Download Macroeconomics: Events and Ideas

S219-S224_Krug2e_Macro_PS_Ch17.qxp
2/26/09
9:48 AM
Page S-219
D Graphics Worth: Krugman Macro 2e Problem & Solution Manual
chapter:
ECONOMICS
MACROECONOMICS
33 17
Macroeconomics: Events and Ideas
1.
Since the crash of its stock market in 1989, the Japanese economy has seen little economic growth and some deflation. The accompanying table from the Organization for
Economic Cooperation and Development (OECD) shows some key macroeconomic
data for Japan for 1991 (a “normal” year) and 1995–2003.
Year
Real GDP
annual
growth
rate
Short-term
interest
rate
Government
debt
(percent
of GDP)
Government
budget
deficit
(percent
of GDP)
−1.81%
1991
3.4%
7.38%
64.8%
1995
1.9
1.23
87.1
4.71
1996
3.4
0.59
93.9
5.07
1997
1.9
0.60
100.3
3.79
1998
−1.1
0.72
112.2
5.51
1999
0.1
0.25
125.7
7.23
2000
2.8
0.25
134.1
7.48
2001
0.4
0.12
142.3
6.13
2002
−0.3
0.06
149.3
7.88
2003
2.5
0.04
157.5
7.67
a. From the data, determine the type of policies Japan’s policy makers undertook at
that time to promote growth.
b. We can safely consider a short-term interest rate that is less than 0.1% to effectively be a 0% interest rate. What is this situation called? What does it imply about the
effectiveness of monetary policy? Of fiscal policy?
1.
Solution
a. From the annual real GDP growth rate, we can see the slow growth of the Japanese
economy: the economy actually contracted in 1998 and 2002, with minimal
growth in 1999 and 2001. We can also see that policy makers used expansionary
monetary policy to spur the economy: short-term interest rates fell from 7.38% in
1991 to 0.04% in 2003. Finally, since government debt as a percentage of GDP
rose from 64.8% in 1991 to 157.5% in 2003 and the government deficit as a percentage of GDP rose from −1.81% to 7.67%, we can conclude that they were also
using expansionary fiscal policy.
b. During 2002 and 2003, the short-term interest rate in Japan was effectively 0%, a
situation known as a liquidity trap. In this case, monetary policy is ineffective since
the interest rate cannot be driven any lower by expansionary monetary policy. In a
case of a liquidity trap, the only effective tool is expansionary fiscal policy—that is,
Keynesian policy.
S-219
S219-S224_Krug2e_Macro_PS_Ch17.qxp
2/26/09
9:48 AM
Page S-220
D Graphics Worth: Krugman Macro 2e Problem & Solution Manual
S-220
MACROECONOMICS, CHAPTER 17
ECONOMICS, CHAPTER 33
2.
The National Bureau of Economic Research (NBER) maintains the official chronology
of past U.S. business cycles. Go to its website at http://www.nber.org/cycles/
cyclesmain.html to answer the following questions.
a. How many business cycles have occurred since the end of World War II in 1945?
b. What was the average duration of a business cycle when measured from the end of
one expansion (its peak) to the end of the next? That is, what was the average
duration of a business cycle in the period from1945 to 2001?
c. When and what was the last announcement by the NBER’s Business Cycle Dating
Committee, and what was it?
2.
Solution
a. Answers will vary. But as of December 2008, there had been 11 business cycles
since the end of 1945. This includes the recession that began in December 2007
and, at the time of writing, still continued.
b. As of December 2008, the average duration of a business cycle for the period
1945–2005, when measured from the end of one expansion (peak) to the next,
was 67 months.
c. As of December 2008, the last NBER Business Cycle Dating Committee announcement was of the NBER’s Determination of the December 2007 Peak in Economic
Activity, on December 11, 2008.
3.
The fall of America’s military rival, the Soviet Union, in 1989 allowed the U.S. to significantly reduce its defense spending in subsequent years. Using the data in the following table from the Economic Report of the President, replicate Figure 33-3 for the
1990–2000 period. Given the strong economic growth in the U.S. during the late
1990s, why would a Keynesian see the reduction in defense spending during the
1990s as a good thing?
Year
Budget deficit
(percent of GDP)
Unemployment
rate
1990
3.9%
5.6%
1991
4.5
6.8
1992
4.7
7.5
1993
3.9
6.9
1994
2.9
6.1
1995
2.2
5.6
1996
1.4
5.4
1997
0.3
4.9
1998
−0.8
4.5
1999
−1.4
4.2
2000
−2.4
4.0
S219-S224_Krug2e_Macro_PS_Ch17.qxp
2/26/09
9:48 AM
Page S-221
D Graphics Worth: Krugman Macro 2e Problem & Solution Manual
MACROECONOMICS: EVENTS AND IDEAS
3.
Solution
The accompanying diagram replicates Figure 33-3 for the 1990–2000 period. It was
fortunate that defense spending fell and the budget deficit declined during this period
because additional spending at a time of strong growth (and low unemployment
rates) is likely to have created inflationary pressure.
