Compare this effect to the effect of an open-market purchase of securities shown in Table 1. What do you conclude?
1. Suppose there is $120 billion of cash and that half of this cash is held in bank vaults as required reserves (that is, banks hold no excess reserves). How large will the money supply be if the required reserve ratio is 10 percent?121⁄2 percent? 162⁄3 percent?
7. If the government takes over a failed bank with liabilities(mostly deposits) of $2 billion, pays off the depositors, and sells the assets for $1.5 billion, where does the missing $500 million come from? Why?
6. Excess reserves make a bank less vulnerable to runs.Why, then, don’t bankers like to hold excess reserves?What circumstances might persuade them that it would be advisable to hold excess reserves?
5. Each year during the Christmas shopping season, consumers and stores increase their holdings of cash.Explain how this development could lead to a multiple contraction of the money supply. (As a matter of fact, the authorities prevent this contraction from occurring by methods explained in the
. Since 2008 a rash of bank failures has occurred in the United States. Explain why these failures did not lead to runs on banks.
3. What is fractional reserve banking, and why is it the key to bank profits? (Hint: What opportunities to make profits would banks lose if reserve requirements were 100 percent?)Why does fractional reserve banking give bankers discretion over how large the money supply will be? Why does it make
2. How is “money” defined, both conceptually and in practice?Does the U.S. money supply consist of commodity money, full-bodied paper money, or fiat money?
1. If ours were a barter economy, how would you pay your tuition bill? What if your college did not want the goods or services you offered in payment?
4. For each of the transactions listed in Test Yourself Question 3, what will be the ultimate effect on the money supply if the required reserve ratio is one-eighth(12.5 percent)? Assume that the oversimplified money multiplier formula applies.
3. Use tables such as Tables 2 and 3 to illustrate what happens to bank balance sheets when each of the following transactions occurs:a. You withdraw $100 from your checking account to buy concert tickets.b. Sam finds a $100 bill on the sidewalk and deposits it into his checking account.c. Mary Q.
2. How would your answer to Test Yourself Question 1 differ if the reserve ratio were 25 percent? If the reserve ratio were 100 percent?
. Suppose banks keep no excess reserves and no individuals or firms hold on to cash. If someone suddenly discovers $12 million in buried treasure and deposits it in a bank, explain what will happen to the money supply if the required reserve ratio is 10 percent.
5. (More difficult) Advocates of lower taxes on capital gains argue that this type of tax cut will raise aggregate supply by spurring business investment. Compare the effects on investment, aggregate supply, and tax revenues of three different ways to cut the capital gains tax:a. Reduce capital
4. Which of the proposed supply-side tax cuts appeals to you most? Draw up a list of arguments for and against enacting such a cut right now.
3. If the government decides that aggregate demand is excessive and is causing inflation, what options are open to it? What if the government decides that aggregate demand is too weak instead?
2. Explain why G has the same multiplier as I, but taxes have a different multiplier.
1. The federal budget for national defense increased substantially to pay for the Iraq and Afghanistan wars. How would GDP in the United States have been affected if this higher defense spending led toa. larger budget deficits?b. less spending elsewhere in the budget, so that total government
5. Now put yourself in charge of the economy in Test Yourself Question 2, and suppose that full employment comes at a GDP of $1,840. How can you push income up to that level?208 Part 3 Fiscal and Monetary Policy
4. Suppose you are put in charge of fiscal policy for the economy described in Test Yourself Question 1. There is an inflationary gap, and you want to reduce income by $120. What specific actions can you take to achieve this goal?
3. Return to the hypothetical economy in Test Yourself Question 1, and now suppose that both taxes and government purchases are increased by $120. Find the new equilibrium under the assumption that consumer spending continues to be exactly three-quarters of disposable income (as it is in Test
2. Consider an economy similar to that in the preceding question in which investment is also $200, government purchases are also $500, net exports are also $30, and the price level is also fixed. But taxes now vary with income, and as a result, the consumption schedule looks like the following:GDP
1. Consider an economy in which tax collections are always $400 and in which the four components of aggregate demand are as follows:GDP Taxes DI C I G (X IM)$1,360 $400 $ 960 $ 720 $200 $500 $30 1,480 400 1,080 810 200 500 30 1,600 400 1,200 900 200 500 30 1,720 400 1,320 990 200 500 30 1,840 400
5. Explain in words why rising prices reduce the multiplier effect of an autonomous increase in aggregate demand.
4. Why do you think wages tend to be rigid in the downward direction?
3. Give two different explanations of how the economy can suffer from stagflation.
2. Comment on the following statement: “Inflationary and recessionary gaps are nothing to worry about because the economy has a built-in mechanism that cures either type of gap automatically.”
