Course Course Number University or College Professor’s Name Macro3 Module Assignment #1 Answers ( Student Name: ____________________________ Section: __________________________________ points) Please limit your answers to the spaces provided. If necessary, write on the back of the page. Do not attach printout or additional pages. All questions pertain to the Macro3 module in the SimEcon® software package. Make sure that you have read the “Macro3 Manual” and “SimEcon® Operation Instructions.” These materials may be found at the Class Web site prior to beginning the assignment. For many of the assignment’s questions, it will be necessary to refer to those instructions. For many of the assignment’s questions, it will be necessary to refer to your text. Open the Macro3 module. You will see a table entitled, “State of the Macroeconomy.” Select the button entitled “Inflation” and click “Continue.” You will see a table entitled “Initial State of the Economy.” Print out or copy this page for reference. Click “Continue.” In order to combat inflation and with no other policy goals, the government should decrease (increase, decrease, leave unchanged) government spending, increase (increase, decrease, leave unchanged) taxes and decrease (increase, decrease, leave unchanged) the money supply. First set government spending equal to $820 and leave all other policies unchanged. Click “No Shock.” As a result of this increase in government spending, the inflation rate increased (increased, decreased, remained unchanged). State the actual new inflation rate here: 8.8%. Given that the stated policy goal was to combat inflation, was this a wise policy? No (Yes, No). Did this policy have a big effect on real GDP? No, the effect was very small, less than 1. If the government spending multiplier was 1/(1-Marginal Propensity to Spend) what would the multiplier analysis predict for the effect of government spending on real GDP? The marginal propensity to spend in this module is 0.89 (MPC I = 0.9, MP Import = -0.01) so the multiplier is 1/0.11, about 9.09 This predicts a rise of GDP (with government spending up 20) of over 180. Why was the prediction of the multiplier analysis so different from the actual result? The multiplier analysis assumes that both real interest rates and the price level remain constant, neither is true in this module. The real interest rate rose from 7.094 to 7.294, causing. “crowding out” of private spending, and part of the increase in aggregate demand (caused by the rise in government spending) got taken up by a greater increase in the price level -- the inflation rate rose from 8.51% to 8.8%. Click “New Policy” and continue to reset the choices. Keep government spending at its original level of $800 and change taxes to $780. Do not change the money supply. Click “No Shock.” Compared to the original state of the economy, inflation has increased (increased, decreased, remain unchanged). State the actual new inflation rate here: 8.77%. Note that the absolute value of the change in taxes was equal to the absolute value of the change in government spending in the last example. Were the respective changes in inflation equal to each other? No (Yes, No). Why or why not? (Hint: consider the respective multipliers.) An increase in Course Macro3 Module Exercise #1 Answers Page 2 government spending will have a relatively greater impact on aggregate demand than the same amount of decrease in taxes. The government spending multiplier is greater than the taxation multiplier. As a result the effect of a change in government spending on inflation is greater than the effect of a tax change. What is the ratio of the usual spending multiplier to the usual tax multiplier? The ratio is about 1.1. What is the ratio of the impact of government spending on GDP in this module to the impact of taxes? It is about 1.1. Explain why the two ratios are related in this way. Both impacts are reduced in the same way by the same forces, crowding out and price effects. Click “New Policy,” keep government spending and taxes at their original levels of $800 and increase the money supply to 74. Click “No Shock.” Compared to the original state of the economy, inflation has increased (increased, decreased, remained the same). State the actual new inflation rate here: 9.92%. How did this policy affect aggregate demand and what caused this change in inflation? Explain your answer in terms of aggregate demand and supply and distinguish between the short and long run. The increase of the money supply caused an increase in aggregate demand. Since aggregate supply remained the same in the short run this caused an excess of aggregate demand over aggregate supply. In the short run GDP was beyond its full employment level. Click “Back” twice and you will again see the “State of the Macroeconomy.” Select “Recession” and click “Continue.” You will see the “Initial State of the Economy.” Print out or copy this table for future reference. What is the initial unemployment rate? 7.00%. Click “Continue.” In order to combat a recession and with no other policy goals, the government should increase (increase, decrease, leave unchanged) government spending, decrease (increase, decrease, leave unchanged) taxes and increase (increase, decrease, leave unchanged) the money supply. Set government spending to $525 and leave all other policies unchanged. Click “No Shock.” As a result of this decrease in government spending, the unemployment rate increased (increased, decreased, remained unchanged). State the actual unemployment rate here: 7.98%. Given that the stated policy goal was to combat the recession, was this a wise policy? No (Yes, No). Click on “New Policy” to reset your choices. Set taxes equal to $765 and click “No Shock.” As a result of the decrease in taxes, what has happened to the unemployment rate? It has decreased. State the actual unemployment rate here: 6.79%. Given that the stated policy goal was to combat the recession, was this a wise policy? Yes (Yes, No). Click “No Shock Long Run.” What is the long run unemployment rate? 5%. Some economists consider a 5% unemployment rate to be the “natural” rate of unemployment in the United States. What is meant by the “natural” rate of unemployment? The natural rate of Course Macro3 Module Exercise #1 Answers Page 3 unemployment refers to unavoidable unemployment of those workers