Type:
Solution Manual
Resource:
Macroeconomics Policy and Practice
Edition:
2nd Edition
Author(s):
Frederic S. Mishkin
Online Instructor’s Manual By
Frederic S. Mishkin Columbia University
Martin Pereyra University of Missouri For
Macroeconomics: Policy and Practice Second Edition
Frederic S. Mishkin Columbia University
Contents Chapter 1
The Policy and Practice of Macroeconomics ..............................................................
1
Chapter 2
Measuring Macroeconomic Data ................................................................................
13
Chapter 3
Aggregate Production and Productivity ......................................................................
23
Chapter 4
Saving and Investment in Close and Open Economies ...............................................
32
Chapter 5
Money and Inflation ....................................................................................................
44
Chapter 6
The Sources of Growth and the Solow Model ............................................................
57
Chapter 7
Drivers of Growth: Technology, Policy, and Institutions ...........................................
71
Chapter 8
Business Cycles: An Introduction ...............................................................................
81
Chapter 9
The IS Curve ...............................................................................................................
89
Chapter 10
Monetary Policy and Aggregate Demand ...................................................................
97
Chapter 11
Aggregate Supply and the Phillips Curve ...................................................................
109
Chapter 12
The Aggregate Demand and Supply Model ................................................................
120
Chapter 13
Macroeconomic Policy and Aggregate Demand and Supply Analysis .......................
136
Chapter 14
The Financial System and Economic Growth .............................................................
152
Chapter 15
Financial Crises and the Economy ..............................................................................
162
Chapter 16
Fiscal Policy and the Government Budget ..................................................................
174
Chapter 17
Exchange Rates and International Economic Policy ...................................................
190
Chapter 18
Consumption and Saving ............................................................................................
205
Chapter 19
Investment ...................................................................................................................
220
Chapter 20
The Labor Market, Employment, and Unemployment ...............................................
230
Chapter 21
The Role of Expectations in Macroeconomic Policy ..................................................
240
Chapter 22
Modern Business Cycle Theory ..................................................................................
251
Epilogue
Policy and Practice: Where Do Macroeconomists Agree and Disagree? ....................
259
Web Chapter
Financial Crises in Emerging Market Economies .......................................................
261
.
Web Chapter Financial Crises in Emerging Market Economies ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline Dynamics of Financial Crises in Emerging Market Economies Stage One: Initiation of Financial Crisis Stage Two: Currency Crisis Stage Three: Full-Fledged Financial Crisis Application: Crisis in South Korea, 1997–1998 Financial Liberalization/Globalization Mismanaged Perversion of the Financial Liberalization/Globalization Process: Chaebols and the South Korean Crisis Stock Market Decline and Failure of Firms Increase Uncertainty Adverse Selection and Moral Hazard Problems Worsen and Aggregate Demand Falls Currency Crisis Ensues Final Stage: Currency Crisis Triggers Full-Fledged Financial Crisis Recovery Commences Application: The Argentine Financial Crisis, 2001–2002 Severe Fiscal Imbalances Adverse Selection and Moral Hazard Problems Worsen Bank Panic Begins Currency Crisis Ensues Currency Crisis Triggers Full-Fledged Financial Crisis Recovery Begins Policy and Practice: Preventing Emerging Market Financial Crises Beef Up Prudential Regulation and Supervision of Banks Encourage Disclosure and Market-Based Discipline Limit Currency Mismatch Sequence Financial Liberalization
Overview and Teaching Tips This Web chapter is for instructors who want to have a more international orientation of their courses. It extends the analysis in Chapter 15 on financial crises to economies that are just entering the world marketplace. The analysis is parallel to that in Chapter 15, with Figure W.1, which is similar to Figure 15.1, outlining the dynamics of financial crises in emerging market economies. Then the chapter takes
.
262
Mishkin • Macroeconomics: Policy and Practice, Second Edition
students through two detailed applications, South Korea in 1997–1998 and Argentina in 2001–2002, to illustrate how useful the analysis in the chapter is. I have found that my students particularly enjoy the discussion of the crazy government policies that promote financial crises in emerging market countries, and I spend a lot of time on this in the case on South Korea because the perverse policies to help out the chaebols, who had enormous influence on South Korean politics. Similarly, I spend a lot of time in the case on Argentina discussing how severe fiscal imbalances led to policies that encouraged banks to take on government debt, which eventually was to be their downfall. Once the case discussions are finished, students can use the material at the end of the chapter to debate differing policies to prevent future emerging market financial crises. They also enjoy the global box on the Icelandic financial crisis because it illustrates how advanced economies can find themselves in similar circumstances to emerging market economies and be subjected to the enormous costs of financial crises.
