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Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises 87 Chapter 26 Inflation and Monetary Policy Review Questions 2. If the Fed increases the interest rate target, the price of bonds drops. Bonds become more attractive, so people sell stocks to acquire bonds, and stock prices drop as well. Conversely, if the Fed lowers the interest rate target, the price of bonds and stocks increases. An expected change in the Fed’s interest-rate target will also cause movements in stock and bond prices. For example, if people expect the Fed to raise its interest rate target in the near future, they also expect stock and bond prices to fall in the near future. People will want to sell their bonds and stocks now, before the target is raised, so the prices of bonds and stocks will drop in the present. 4. A negative supply shock sends prices up and unemployment up as well. The Fed faces a tradeoff because shifting the AD curve rightward would lessen the rise in unemployment, but increase prices further. Shifting the AD curve leftward would lessen the rise in prices, but increase unemployment further. A hawk policy moves the AD curve leftward because it is tougher on inflation, while a dove policy moves the AD curve to the right, in order to lessen the rise in unemployment. 6. The Phillips curve describes the relationship between inflation and unemployment in the short run. By adjusting the rate at which the AD curve shifts, the Fed moves along the Phillips curve in the short run. The long-run Phillips curve is vertical since in the long run the unemployment rate returns to its natural rate; monetary policy only determines the price level. 8. The uncertain and changing time lags before monetary policy affects the economy, and lack of knowledge of the economy’s potential output are two of the most important information problems faced by the Fed. 10. First, it made announcements designed to reassure the public by pointing out that a modest deflation rate was unlikely to create a downward spiral for the economy, and that if the deflation was perceived to be temporary, it would not affect the economy significantly. Second, it announced that it was prepared to change the way it conducts monetary policy should the need arise. By buying long term government bonds, the Fed could still reduce other interest rates in the economy. Finally, the Fed could lower the real interest rate by raising expected inflation, if the need arose. (It could do this by announcing believable policies designed to raise the inflation to a modest, positive level.) Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises 88 Problems and Exercises 2. The tax hike is a negative spending shock, which would shift the AD curve to the left. With passive monetary policy, the Fed would leave the money supply unchanged. The economy would slide down the AS curve to point F. Both output and the price level would fall (and the money demand curve would shift to the left, moving money market equilibrium to point B). If the Fed decides to use active policy to neutralize the spending shock, it must increase the money supply. This action would lead to a lower interest rate (at point C), which would stimulate consumption and investment spending by enough to offset the initial spending shock. The economy would return to point E. 4. Possibly, the announcement itself would be enough to change the behavior of workers and firms. Understanding that the new Chair would fight unemployment even at the cost of inflation, they would expect higher inflation in the future. People would build higher inflation into their contracts and the Phillips curve would shift upwards. At each level of unemployment, there would be a higher inflation rate. If the announcement were not enough to change expectations, but the Chair did, in fact, turn out to be more concerned with unemployment than inflation, the aggregate demand curve would begin shifting rightward more rapidly. The economy would ride up the Phillips curve in the short run, and once a higher inflation rate were built in to contracts, the Phillips curve would shift upward. Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises 89 6. The Fed would have to increase the money supply increasingly more rapidly in each successive year. This year, for example, it could increase the money supply by enough to choose the unemployment rate-inflation rate combination of U2 and 9%. But, as the short run Phillips curve shifts rightward to PCbuilt-in inflation = 9%, the Fed would have to increase the money supply even more next year, in order to move the economy to point K. But this, in turn, would make the short run Phillips curve shift rightward again. The inflation rate would rise continuously. 