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2 INTRODUCTION EY TERMS U-27 3 Organisation for Economic Cooperation and merging economies 10 Development (OECD) 10 RICS 10 QUICK CHECK 1, Using the information in this chapter, label each of the following statements true, false or uncertain. Explain briefly. 2. The unemployment rate in the USA increased consider- ably at the end of the last decade, but it is still substan- tially lower than the unemployment rate in Europe. b. ln the 1960s and early 19705, the USA had a higher rate of unemployment than Europe, but at the time of writing ithas a much lower rate of unemploymernt. <. After the turn of the millennium, European countries experienced a slowdown in output growth. d. The BRICs all experienced very high growth rates of outputin the past two decades and stable inflation. e. China's growth has contributed to half of word growth during the recession which started in 2008, and itis likely to become a new engine of world growth in the future, mm : The European “unemployment miracle” refers to the extremely low rate of unemployment that Europe has been enjoying since the 1980s. Income per capita in the euro area has declined com- pared to the USA since 1970, and this is true for ali the largest member countries. h. Even though the USA is the richest country in the world, it borrows hundreds of billions of dollars annually from the rest of the world. E 2. Macroeconomic policy in Europe Beware of simplistic answers (0 complicated macroeconomic questions. Consider each of the following statements and com- ment on whether there is another side to the story. a. There is a simple solution to the problem of high Euro- pean unemployment: reduce labour market rigidities. b. What can be wrong about joining forces and adopting a common currency? The euro is obviously good for Europe. 3. Productivity growth in China Productivity growth is at the heart of recent economic develop- ments in China. a. How has China achieved high rates of productivity growth in recent decades? UESTIONS AND PROBLEMS . Has Europe achieved high rates of productivity growth in International Monetary Fund (IMF) 41 the past decade? . To what degree do you think China's methods of achiev- ing productivity growth are relevant to Europe? . Do you think China's experience provides a model for developing countries to follow? DIG DEEPER 4, Productivity growth in the USA The average annual growth rate of output per worker in the USA rose from 1.8% during the period 1970-1995 to 2.8% for the years 1996-2006. This has led to talk of a New Economy and of sustained higher growth in the future than in the past. . Suppose output per worker grows at 1.8% per year. What will output per worker be — relative to today's level — in 10 years? 20 years? 50 years? . Suppose output per worker grows instead at 2.8% per year. What will output per worker be - relative to today's level —in 10 years? 20 years? 50 years? . Yf the USA has really entered a New Economy, and the average annual growth tate of output per worker has increased from 1.8% per year to 2.8%, how much higher will the US standard of living be in 10 years, 20 years and 50 years relative to what ¿twould have been had the USA remained in the Old Economy? _Can we be sure the USA has really entered a New Economy, with a permanently higher growth rate? Why or why not? 5. When will Chinese output catch up with US output? In 2008, US output was $14.3 trillion and Chinese output was $4.4 trillion. Suppose that from now on, the output of China grows at an annual rate of 10% per year (roughly what it has done during the past decade), while the output of the grows at an annual rate of 3% per year. a. Using these assumptions and a spreadsheet, plot us and Us. A years Chinese output over the next 100 years. How many yea” will it take for China to have a level of output equal E that of the USA? mi b. When China catches up with the USA in total output, he residents of China have the same standard of living 25 residents? Explain. EXPLOF 6. Post-44 This ques handle tf growth iñ available Finance $ your fav growth re Did any | definitior negative; a. How! 19701 b. How) Y 42 INTRODUCTION KEY TERMS EU-27 3 Organisation for Economic International Monetary emerging economies 10 Cooperation and Fund (IMF) 11 BRICS 10 Development (OECD) 10 QUESTIONS AND PROBLEMS b. Has Europe achieved high rates of productivity growth in the past decade? e. To what degree do you think China's methods of achiev- ing productivity growth are relevant to Europe? QUICK CHECK 4. Using the information in this chapter, label each of the following statements true, false or uncertaii, Explain brief. a. The unemployment rate in the USA increased consider- ably at the end of the last decade, but it is still substan- tially lower than the unemployment rate in Europe. b. In the 19605 and early 19705, the USA had a higher rate of unemployment than Europe, bur at the time of writing it has a much lower rate of unemployment. d. Do you think China's experience provides a model for developing countries to follow? DIG DEEPER 4. Productivity growth in the USA The average annual growth rate of output per worker in the USA rose from 1.8% during the period 1970-1995 to 2.8% for the years 1996-2006. This has led to talk of a New Economy and of sustained higher growth in the future than in the past. a. Suppose Output per worker grows at 1.8% per year. What will output per worker be — relative to today's level - in 10 years? 20 years? 