◼
Answers to End-of-Chapter Questions
1. Mismanagement of financial liberalization or financial globalization that leads to excessive risk taking by financial institutions that eventually blows up and leads to a financial crisis. The second cause is severe fiscal imbalances that lead to a sovereign debt crisis that ends up destroying the balance sheets of financial institutions, which then leads to a financial crisis. 2. If financial liberalization and globalization are not done properly, financial institutions have tremendous incentives to take on risk and a lending boom ensues. When the lending boom crashes, it destroys the balance sheets of financial institutions, which hinders their ability to do financial intermediation, which increases moral hazard and adverse selection problems, so financial markets seize up. In addition, the destruction of financial institutions’ balance sheets makes it difficult for a country’s central bank to raise interest rates, and this can lead to a currency crisis, which then precipitates a financial crisis. 3. Severe fiscal imbalances can result in governments encouraging financial institutions to buy the government debt. Then when the government is unable to repay the debt, financial institutions suffer substantial losses. The resulting destruction of their balance sheets hinders the ability of financial institutions to do financial intermediation, which increases moral hazard and adverse selection problems, so financial markets seize up. In addition, the destruction of financial institutions’ balance sheets makes it difficult for a country’s central bank to raise interest rates, and this can lead to a currency crisis, which then precipitates a financial crisis. 4. A rise in interest rates as a result of rising interest rates abroad increases moral hazard and adverse selection problems, while a collapse in the stock market decreases the net worth of firms, which also increases moral hazard and adverse selection problems. Failures of prominent financial firms also increase uncertainty and makes asymmetric information worse, again increasing adverse selection and moral hazard problems. All of these contribute to financial markets seizing up and thus help promote financial crises. 5. Deterioration in bank balance sheets makes it difficult for central banks to raise interest rates to defend the currency because if they do so it will make banks worse off. Once speculators recognize this, they have a one-way bet and will start selling off the currency, which can result in a collapse of the currency and a currency crisis. Severe fiscal balances, besides leading to a deterioration of bank balance sheets if a sovereign debt crisis occurs, can also contribute directly to a currency crisis,
.
Web Chapter
Financial Crises in Emerging Market Economies
263
because once investors in the government debt suspect they will not be paid back, they will sell off the currency, which can trigger a currency crisis. 6. With debt contracts denominated in foreign currency, the debt burden of domestic firms increases when there is an unanticipated decline in the value of the domestic currency. Because assets are typically denominated in domestic currency, there is a resulting deterioration in firms’ balance sheets and a decline in net worth, which then increases adverse selection and moral hazard problems. The increase in asymmetric information problems leads to a decline in investment and economic activity. 7. The financial crises increased financial frictions sharply, which caused the aggregate demand curve to shift sharply to the left. In addition, the currency crisis which led to a collapse in the value of the domestic currency increased the cost of imports, thereby shifting the short-run aggregate supply curve upward. The result was a rise in inflation and a sharp decline in output. 8. They can put in place regulations to increase the amount of bank capital so banks have a greater cushion if they suffer loan losses and also have greater incentives to pursue safer investments because they have more to lose. Prudential supervision can also encourage banks to have better risk management, which will make excessive risk-taking less likely. Emerging market countries can also devote more resources to bank supervisors, so they are able to effectively monitor banks to keep them from taking on too much risk. All of these steps would make banks more able to withstand negative shocks and would reduce risk taking, thereby making the likelihood of a banking and a financial crisis much lower. 9. Emerging market countries can adopt regulations or impose taxes that restrict businesses from borrowing in foreign currencies. Prudential regulation and supervision of banks can limit them from borrowing in foreign currencies. Moving to a flexible exchange rate system reveals the risk of borrowing in foreign currencies, and so less foreign-currency borrowing may then result. Monetary policy that promotes price stability will make it more desirable to borrow in domestic currency, making currency mismatch less likely. 10. Emerging market countries might want to implement financial liberalization and globalization gradually because this would give them time to set up better prudential regulation and supervision to limit risk taking by financial institutions.
◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Application: Crisis in South Korea: 199 –1998 Data Source Federal Reserve Bank of St. Louis database (FRED):
http://research.stlouisfed.org/fred2/series/BPBLTD01KRQ637S?cid=32286. Here you can find data about South Korea’s current account balance (exports minus imports). Change the graph dates (click “Edit Graph”) to 1995 to 1999 and compare it with Figure W.7 in the web chapter. Note that the current account balance improves sharply as the won depreciates, thereby contributing to South Korea recovery from the crisis.
.
264
Mishkin • Macroeconomics: Policy and Practice, Second Edition
Related Article Hahm, Joon Ho and Frederic S. Mishkin, “Causes of the Korean Financial Crisis: Lesson for Policy”: http://www.nber.org/papers/w7483. In this paper, you can find a rigorous analysis of the South Korean crisis of 1997 . Check pages 57 to 64 for data about economic indicators before and after the crisis. Discussion Question As shown in the textbook and the data sources, South Korea benefited partially from the depreciation of its currency, which resulted in an increase in their net exports in the aftermath of the financial crisis. Comment on the pros and cons of a sharp depreciation of the local currency. Answer: A sharp depreciation of the local currency will lower the price of domestic production and thereby increase exports. At the same time it increases the price of imports, resulting in an improvement of the current account balance. However, a couple of caveats apply. One is that if a country relies heavily on imports to supply important raw materials or energy, this could result in a huge increase in production costs for the private or public sector. In addition, if many debtors have their debts denominated in foreign currency, the depreciation of the local currency will significantly increase the burden of their debt. In most financial crisis in emerging countries, the depreciation of the local currency is not a policy choice, but rather a consequence of the crisis, but it is important to consider its effects. For example, many emerging economies have encouraged their banking systems to lend only in their local currencies, precisely to avoid the potential problem described above.
B. For Information About Application: The Argentine Financial Crisis: 2001– 2002 Data Source The Guardian, “Timeline: Argentina’s Economic Crisis”: http://www.theguardian.com/world/2001/dec/20/argentina1. Here you can find a timeline that identifies the most important events leading to the financial crisis described in the textbook. Related Article Federal Reserve Bank of San Francisco, “Learning from Argentina’s Crisis”: http://www.frbsf.org/economic-research/publications/economic-letter/2002/october/learning-fromargentina-crisis/. This paper analyses the Argentinean financial crisis, including a comparison with the South Korean crisis. Discussion Questions How would you avoid the problem of provinces controlling a large percentage of public spending but the federal government being in charge of collecting revenue in Argentina? Why do you think this would be an important issue to solve? Answer: Solving this problem would be very important for Argentina because it is a constant source of trouble for every government. As stated in the textbook, this structure makes it very difficult for the federal government to control the budget, thereby casting constant doubts about the Argentinean government to honor its debt payments. Whenever the Argentinean economy suffers a negative shock, analysts wonder about the government ability to pay back its debt and how it will solve that problem. Maybe a way out of this problem is to hold provinces more accountable for their public spending and maybe allow provinces to raise part of their revenue. This, however, may debilitate the implicit power exerted by the federal government.
.
Web Chapter
Financial Crises in Emerging Market Economies
265
C. For Information About Policy and Practice: Preventing Emerging Market Financial Crises Data Source Giordano, Claire, “Prudential Regulation and Supervision Instruments and Aims: a General Framework”: http://www.bancaditalia.it/studiricerche/convegni/atti/Financial_Market_Regulation/background_paper/gi ordano.pdf. In this paper, you can find a list of prudential supervision measures recommended by two authors (Mishkin and White); check table 1 on page 3. Related Article Mishkin, Frederic S., “Prudential Supervision: Why Is It Important and What are the Issues?”: http://www.nber.org/papers/w7926. In this paper, the author of the textbook outlines the most important characteristics and goals of prudential supervision. Discussion Question As a potential solution to currency mismatch and other problems experienced by emerging markets economies facing financial crises, some authors have proposed the adoption of a foreign currency, like the U.S. dollar, a concept known as “dollarization”. Based on this paper, http://research.stlouisfed.org/publications/review/01/11/29-40Antinolfi.pdf, comment on the impacts that such a policy could have on an emerging market economy. Answer: Dollarizing an economy has potential benefits, and a few countries (as explained in the paper) have chosen to follow this recommendation and harvested some interesting results (e.g., no currency mismatch, low inflation). However, one needs to consider that abandoning the use of a local currency means abandoning the possibility of conducting independent monetary policy. This is in general a good idea only if the government recognizes that it cannot handle its own monetary policy or that the U.S. monetary policy (that the emerging country will implicitly adopt) is superior to the domestically designed monetary policy. In addition, usually societies are reluctant to abandon their local currencies, which can potentially make things difficult during the transition to a fully dollarized economy.