who are between jobs for a relatively short period of time. Should society be satisfied with the long run unemployment rate indicated above? Yes (Yes, No). Why or why not? In modern postindustrial societies, many jobs are eliminated through automation or changes in consumer preferences or for many other reasons and many workers go through two or three careers in their lifetime. In addition to this type of “structural” unemployment, there is always some turnover “frictional” unemployment in a free labor market in which workers can quit and look for other jobs and can be fired for poor performance. Some unemployment of these types is unavoidable. Click “See Graph” and draw this graph of the long run situation on the next page. P LRAS SRAS AD Y Is this economy close to full employment? Yes (Yes, No). Using the graph above, what are your reasons for your answer? The short run aggregate supply and aggregate demand curves intersect near the long run, full employment, aggregate supply curve. This indicates that we are near full employment. Click “New Policy” and this time increase government spending to $1050, decrease taxes to 765, and increase the money supply to $72. Will these changes have an expansionary effect on the economy or a contractionary effect? Expansionary effect. Click “No Shock.” What has happened to the unemployment rate? It has decreased. What is the new unemployment rate? 3.52%. What has happened to the inflation rate? It has increased. What is the new inflation rate? 11.26%. Which groups would be more inclined to support these policies in the last example, people on “fixed incomes,” the wealthy, or unskilled low-wage workers and homeless people? Unskilled low-wage workers and the long-term unemployed. What are your reasons for your answer? The unskilled and those with skills not currently considered desirable are more likely to support policies that reduce unemployment since that can have a direct impact on the quality of their lives. On the other hand, high inflation rates impose the highest costs on people whose incomes do not rise with the price level (people living on private pensions for example, people on welfare) and on the wealthy who own assets like bonds that do not protect them against (unexpected) inflation. Course Macro 3 Module Assignment #1 Page 4 What is the Phillips Curve, and what does the concept of a Phillips Curve say about these results? The Phillips Curve indicates a short run trade-off between unemployment and inflation. The policies that have just been enacted in response to the recession have decreased unemployment but have increased inflation. This scenario provides an example of the Phillips Curve. Click “No Shock-Long Run.” What is the long run rate of unemployment? 5%. Does this represent the full employment level of output? Yes (Yes, No). Why is the long run unemployment rate for this example the same as the long run unemployment rate in the last example? Because in this module in the long run the economy always tends toward equilibrium at full employment, a “natural” rate of 5% unemployment. Click “Back” twice and this time go back to “Inflation” as the current state of the macroeconomy. When you get to the table entitled, “Initial State of the Economy” click “Continue.” Decrease government spending to $780, increase taxes to $805 and decrease the money supply to $71. Is the government now experiencing a budget deficit, a budget surplus or a balanced budget? Budget surplus. What will be the combined effect of these policies on the economy? Contractionary effect (contractionary effect, expansionary effect, no effect). Will these policies work in tandem, or will they contradict each other? They will work in tandem. Click “No Shock.” What has happened to the inflation rate as a result of these policies? Inflation has gone down. What has happened to unemployment as a result of these policies? Unemployment has risen. If the stated goal was to reduce inflation while eliminating all unemployment, do you think that this government has totally and completely succeeded in its goals? No (Yes, No). Why or why not? This government did manage to reduce inflation, but at the expense of a higher unemployment rate. Is this stated goal realistic? No (Yes, No). If you considered 5% unemployment to the inevitable equilibrium “natural” rate of unemployment, how would your answers change? In this case, I would say that these policies are wise, because even though unemployment has risen, it is still below 5%. Moreover, inflation has been reduced. Click “Back” twice this time choose “Recession” as the current state of the macroeconomy. Increase government spending to $570, increase taxes to $950, and increase the money supply to $72. Assuming that the stated policy goal is to combat the recession and nothing else, are these policies working in tandem or are they contradicting each other? They are contradicting each other. What are your reasons for your answer? Increasing government spending and increasing the money supply increase aggregate demand, increasing taxes has a contractionary effect. Some policies are working to end the recession, while other policies are working to make the recession worse. Given the stated policy goal, before going further, do you think that these policies taken together are the wisest choice possible? No (Yes, No). Now click “No Shock.” What has happened to the unemployment rate as a result of these policies? Unemployment has fallen. What has happened to the inflation rate as a result of Course Macro 3 Module Assignment #1 Page 5 these policies? Inflation has increased. Given a new overall policy goal of ending the recession and controlling inflation, and given the relative magnitude of the indicated changes, is this set of policies successful in achieving the new stated goals? Yes (Yes, No). In the real world, are there times when a government enacts policies that contradict each other? Yes (Yes, No). Why or why not? Governments enact policies that contradict each other because governments often face competing goals and policy objectives and have additional objectives (e.g., provision of government goods and services) not considered here. What bearing would the concept of a Phillips Curve have on this discussion? The Phillips Curve implies that combating recession and controlling inflation are competing policy goals.