1. Explain why a decrease in the price of foreign oil shifts the aggregate supply curve outward to the right. What are the consequences of such a shift?
4. Use an aggregate supply-and-demand diagram to show that multiplier effects are smaller when the aggregate supply curve is steeper. Which case gives rise to more inflation—the steep aggregate supply curve or the flat one? What happens to the multiplier if the aggregate supply curve is vertical?
3. Add the aggregate supply and demand schedules below to the example in Test Yourself Question 1 of the appendix to Chapter 9 on page 399 to see how inflation affects the multiplier.(1) (2) (3) (4)Price Level Aggregate Demand When Investment Is $240 Aggregate Demand When Investment Is $260
2. Suppose a worker receives a wage of $20 per hour.Compute the real wage (money wage deflated by the price index) corresponding to each of the following possible price levels: 85, 95, 100, 110, 120. What do you notice about the relationship between the real wage and the price level? Relate your
1. In an economy with the following aggregate demand and aggregate supply schedules, find the equilibrium levels of real output and the price level. Graph your solution. If full employment comes at $2,800 billion, is there an inflationary or a recessionary gap?Aggregate Quantity Demanded Price
4. Try to remember where you last spent a dollar. Explain how this dollar will lead to a multiplier chain of increased income and spending. (Who received the dollar?What will he or she do with it?)
3. Does the economy this year seem to have an inflationary gap or a recessionary gap? (If you do not know the answer from reading the newspaper, ask your instructor.)
2. Look back at the income-expenditure diagram in Figure 3 and explain why some level of real GDP other than$6,000 (say, $5,000 or $7,000) is not an equilibrium on the demand side of the economy. Do not give a mechanical answer to this question. Explain the economic mechanism involved.
1. For about 30 years now, imports have consistently exceeded exports in the U.S. economy. Many people consider this imbalance to be a major problem. Does this chapter give you any hints about why? (You may want to discuss this issue with your instructor. You will learn more about it in later
7. Use both numerical and graphical methods to find the multiplier effect of the following shift in the consumption function in an economy in which investment is always $220, government purchases are always $100, and net exports are always –$40. (Hint: What is the marginal propensity to
6. (More difficult) An economy has the following consumption function:C = 200 + 0.8DI The government budget is balanced, with government purchases and taxes both fixed at $1,000. Net exports are$100. Investment is $600. Find equilibrium GDP.What is the multiplier for this economy? If G rises
5. (More difficult) Keep everything the same as in Test Yourself Question 4 except change investment to I =$1,100. Use the equilibrium condition Y = C + I + G + (X– IM) to find the equilibrium level of GDP on the demand side. (In working out the answer, assume the price level is fixed.) Compare
4. (More difficult)89 Consider an economy in which the consumption function takes the following simple algebraic form:C = 300 + 0.75DI and in which investment (I) is always $900 and net exports are always –$100. Government purchases are fixed at $1,300 and taxes are fixed at $1,200. Find the
2. From the following data, construct an expenditure schedule on a piece of graph paper. Then use the income-expenditure (45° line) diagram to determine the equilibrium level of GDP. Compare your answer with your answer to the previous question.Income Consumption Investment Government Purchases
Now suppose investment spending rises to $260, and the price level is fixed. By how much will equilibrium GDP increase? Derive the answer both numerically and graphically.
8. (More difficult) Between 2008 and 2009, real disposable income (in 2005 dollars) barely increased at all, owing to a recession. (It rose from $10,043 billion to $10,100 billion.) Use the data on real consumption expenditures given on the inside back cover of this book to compare the change in C
7. In 2001 and again in 2003, Congress enacted changes in the tax law designed to promote saving. If such saving incentives had been successful, how would the consumption function have shifted?
6. Explain why permanent tax cuts are likely to lead to bigger increases in consumer spending than temporary tax cuts do.
5. What is a consumption function, and why is it a useful device for government economists planning a tax cut?
4. Look at the scatter diagram in Figure 3. What does it tell you about what was going on in this country in the years 1942 to 1945?
3. The marginal propensity to consume (MPC) for the United States as a whole is roughly 0.90. Explain in words what this means. What is your personal MPC at this stage in your life? How might that change by the time you are your parents’ age?
