This assignment contributes 10% towards your final course grade.
Answer the following five questions. Each question is worth 20 marks. Your answers should average about half a page per question for a total of about three pages, double spaced.
- Explain fully the role played by unplanned investment in inventories in determining equilibrium in the Keynesian model. Use the examples of AD > GDP and AD < GDP to illustrate your answer. Note that in your textbook AD = C + I + G + NX is the same as AE.
- In the Keynesian model the economy is in equilibrium when AE=Y or AD=Y. Note that most textbooks use AE=Y but this textbook uses AD instead of AE. AE or AD refers to the purchases by consumers, businesses, and governments of thousands of different goods and services in a given year. Producers have to estimate how much of each of these goods and services will be bought. It’s impossible to correctly estimate the quantity of every good and service. We expect that in a given year AD will exceed or fall short of the output by producers because of the impossibility of perfect estimates. Since prices are assumed to be constant in the Keynesian model, producers have no choice but to add any excess of output over AD to their inventories. In fact they will not find out that they had over-produced until they see the unplanned increase in their inventories. Once they see these increases they will know that they had over-produced and will cut back. That is how AD>Y leads to a fall in output, income, and employment and moves the economy towards its equilibrium. In the opposite case, if AD<Y, producers will meet this excess demand not by increasing prices but by reducing inventories. In fact, producers will not know that they had under-produced until they observe this unplanned disinvestment in inventory. Once they observe that they will know that they under-produced and will increase output, income, and employment towards the economy equilibrium.
2. Why are there two measures of GDP? How is the income measure different from the expenditure measure? Why must the two measures, using different data, be equal? Why might they not be equal? Why do we need to compute nominal and real GDP using both measures?
- The two measures are the expenditure and income measures. The income measure adds up the four factor incomes, wages, interest, rent, and profits, and two non-income amounts, indirect taxes and depreciation. The expenditure measure adds up the expenditures of consumers, business investments, and the government. Since these expenditures include expenditures on imported goods, imports are subtracted from exports and NX is added to C+I+G.
- The two measures should be equal because they are two ways of measuring the same GDP for a given year. In the circular flow model you learn that income is equal to output. Any increase in GDP creates and equal increase in national income. The two measures are not usually equal because of computational errors. This is indicated by a statistical discrepancy. Since we cannot add the physical quantity of cars produced to the physical quantity of houses or apples, we need to add money values. This total money value provides a nominal or money value of GDP. In like manner we add up the nominal values for wages, interest, rent, and profits. However, we can convert this nominal value to a real value by dividing out any inflation. To do that we need the GDP deflator. This is a comprehensive price index which measures the average price level for a given year. Real GDP is:
- (Nominal GDP/GDP deflator)*100
- Real GDP measures the output produced in a given year and the increase in that output from one year to the next.
- Real GDP can increase both because an economy has unemployment and because of economic growth. Explain fully the difference between these two ways of increasing GDP. Why does the Keynesian model focus only on increasing GDP by reducing unemployment and not on economic growth?
This question deals with the difference between the short-run and the long-run in macroeconomics. The focus of Keynesian economics is the short-run fluctuations in income, output, and unemployment around its long-run trend increase. This focus is due to the fact that the Keynesian model was born out of the Great Depression of the 1930s. Recessions and depressions are explained in macroeconomics by the business cycle. AD plays a key role in explaining these fluctuations. High AD pushes the economy into a boom, while low AD causes recessions. Keynesian economics focuses on ways to increase AD during recessions and to reduce AD during booms in order to stabilize the economy close to its trend or full employment GDP.
If the economy is in recession, its actual GDP is less than its trend or full employment GDP. An increase in AD will increase GDP by reducing unemployment until full employment GDP is reached. This is not economic growth.
Economic growth steepens the long-run trend line. It causes a growth in the capacity of an economy to produce GDP which is caused by increases in land, labour, capital, and entrepreneurship, as well as increased education and training of the labour force, and new technology. Note that GDP need not increase only the capacity to produce more increases. It’s crucial not to confuse long-run economic growth with short-run increases in GDP caused by reducing unemployment.