.
Chapter 1 The Policy and Practice of Macroeconomics ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline The Practice of Macroeconomics The Process: Developing Macroeconomic Models The Purpose: Interpreting Macroeconomic Data Macroeconomic Policy How Can Poor Countries Get Rich? Is Saving Too Low? Do Government Budget Deficits Matter? How Costly Is It to Reduce Inflation? How Can We Make Financial Crises Less Likely? How Active Should Stabilization Policy Be? Should Macroeconomic Policy Follow Rules? Are Global Trade Imbalances a Danger? How We Will Study Macroeconomics Emphasis on Policy and Practice Concluding Remarks
Chapter Overview and Teaching Tips The first chapter of this textbook has several objectives. The first is to convince students that macroeconomics is worth studying. This chapter pursues this goal by showing the student that macroeconomics is an exciting field because it focuses on phenomena that affect everyday life. A second objective of the chapter is to help the student understand what the practice of macroeconomics is all about and what central policy issues are addressed in the study of macroeconomics. Finally, the chapter provides an overview for the entire book, previewing the topics that will be covered in later chapters. The chapter also provides students with a guide as to how they will be studying macroeconomics, by explaining and developing macroeconomic models and then applying these models to understand the policy and practice of macroeconomics. In teaching this chapter, the most important goal should be to motivate students by getting them excited about what they are about to learn. I have found that there are two ways to do this. First is to talk about the basic macroeconomic data in Figures 1.2 to 1.10 and explain that numerous real world applications in the book will be used to show how macroeconomic analysis can explain this data. Second is to have the students give their initial reactions to the eight basic policy questions posed in the chapter: How can poor countries get rich? Is saving too low? Do government budget deficits matter? How costly is it to reduce inflation? How can we
.
Mishkin • Macroeconomics: Policy and Practice, Second Edition
2
make financial crises less likely? How active should stabilization policy be? Should macroeconomic policy follow rules? Are global trade imbalances a danger? Once they have given their initial views, the instructor can tell the students that they will have much clearer understanding of these issues when they have finished the course and will have mastered analytic frameworks that can help them have informed views about the issues.
◼
Answers to End of Chapter Review Questions and Problems
Answers to Review Questions Preview 1. Economic growth, labor market conditions (the unemployment rate and growth in the number of jobs), inflation, the value of the U.S. dollar, and changes in economic policy measures such as interest rates and tax rates all will have significant impacts on your future. The Practice of Macroeconomics 2. Endogenous variables are the variables whose behavior a model seeks to explain. Changes in the values of these variables are explained in terms of changes in exogenous variables, whose values are not explained by the model but instead are determined outside the model and taken as given. For example, an economist might build a model to explain why inflation rates differ over time and across countries based on changes in money supply growth. In this model, the inflation rate is the endogenous variable, and money supply growth is the exogenous variable. 3. First, identify the question of interest and decide which endogenous variables the model will seek to explain. Then decide which exogenous variables will be used to explain the endogenous variables of interest. Third, express the model in equation or graphic form that will relate changes in the endogenous variables to changes in the exogenous ones. Fourth, compare the predictions of the model with data for the endogenous and exogenous variables. Finally, if the model fits (explains) the data well, use it to make predictions and analyze policy. If it doesn’t explain the data well, then revise the model and try again. 4. Real gross domestic product, which measures an economy’s aggregate output, is important because it gives information about both long-term growth and short-run fluctuations of output. The unemployment rate measures how fully labor resources are being used in the economy and how widespread the economic hardship experienced by unemployed workers may be. The inflation rate gives an overall measure of how rapidly prices are rising and signals how serious the costs of inflation may be at any given time. 5. The business cycle is a sequence of recurring but irregular fluctuations in economic activity. A recession is the period of the business cycle during which economic activity is declining. Macroeconomists study business cycles and are particularly concerned with the causes of recessions and depressions. 6. During periods of inflation, the overall level of prices rises. It falls during deflationary periods. Macroeconomic Policy 7. A nation’s saving rate is the percentage of income that is saved each year. Nations with higher saving rates tend to also have higher investment levels, which promotes their economic growth. A higher saving rate also means that individuals and households will be better prepared to cope with the potentially severe financial problems they may encounter during a recession. Government policies may encourage or discourage saving and the saving rate. All these factors make the saving rate an important macroeconomic concern.