2. What would the circular flow diagram (Figure 1) look like in an economy with no government? Draw one for yourself.
1. Explain the difference between investment as the term is used by most people and investment as defined by an economist.
2. Which of the following acts constitute investment according to the economist’s definition of that term?a. Pfizer builds a new factory in the United States to manufacture pharmaceuticals.b. You buy 100 shares of Pfizer stock.c. A small drugmaker goes bankrupt, and Pfizer purchases its factory
1. What are the four main components of aggregate demand? Which is the largest? Which is the smallest?
6. Discuss some of the pros and cons of increasing development assistance, both from the point of view of the donor country and the point of view of the recipient country.
5. Comment on the following: “Sharp changes in the volume of investment in the United States help explain both the productivity slowdown in 1973 and the productivity speed-up in 1995.”
4. Explain why the best educational policies to promote faster growth might be different in the following countries.a. Mozambiqueb. Brazilc. France
3. The previous chapter pointed out that, because faster capital formation comes at a cost (reduced current consumption), it is possible for a country to invest too much.Suppose the government of some country decides that its businesses are investing too much. What steps might it take to slow the
1. Explain the different objectives of (long-run) growth policy versus (short-run) stabilization policy.
5. Show on a graph how capital formation shifts the production function. Use this graph to show that capital formation increases labor productivity. Explain in words why labor is more productive when the capital stock is larger.
4. Two countries have the production possibilities frontier(PPF) shown in Figure 3. Consumia chooses point C, whereas Investia chooses point I. Which country will have the higher PPF the following year? Why?
2. Imagine that new inventions in the computer industry affect the growth rate of productivity as follows:Year of Invention Following Year 5 Years Later 10 Years Later 20 Years Later 0% –1% 0% +2% +4%a. Cable television ratesb. Football ticketsc. Internet accessd. Household cleaning servicese.
1. The following table shows real GDP per hour of work in four imaginary countries in the years 2000 and 2010.By what percentage did labor productivity grow in each country? Is it true that productivity growth was highest where the initial level of productivity was the lowest? For which
3. Which of the following prices would you expect to rise rapidly? Why?
2. Imagine that new inventions in the computer industry affect the growth rate of productivity as follows:Year of Invention Following Year 5 Years Later 10 Years Later 20 Years Later 0% –1% 0% +2% +4%Would such a pattern help explain U.S. productivity performance since the mid-1970s? Why?
1. The following table shows real GDP per hour of work in four imaginary countries in the years 2000 and 2010.By what percentage did labor productivity grow in each country? Is it true that productivity growth was highest where the initial level of productivity was the lowest? For which
5. Show why each of the following complaints is based on a misunderstanding about inflation:a. “Inflation must be stopped because it robs workers of their purchasing power.”b. “Inflation makes it impossible for working people to afford many of the things they were hoping to buy.”
4. Why is it so difficult to define full employment? What unemployment rate should the government be shooting for today?
3. “Unemployment is no longer a social problem because unemployed workers receive unemployment benefits and other benefits that make up for most of their lost wages.” Comment.
2. Why is it not as terrible to become unemployed nowadays as it was during the Great Depression?
1. If an earthquake destroys some of the factories in Poorland, what happens to Poorland’s potential GDP?What happens to Poorland’s potential GDP if it acquires some new advanced technology from Richland and starts using it?
6. Suppose you agree to lend money to your friend on the day you both enter college at what you both expect to be a zero real rate of interest. Payment is to be made at graduation, with interest at a fixed nominal rate. If inflation proves to be lower during your college years than what you both
5. What is the real interest rate paid on a credit card loan bearing 18 percent nominal interest per year, if the rate of inflation isa. zero?b. 4 percent?c. 8 percent?d. 15 percent?e. 20 percent?
4. Country A and Country B have identical population growth rates of 1 percent per annum, and everyone in each country always works 40 hours per week. Labor productivity grows at a rate of 2 percent in Country A and a rate of 2.5 percent in Country B. What are the growth rates of potential GDP in
3. Most economists believe that from 2003 to 2006, actual GDP in the United States grew faster than potential GDP. What, then, should have happened to the unemployment rate over those three years? Then, from 2006 to 2010, actual GDP grew slower than potential GDP, even contracting for several
2. If output rises by 35 percent while hours of work increase by 40 percent, has productivity increased or decreased? By how much?

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