50 years? €. After the turn of the millennium, European countries experienced a slowdown in output growth, d, The BRICs all experienced very high growth rates of output in the past two decades and stable inflation, e, China's growth has contributed to half of world growth during the recession which started in 2008, and it is likely to become a new engine of world growth in the future. b. Suppose output per worker grows instead at 2,8% per year, What will output per worker be - relative to today's level —in 10 years? 20 years? 50 years? f. The European “unemployment miracle refers to the extremely low rate of unemployment that Europe has been enjoying since the 1980s. <. 1f the USA has really entered a New Economy, and the average annual growth rate of output per worker has increased from 1.8% per year to 2.8%, how much higher will the US standard of living be in 10 years, 20 years and 50 years relative to whatitwould have been had the USA remained in the Old Economy? Can we be sure the USA has really entered a New Economy, with a permanently higher growth rate? Why or why not? g. Income per capita in the euro area has declined com- pared to the USA since 1970, and this is true for all the largest member countries. h. Even though the USA is the richest country in the world, it borrows hundreds of billions of dollars annually from. the rest of the world. a 2. Macroeconomic policy in Europe Beware of simplistic answers to complicated macroeconomic questions. Consider each of the following statements and com- h - 5. When will Chinese output catch up with US output? ment on whether there is another side to the story. In 2008, US output was $14.3 trillion and Chinese output was $4.4 trillion. Suppose that from now on, the output of China grows atan annual rate of 10% per year (roughly what it has done during the past decade), while the output of the USA grows at an annual rate of 3% per year. a. There is a simple solution to the problem of high Euro- pean unemployment: reduce labour market rigidities. b. What can be wrong about joining forces and adopting a common currency? The euro is obviously good for Europe. a. Using these assumptions and a spreadsheet, plot US and Chinese output over the next 100 years. How many years will it take for China to have a level of output equal 10 that of the USA? b. When China catches up with the USA in total output, residents of China have the same standard of living 85 residents? Explain. 3, Productivity growth in China Productivity growth is at the heartof recent economic develop- ments in China. a. How has China achieved high rates of productivity growth in recent decades? will Us EXPLORE FURTHER 6. Post-war recessions in Europe This question looks at the recessions of the past 40 years. To handle this problem, first obtain quarterly data on output growth in your country for the period 1970 to the latest year available from the Eurostat website (go to the Economy and Finance Section under Statistics Databases). Copy the data to your favourite spreadsheet program. Plot the quarterly GDP growth rates from 1970 through the more recent available year. Did any quarters have negative growth? Using the standard definition of recessions as two or more consecutive quarters of negative growth, answer the following questions: a. How many rec 1970? b. How many quarters has each recession lasted? sions has the economy undergone since FURTHER READING CHAPTER 1 ATOUR OF THE WORLD 13 e. In terms of length and magnitude, which two recessions have been the most severe? 7. From problem 6, write down the quarters during which the economy has experienced negative output growth since 1970. Go to the Eurostat web page. Retrieve the monthly data series on the unemployment rate for the period 1970 to the most recent year available. Make sure all data series are seasonally adjusted. a. Look ar each recession since 1970. What was the unemployment rate in the first month of the first quarter of negative growth? What was the unemployment rate in the last month of the last quarter of negative growth? By how much did the unemployment rate increase? Ed . Which recession had the largest increase in the rate of unemployment? MyEconLab e This text comes with a web page (www.prenhall.com/ blanchard), which is updated regularly. For each chapter, the page offers discussions of current events, and includes relevant articles and Internet links. You can also use the page to make comments on the text, and engage in discussions with other readers. e The best way to follow current economic events and issues is to read The Economist, a weekly magazine published in England. The articles in The Economist are well informed, well written, witty and opinionated. Make sure to read it regularly. (You may have purchased this book together with a 12-week subscription to the web version of The Economist. Take advantage of this.) INTRODUCTION c. Using the prices for 2007 as the set of common prices, what is real GDP in 2006 and in 2007? By what percent- age does real GDP change from 2006 to 2007? d. Why are the two output growth rates constructed in (b) and (c) different? Which one is correct? Explain your answer. 5. Consider the economy described in problem 4. a. Use the prices for 2006 as the set of common prices to compute real GDP in 2006 and in 2007. Compute the GDP deflator for 2006 and for 2007 and compute the rate of inflation from 2006 to 2007. b. Use the prices for 2007 as the set of common prices to compute real GDP in 2006 and in 2007. Compute the GDP deflator for 2006 and for 2007 and compute the rate of inflation from 2006 to 2007. c. Why are the two rates ofinflation different? Which one is correct? Explain your answer. 