.
Chapter 1
The Policy and Practice of Macroeconomics
3
8. When government has a budget deficit, it is spending more than the tax revenues it collects and, therefore, must borrow money and go deeper into debt. Macroeconomists have concerns about the size of budget deficits, the burden deficits may impose on future generations facing higher taxes to pay off the government’s debt, and the inflation that may result if a government decides to print more money to cover its deficit and debt. The degree of these concerns increases with the size of the budget deficit. 9. Fiscal policy refers to a government changing its taxes or spending or both. Monetary policy is a central bank’s control of interest rates and the amount of money in an economy. These policies are used for such purposes as influencing an economy’s saving rate, reducing or expanding the size of a government’s budget deficit, influencing the inflation rate and unemployment rate in an economy, or limiting business cycle fluctuations and stabilizing economic activity. 10 Stabilization policy is the use of fiscal and monetary policies to stabilize economic activity by reducing business cycle fluctuations. One debate concerns how active stabilization policy should be. It pits nonactivists, macroeconomists who believe that the economy has a self-correcting mechanism that works rapidly to reduce unemployment without the need for stabilization policy, against activists, who think this self-correcting mechanism is too slow and therefore call for the active use of fiscal and monetary policies to reduce unemployment when it is unacceptably high. A second debate arises between macroeconomists who advocate the use of policy rules to specify in advance precisely how policymakers must react to changes in unemployment or inflation and those who would allow policymakers greater latitude to use their discretionary judgment to formulate the policy response they believe is most appropriate in a given situation. 11 Global trade imbalances occur when some countries run large trade deficits and become increasingly indebted to and dependent on large capital inflows from other countries that are running large trade surpluses. These imbalances are not sustainable in the long run. Economists focus on them because a ready supply of funds from abroad can result in too much investment in particular asset markets, and if the flows are reduced suddenly, it can lead to financial crises, which have detrimental effects on economic activity.
Answers to Problems The Practice of Macroeconomics 1. a.
The endogenous variable is the variable explained by your model, in this case, the prevalence of diabetes in children. The exogenous variable is a variable that is determined outside the model and that presumably has an impact on the endogenous variable. In this case, a child’s weight would be the exogenous variable. b. Other exogenous variables should include factors that one way or another might contribute to diabetes: hours of exercise, income level, education, etc. Choosing the proper exogenous variables and testing their effects is an important part of advancing scientific knowledge.
2. A model is as good as its predictive power, in terms of explaining both previous and future changes in the explained variable. If a current model does not “fit the data,” meaning that it cannot replicate current trends in diabetes prevalence, then the researcher has to go back to step 2 and look for other explanatory variables. This process should be repeated until the model can explain current trends and, therefore, can be used to predict future changes. 3. a. According to the graph, Spain’s real GDP growth rate decreased from the first quarter of 2007 until the third quarter of 2009. After that the growth rate rose but reached a peak of only 0.6 percent in the third quarter of 2011 and then turned negative again in 2012. Thus, the overall trend for the Spanish growth rate has been downward.
.
