Download Macro 3 Exercise #2 Answers

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Macro 3 Exercise #2 Answers (
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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 “Recession” and click “Continue.” You will see a table entitled, “Initial State
of the Economy.” Print out this table for future reference. Look at this table. If you add
consumption plus investment plus government spending plus net exports, what is the total
amount? $2,330.36. What is the reported GDP? $2,330.36. Why are these two amounts equal?
They are equal because the two figures represent both sides of the aggregate expenditure
equation, i.e., Y = C + I + G + X.
What is the difference between the nominal value of an economic variable, for example,
consumption, and the real value of that variable? The nominal value of a variable represents
the actual amount in dollars and cents that is paid or received. The real value of a variable
represents the value in terms of real quantities of goods and services measured at a
standard price level. If you know the nominal value of output, how do you obtain the real value
of that output? Real output = Nominal GDP/Price Index, where the price index is the GDP
deflator. Note that the quantities given for GDP, C, I, and G are already expressed in real
terms.
What is the current unemployment rate in this example? 7.00%. Many economists consider an
unemployment rate above what percent to be indicative of a recession? 5%. Is this economy in
a recession? Yes (Yes, No). Other things being equal, and assuming that the unemployment rate
is the only concern, this administration should increase (increase, decrease, leave unchanged)
government spending, decrease (increase, decrease, leave unchanged) taxes and increase
(increase, decrease, leave unchanged) the money supply.
Click “Continue.” Increase government spending to $1,450 and click “No Shock.” With taxes at
$865, does this represent a budget surplus or a budget deficit? This represents a budget
deficit. What was the old level of GD? $2,330.36. What is the new level of GDP? $2,351.69.
What was the old unemployment rate? 7%. What is the new unemployment rate? 4.87%. Has
this administration succeeded in reducing unemployment and increasing output? Yes (Yes, No).
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Macro 3 Exercise #2 Answers
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There are costs to these positive results. What was the old real interest rate? 8.065%. What is
the new real interest rate? 17.308%. Has the real interest rate increased or decreased? It has
increased. When this administration authorized an increase in government spending without
changing any other variable, why did this cause an increase in interest rates? When the
administration increased government spending it started to increase GDP. The rise in
GDP caused an increase in the demand for money. Since there was no rise in the money
supply the price of money (the nominal interest rate) went up. Since there was no change
in the expected inflation rate the real interest rate went up.
How did this change in interest rates affect investment? It caused investment to go down to
zero. What term is used to refer to this loss of investment due to a rise in interest rates? This is
referred to as crowding out. Why is investment inversely related to the interest rate? The
real interest rate represents a cost of business investment. Business owners and managers
must usually borrow money in order to finance investment projects. Even if they do not
need to borrow the real rate represents the opportunity cost -- what they could make by
lending the funds they would otherwise use for their own investment. Does consumption
change as a result of interest rate changes? Yes, there is also crowding out of consumption,
higher real rates increase the return to savings, so there is a higher opportunity cost of
spending on consumer goods. Does this phenomenon represent a disadvantage of spurring
economic expansion through deficit spending? Yes (Yes, No). How much of a disadvantage
was it? In the absence of crowding out and with constant prices the change in spending of
300 would cause a change in GDP of (1/.11) times 300 = 2727.3. The actual change was
about 21. Part of this difference is due to crowding out, but part is due to the effect of the
government spending on the price level instead of on real GDP.
Click “See Graph.” Draw this graph below. Label all axes and indicate the old and new
aggregate demand and aggregate supply lines. Indicate the full employment level of output.
AS´
P
AS
AD´
AD
GDP
GDPFE
According to most economists, what happens to the macroeconomy in the long run? Most
economists believe that the economy gravitates toward full employment equilibrium in the
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long run. What is the full employment level of output that is indicated on this graph? $2,350
(Note that this answer applies to the entire assignment.) Click the “Back” button. Then click
“No Shock-Long Run.” What is the reported real GDP in the long run? $2,350.03. Is this
output significantly different from the full employment level of output? No (Yes, No). What is
the reported unemployment rate in the long run? 5.00%. Would a significant number of
economists consider this to be acceptable, i.e., would they consider this unemployment rate to be
equal to a “natural” rate of unemployment? Yes (Yes, No). What is the reported inflation rate
in the long run? 0.03%. Does this seem to be an “acceptable” level of inflation? Yes (Yes,
No). However, does anybody really know how long the “long run” is? No (Yes, No).
Click “New Policy.” What is the difference between fiscal and monetary policy? Fiscal policy
represents the government’s attempt to regulate the macroeconomy by changing
government spending and/or taxes. Monetary policy represents the government’s attempt
to regulate the macroeconomy by changing the money supply. Suppose that the government
wanted to combat the recession strictly through monetary policy. In that case, would this
administration be changing government spending or taxes? No (Yes, No).
Click “Continue.” Decrease the money supply to $55 and click “No Shock.” Refer to the
resulting table on your screen showing this change as well as the original table that you saw at
the beginning of this assignment. What was the old level of GDP? $2,330.36. What is the
new level of GDP? $2,321.74. What was the old unemployment rate? 7%. What is the new
unemployment rate? 7.86%. Has this administration succeeded in reducing unemployment and
increasing output? No (Yes, No). Was decreasing the money supply a wise decision considering
that the economy was in a recession? No (Yes, No).