- Explain fully how the AS/AD model is related to the Keynesian model and how it is different from the Keynesian model.
The AS/AD model builds on the Keynesian model by removing the constraint in the Keynesian model of a constant price level and by adding the AS curve. The Keynesian model focuses exclusively on the key role played by AD in causing recessions and the Great Depression of the 1930s. By increasing AD, the economy will increase output, income, and employment until full employment or capacity GDP is reached. Keynes assumed that the price level would not rise.
With the 1973 oil shock two lessons were learnt. Firstly, supply shocks can occur in addition to demand shocks. It was for this reason that the AS curve was added. The second lesson learnt was that the price level is not constant. By 1974 the inflation rate in Canada, for example, had reached 10%. The price level can increase by both demand and supply shocks. In general an increase in AD will increase both output and the price level. On the other hand a decrease in AS will decrease output as well as increase the price level.
One convention was to use AE=C+I+G+NX for the Keynesian model and AD=C+I+G+NX for the AS/AD model. AE assumes a fixed price level while AD=f(P). Changes in P cause movements up and down the AD curve while changes in P shifts the AE curve up or down.
- Your textbook uses AD in both the Keynesian model and in the AS/AD model. In most other textbooks the authors use AE instead of AD in the Keynesian model. Explain why both AD and AE are equal to C + I + G + NX. Since both are equal to C + I + G + NX, in what ways are they different? Use graphs to illustrate.
This question is somewhat related to the previous question, but it is focussed on how AE is similar to AD but also different from AD. The AS curve is therefore not relevant. Both AD and AE represent the total spending by consumers, investors, and governments as well as the net spending by foreigners. This is why they are interchangeable and require a convention as to which one to use in the Keynesian model and in the AS/AD model. Given the latter’s name, it make sense to use AD in the AS/AD model and use AE in the Keynesian model.
The different ways in which AD and AE are used in macroeconomics is more important than the similarity. Total spending is related both to total income and to the price level. This is not a problem in the Keynesian model because the price level is assumed to be constant. In that case total spending is affected only by changes in total income. Using AE instead of AD, AE=f(Y). As Y increases, AE increases.
In reality the price level is not constant. Replacing AE with AD, AD=f(Y, P). Now we have a problem graphing this function since we only have two axes and three variables. We find a way to resolve this by combining the equilibrium points from the Keynesian-cross diagram, caused by shifting the AE curve when the price level changes, with the price level. This is explained by Figures 5.9 and 5.10 on pages 113-114 of the textbook.
Assignment 2 (10%)
This assignment contributes 10% towards your final course grade.
Answer the following five questions. Each question is worth 20 marks. Your answers should average about half a page per question for a total of about three pages, double spaced.
- Explain the difference between currency and bank money. Which institutions in Canada are responsible for producing these two types of money? Explain fully.
Currency consists of paper money and token coins. In Canada the paper money is printed by the Bank of Canada and is also called Bank of Canada notes or bills. The token coins are minted by the Royal Canadian Mint. They are called token coins because real gold and silver coins were part of the money supply in the past. Another term for currency is cash.
Bank money is the total value of deposits by households, businesses, and governments in the commercial banks. In Canada these banks include the Royal Bank, CIBC, the Bank of Montreal, TD Canada Trust, and Scotia Bank. The total money supply in both Canada and the US consists of currency and bank money.
When currency is deposited into a commercial bank, the banking system keeps the currency as reserves and adds bank money equal to some multiple of the currency. For example, assuming a reserve ratio of 5% of total deposits and a new deposit of currency of $1,000.00, the economy loses currency of $1,000 but gets additional bank money of $20,000. That’s a net increase in the money supply of $19,000. There are different measures of the money supply depending which bank deposits are included. For example, the M1 money supply includes only demand deposits. The M2 money supply adds other types of deposits. In Canada there is also the problem of deposits in near banks such as Vancity in BC.
- Why is money important for an economy?