8. The problem is that ongoing, expected deflation creates difficulties for monetary policy. The Fed can lower its Federal Funds rate target all the way to 0%--but it can't use open market operations or any of its other tools to make the Federal Funds rate fall below 0%. Think about what would happen if the Federal Funds rate fell to 0%. If this happened, the Fed would not be able to use open market operations to reduce interest rates further. This could limit the Fed’s ability to raise aggregate expenditure and output with monetary policy. Challenge Questions 2. Assume the economy is initially in equilibrium at point E. If the Fed wrongly believes that the natural rate of unemployment is higher and acts to bring the economy back to its supposed potential, it will decrease the money supply. This will cause the interest rate to rise from r1 to r2, Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises 90 causing the AD curve to shift leftward from AD1 to AD2. The economy will experience a lower price level and higher unemployment (at point F). With no more intervention, wage rates will eventually fall, causing the AS curve to shift rightward from AS1 to AS2, returning the economy to full employment (at point G). If the Fed, however, continues to decrease the money supply in an effort to maintain output below potential, the public will come to expect deflation in the future, and the economy will experience ongoing deflation. 4. No. As people see the Fed increasing the money supply more rapidly in each successive year, their expectations of future inflation rates would change and the short run Phillips curve would shift rightward by increasingly larger amounts in successive years. This would make it even harder for the Fed to keep the unemployment rate below the natural rate. Economic Applications Exercises 2. a. These diagrams confirm Fed’s implementation of expansionary monetary policy during recessions and contractionary monetary policy to fight inflation. b. Bernanke does not argue for strict rules, but for what he calls constrained discretion. Constrained discretion is defined by two principles. First, through its words and (especially) its actions, the central bank must establish a strong commitment to keeping inflation low and stable. Second, subject to the condition that inflation be kept low and stable, and to the extent possible given our uncertainties about the structure of the economy and the effects of policy, monetary policy should strive to limit cyclical swings in resource utilization. In short, under constrained discretion, the central bank is free to do its best to stabilize output and employment in the face of short-run disturbances, with the appropriate caution born of our imperfect knowledge of the economy and of the effects of policy. However, a critical proviso is that, in conducting stabilization policy, the central bank must also maintain a strong commitment to keeping inflation—and, hence, public expectations of inflation—firmly under control. Because monetary policy influences inflation with a lag, keeping inflation under control may sometimes require the central bank to anticipate and move in advance of inflationary developments--that is, to engage in “preemptive strikes” on inflation. In Bernanke’s view, constrained discretion characterizes the current monetary policy framework of the United States. Chapter 27 Fiscal Policy: Taxes, Spending, and the Federal Budget Review Questions 2. The three broad categories of government outlays are government purchases, transfer payments, and interest on the debt. Transfer payments are the largest category. Government purchases have been stable as a percentage of GDP, interest relative to GDP has fallen, and transfers relative to GDP have grown. 4. The federal government receives most of its revenue from personal income, corporate profits, and Social Security taxes. Recently, there has been a steady increase in social security tax revenues as a fraction of GDP. This is mainly a result of demographics, especially the large number of people born in the 1950s who are now peak-earners, and the higher tax rates imposed on current earnings to pay benefits to retiring baby boomers in the future. All other sources of revenue have trended slightly downward, due to the slow recovery from the 2001 recession and the significant long-term reductions in tax rates. Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises 91 6. The cyclical deficit is the part of the deficit that changes as the economy changes, rising during recessions and falling during booms. The cyclical deficit acts as an automatic stabilizer and so is a good thing for the economy. The structural deficit is the rest of the deficit—the part that does not depend on macroeconomic conditions. 8. False. If GDP rises while government receipts and expenditures remain constant, then the national debt as a fraction of GDP will fall. 10. According to the OMB numbers, the Bush administration is temporarily violating the guideline for responsible government by allowing debt to rise faster than GDP through 2006. This policy will cause both interest payments relative to GDP and the tax burden to rise, although after 2006 the debt-to-GDP ratio will fall a little. The Democratic Caucus numbers show a long run violation of the guideline for responsible government (the debt-to-GDP ratio rises continually). Part of the difference in outcomes arises because the OMB projects only five years into the future, rather than 10, but the rest arises from differing assumptions. The OMB leaves out estimates of government outlays for military operations in Iraq or Afghanistan beyond 2003, does not add the expenses of a proposal to start a Medicare prescription