6. Consider the economy described in problem 4. a. Construct real GDP for years 2006 and 2007 by using the average price of each good over the two years. b. By what percentage does real GDP change from 2006 to 2007? c. What is the GDP deflator in 2006 and 2007? Using the GDP deflator, what is the rate of inflation from 2006 to 2007? d. 1s this an attractive solution to the problems pointed out in problems 4 and 5 (i.e., two different growth rates and two different inflation rates, depending on which set of prices is used)? (The answer is yes and is the basis for the construction of chained-type deflators. See the appendix to this chapter for more discussion.) DIG DEEPER 7. Hedonic pricing As the second Focus box in this chapter explains, itis difficult to measure the true increase in prices of goods whose charac- teristics change over time. For such goods, part of any price increase can be attributed to an increase in quality. Hedonic pricing offers a method to compute the quality-adjusted increase in prices. a. Consider the case of a routine medical check-up. Name some reasons you might want to use hedonie pricing to measure the change in the price of this service. Now consider the case of a medical check-up for a pregnant woman. Suppose that a new ultrasound method is introduced. In the first year that this method is available, half of doctors offer the new method, and half offer the old method. A check- up using the new method costs 10% more than a check-up using the old method. b. In percentage terms, how much of a quality increase does the new method represent over the old method? (Hint: Consider the fact that some women choose to see a doctor offering the new method, when they could have chosen to see a doctor offering the old method.) Now, in addition, suppose that in the first year the new ultra- sound method is available, the price of check-ups using the new method is 15% higher than the price of check-UpS in the previ- ous year (when everyone used the old method). €. How much of the higher price for check-ups using the new method (as compared to check-ups in the previous year) reflects a true price increase of check-ups and how much represents a quality increase? In other words, how. much higher is the quality-adjusted price of check-ups using the new method as compared to the price of check- ups in the previous year? In many cases, the kind of information we used in parts (b) and (c) is not available. For example, suppose that in the year the new ultrasound method is introduced, all doctors adopt the new method, so the old method is no longer used. In addi- tion, continue to assume that the price of check-ups in the year the new method is introduced is 15% higher than the price of check-ups in the previous year (when everyone used the old method). Thus, we observe a 15% price increase in check-ups, but we realise that the quality of check-ups has increased. d. Under these assumptions, what information required to compute the quality-adjusted price increase of check-ups is lacking? Even without this information, can we say anything about the quality-adjusted price increase of check-ups? ls it more than 15%? Less than 15%? Explain. 8. Measured and true GDP Suppose that instead of cooking dinner for an hour, you decide to work an extra hour, earning an additional €12. You then purchase some (i takeaway) Chinese food, which costs you €10. a. By how much does measured GDP increase? b. Do you think the increase in measured GDP accurately reflects the effect on output of your decision to work? Explain. EXPLORE FURTHER 9. The labour market and the recession of 2007-2012 Go to the Eurostat web page and retrieve the quarterly data al constant prices for your country and for the EU-27. a. Plot the quarterly GDP growth rates from 2005 10 a Did any quarters have negative growth? How did yo! country differ from the average EU-27? Now retrieve the monthly data series on the participation ' e employment, the employment-to-population ratio an unemployment rate for the period 2007-2012, Mi data series are seasonally adjusted. take Sure pi oa ¿pS 58 THE CORE THE SHORT RUN KK ___gq/<— .mber about the components of SUMMARY ” Here's what you should remember about our first model of output d etermination: Here's what yotl should reme: GDP: + GDPis the sum of consumption, investment, government and exports minus spending, inventory investment, d determines production. Produc- Income in turn affects demand. e The consumption function shows how consumprion depends on disposable income. The propensity to E sume describes how much consumption increases or given increase in disposable income. e Equilibrium output is the level of output at which En duction equals demand. In equilibriuma, output equal 5 autonomous spending multíplied by the multiplier. Autonomous spending is that part of demand that does not depend on income. The multplier is equal to 1/(1 —c,), Where C1 is the propensity to consume. e increases in consumer confidence, investment demand and government spending, as well as decreases in taxes, all increase equilibrium output in the short run. e Analternative way of stating the goods-market equilib- rium condition isthat investment must be equal to saving d public saving. For this reason, — the sum of private ani ] Ml the equilibriam condition is called the [S relation (£ for investment, S for saving). e Intheshortrun, deman tion is equal to income, imports. : the purchase of goods and services sumption (C) is pia ss the largest component of by consumers. Consumption i: demand. he stun of non-residential investment= e Investment (1) is t ñ , the purchase of new plants and new machines by firms — - the purchase of new and of residential investment houses or apartments by people. e Government spending (G) is the purchase of goods and services by national, regional and local governments. e Exports (X) are purchases of domestic goods by fot- eigners. Imports (IM) are purchases of foreign goods by resident consumers, firms