The key function of money is to facilitate exchange of goods and services between buyers and sellers. Specialization increases the productivity of every economy. A highly specialized economy is far more productive than a self-sufficient economy. Since the goal of every economy is to maximize the output of goods and services, specialization is essential to achieving that goal.
A specialized economy depends crucially on exchange. Using a very simple example, if you specialize in producing apples you may need to exchange some of your apples for oranges. Exchanging your apples directly for oranges is called barter. The problem with barter is that it requires a double coincidence of wants. You need to find someone who both wants your apples and has oranges. Thinking in terms of a local market, you might take your apples to market and observe many sellers of oranges. But the first 20 sellers you ask might not want your apples.
Barter is an inefficient mode of exchange which limits specialization which reduces productivity. Money acts as a medium of exchange. In this simple example, you would sell apples for money to anyone who is willing to buy them. You could take the money you received for the apples and buy oranges from anyone selling oranges. Using this indirect method of exchanges enhances immensely the efficiency of exchange allowing a far greater degree of specialization which greatly increases the GDP of the economy.
Note that when you sold your apples for money you did not make an immediate purchase of oranges as you would do with barter. This is a second deficiency of barter. A second important function of money is the store of value function. In this simple example you can store the money from the sale of the apples as long as you wish and buy oranges at a much later time. With barter it’s difficult, if not impossible, to store the oranges for later use far into the future.
Another function of money is unit of account or measure of value. Without a common measure of value, we would not be able to compute aggregates such as GDP nor easily compare values. For example, if the price of apples is $2.50 per kilo and the price of oranges is $5.00 per kilo, we can quickly figure out that oranges are twice as valuable as apples in a market economy. A final important function of money is as a standard for deferred payments, borrowing and lending.
- Suppose that the Bank of Canada sells $2 billion of bonds on the open market. Use the Keynesian transmission mechanism to explain fully how this sale will reduce GDP by $40 billion if the money multiplier is 4 and the income multiplier with respect to the money supply is 5.
The Keynesian transmission mechanism explains how changes in the money supply changes income, output, and employment by changing AD. This example is called a tight money policy as it is intended to reduce nominal GDP, inflation, by reducing the money supply. The first step is the Bank of Canada selling bonds. The bond market is open to households, businesses, and banks, as well as the Bank of Canada.
The assumption of the Keynesian model is that currency is withdrawn from the banks to buy the bonds. This reduces the excess reserves of banks by $2b. Since the money multiplier is 4, the total money supply falls by $8. Explain the steps involved in this multiple decrease in the money supply with an example. This is a key part of your answer. This decline in the money supply increases the interest rate, both from the price of bonds falling because of the sale of bonds and the fall in excess reserves reducing loans, which reduces both investment and consumption. The fall in C+I reduces AD=C+I+G+NX. The fall in AD reduces GDP. Since the income multiplier with respect to the money supply is 5, the fall in income is 8*5=$40b. Explain the steps involved in this multiple decrease. This is the second key part of your answer.
- Explain fully why the Monetarist School claims that monetary policy is stronger than fiscal policy in stabilizing the economy to reduce recessions and inflations.
Both policies stabilize the economy by changing AD. Fiscal policy changes AD by changing taxes and government spending. Monetary policy changes the money supply, which changes AD by changing the interest rate. There are two key points to the monetarist argument against fiscal policy. The first is that changes in AD are very sensitive to changes in the interest rate. This works in favour of monetary policy but against fiscal policy. Let us use the example of a recession. An easy money policy will lower the interest rate. This will cause a significant increase in AD if changes in AD are very sensitive to changes in the interest rate.
The second part of the Monetarist argument is the crowding-out effect. To fight a recession, an expansionary fiscal policy creates a budget deficit, which increases borrowing by the federal government. This increased borrowing pushes up the interest rate. Assuming that changes in AD are very sensitive to changes in the interest rate, the fall in AD is significant and will largely offset the increased AD caused by the expansionary fiscal policy. You should try to use both a recession and an inflation to illustrate your answer.