4
Mishkin • Macroeconomics: Policy and Practice, Second Edition
b. According to data, Spain experienced a recession from the first quarter of 2009 until the third quarter of 2010. However, Spain entered another recession in the first quarter of 2012, when its real GDP growth rate again became negative. Although the real GDP growth rate is not the only indicator of a recession, it usually moves together with other indicators such as the unemployment rate or investment. 4. Although unemployment definitely has negative consequences in terms of decreased production of goods and services, that is not the only reason why it is such an important macroeconomic topic. Most modern societies are structured based on the idea that individuals need a job to provide for themselves and their families. An individual’s inability to find a job will have important psychological (e.g., depression, lack of confidence) and social (e.g., rejection, lower status) consequences. These considerations will play a crucial role in evaluating potential solutions to mitigate these negative effects (e.g., unemployment insurance). Macroeconomic Policy 5. Budget deficits by themselves are not inherently good or bad. However, as we will study later, they can be the source of inflation if governments pay for a budget deficit by printing money. Very high inflation rates (sometimes in excess of 50 percent per month) have a disastrous effect on any economy. High inflation rates decrease incentives to invest and distort relative prices, making economic decisions more difficult. High inflation rates for a sustained period eventually translated into stagnating or decreasing real GDP growth rates in Latin American countries, making this experience an example to avoid. Subsequent (and costly) economic reforms put these countries on the right track again, mostly by reducing budget deficits and inflation. 6. a. The immediate effect of the destruction created by a civil war is a decrease in the economy’s ability to produce goods and services. Goods cannot be moved from producer to buyers, and fewer individuals are able or willing to work during a civil war, decreasing the labor force and work opportunities. Countries with a history of frequent civil wars have significantly lower real GDP growth rates than countries with more stable political regimes. b. A civil war kills incentives to invest, which implies postponing present consumption and putting resources away in order to increase future consumption. The chaos and uncertainty created by a civil war increase incentives for present consumption and, therefore, result in lower economic growth. As we will study later, investment is a major driving force for economic growth.
.
Chapter 1
The Policy and Practice of Macroeconomics
5
7. As a financial crisis develops, businesses find it more difficult to get access to external funds and, therefore, cannot meet their obligations. This results in business failures as well as rising unemployment. At the same time, the decrease in asset prices translates into a decrease in consumption expenditures, decreasing demand for most goods and services. Businesses respond by firing workers, which increases unemployment even more. It is now more difficult to create new jobs, as credit is restricted and demand is uncertain, which decreases investment and, therefore, directly affects economic growth. Financial crisis are usually associated with decreases in real GDP. 8. The fact that Americans currently are not saving enough might have very important implications for future generations. One of them is that future generations might face higher taxes than present generations to pay for the debt accumulated to allow higher current consumption by the present generation. Higher future taxes might result in lower standards of living, as future generations will have to set aside a higher percentage of their income to pay for taxes. Another implication of this situation is that future generations should expect to receive less help from their children to support them when they retire. This follows from the fact that their children will probably face higher taxes. We will later study the different policies that can affect incentives to save for the future. 9. According to the post, the American Recovery and Reinvestment Act was a policy instrument designed to affect the economic environment and lift the American economy from its recession. This constitutes a typical activist policy, in which the government takes action using either fiscal or monetary policies (or both) to spur consumption and investment and create jobs. Not surprisingly, many nonactivist policymakers criticized the current administration for following this path, arguing that such a set of policies will do more harm than good to the economy. The debate about activist and nonactivist policy is fascinating and will be discussed later. 10. There is little doubt that actions taken by the Federal Reserve (some of them in coordination with the U.S. Treasury) in the aftermath of the subprime financial crisis were necessary to restore confidence in the U.S. financial system. A significant part of these actions involved providing liquidity to different participants in the financial system. This fueled fears of higher inflation rates in the future, as persistent increases in the money supply usually result in high inflation rates, as will be discussed later. Inflation, however, remained at low rates during 2008 and 2009, and expected inflation rates did not increase significantly, as detractors of the Federal Reserve’s approach forecasted. The relationship between monetary policy and inflation is far from simple. However, it is crucial to understand the effects of monetary policy on inflation because high inflation can be detrimental for economic growth. 11. a. The American Recovery and Reinvestment Act of 2009 can be considered an example of discretionary macroeconomic policy. It was essentially a set of policies intended to support economic agents affected by the subprime financial crisis and to promote economic recovery. b. One of the fears related to conducting discretionary policy is that agents will come to expect that the government will react to accommodate unusual economic downturns. This becomes a problem when financial intermediaries expect government assistance when there is a financial crisis. It also affects incentives for households that come to expect some type of support during contractions. In this sense, this problem looks very much like raising children: If kids expect to be “bailed out” when they do not behave as asked, then it is quite possible that their incentives to behave properly decrease. From the point of view of financial intermediaries, this would mean that they do not have a huge incentive to appropriately price risks.
◼
Answers to Data Analysis Problems
1. PINCOME is exogenous, and PCEC is endogenous; M1SL and PAYEMS are unrelated; GS10 is exogenous, and PSAVERT is endogenous. Scatterplots are shown below.