and the national government. e Inventory investment is the difference berween produc- tion and purchases. It can be positive or negative. KEY TERMS A trade balance 44 endogenous variables 47 econometrics 52 trade surplus 44 trade deficit 44 consumption (C) 43 investment (1) 43 fixed investment 43 exogenous variables 47 dynamics 52 fiscal policy 47 saving 54 ; i 55 rvresidential inventory investment 44 equilibrium 47 private saving (S) non- . , h í -G) 55 investment 43 identity 44 equilibrium in the goods public saving (T— 6) residential investment 43 disposable income (Y) 45 market 48 budget surplus 55 consumption function 45 equitibriam condition 48 budget deficit 55 govemment spending (G) 44 behavioural equation 45 autonomous spending 48 IS relation 55 linear relation 45 balanced budget 49 govemment transfers 44 imports (IM) 44 exports 0) 44 net exports (X- IM) 24 propensity to save (1 cp) 58 paradox of saving 56 parameters 45 propensity to consume (c,) 45 multiplier 49 geometric series 51 QUESTIONS AND PROBLEMS QUICK CHECK 4. Using the information in this chapter, label each of the following statements true, false or uncertain. Explain briefiy. a. The largest component of GDP is consumption. b. Government spending, including transfers, was equal, on average, to 20.9% of GDP in EU-15 in 2008. <. The propensity to consume has to be positive, but other- wise it can take on any positive value. d. Fiscal policy describes the choice of government spending and taxes and is treated as exogenous in our goods market model. e. The equilibrium condition for the goods market states that consumption equals output. £. An increase of one unit in government spending leads to an increase of one unit in equilibrium output. g. An increase in the propensity to consume leads to a decrease in output. 2. Suppose that the economy is characterised by the following behavioural equations: C= 180 +0.8Y, 1=160 G=160 T=120 Solve for the following variables. a. Equilibrium GDP (Y) b. Disposable income (Yp) <. Consumption spending (C) 3. Use the economy described in problem 2. a. Solve for equilibrium output. Compute total demand. Isit equal to production? Explain. b. Assume that Gis now equal to 110. Solve for equilibrium Output. Compute ¿otal demand. ls it equal to production? Explain. E e that G is equal to 110, so output is given by your nswer to (b), Compute private plus public saving. ls the S A ala um of private and public saving equal to investment? Explain, DIG DEEPER 4. The ba o E balanced budget multiplier oth politic A We often pal and macroeconómic reasons, governments Welle eluctant to run budget deficits. Here, we examine Pp Y el , , A der Policy changes in G and T that maintain a balanced Are macroer - "acroeconomically neutral. Put another way, we CHAPTER 3 THE GOODS MARKET 59 examine whether it is possible to affect output through changes in G and T so that the government budget remains balanced. Start from equation (3,8). a. By how much does Y increase when G increases by one unit? b. By how much does Y decrease when T increases by one unit? c. Why are your answers to (a) and (b) different? Suppose that the economy starts with a balanced budget: G=T. If the increase in G is equal to the increase in T, then the budget remains in balance. Let us now compute the balanced budget multiplier. d. Suppose that G and T increase by one unit each. Using your answers to (a) and (b), what is the change in equi- librium GDP? Are balanced budget changes in G and T macroeconomically neutral? e. How does the specific value of the propensity to consume affect your answer to (a)? Why? 5. Automatic stabilisers So far in this chapter, we have assumed that the fiscal policy variables G and T are independent of the level of income. In the real world, however, this is not the case. Taxes typically depend on the level of income and so tend to be higher when income is higher. In this problem, we examine how this automatic response of taxes can help reduce the impact of changes in autonomous spending on output. Consider the following behavioural equations: C=c2+C Y, T=t+t Y Y =Y-T G and 1 are both constant. Assume that t, is between 0 and 1. a. Solve for equilibrium output. b. What is the multiplier? Does the economy respond more to changes in autonomous spending when t, is 0 or when £, is positive? Explain. c. Why is fiscal policy in this case called an automatic stabiliser? 6. Balanced budget versus automatic stabilisers It is often argued that a balanced budget amendment would actually be destabilising. To understand this argument, con- sider the economy of problem 5. a. Solve for equilibrium output. b. Solve for taxes in equilibrium. ¡DO THE CORE THE SHORT RUN Suppose that the government starts with a balanced budget and that there is a drop in Cp. e. What happens to Y? What happens to taxes? d. Suppose that the government cuts spending in order to keep the budget balanced. What will be the effect on Y? Does the cut in spending required to balance the budget counteract or reinforce the effect of the drop in cy on output? (Don't do the algebra. Use your intuition and give the answer in words.) 