Unemployment rate,
budget deficit
(percent of GDP)
8%
Unemployment rate
6
4
2
Budget deficit
0
–2
00
20
98
19
96
19
94
19
92
19
19
90
–4
Year
4.
In the modern world, central banks are free to increase or reduce the money supply as
they see fit. However, some people harken back to the “good old days” of the gold
standard. Under the gold standard, the money supply could expand only when the
amount of available gold increased.
a. Under the gold standard, if the velocity of money was stable when the economy
was expanding, what would have had to happen to keep prices stable?
b. Why would modern macroeconomists consider the gold standard a bad idea?
4.
Solution
a. For prices to remain stable when the economy was expanding and the velocity of
money was stable, the stock of gold would have had to grow at the same rate as real
GDP.
b. Under the gold standard there is no room for activist monetary policy, which
modern macroeconomists favor.
5.
Monetarists believed for a period of time that the velocity of money was stable within
a country. However, with financial innovation, the velocity began shifting around
erratically after 1980. As would be expected, the velocity of money is different across
countries depending upon the sophistication of their financial systems—velocity of
money tends to be higher in countries with developed financial systems. The accompanying table provides money supply and GDP information in 2005 for six countries.
Country
National
currency
Egypt
Egyptian pounds
South Korea
Korean won
Thailand
Thai baht
United States
U.S. dollars
Kenya
Kenyan pounds
India
Indian rupees
Source: Datastream.
M1
(billions in
national
currency)
Nominal GDP
(billions in
national
currency)
101
539
77,274
806,622
863
7,103
1,369
12,456
231
1,415
7,213
35,314
S-221
S219-S224_Krug2e_Macro_PS_Ch17.qxp
2/26/09
9:48 AM
Page S-222
D Graphics Worth: Krugman Macro 2e Problem & Solution Manual
S-222
MACROECONOMICS, CHAPTER 17
ECONOMICS, CHAPTER 33
a. Calculate the velocity of money for each of the countries. The accompanying table
shows GDP per capita for each of these countries in 2005 in U.S. dollars.
Nominal GDP per capita
(U.S. dollars)
Country
Egypt
$1,270
South Korea
16,444
Thailand
2,707
United States
41,886
Kenya
572
India
710
Source: IMF.
b. Rank the countries in descending order of per capita income and velocity of
money. Do wealthy countries or poor countries tend to “turn over” their money
more times per year? Would you expect that wealthy countries have more sophisticated financial systems?
5.
Solution
a. The velocity of money is defined as nominal GDP divided by the quantity of
money. For example, the velocity of money in Egypt is 539/101 = 5.3. The velocity
of money for each of the countries is in the accompanying table.
Country
Velocity of money
Egypt
South Korea
5.3
10.4
Thailand
8.2
United States
9.1
Kenya
6.1
India
4.9
b. Rank in descending order of velocity: South Korea, United States, Thailand, Kenya,
Egypt, India. Rank in descending order of per capita income: United States, South
Korea, Thailand, Egypt, India, Kenya. According to the above rankings wealthy
countries tend to have a higher velocity of money than do poor countries, but the
relationship is not exact. One would expect that wealthy countries have more
sophisticated financial systems.
6.
The chapter explains that Kenneth Rogoff proclaimed Richard Nixon “the all-time
hero of political business cycles.” Using the table of data below from the Economic
Report of the President, explain why Nixon may have earned that title. (Note: Nixon
entered office in January 1969 and was reelected in November 1972. He resigned in
August 1974.)
Government
budget balance
(billions of dollars)
Year
Government receipts
(billions of dollars)
Government spending
(billions of dollars)
1969
$186.9
$183.6
$3.2
3.3%
3.7%
6.68%
1970
192.8
195.6
−2.8
5.1
6.6
6.46
1971
187.1
210.2
−23.0
6.5
13.4
4.35
1972
207.3
230.7
−23.4
9.2
13.0
4.07
1973
230.8
245.7
−14.9
5.5
6.6
7.04
M1 growth
M2 growth
3-month Treasury
bill rate
S219-S224_Krug2e_Macro_PS_Ch17.qxp
2/26/09
9:48 AM
Page S-223
D Graphics Worth: Krugman Macro 2e Problem & Solution Manual
MACROECONOMICS: EVENTS AND IDEAS
Solution
6.
The data indicate that President Nixon may have used fiscal and monetary policy to
aid his reelection efforts. From his first year in office, 1969, to his reelection year,
1972, federal spending grew by 27% but federal receipts grew by only 11%. Overall,
the federal budget balance went from a $3.2 billion surplus to a $23.4 billion deficit
as a result of these expansionary fiscal policies. Nixon also used expansionary monetary policy to increase his popularity. Both M1 and M2 grew increasingly rapidly from
1969 to 1972. In response, the three-month Treasury bill rate (a short-term interest
rate) fell from 6.68% to 4.07% during this same time period. After his reelection,
these expansionary policies were reversed and the budget deficit shrank by $8.5 billion, or by more than a third; the growth of M1 fell 3.7 percentage points, the growth
of M2 fell 6.4 percentage points, and the three-month Treasury bill rate rose to
7.04%.
