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Macro3 Problem #4 Answers (
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Open the Macro3 module. Select “Recession” as the state of the macro-economy.
Enact a set of policies that would be supported by fiscally conservative politicians that
represent creditors and people on fixed incomes. Demonstrate this by showing how
your policies reduced unemployment, reduced inflation, or controlled interest rates.
In performing this analysis, you need to answer the following question. If you owned
bonds or lived on a pension, which would be more important for you, controlling
inflation, or reducing the unemployment rate?
People living on fixed incomes should be concerned with inflation, since by definition of the
term “fixed income” any inflation would cause a decline in the purchasing power of their
incomes. Creditors would be especially concerned with unexpected increases in inflation
which would not have been taken into account when the interest rates on the loans were set.
Such unexpected inflation would reduce the real returns on those loans, and would therefore
represent a loss to the owners of the debt.
The current budget is running a deficit, which affects the mix of investment and
consumption, which might constitute a drawback. However, trying to correct the deficit by
increasing taxes or curtailing spending would make the recession worse, so I left
government spending and taxes unchanged at $950 and $865 respectively. In order to
combat the recession, I increased the money supply to $66. If the economy were at or near
full employment, such as increase in the money supply cause a high rate of inflation.
However, the unemployment rate is 7%, so increasing the money supply will help
ameliorate that without causing much inflation.
As a result of my policies, unemployment went down from 7% to 5.06% and inflation went
from -11.57% (massive deflation) to -0.16% (a tiny amount of deflation). Real interest rates
decreased slightly, from 8.065% to 8.030%. Of course, the rise in the inflation rate
(decrease in deflation) would reduce the gains made by those on fixed incomes—who gain
from deflation. If this change were unexpected then nominal interest rates on debt from
before the change would yield lower real returns to the owners of the debt. Actual price
increases are not necessary for these results.
(1) Institute a demand shock and see how that affects the results of your policies,
then institute a supply shock and see how that affects the results of your
policies.
(2) Do your policies serve debtors or creditors in the short run, or long run, or
both? Explain, making specific reference to each of the reported values
(inflation, unemployment, real GDP and its components, the exchange rate).
For the demand shock, I increased expected inflation from 1% to 5%. This caused
unemployment to go down even further to 4.49%, and real GDP, consumption and
investment all rose. However, inflation rose to 3.78%. Real interest rates fell by 0.02%.
To many an inflation rate even this high would be unacceptable. Likewise, the currency
depreciated, from 0.9774 without the shock to 0.9401 with the shock. This inflation
would make the economy more unstable and the devaluation of the currency would make
imports of materials and other inputs more expensive. Because of the demand shock, my
policies failed at protecting people on fixed incomes and creditors.
I chose a supply shock of 10. Unemployment fell from 5.06% to 4.08. Real GDP,
consumption and investment all rose slightly. Inflation fell from –0.16% to –0.53%. The
currency appreciated slightly from 0.9774 to 0.9809.. A supply shock such as this was
probably a drop in production costs (e.g., a lower oil price) and for most firms that would
mean higher profits—which is why supply increased. However, this would assist
creditors or those on fixed incomes only to the extent that some of the price decrease was
unexpected..
Now repeat this assignment, only this time, enact a set of policies that would be
supported by the unskilled workers and shareholders in firms.
(1) Institute a demand shock and see how that affects the results of your policies,
then institute a supply shock and see how that affects the results of your
policies.
(2) Do your policies affect the interests of these groups in long run?
Low skilled workers have their best chance at getting a job and even moving up to better
jobs when the unemployment rate is low, even below full employment. Shareholders
want profits and firms’ profits are usually the highest when demand is high and so is
production. Increases in the money supply might reduce unemployment over time, but
government spending may create jobs more quickly, although that aspect is not covered
in this module. In order to serve these interests, the government should increase spending
to $1,150, leave taxes unchanged at $865 and increase the money supply to $70. The
purpose of the increase in the money supply is to prevent the interest rate from going too
high. A high interest rate would tend to crowd out private investment, and reduce the
impact of the increase in government expenditure..
As a result of my policies, the unemployment rate decreased from 7.00% to 3.86%.
Inflation went up from -11.57% to 8.49%. This is good for these groups because the low
unemployment rate opens up major opportunities for low skilled workers, although it
comes at the cost of a declining real wage for workers overall. Profits in the short run at
least would be higher due to the increase in demand and the rise in prices of final goods,
relative to costs. The negative side of this is that even though real GDP went up from
$2,330.36 to $2,361.72, consumption fell from $1,127.21 to $1,106.82 and investment
went down significantly from $265.15 to $119.30. Even with the expanded money
supply, the higher interest rate (10.009% compared to 8.065%) is crowding out private
investment and consumer spending. The lower level of private investment will inhibit
economic growth in the future.
What this government is doing is serving the short term interests of the given groups, but
forcing future generations to pay for it in terms of lower economic growth. Moreover,
the public is enjoying less current consumption that was originally the case. The long run
real wage and unemployment rate have not changed, so the policies were helpful to these
groups only in the short run.
I instituted a demand shock by increasing expected inflation from 1% to 5%. All the
resulting changes were small, except for unemployment and inflation. Unemployment
went down from 3.86% to 3.33% and inflation increased from 8.49% to 12.89%. This
shock exaggerated the effects of the policies.
I instituted a supply shock of –10. This significantly lowered real GDP, consumption and
investment. It also increased unemployment from 3.86% to 4.70%. The changes in
inflation, interest rates and the exchange rate were small. Thus, this supply shock served
to negate the positive impact of my policies. My policies were supposed to create jobs
and reduce unemployment, but the supply shock cancelled the effect.