EC Intermed Macroeconomics: Problem Set 1 – Econ 225, Sections 002 and 003. Q&A

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Problem Set 1 – Econ 225, Sections 002 and 003 Chapter 5 – Questions 6, 7, 9 6) The Bush-Greenspan Policy Mix: in 2001, the Fed pursued a very expansionary monetary policy. At the same time, President George W. Bush pushed through legislation that lowered income taxes. a) Illustrate the effect of such a policy mix on output.

By lowering income taxes, consumptions increases therefore the output increases as well.

Decrease in T shifts the IS curve to the right. An expansionary monetary policy means that M will be increased, an increase in M would shift LM curve down, therefore brining the interest rate down. Overall output increases. b) Describe how this policy mix differs from the Clinton-Greenspan mix (described earlier in chapter 5) – illustrate the effects of this in a separate IS/LM diagram.

Clinton-Greenspan policy included a contractionary fiscal policy that would shift IS left and an expansionary monetary policy which would shift LM curve down. c) What happened to output in 2001? How do you reconcile the fact that both fiscal and monetary policies were expansionary with the fact that growth was so low in 2002? Illustrate the effect of this in an IS/LM diagram.

In 2001 there was a recession which was caused by a decrease in investment spending and then later on there was a decline in the stock market. The expansionary monetary and fiscal policies were supposed to decrease the effect of the recession by unfortunately they were applied too late and the recession was unavoidable.

7) Policy Mixes – suggest a policy mix to achieve each of the following objectives: a) Increase Y while keeping i constant.

Increase in G or decrease in T would shift IS curve to the right and then increase in M would shift the LM curve down and therefore the output is increased while the interest rate stayed the same. b) Decrease the fiscal deficit while keeping Y constant. What happens to i? To investment?

In order to achieve this state we should reduce government spending or increase taxes which would shift the IS curve to the left. Then we should increase M which would shift the LM curve down. The interest rate would fall and since the interest rate fell the investment would increase. And the output stayed the same.

9) The Clinton-Greenspan policy mix: As described in this chapter, during the Clinton administration the policy mix changed toward more contractionary fiscal policy and more expansionary monetary policy. This question explores the implications of this change in the policy mix, both in theory and fact. a) Suppose G falls, T rises, and M increases, and that this combination of policies has no effect on output. Show the effects of these policies in an IS/LM diagram. What happens to the interest rate? What happens to investment?

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Well the decrease in G and an increase in T would shift LS curve to the left. The increase in M would shift the LM curve down. Therefore the interest rate would fall and therefore investment would increase. b) Go to the website Economic Report of the President (www.gpoaccess.gov/eop). Look at Table B-79 in the statistical appendix. What happened to federal receipts (tax revenues), federal outlays, and the budget deficit as a percentage of GDP over the period 1992 to 2000? (Note that federal outlays include transfer payments, which would be excluded from variable G, as we define it in our IS/LM model. Ignore the difference.)

Receipts rose, outlays fell and the budget deficit fell as well. c) The Federal Reserve Board of Governors posts the recent history of the federal funds rate at http://www.federalreserve.gov/releases/h15.data.htm. You will have to choose to look at the rate on a daily, weekly, monthly, or annual interval. Look at the years between 1992 and 2000. When did monetary policy become more expansionary?

In September 4,1992 the FFR was 3 % then it started increasing until February 1, 1995 when it hit 6% and then until the year of 2000 it was playing between 5 and 6 going up and down by basic 25 points. Between those years the lost it got was 4.75 in November 17, 1998. d) Go to table B-2 of the Economic Report of the President and collect data on real GDP and real gross domestic investment for the period 1992 and 2000. Calculate investment as a percentage of GDP for each year. What happened to investment over this period?

In 1992 the investment was 12.1% of GDP and it was increasing during that period until it reached 17.7% in 2000 e) Finally, go to Table B-31, and retrieve data on real GDP per capita (in chained 2005 dollars) for the period. Calculate the growth rate for each year. What was the average annual growth rate over the period 1992 to 2000? How did growth between 1992 and 2000 compare to the Post World War II average (2.6%)?

For the period of 1992-2000 the average annual growth rate of GDP per person was 2.49%. The second half of this period was definitely better than the first half, because the first half of the period the average annual growth rate was about 2% and the second half it was about 3%.

Chapter 6 – Question 5

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5. Bargaining Power and Wage Determination – Even in the absence of collective bargaining, workers do have some bargaining power that allows them to receive wages higher than their reservation wage. Each worker’s bargaining power depends both on the nature of the job and on the economy-wide labor market conditions. Let’s consider each factor in turn. a) Compare the job of a delivery person and a computer network administrator. In which of these jobs does a worker have more bargaining power? Why? Well a computer network administrator would have much more bargaining power than delivery person would, because: 1) delivery person does not require a lot of training for that job 2) it would be much harder to replace computer network administrator than a delivery person. b) For any given job, how do labor market conditions affect a worker’s bargaining power? Which labor market variable would you look at to assess labor-market conditions?

There are many factors that can affect the bargaining power but one of the most important ones is the unemployment rate. If unemployment rate gets too high it is very easy for a company to find a replacement for a particular job than when the unemployment rate is low. Therefore, when the unemployment rate is high the bargaining power is low and vice versa. c) Suppose that for given labor-market conditions [the variables you identified in part (b)], worker bargaining power throughout the economy increases. What effect would this have on the real wage in the medium run? What effect would this have on the real wage in the medium run? In the short run? What determines the real wage in the model described in this chapter?

The real wage in this model is given by the price-setting relations (which is w/p=1/ (1+u)).

Chapter 7 – Question 6 6. Suppose that the interest rate has no effect on investment. a) Can you think of a situation in which this might happen?

Maybe a country just came out of a huge recession and the companies are not feeling very comfortable about borrowing money or investing at any interest rate b) What does this imply for the slope of the IS curve?

Well since the interest rate has no effect on investment that would mean that the IS curve is vertical because the interest rate would not affect the output. c) What does imply for the slope of the LM curve?

LM curve would not be affected by this. d) What does this imply for the slope of the AD curve?

Not sure.. would it be a vertical line?

Continue to assume that the interest rate has no effect on investment. Assume that the economy starts at the natural level of output. Suppose there is a shock to the variable z, so that the AS curve shifts up.

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e) What is the short-run effect on output and the price level?

Not sure f) What happens to output and the price level over time? Explain in words.

Would AS curve shift up.

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