7. Taxes and transfers Recall that we define taxes, T, as net of transfers. In other words, T = taxes - transfer payments a. Suppose that the government increases transfer payments to private households, but these transfer payments are not financed by tax increases. Instead, the government borrows to pay for the transfer payments. Show in a diagram (similar to Figure 3.2) how this policy affects equilibrium output. Explain. b. Suppose instead that the government pays for the increase in transfer payments with an equivalent increase in taxes. How does the increase in transfer payments affect equilibrium output in this case? €. Now suppose that the population includes two kinds of people: those with high propensity to consume and those with low propensity to consume. Suppose the transfer policy increases taxes on those with low propensity to consume to pay for transfers to people with high propen- sity to consume. How does this policy affect equilibrium output? d. How do you think the propensity to consume might vary across individuals according to income? In other words, how do you think the propensity to consume compates for people with high incomes and people with low incomes? Explain. Given your answer, do you think tax cuts will be more effective at stimrulating output when they are directed toward high-income or toward low-income taxpayers? x 8. Investment and income This problem examines the implications of allowing investment to depend on output. Chapter 5 carries this analysis much further and introduces an essential relation — the effect of the interest rate on investment — not examined in this problem. a. Suppose the economy is characterised by the following behavioural equations: C=Cp+C1Yp Y)=Y-T 1=b,+b,Y Government spending and taxes are constant. Note that investment now increases with output. (Chapter 5 dis- eusses the reasons for this relation.) Solve for equilibrium ouiput. b. Whatis the value ofthe multiplier? How does the relation between investment and output affect the value of the multiplier? For the multiplier to be positive, what condi- tion must (c, + b,) satisfy? Explain your answers. c. Suppose that the parameter by, sometimes called busi- ness confidence, increases. How will equitibrium output be affected? Will investment change by more or less than the change in b,? Why? What will happen to national saving? EXPLORE FURTHER 9. The paradox of saving revisited You should be able to complete this question without doing any algebra, although you may find making a diagram helpful for part (a). For this problem, you do not need to calculate the magnitudes of changes in economic variables — only the direc- tion of change. a. Consider the economy described in problem 8, Suppose that consumers decide to consume less (and therefore to save more) for any given amount of disposable income. Specifically, assume that consumer confidence (co) falls. What will happen to output? b, As a result of the effect on output you determined in part (8), what will happen to investment? What will happen to public saving? What will happen to private saving? Explain. (Hint: Consider the saving-equals-investment characterisa- tion of equilibrium.) What is the effect on consumption? c. Suppose that consumers had decided to increase con sumption expenditure, so that cy had increased. What would have been the effect on output, investment and private saving in this case? Explain. Whar would have been the effect on consumption? d. Comment on the following logic: When output is 100 low, what is needed is an increase in demand for goods and services. Investment is one component of demant> and saving equals investment. Therefore, if the govem” ment could just convince households to attempt 10 sa more, then investment, and output, would increase: PmyEconias] > —_- E e 80 THECORE THE SHORT RUN QUESTIONS AND PROBLEMS QUICK CHECK 4. Using the information in this chapter, label each of the following statements true, false or uncertain. Explain briefty. a. Income and financial wealth are both examples of stock variables. b. The term investment, as used by economists, refers to the purchase of bonds and shares of stock. c. The demand for money does not depend on the interest rate because only bonds earn interest. About two-thirds of US currency is held outside the USA. e. The central bank can increase the supply of money by selling bonds in the bonds market. ES m - The central bank can determine the money supply, but it cannot determine interest rates because interest rates ate determined in the private sector. g. Bond prices and interest rates always move in opposite directions. h. Since the Great Depression, the USA has used federal deposit insurance to deal with bank runs. 2. Suppose that a person's yearly income is ES0,000. Also suppose that this person's money demand function is given by mM? =€Y(0.30-1) a. What is this person's demand for money when the inter- est rate is 5%? 10%? b. Explain how the interest rate affects money demand. e. Suppose that the interest rate is 10%. In percentage terms, what happens to this person's demand for money if her yearly income is reduced by 50%? d. Suppose that the interest rate is 5%. In percentage terms, what happens to this person's demand for money if her yearly income is reduced by 50%? e. Summarise the effect of income on money demand. In percentage terms, how does this effect depend on the interest rate? 3. Consider a bond that promises to pay €100 in one year. a. What is the interest rate on the bond ifits price today is €75? €85? €95? b. What is the relation between the price of the bond and the interest rate? e. If the interest rate is 8%, what is the price of the bond today? 4. Suppose that money demand is given by M1 =eY(0.25-i) where EY is €100, Also, suppose that the supply of money is €20. a. Whatis the equilibrium interest rate? b. 1f the central bank wants to increase i by 10 percentage points (e-g., from 2% to 12%), at what level should it set the supply of money? DIG DEEPER 5. Suppose that Q person's wealth is €50,000 and that her yearly income is €60,000. Also suppose that her money demand function is given by mM? = eY(0.35 -1) a. Derive the demand for bonds. Suppose the interest rate increases by 10 percentage points. What is the effect on the demand for bonds? b. What are the effects of an increase in wealth on the demand for money and the demand for bonds? Explain in words. c. What ate the effects of an increase in income On the demand for money and the demand for bonds? Explainin words. d. Consider the statement “When people earn more money, they obviously will hold more bonds. What is wrong with this statement? 