Economics 102

Fall 2002

Exam 3—L. Stone

1. a. Suppose that there is a sudden INCREASE in consumption (because consumers become more optimistic and wish to spend more at every income level), perhaps because they are happy about the economy. Assume that the economy starts out in full employment.

Show and EXPLAIN, using the 3-diagram model AND an AS-AD graph, what will happen in the short run and how the economy will readjust in the long run. Be careful to label everything and to show all connections!! (15 points)

In the short run: C rise, C+I+G rises, AD rises, Y rises, P rises (somewhat)

In the long run: : Y>Y_F so wages and prices rise. AS decreases (shifts leftward), money demand rises, r rises, quantity of I falls, C+I+G falls, Y returns to Y_F, prices rise further.

b. List a SPECIFIC monetary policy AND a SPECIFIC fiscal policy that would prevent the consumption shift from affecting the economy. (4 points)

FISCAL: decrease government spending or raise taxes

MONETARY: sell bonds or raise the discount rate or raise reserve requirements

c. Briefly explain why (a) it might be desirable to let the economy readjust by itself rather than using a fiscal or monetary policy, and (b) why it might NOT be desirable to let the economy readjust by itself. (6 points)

a. Lags mean that policies may be mistimed or inadequate and may actually aggravate the problem.

b. It may take a long time for the economy to adjust on its own, and intervention will speed the return to full employment.

2. Assume that the economy is at full employment, and that people assume that this year’s inflation rate will be equal to last year’s. The money supply has been increasing at a rate of 5% per year for as long as anyone can remember. The unemployment rate is 4%, which is the natural rate of unemployment for this economy.

a. Carefully explain the impact of a decrease in the growth rate of the money supply to 7% on both inflation, interest rates, and unemployment in the short run. (Draw graphs as necessary…) (10 points)

The rate of increase of the money supply now is MORE than the rate of increase of money demand, and thus interest rates will FALL in the short run. (Note: must either have a graph showing both curves shifting, or must clearly state rate of increase or percentage change is more, not just something like money supply is more than money demand). This increases the quantity of investment, and causes a short-run rise in output, and thus a decrease in unemployment. Inflation will begin to rise (it is equally correct to say that prices are constant in the short run).

b. What is the long run effect of this change in the rate of money supply growth on inflation, and unemployment? Briefly explain WHY, and state what the numerical value of each will be in the new long-run equilibrium. (5 points)

Eventually, expectations adjust to a higher rate of inflation; interest rates fall again, and the economy returns to full employment. Inflation = 7%, and unemployment = 4%.

c. Briefly explain why central bank credibility is important to fighting inflation. (5 points)

As in a., the short-run tradeoff between unemployment and inflation is based on the fact that expectations don’t change much in the short run. If the central bank is credible, expectations adjust faster, and recessions due to either changes in money growth or due to supply shocks are shorter.

3. a. Briefly explain why unemployment is undesirable. (4 points)

It represents a loss of potential output (and thus lower incomes and standards of living).

It is socially disruptive.

b. Briefly explain why inflation is undesirable. (6 points)

When inflation is expected, costs are relatively low (menu and shoeleather costs), although high expected inflation will make these costs more significant.

When inflation is unexpected, there are income redistributions (from lenders to borrowers), and in the extreme case, the financial system breaks down because no one wants to lend money, and thus there is no savings or investment, and this lowers long-term growth.

4. Issues related to government budget deficits:

a. Explain the difference between a balanced budget and a cyclically balanced budget (your answer should include a definition of the structural deficit). (5 points)

A balanced budget means that the budget is balanced every year (or G = T every year).

A cyclically balanced budget means that there is no deficit when the economy is at full employment (the structural deficit is zero).

b. Identify the two methods of financing government budget deficits, and explain why each is undesirable. (14 points) (Note: to receive full credit, you must explain WHY the effects you state will may occur when there are budget deficits. That is, don’t just list, explain.) (10 points)

1. Printing money creates inflation: If money is created to finance the deficit (that is, if the Fed buys bonds from the Treasury), the money supply increases. This will increase inflation in the long run (must have some explanation here of why—either graphs or quantity equation explanation. (5 points)

2. Borrowing money can crowd out investment, which lowers long-term growth: If the government borrows money, it will tend to raise interest rates, which will crowd out investment. (Demand for loanable funds increases, which increases the interest rate, or any notion that more borrowing drives up the interest rate.) (5 points)

c. What is the Ricardian equivalence theorem, and what does it have to do with the budget deficit debate? (10 points)

The Ricardian equivalence theorem states that it doesn’t matter if you cover additional government spending by raising taxes now versus borrowing the money now. If you raise taxes now, consumption falls. If you borrow the money, consumers realize that taxes must rise in the future. Thus they will save more now, and consumption falls now, too. This means that interest rates don’t rise, and investment is not crowded out.

5. a. What is a consumption tax, and why would it be desirable? (6 points)

A consumption tax is a tax on consumption, as opposed to the current tax structure which taxes income, whether you consume it or not. This would make consumption more expensive (and saving cheaper), and thus saving rises. This would be desirable because it should increase long-term growth.

b. What is the primary reason why consumption taxes might not be desirable? (3 points)

They are regressive (they fall harder on the poor than the rich). (Also, they might not stimulate savings enough to make up for lost tax revenues.)

6. a. Why do we say that inflation is wholly related to the rate of growth of the money supply in the long run? (Or, in other words, why is inflation “always and everywhere a monetary phenomenon.”) (4 points)

The quantity theory states that MV=PY

Thus percentage change in M + percentage change in V = percentage change in P (inflation rate) plus percentage change in Y (growth rate)

Thus, in the long run, with V and Y fixed, any change in the money supply must translate directly into inflation.

(Alternative explanation. If prices can change (long run), more money (with the same amount of goods) must mean that money buys less.

b. What happens to the velocity of money during hyperinflations? (3 points)

It increases, because people to try to spend money as fast as they get it (because it is losing value).

c. Why is it so hard to stop hyperinflation? (I can think of 2 good reasons.) (4 points)

1. Stopping hyperinflation requires reducing money growth or cutting the money supply. This causes recession.

2. Central banks of countries that have hyperinflation are generally not credible, so expectations of inflation are built into the system, and it is very difficult to change that.

BONUS QUESTION!

1. Explain how the Fed “sets” the federal funds rate. (Possible 4 points)

The Fed sets a TARGET RATE. If the actual rate is not equal to the target rate, the Fed uses open market operations to adjust the money supply until the actual rate is roughly equal to the target rate.

2. If the Fed increases the money supply, short-term nominal and real interest rates tend to fall immediately, but long-term nominal rates tend to rise. Why? Explain carefully. (possible 6 points)

nominal rate = real rate + expected inflation

An increase in the money supply, with fixed prices (no change in money demand), causes lower real interest rates (see money market graph), and so nominal rates fall too. But at the same time, a higher money supply means higher future inflation, so expectations of long term inflation increase. The long term real rate probably doesn’t change, but with higher expected inflation, long-term nominal rates will be higher.