- Implementation of monetary policy is fraught with many pitfalls. One important problem is deciding whether the central bank should target the money supply or target the interest rate. Assuming that the goal is to reduce inflation, explain the primary concern with each of these two different targets.
Monetary policy encounters many implementation problems. One of these problems has to do with choosing a target money supply or money supply growth rate, versus choosing an interest rate target. Both of these targets are fraught with pitfalls. Fighting inflation requires a tight money policy.
Using a money supply target implies reducing the money supply or the rate of growth of the money supply. The problem is which measure of the money supply should be used as the target: M1, M2, or some other measure? M1, for example, focuses on the medium of exchange function, while M2 focuses on the store of value function of money. If M1 is chosen as the measure of money, a reduction in its value, or its rate of growth, will not reduce the value of M2, or its growth, by the same amount or percent. This applies equally to any other measure of the money supply and also of near-bank money.
Turning to the interest rate target, the problem is that the interest rate is determined by both the supply and demand for money. But the central bank only controls the money supply. An example of an interest rate target may be to increase the interest rate from 4% to 6% to reduce inflation by reducing AD. As the central bank reduces the money supply or the rate of growth of the money supply to reach its 6% interest rate target, the demand for money can change. A fall in money demand will partially offset the fall in the money supply, requiring the central bank to reduce the money supply, or its rate of growth, even further. In like manner, if the demand for money increases, the interest rate target of 6% may be reached without much reduction in the money supply or its rate of growth.
Assignment 3 (10%)
This assignment contributes 10% towards your final course grade.
Answer the following five questions. Each question is worth 20 marks. Your answers should average about half a page per question for a total of about three pages, double spaced.
- Explain fully why an economy can suffer from stagflation. Why is that considered the worst possible macroeconomic problem?
Stagflation is caused by a negative supply shock. The AS curve shifts to the left causing an increase in the price level and a fall in GDP, income, and employment. One of the best examples is the quadrupling of the price of oil in 1973. Generally speaking a negative supply shock is caused by a significant increase in production cost, such as an increase in labour cost across the economy.
The word stagflation combines stagnation with inflation. Since both are bad, this is considered the worst possible outcome for an economy. Compared to a negative demand shock which reduces GDP, income, and employment as well, the price level falls rather than increases. Inflation is therefore moderated by a negative demand shock. The only solution to stagflation is supply-side policies such as tax cuts to increase productivity and shift the AS curve to the right.
- Compare the use of an expansionary fiscal policy in the basic Keynesian model to the use of this same policy based on the Phillips Curve of Chapter 12.
In the standard Keynesian model the price level is constant. An expansionary fiscal policy increase AD by cutting taxes and increasing government spending. This pushes the economy to its full employment output. GDP and income rises while unemployment falls.
The Phillips Curve suggested a trade-off between unemployment and inflation. Policy makers used an expansionary fiscal policy to reduce unemployment by increasing inflation. This was popular with voters because the majority view was that unemployment was far worse than inflation.
Post-Phillips Curve analyses suggested that the trade-off between unemployment and inflation was only temporary because unemployment cannot be reduced permanently below the NRU. The result of an expansionary fiscal policy will be a temporary reduction in unemployment but a permanent increase in inflation. This is one of many examples of short-run gain for long-term pain. See Figure 12.2 on page 275 of the textbook.
- Even though the ideas implicit in the Phillips Curve were derived from long-run data from the British economy, it turned out that the trade-off between unemployment and inflation implied by the Phillips Curve was a short-run phenomenon. This implies that using an expansionary fiscal policy produces long-term pain for short-term gain. This was the accepted economic theory in the 1970s. With that in mind, why do you think politicians in most democracies during the 1970s, including Canada and the U.S., opted for the short-term gain despite being aware of the long-term pain?
There are several parts to the answer to this question. Firstly, Western democracies often sacrifice sound economic policies for political expediency. The standard argument by most politicians is that they must first win over voters with popular promises before they can implement efficient but unpopular policies. As a result they focus on the next election. This is only one of many examples of policies which bring short-term gain but long-term pain. Winning the vote takes precedence over unpopular long-term solutions to fundamental economic problems.