6. The demand for bonds In this chapter, you learned that an increase in the interestrate males bonds more attractive, s0 it leads people to hold more S theirwealth in bonds, as opposed to money. However, you also, learned that an increase in theinterest rate reduces the price y bonds. How can an increase in the interest rate make bonds mole attractive and reduce their price? 7. ATMs and credit cards This problem examines the effect of the introduction dl ATM and credit cards on money demand. For simplicitY: CA examine a person's demand for money over A period Q 3 days. Suppose that before ATMs and credit cards, this person to the bank once at the beginning of each four-day perio withdraws from her savings account all the money * for four days. Assume that she spends €4 per day. gos and he needs gos a. How much does this person withdraw each time she a for to the bank? Compute this person's money hold! days 1 through 4 (in the morning, before she sE of the money she withdraws). pen san 402 THE CORE THÉ SHORT RUN QUESTIONS AND PROBLEMS Now consider the following IS-LM model: QUICK CHECK 4. Using the information in this chapter, label each of the E=0 PIO following statements true, false or uncertain. Explain briefly. I=bp+D,Y bai M/P =d,Y - dal a. The main determinants of investment are the level of sales and the interest rate. jables in the IS relation are con- b. If all the exogenous val stant, then a higher level of output can be achieved only by lowering the interest rate. c. The IS curve is downward sloping because goods market in taxes leads to a equilibrium implies that an increase Í lower level of output. d. If government spending and taxes increase by the same amount, the IS curve does not shift. e. The LM curve is upward sloping because a higher level of the money supply is needed to increase Output. f. An increase in government spending leads to a decrease in investment. g. Government policy can inc the interest rate only if botl b. Solve for equilibrium output. Assume C; + b, < 1. (Hint: You may want to work through problem 2 if you are having trouble with this step.) . Solve for the equilibrium interest rate. relation.) a. Solve for investment. e. Under what conditions On the parameters of the model (i.€., Cu Co and so on) will investment increase when G decreases? (Hint: If G decreases by one unit, by how much does l increase? Be careful: you want the change in Tto be positive when the change in G is negative.) £. Explain the condition you derived in part (e). (Hint: Use the LM 4. Consider the following IS-LM model: C=400+0.25Y, 1= 300 + 0,25Y - 1,500i rease output without changing E monetary and fiscal policy variables change. G=600 2, Consider first the goods market model with constant invest- T= 400 ment that we saw in Chapter 3. Consumption is given by (M/PJ =2Y - 12,0001 M/P=3,000 C=cy+a(Y-T) and I, G and Tare given. a. Solve for equilibrium output. multiplier? let investment depend on both sales and the interest rate: I=by+b,Y - bai a. Derive the IS relation. (Hint: You want an equation with Y on the left side and everything else on the right.) b. Derive the LM relation. (Hint: lt will be convenient for n with ion the left side later use to rewrite this equatio and everything else on the right) . Solve for equilibrium real output, (Hint: Substitute the expression for the interest rate given by the LM equation into the IS equation and solve for output.) d. Solve for the equilibrium interest rate. (Hint: Substitute the value you obtained for Y in part (c) into either well or LM equations and solve for i. If your algebra is correch you should get the same answer from both equation$- . Solve for the equilibrium: values of Cand I, and verify! value you obtained for Y by adding C, 1 and 6. h Now suppose that the money supply increases 10 m/? e 4,320. Solve for Y, i, Cand I, and describe in yrords Y effects of an expansionary monetary policy. eel SetM/P equal to ts initial value of 3,000. Now suppose E government spending increases to G = 840. sumi las the effects of an expansionary fiscal policy on Y, ! an What is the value of the Now o b. Solve for equilibrium output, Ata given interest rate, is us spending bigger the effect of a change in autonomo! than what it was in part (a)? Why? (Assume €, + b,<1) Next, write the LM relation as M/P=dyY - di €. Solve for equilibrium output. (Hint: Eliminate the inter- est rate from the IS and LM relations.) Derive the multi- plier (the effect of a change of one unit in autonomous spending on output). a. 1s the multiplier you obtained in part (c) smaller or larger than the multiplier you derived in part (a)? Explain how your answer depends on the parameters in the behavioural equations for consumption, investment and money demand. he o se DIG DEEPER 5. Investment and the interest rate ely A Paiva. The chapter argues that investment depends 1 gon the interest rate because an increase in the cost 0 3. The response of investment to fiscal policy a. Using the 7S-LM diagram, show the effects on output and the interest rate of a decrease in government spending. Can you tell what happens o investment? Why? oy aida on ng CHAPTER $ GOODS AND FINANCIAL MARKETS: THE 1S-LM MODEL 10 discourages investment. However, firms often finance their investment projects using their own funds. Tf a firm is considering using its own funds (ratherthan borrow- ing) to finance investment projects, will higher