drug benefit in 2006, and assumes that the tax cuts set to expire between 2004 and 2008 will, indeed, expire. The Democratic Caucus makes none of these assumptions. Problems and Exercises 2. If other things remain constant, it is impossible to keep all of your promises in the short run. If you cut taxes and increase transfers and government purchases then the budget deficit will rise. This will increase the national debt, and may, at least in the short run, increase national debt as a fraction of GDP. In the long run, however, if the tax cuts raise labor force participation rates by more than the extra transfers reduce them, the tax base may rise by enough to bring in enough revenues to offset government outlays. The lower tax rates may also lead to more investment spending in the economy, which will cause GDP to rise and therefore reduce national debt as a fraction of GDP. So it is possible to keep all of your campaign promises in the long run. 4. a. Revenue from Type A households =10 250,000 0.15 = 375,000 zips Revenue from Type B households = 10 50,000 0.15 = 75,000 zips Revenue from Type C households = 10 20,000 0.15 = 30,000 zips Total tax revenue = 375,000 + 75,000 + 30,000 = 480,000 zips b. Revenue from Type A households =10 150,000 0.15 = 225,000 zips Revenue from Type B households = 10 30,000 0.15 = 45,000 zips No tax revenue collected from Type C households. Total tax revenue = 225,000 + 45,000 = 270,000 zips If the government continues to spend 480,000 zips, the budget deficit will be 480,000 – 270,000 = 210,000 zips. The recession causes a budget deficit. c. Revenue from Type A households =10 400,000 0.15 = 600,000 zips Revenue from Type B households = 10 70,000 0.15 = 105,000 zips Revenue from Type C households = 10 30,000 0.15 = 45,000 zips Total tax revenue = 600,000 + 105,000 + 45,000 = 750,000 zips If the government continues to spend 480,000 zips, the budget will be in surplus, and the surplus will be equal to 750,000 – 480,000 = 270,000 zips. (Alternatively, the deficit is – 270,000 zips.) Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises 92 During recessions the government deficit increases, and during booms it falls. These are changes in the cyclical deficit. Since the government collects fewer taxes during recessions, household disposable income decreases by less than it otherwise would, so consumption spending decreases by less and the recession is milder. In booms, the government collects more tax, so household disposable income increases by less than it otherwise would, consumption spending increases by less and the boom is milder. 6. Country A is in trouble. Between 1999 and 2000, the debt grew by 100% but GDP only grew by 10%; from 2000 to 2001, the debt grew again by 50%, but GDP grew only by 36%. In country B, between 1999 and 2000, the debt grew by about 9% while GDP grew by about 11%; from 2000 to 2001, the debt grew by about 4.5% and GDP grew by about 10%. Country B meets the minimal guideline for responsible government. 8. a. Economica’s budget deficit = ($10 + $5) - $12 = -$2, which means that it has a surplus of $2 million. b. The budget deficit equals the sum of the cyclical deficit and the structural deficit. Assuming that the current unemployment rate of 6% is higher than the unemployment rate at full employment, output would be below potential GDP, and there would be a cyclical deficit. Since the cyclical deficit is positive and the actual budget deficit is negative, we can see from the following equation that the structural deficit would also be negative, i.e., there is a structural surplus: Budget deficit = cyclical deficit + structural deficit or -$2 million = (some positive number) + structural deficit. The only way this equation can be true is if the structural deficit is some negative number, which is a structural surplus. Economic Applications Exercises 2. a. The diagrams and data confirm that in the short-run, the increase in real per-capita disposable personal income is inversely related to personal tax rates or directly related to personal consumption. Chapter 28 Exchange Rates and Macroeconomic Policy Review Questions 2. Foreigners supply foreign currency (say, in the market where their currency is exchanged for U.S. dollars) because they want to buy U.S. goods and services or U.S. assets. In general economists believe that the supply curve for foreign currency is upward sloping. As the price of foreign currency increases, U.S. goods and services become cheaper. Foreigners buy more U.S. goods and services, and supply more foreign currency to get the dollars with which to buy the goods. The following shift the supply of foreign currency schedule to the right: an increase in foreign GDP, an increase in the relative interest rate in the United States, a change in tastes that makes U.S. goods more desirable to foreigners, a relative decrease in prices in the United States, and an expectation that the foreign currency will depreciate. The following shift the supply of foreign currency curve to the left: a decrease in foreign GDP, a decrease in the relative interest rate in the United States, a change in tastes that makes U.S. goods less desirable to foreigners, a relative Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises 93 increase in prices in the United States, and an expectation that the foreign currency will appreciate. 