7.
The economy of Albernia is facing a recessionary gap, and the leader of that nation
calls together five of its best economists representing the classical, Keynesian, monetarist, real business cycle, and modern consensus views of the macroeconomy. Explain
what policies each economist would recommend and why.
7.
Solution
In response to a recessionary gap in Albernia, the economists representing the different views of the macroeconomy would make the following suggestions.
Classical: Do nothing. The recessionary gap will exist only in the short run, and the
only focus for policy makers is the long run.
Keynesian: The best policies to alleviate the recessionary gap are fiscal policies.
Although expansionary monetary policies can be effective in promoting economic
growth, they will not be very effective when the economy is in a deep recession or
depression, when the economy may face a liquidity trap.
Monetarist: The government should not engage in discretionary fiscal or monetary
policies because such policies can worsen economic fluctutations. GDP will grow
steadily without inflationary pressure if the money supply grows steadily.
Real business cycle: The government should engage in policies that increase total factor
productivity. Changes in monetary or fiscal policy that simply stimulate demand will
have no effect on the economy because the aggregate supply curve is vertical.
Modern consensus: Both monetary and fiscal policies can reduce a recessionary gap,
although if a liquidity trap exists, it will reduce or eliminate the effectiveness of monetary policy. Discretionary monetary policy is generally preferred over discretionary fiscal policy.
8.
Which of the following policy recommendations are consistent with the classical,
Keynesian, monetarist, and/or modern consensus views of the macroeconomy?
a. Since the long-run growth of GDP is 2%, the money supply should grow at 2%.
b. Decrease government spending in order to decrease inflationary pressure.
c. Increase the money supply in order to alleviate a recessionary gap.
d. Always maintain a balanced budget.
e. Decrease the budget deficit as a percent of GDP when facing a recessionary gap.
8.
Solution
a. Monetarists would support such a policy; they believe in a monetary policy rule
that allows the money supply to grow at the same rate as GDP. Since classical
economists focus on long-term policies, they would also recommend such a policy.
Keynesians and followers of the modern consensus believe that discretionary
monetary policy can be useful in addressing short-run problems and would not
recommend a monetary policy rule.
S-223
S219-S224_Krug2e_Macro_PS_Ch17.qxp
2/26/09
9:48 AM
Page S-224
D Graphics Worth: Krugman Macro 2e Problem & Solution Manual
S-224
MACROECONOMICS, CHAPTER 17
ECONOMICS, CHAPTER 33
b. Classical economists would see the inflationary pressure as a short-run problem
and would not advocate any policy; their view would be that the inflationary pressure will not exist in the long run. Monetarists would also be reluctant to endorse
fiscal policy in the short run; they believe discretionary fiscal policy actually makes
the economy worse. Contractionary fiscal policy, such as a decrease in government
spending, would definitely be recommended by Keynesians and, only in very
unusual circumstances, by followers of the modern consensus.
c. Classical economists would see a recessionary gap as a short-run problem and
would not advocate any policy; their view would be that the recessionary gap will
not exist in the long run. Monetarists would also be reluctant to endorse a shortrun discretionary monetary policy because they believe it will make the economy
worse. Expansionary monetary policy, such as an increase in the money supply,
would be recommended by Keynesians and by followers of the modern consensus if
the economy is not suffering from a liquidity trap.
d. Keynesians and followers of the modern consensus would disagree with this policy
recommendation. A balanced-budget rule would eliminate the possibility of using
discretionary fiscal policy whenever a recessionary or expansionary gap exists. In
fact, a balanced-budget rule would require that the government employ contractionary fiscal policy during recessions (making the recession worse). Monetarists
would be sympathetic to a balanced-budget rule because of the problem of crowding out. Given classical economists’ focus on the long run, they would probably
favor such fiscal conservatism.
e. No one would agree with this policy recommendation. Decreasing the budget
deficit as a percent of GDP when facing a recessionary gap would be using contractionary fiscal policy (a decrease in government spending or an increase in taxes)—
and that would make the recession worse.
9.
Using a graph like Figure 33-4, show how a monetarist can argue that a contractionary fiscal policy need not lead to a fall in real GDP given a fixed money supply.
Explain.
9.
Solution
As you can see in the accompanying figure, contractionary fiscal policy shifts the
aggregate demand curve leftward, from AD1 to AD2, in panel (a). Correspondingly,
there is a decrease in money demand, and the money demand curve shifts leftward,
from MD1 to MD2, in panel (b). This leads to a fall in the interest rate from r1 to r2,
which has the effect of increasing investment spending and expanding the economy.
If the increase in investment spending is sufficient to counteract the effect on real
GDP of the contractionary fiscal policy, then the monetarist is indeed correct.
Panel (a)
Panel (b)
Aggregate
price level
SRAS
E1
P1
P2
Interest
rate
MS
r1
MD1
r2
E2
MD2
AD2
Y2
Y1
AD1
Real GDP
M
Quantity
of money