interest rates discourage the firm from undertaking these projects? Explain. (Hint: Think of yourself as the owner of a finn that has carned profits and imagine that you are going to use the profits either to finance new investment projects or to buy bonds. Will your decision to invest in new projects in your firm be affected by the interest rate?) 6. The liquidity trap a. Suppose the interest rate on bonds is negative. Will people want to hold bonds or to hold money? Explain. b, Draw the demand for money as a function of the interest rate for a given level of real income. How docs your answer to part (a) affect your answer? (Hint: Show that the demand for money becomes very flat as the interest rate gets very close to zero.) <. Derive the LM curve. What happens to the LM curve as the interest rate gets very close to zero? (Hint: Itbecomes very flat.) d. Consider your LM curve. Suppose that the interest rate is very close to zero, and the central bank increases the supply of money. What happens to the interest rate at a given level of income? e, Can an expansionary monetary policy increase output when the interest rate is already very close to zero? The inability of the central bank to reduce the interest rate when it is already very close to zero is known as the liquidity trap and was first mentioned by Keynes in 1936 in his General Theory — which taid the foundations of the IS-LM model. 7. Policy mixes Suggest a policy mix to achieve each of the following objectives. a. Increase Y while keeping i constant. b, Decrease the fiscal deficit while keeping Y constant. What happens to 1? to investment? 8. The (less paradoxical) paradox of saving A chapter problem atíhe end of Chapter 3 considered the effect Of a drop in consumer confidence on private saving and invest- ment, when investment depended on output but not the inter- £st rate, Here, we consider the same experiment in the context Of the IS-LM framework, in which investment depends on the Interest rate and output. Fl FURTHER READING a. Suppose households attempt to save more, so that con- sumer confidence falls, In an IS-LM diagram, show the effect of the fall in consumer confidence on output and the interest rate. b. How will the fall in consumer confidence affect consump- tion, investment and private saving? Will the attempt to save more necessarily lead to more saving? Will this attempt necessarily lead to less saving? EXPLORE FURTHER 9, Consumption, investment and the recession of 2007-2010 This question asks you to examine the movements of invest- ment and consumption before, during and after the recession 0f2007-2010. Go to the Eurostat website (http: /epp.eurostat. ec.europa.eu/portal/page/portal/eurostat/home/). Find the data on the percentage change in real GDP and its com- ponents and on the contribution of the components of GDP to the overall percentage change in GDP. Investment is more vari- able than consumption, but consumption is much bigger than investment, so smaller percentage changes in consumption can have the same impact on GDP as much larger percentage changes in investment. Note that the quarterly percentage changes are annualised (i,e. expressed as annual rates). Get quarterly data on real GDP, consumption, gross private domestic investment and non-residential fixed investment for the years 2005-2010. a. Identify the quarters of negative growth in 2009 and 2010. b, Track consumption and investment around 2009 and 2010. Which variable had the bigger percentage change around this time? Compare non-residential fixed invest- ment with overall investment. Which variable had the bigger percentage change? €. Get the contribution to GDP growth of consumption and investment for 2008-2010. Calculate the average of the quarterly contributions for each variable for each year. Now calculate the change in the contribution of each variable for 2009 and 2010 (Le. subtract the average contribution of consumption in 2009 from the average contribution of consumption in 2010, subtract the aver- age contribution of consumption in 2009 from the aver- age contribution of consumption in 2010, and do the same for investment for both years). Which variable had the bigger fall in contribution to growth? What do you think was the proximate cause of the recession of 2007-2010? (Was ita fall in investment demand or a fall in consumption demand?) MyEconLab > For a discussion of the liquidity trap', see “Krugman Liquidity Trap vs Roche BSR' on YouTube. 5. Eliminating a trade deficit a. Consider an economy with a trade deficit (NX < 0) and with output equal to its natural level. Suppose that, even though output may deviate from its natural level in the short run, ít returns to its natural level in the medium run. Assume that the natural level is unaffected by the real exchange rate. Whar must happen to the real exchange rate over the medium run to eliminate the trade deficit (L.e., to increase NX to 0)? b. Now write down the national income identity. Assume again that output returns to its natural level ín the medium run. If NX increases to O, what must happen to domestic demand (C +1+G) in the medium run? What government policies are available to reduce domestic demand in the medium run? Identify which components of domestic demand each of these policies affect. EXPLORE FURTHER 6. Retrieve the nominal exchange rates between Japan and the USA from the Internet. A useful and free Canadian site that allows you to construct graphs online is the Pacific Exchange Rate Service (http: /fx.sauder.ubc.ca), provided by Werner Antweiler at the Sauder School of Business, University of British Columbia. a. Plot the yen versus the dollar since 1979. During which time period(s) did the yen appreciate? During which period(s) did the yen depreciate? FURTHER READING CHAPTER 6 THE /S-1.4 MODEL IN AN OPEN ECONOMY 135 b. Given the current Japanese slump (although there are some encouraging signs at the time of writing), one way of increasing demand would be to make Japanese goods more attractive. Does this require an appreciation or a depreciation of the yen? c. What has happened to the yen during the past few years? Has it appreciated or depreciated? Is this good or bad for Japan? 