4. In the very short run, exchange rates move mainly due to changes in interest rates and expectations of future exchanges rates since these forces drive hot money. In the short run, business cycles account for most of the change in exchange rates. Countries with higher relative GDPs demand more foreign currency, causing their own currencies to depreciate. 6. Purchasing power parity says that the exchange rate between two countries should adjust until the average price of goods is approximately the same in the two countries. Exchange rates might deviate from purchasing power parity because of high transportation costs, barriers to trade, and the inherent difficulty in trading some goods. 8. A managed float is when the central bank intervenes in the foreign currency market to prevent an appreciation or depreciation of its currency. Governments use a managed float to help their export-oriented industries, to keep costs down for firms that import inputs, or to decrease the risks of international trade that arise from exchange rate changes. 10. During the 1980s interest rates rose due to the rising budget deficit, a burst of investment spending, and a drop in the private saving rate. All of these contributed to a higher U.S. interest rate, and a capital inflow, as foreigners purchased more U.S. assets than Americans purchased of foreign assets. The dollar appreciated making American goods more expensive to foreigners, and foreign goods cheaper to Americans, and a trade deficit resulted. The trade deficit persisted in the 1990s because of the continuing budget deficit, strong investment spending, and relatively low private savings. 12. Managed floats are controversial because countries often intervene when the forces behind an appreciation or depreciation are strong, which only serves to delay inevitable changes in the exchange rate—sometimes at great cost to a country’s currency reserves. Problems and Exercises 2. a. Setting the quantity of pounds demanded equal to the quantity supplied, we have 10 – 2e = 4 + 3e 6 = 5e e = 6/5, or 1.2 dollars per pound. b. After the U.S. government intervenes, the demand for pounds equation becomes 12 – 2e. Resolving for equilibrium, the exchange rate climbs to 1.6 dollars per pound, a depreciation of the dollar. The U.S. government might intervene in this way if it wanted to help its export-oriented industries. Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises 94 4. Dollars per Peso S1 pesos pesos S2 e1 D1 e2 D2 pesos pesos Quantity of pesos a. As the money supply decreases, the interest rate rises, causing a and I to fall, and, therefore, decreasing GDP. As the interest rate rises, U.S. assets are more attractive to Americans and Mexicans. This, combined with the fall in U.S. GDP, causes the demand curve for Mexican pesos to shift leftward and the supply curve to shift rightward. The U.S. dollar appreciates. b. The U.S. dollar appreciation causes net exports to fall, further shrinking equilibrium GDP in the U.S. c. If the Mexican central bank raised its interest rates just as much as the United States, then the dollar would not appreciate as much. (It might still appreciate somewhat, depending on the relative decline in U.S. and Mexican GDP, and the impact of these declines on U.S. net exports). While U.S. output would still fall, it would not fall as much as in the initial analysis. 6. a. b. A fixed rate of 1.41 dinars per dollar is the equivalent of $0.71 per dinar. Since this is higher than the market equilibrium price of $0.50 per dinar, Jordan’s central bank must buy dinars to keep the dinar from depreciating. Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises 95 c. Jordan would eventually run out of foreign reserves, and so could not buy dinars forever. d. An expected fall in the dinar causes the supply curve for dinars to shift rightward from S 1 to S2and the demand curve to shift leftward D1 to D2. e. The end result is that Jordan’s central bank must buy even more dinars to maintain the fixed rate 8. Since Country B has the higher inflation rate, its relative price level is rising. As its basket of goods becomes relatively more expensive, only a depreciation of its currency can restore purchasing power parity. Traders would buy Country A’s currency in order to buy its goods for resale in Country B. Country A’s currency will appreciate relative to Country B’s (alternately stated: Country B’s currency will depreciate relative to Country A’s). 