Secondly, there is much misinformation on what the NRU is for a given country, as its difficult to measure and varies from one country to another. The best estimate for Canada is 6.5%. It is somewhat lower for the US. Most voters have no idea that the unemployment rate cannot be reduced permanently below the NRU. It would be political suicide for any government in Canada to be honest with Canadian voters and publicly announce that they have to live with an unemployment rate of at least 6.5%.
Finally, given the uncertainties associated with estimating the NRU, if the current unemployment rate happens to be above the NRU, an expansionary fiscal policy will permanently reduce unemployment by the difference between the actual unemployment rate and the NRU.
- Explain why the Monetarist School uses the slogan that inflation is always a “monetary phenomenon.” Can an economy suffer from inflation even if the money supply is not increased? Explain fully.
In the Keynesian model, inflation and unemployment are caused by the business cycle. In turn the business cycle is driven by AD. Too little AD creates unemployment and too much AD creates inflation. Since AD can be increased without increasing the money supply, inflation can occur without an increase in the money supply. Furthermore, an increase in the money supply creates inflation only by increasing AD to a level past full employment GDP. It does this by lowering the interest rate.
With the negative supply shock caused by the quadrupling of the price of oil in 1973, cost-push inflation was acknowledged by economists. This is another way in which inflation can be caused without an increase in the money supply. Any widespread increase in production cost can cause cost-push inflation.
The Monetarist School acknowledges these non-monetary causes of inflation but regards them as short-run only. According to the Monetarist School, inflation can only persist in the long-run if the rate of increase of the money supply exceeds the rate of growth of real GDP. They rationalize this explanation as follows. Inflation increases the demand for money, which increases the interest rate. This increase in the interest rate will reduce AD, which will reduce the inflation. However, if the money supply increases to meet the increased money demand, the inflation will persist.
- Explain fully how an easy money policy can lower the interest rate in the short-run but increase the interest-rate in the long-run. Be sure to distinguish between real and nominal interest rates.
The Fed increases the money supply by buying bonds. This increases the price of bonds, which lowers the interest rate. In addition, buying bonds injects excess reserves into the banks. The banks must lower the cost of borrowing to attract additional borrowers.
The lower interest rate increases AD, which increases inflation as the economy moves closer to full employment GDP. If AD increases past full employment GDP, the inflation rate increases. After some period of inflation, inflation-expectation increases. This increases the nominal interest rate. It’s the nominal not the real interest rate which rises in the long-run. The real cost of funds is the same but lenders need to be compensated for higher inflation expectation.
Assignment 4 (10%)
This assignment contributes 10% towards your final course grade.
Answer the following five questions. Each question is worth 20 marks. Your answers should average about half a page per question for a total of about three pages, double spaced.
- What are the three sources of funding a national debt? Why are they all problematic? Why is foreign debt far more problematic for a country than domestic debt?
The three sources of funding a national debt are:
Printing money. Using this method will increase inflation. Its use has to be limited.
Borrowing from domestic savers. This increases the interest rate, crowds out investment, and reduces economic growth. While it keeps current taxes lower, future taxes will have to be increased to pay interest and re-pay the principal. Since the primary reason for borrowing is that taxes are politically unpopular, this will be very difficult to achieve in democracies. Look at the example of Greece today.
Borrowing from foreigners. A domestic debt means that a country is borrowing from its own citizens. It’s really a transfer of savings from domestic lenders to domestic taxpayers who receive government services but postpone the payment of taxes. To re-pay a domestic debt, taxes are increased and transferred to those who had previously loaned to the government.
A foreign debt means that a country is living beyond its means by using a portion of the GDP of the creditor nation. This is achieved by importing more goods and services from the lender country than exporting goods and services to pay for those imports. To repay this debt some of our future GDP will have to be used. This reduces our future standard of living. This is far more difficult for governments to achieve since taxes and exports have to be increased to send funds to foreigners.
- Explain fully the concept of “Twin Deficits” and use this concept to explain why the cause of the US trade deficit with China is largely due to American wars across the globe.