7. Saving and investment throughout the world Retrieve the most recent World Economic Outlook (WEO) from. the website of the International Monetary Fund (www.imf.org). Tn the Statistical Appendix, find the table titled “Summary of Sources and Uses of World Saving”, which lists saving and investment (as a percentage of GDP) around the world. Use the data for the most recent year available to answer parts (a) and (b). a. Does world saving equal investment? (You may ignore small statistical discrepancies.) Offer some intuition for your answer, bh. How does US saving compare to US investment? How is the USA able to finance its investment? (We explain this explicitly in the next chapter, but your intuition should help you figure it out now.) MyEconLab e Tf you want to learn more about international irade and international economics, read the very good textbook by Paul Krugman and Maurice Obstfeld, International Economics, Theory and Policy (New York: Pearson Addison- Wesley, 7th edn, 2007). If you want to know current exchange rates between nearly any pair of currencies in tfte world, look at the currency con- Verter at www,oanda.com. e A good discussion of the relation among trade deficits, budget deficits, private saving and investment is given in Barry Bosworth, Saving and Investment in a Global Economy (Washington, DC: Brookings Institution, 1993). e A good discussion of the US trade deficit and its implications for the future is given in William Cline, The United States as a Debtor Nation (Washington, DC: Peterson Institute, 2005). be my hat use s- hat We we CHAPTER 7 OUTPUT, THE INTEREST RATE AND THE EXCHANGE RATE “5 SUMMARY e In an open economy, the demand for domestic goods is equal to the domestic demand for goods (consumption, plus investment, plus government spending) minus the value of imports (in terms of domestic goods), plus exports. e In an open economy, an increase in domestic demand leads to a smaller increase in output than it would in a closed economy because some of the additional demand falls on imports. For the same reason, an increase in domestic demand also leads to a deterioration of the trade balance, e An increase in foreign demand leads, as a result of increased exports, to both an increase in domestic output and an improvement of the trade balance. e Because increases in foreign demand improve the trade balance and increases in domestic demand worsen the KEY TERMS trade balance, countries might be tempted to wait for increases in foreign demand to move them out of a reces- sion. When a group of countries is in recession, coordina- tion can, in principle, help them get out of it, e If the Marshall-Lerner condition is satisfied — and the empirical evidence indicates that it is — a real deprecia- tion leads to an improvement in net exports. e A real depreciation leads first to a deterioration of the trade balance, and then to an improvement. This adjust- ment process is known as the J-curve. e The condition for equilibrium in the goods market can be tewritten as the condition that saving (public and private) minus investment must be equal to the trade balance, A trade surplus corresponds to an excess of saving over investment. A trade deficit corresponds to an excess of investment over saving. demand for domestic Marshall-Lerner goods 138 condition 143 domestic demand for J-curve 146 goods 138 QUESTIONS AND PROBLEMS QUICK CHECK 1. Using the information in this chapter, label each of the following statements true, false or uncertain. Explain briefly. a, The current US trade deficit is the result of unusually high investment, not the result of a decline in national saving. 154 The national income identity implies that budget deficits cause trade deficits, + Opening the ecanomy to trade tends to increase the Multiplier because an increase in expenditure leads to More exports. E Tf the trade deficit is equal to zero, then the domestic demand for goods and the demand for domestic goods are equal. Pp A real depreciation leads to an immediate improvement ln the trade balance. Á small open economy can reduce its trade deficit rough fiscal contraction at a smaller cost in output than “an a large open economy. The current high US trade deficit is solely the result of a Teal appreciation of US goods between 1995 and 2002. qe flexible exchange rates 153 fixed exchange rates 153 devaluation 153 depreciation 153 revaluation 153 appreciation 153 2. Real and nominal exchange rates and inflation Using the definition of the real exchange rate (and Proposi- tions 7 and 8 in Appendix 1 at the end of the book), you can show that : In words: the percentage real appreciation equals the percent- age nominal appreciation plus the difference between domestic and foreign inflation. a. If domestic inflation is higher than foreign inflation, but the domestic country has a fixed exchange rate, what happens to the real exchange rate over time? Assume that the Marshall-Lerner condition holds. What happens to the trade balance over time? Explain in words. b. Suppose the real exchange rate is constant — say, at the level required for net exports (or the current account) to equal zero. In this case, if domestic inflation is higher than foreign inflation, what must happen to the nominal exchange rate over time?