Suppose that the government of this nation wanted to decrease the unemployment rate below the
long run equilibrium rate. Click “New Policy”, and enter the following amounts: $960 for
government spending, 850 for taxes and $70 for the money supply. Is the government running a
significant budget deficit or surplus? The government is running a significant deficit. Other
things being equal, would this policy (compared to the default values), along with the increased
money supply, inflation or deflation? This policy would cause inflation. Click “No Shock” to
see the effects. What is the new level of GDP? $2,358.32. Is it possible for the economy to be
above full employment? Yes (Yes, No). Why or why not? People could be working
overtime when they don’t want to -- not for long anyway. Retired people and others could
be temporarily drawn into the workforce when they really don’t want to work for long.
What is the new unemployment rate? 4.20%. Does the indicated real output level and the
unemployment rate indicate that the economy is above full employment? Yes (Yes, No).
However, there are costs to this type of action. What was the old inflation rate at the initial state
of the economy? 1.00%. What is the new inflation rate as a result of the increase in the money
supply? 5.88%. An increase in the money supply will generally be associated with an increase
(an increase, a decrease, no change) in inflation.
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At this point, click “Supply Shock.” Select “Set Shock Manually” and enter -10. Then click
“Continue.” What is the new unemployment rate? 5.06%. What is the new inflation rate?
6.26%. Compared with the values in the last paragraph, do these new figures indicate an
expansion or a contraction of the economy? They indicate a contraction. The government
pursued an expansionary policy, so why did the economy contract? The supply shock caused a
contraction. This more than offset the effects of the expansionary policy on output and on
unemployment. However, the inward shift in supply made the price level go up even more.
Is the government administration completely responsible for the results? No (Yes, No).
Why or why not? Demand and supply shocks, such as the Arab Oil Embargo of the 1970’s
are beyond the government’s control (at least in terms of monetary and fiscal policy,
foreign relations are another matter). Yet, considering the changes in unemployment that
occurred, would this government be popular with workers in this country? No (Yes, No). Why
or why not? This government would not be popular with the workers because
unemployment increased when it was supposed to have decreased and the inflation made
real wages fall (wage level/price level).
At this point, click “New Policy.” Suppose that this administration wanted to reduce the
unemployment rate. Enter the following amounts: $1,100 for government spending, $800 for
taxes and $75 for the money supply. At this point, click “No Shock.” What is the new
unemployment rate? 2.97%. What is the new inflation rate? 15.95%. Although this policy
succeeded in reducing unemployment, would this policy be popular among those earning fixed,
non-indexed incomes? No (Yes, No). Why or why not? People on fixed incomes would be
earning money that is worth less and less over time as the double-digit inflation proceeds.
Would all workers like this policy? No_ (Yes, No) Why or why not? Workers who got jobs
they would not otherwise have might appreciate the policies, but most would notice the
decrease in their real wages and would not like that.
Assume that at this point, the government was being pressured to control inflation. Other things
being equal, in order to combat inflation, the government would decrease (increase, decrease,
leave unchanged) government spending, increase (increase, decrease, leave unchanged) taxes
and decrease (increase, decrease, leave unchanged the money supply. Click “New Policy.”
This time, enter the following amounts: $900 for government spending, $925 for taxes and $68
for the money supply. Click “No Shock.” Compared to the last paragraph, what has happened to
government spending? It went down. Compared to the last paragraph, what has happened to
taxes? Taxes increased. What has happened to the money supply? It decreased. What is the
new unemployment rate? 4.85%. What is the new inflation rate? 1.27%. Have these policies
succeeded in controlling inflation without a huge increase in unemployment? Yes (Yes, No).
Other things being equal, decreasing the money supply tends to have what effect on the interest
rate? Decreasing the money supply tends to increase the interest rate. Although decreasing
the money supply would help to control inflation, would such a policy necessarily be popular
with business and corporate interests? No (Yes, No). Why or why not? Firms
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often have to borrow money to pay for investment projects. The interest paid on these
loans represents a major cost of these investment projects.
In terms of managing the money supply, even considering only business concerns, does there
seem to be a policy conflict between increasing or decreasing the money supply? Yes (Yes,
No).
If so, what is the nature of that conflict? Increasing the money supply will tend to lower
interest rates, other things being equal. However, increasing the money supply will also
spur inflation, other things being equal.
Other things being equal, if the government increased spending, lowered taxes and increased the
money supply, would the unemployment rate tend to increase or decrease? The unemployment
rate would tend to decrease. Would workers be happy with this change in unemployment?
Yes (Yes, No). However, other things being equal, would such a policy increase or decrease
inflation? Such a policy would tend to increase inflation, other things being equal. Would
the workers be happy with this change in inflation? No (Yes, No). Why or why not?
Workers wages often increase more slowly than inflation and that reduces real wages. Is
there a policy trade-off just considering the concerns of workers? Yes (Yes, No).