10. (a) (b) Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises 96 (c) The initial increase in the money supply causes the interest rate to fall (panel (a)), which increases investment and consumption spending, which shifts the AD curve rightward from AD1 to AD2 in panel (b). The lower interest rate also shifts the supply of pounds curve leftward, and the demand for pounds curve rightward in panel (c). The price per pound measured in U.S. dollars rises, and this dollar depreciation causes net exports to rise. This shifts the AD curve rightward from AD2 to AD3 in panel (b). Monetary policy is more effective when the effects on exchange rates are included. Challenge Questions 2. More spending by the U.S. government causes U.S. interest rates to rise. This makes U.S. assets more attractive, increasing the supply and decreasing the demand for foreign currency. The dollar appreciates, causing net exports to fall, thus reducing real GDP. This makes fiscal policy less effective in changing equilibrium GDP than it would be if the effects on exchange rates were excluded. Economic Applications Exercises 2. a. Virtually all economists argue that free international trade increases the total consumption possibilities for all trading partners. Adam Smith noted in The Wealth of Nations, total output increases in an economy as a result of specialization and division of labor. It is argued that countries gain in a similar manner as a result of international specialization and division of labor. David Ricardo elaborated on this argument by noting that gains from international trade will always occur when each country specializes in the production of those goods and services in which it possesses a comparative advantage. A comparative advantage exists when the opportunity cost of producing a good is lower in the domestic economy than in foreign economies. The gains from trade occur because each country is able to import goods at a lower opportunity cost than it would face if it produced these goods domestically. If each good is produced in the country in which the opportunity cost is lowest, the total output of the world economy is greater. b. Following Smith and Ricardo, most economists support free international trade and recognize only a few possible rationales for trade barriers: to protect “infant industries” that cannot compete effectively during their formative period but will acquire a comparative advantage in the future once a trained labor force and the necessary infrastructure has been developed, Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises 97 to protect industries that are important for national security reasons (to prevent political pressure from countries or cartels - such as OPEC - that might be able to exert control over a critical commodity or resource), as a mechanism for correcting for differences in environmental and labor laws that result in lower production costs in countries with fewer environmental and safety regulations, and as a temporary measure to reduce the adjustment costs associated with job losses due to the loss of comparative advantage in a particular industry. The political reasons for trade barriers include: While consumers always gain from the reduction of trade barriers, firms and workers in specific industries are better off when substantial trade barriers exist. The owners of firms and workers in these industries receive very large losses if trade barriers are eliminated; each individual consumer tends to receive relatively small gains from the elimination of these barriers. If trade barriers are eliminated, the dollar value of the gains to consumers will always outweigh the dollar value of the losses to producers and workers. Each individual consumer, though, has little incentive to lobby for a reduction in specific trade barriers (nor is even aware of most such trade barriers). Each individual worker and owner, however, has a substantial incentive to lobby for such trade restrictions. This “special-interest” effect often results in the passage of laws resulting in trade barriers. There is also a concern that free trade with low-wage economies will reduce the wage of high-wage U.S. workers. In specific industries, such an effect is likely. This argument was at the heart of much of the opposition to NAFTA (since wage rates are generally lower in Mexico). 4. a. When the value of the dollar falls relative to the yen (the number of yen per dollar decreases), Japanese goods become relatively more expensive for the U.S. to import, while U.S. goods become relatively less expensive for Japanese to import. Thus when exchange rates drive the current account, the U.S. current account balance should rise when the value of the dollar decreases relative to the yen. As one can see in the diagram and the data table below, throughout the 1980’s and into the early 1990’s there tended to be an inverse relationship between changes in the U.S. current account balance and changes in the value of the dollar. Interestingly, since the mid-1990’s there has been a direct rather than an inverse relationship between current account and the value of the dollar in terms of yen. b. One can see in the diagram on the Web site that rising real disposable personal income in the U.S. has helped fuel our consumption of imports. Specifically, the current account tended to be in deficit (imports exceeding exports) during times of growing real personal income as Americans used their rising affluence to finance the purchase of imports. Note that in each of the four recessions since 1980 (1981, 1982, 1990-91, and 2001, as well as the near-recession in 1995), the current account balance tended to increase, or at least decline more slowly, indicating that imports tend to decline during recessions. It is interesting to note that real personal disposable income has continued to grow even through our most recent recession, spurring greater consumption of imported goods.