The “Twin Deficits” refer to a trade deficit caused by a budget deficit. A trade deficit means M>X. A budget deficit means G>T. While these two deficits can occur independent of each other, the term is used where one is dependent on the other. This is the case today with the US and its relationship with those countries from whom it borrows to fund its numerous wars. One of these creditor countries is China.
When a country borrows from other countries it has a surplus in its capital account since there is an inflow of receipts from foreign lenders. This inflow of funds must first purchase $US to lend to the US. This increases the US exchange rate. The increased price of the $US reduces US exports while increasing US imports. This causes a trade deficit.
- Explain how countries like Greece have largely misused the Keynesian model to “buy” votes and how this has created “sovereign debt” problems. In this regard, why can countries like Greece, or US states like California and cities like Detroit, become bankrupt, but countries like the US and Canada can never be bankrupt from too much debt?
The Keynesian model suggested that governments can stabilize the economy to reduce both unemployment and inflation by incurring budget deficits during recessions and budget surpluses during booms. Western politicians quickly learnt that they could “buy” votes in democracies by doing what was popular rather than what was needed for economic stabilization.
Deficits are politically popular since voters love increased government services combined with tax cuts. Voters dislike tax increases and cuts in public services. As a result budget surpluses are politically unpopular. A “sovereign debt” is created by many years of accumulated deficits and interest not matched by surpluses.
The difference between Canada and the US, compared with Greece or US states like California and cities like Detroit, is that Canada and the US can print money in addition to borrowing. Greece cannot print money because it adopted the Euro. US states and cities also cannot print money. When the debt of countries such as Greece, or states like California, or cities like Detroit, become so large that it’s difficult to find lenders, they are forced to declare bankruptcy.
- Why does a flexible exchange rate make monetary policy more effective but fiscal policy less effective?
Monetary policy changes AD by changing the interest rate. An easy money policy is intended to increase AD by reducing the interest rate. This fall in the interest rate causes a capital outflow which depreciates the exchange rate which increases NX. The increased NX further increases AD making the monetary policy more effective. A tight money policy is intended to reduce AD by increasing the interest rate. The increase in the interest rate appreciates the exchange rate, which reduces NX and adds to the reduction in AD.
An expansionary fiscal policy creates a budget deficit which increases borrowing which increases the interest rate. This increase in the interest rate appreciates the exchange rate causing a fall in NX and partially offsets the increase in AD caused by the expansionary fiscal policy. The policy is weakened. A contractionary fiscal policy creates a budget surplus. This reduces borrowing, which reduces the interest rate. The fall in the interest rate increases NX, which partially offsets the fall in AD caused by the contractionary fiscal policy. This weakens the policy.
- Explain the difference between a trade deficit, a current account deficit, and a balance of payments deficit. Explain fully why a current account deficit can be good for a country.
The balance of trade is typically the largest single component of the current account. It deals exclusively with the import and export of goods and services. A trade deficit means that in a given year the total value of imports of goods and services exceeds the total value of exports of goods and services. The current account includes many other components such as travel, interest, dividends, immigrant funds, foreign aid, and rental income. Each of these components will have receipts and payments. If the total payments for the year, including the payment for imports of goods and services, exceeds the total receipts for the year, including the receipts from the exports of goods and services, there is a current account deficit.
The balance of payments combines the current account with the capital account. Capital inflows from borrowing are receipts, and capital outflows from lending are payments. If these inflows exceed the outflows, there is a capital account surplus. If this surplus is less than the current account deficit, there is a deficit in the balance of payments. Many other combinations of the two accounts can produce a deficit in the balance of payments. Typically, such deficits will be small because deficits in either account are matched by surpluses in the other account.
A deficit in the current account implies that the country has to borrow. If the borrowing is for capital investment and economic growth, this usually benefits the country. A current account deficit is not good if it leads to borrowing to fund wars, as in the case of the US, or to fund current consumption, as in the case of Greece. Think of the difference between a corporation borrowing to fund its expansion and growth compared with a consumer borrowing on his/her credit cards to fund current consumption.