.
Mishkin • Macroeconomics: Policy and Practice, Second Edition
PCEC (billions of dollars)
Personal Income vs Consumption, Quarterly, 1980:1 - 2013:1 12000.0 10000.0 8000.0
6000.0 4000.0 2000.0 0.0 0.0
2000.0 4000.0 6000.0 8000.0 10000.012000.014000.016000.0
PINCOME (billions of dollars)
Total Nonfarm Payroll (PAYEMS) vs. M1 Money Supply (M1SL), monthly 2000:1 to 2013:5 3000.0 PAYEMS (thousands)
6
2500.0 2000.0 1500.0 1000.0 500.0 0.0 128000
130000
132000
134000
136000
M1SL (billions of dollars)
.
138000
140000
Chapter 1
The Policy and Practice of Macroeconomics
Personal Saving Rate (PSAVERT) vs. 10 year US Treasury Rate (GS10), monthly, 1980:1 to 2013:4 14.0
PSAVERT (percent)
12.0 10.0 8.0 6.0 4.0
2.0 0.0 0.00
2.00
4.00
6.00
8.00
10.00
12.00
14.00
16.00
18.00
GS10 (percent)
2. Data from 2000 Q1 to 2013 Q1 are shown below, with recessions highlighted. a. The highest inflation rate was 4.2percent in the third quarter of 2008. The lowest was –0.8 percent in the third quarter of 2009. Deflation occurred in the second and third quarter of 2009. b. The highest GDP growth rate was 5.4 percent in the second quarter of 2000. The lowest growth rate was –4.6 percent in the second quarter of 2009. c. In general, the periods of recession tend to have the lowest inflation rates and the lowest GDP growth rates. Date PCE Inflation Rate GDP Growth Rate 2000-01-01 2.6 4.2 2000-04-01 2.4 5.4 2000-07-01 2.5 4.1 2000-10-01 2.5 2.9 2001-01-01 2.3 2.3 2001-04-01 2.3 1.0 2001-07-01 1.8 0.6 2001-10-01 1.3 0.4 2002-01-01 0.8 1.6 2002-04-01 1.1 1.5 2002-07-01 1.6 2.3 2002-10-01 2.0 1.9 2003-01-01 2.5 1.5 2003-04-01 1.8 1.8 2003-07-01 1.9 3.0 2003-10-01 1.9 3.9 2004-01-01 2.0 4.1 2004-04-01 2.7 3.9 2004-07-01 2.7 3.0 2004-10-01 3.0 2.9 2005-01-01 2.8 3.3 2005-04-01 2.7 3.1 2005-07-01 3.2 3.1 2005-10-01 3.2 2.8
.
7
8
Mishkin • Macroeconomics: Policy and Practice, Second Edition
Date 2006-01-01 2006-04-01 2006-07-01 2006-10-01 2007-01-01 2007-04-01 2007-07-01 2007-10-01 2008-01-01 2008-04-01 2008-07-01 2008-10-01 2009-01-01 2009-04-01 2009-07-01 2009-10-01 2010-01-01 2010-04-01 2010-07-01 2010-10-01 2011-01-01 2011-04-01 2011-07-01 2011-10-01 2012-01-01 2012-04-01 2012-07-01 2012-10-01 2013-01-01
PCE Inflation Rate 3.1 3.2 2.8 1.9 2.4 2.5 2.4 3.5 3.4 3.7 4.2 1.7 0.2 –0.5 –0.8 1.4 2.4 2.1 1.7 1.5 1.8 2.6 2.8 2.5 2.4 1.6 1.5 1.6 1.2
3. a.
GDP Growth Rate 3.0 3.0 2.2 2.4 1.2 1.7 2.5 2.2 1.6 1.0 –0.6 –3.3 –4.2 –4.6 –3.3 –0.1 1.9 2.5 2.8 2.4 1.8 1.9 1.6 2.0 2.4 2.1 2.6 1.7 1.8
Germany experienced the highest unemployment rate in 2005 at 11.2 percent; Japan experienced the lowest unemployment rate in 2007 at 3.6 percent. b. During years of recession shown in the table, the average unemployment rate is 6.6 percent. When not in recession, the unemployment is lower at 6.2 percent. This is expected because the unemployment rate rises during recessions and falls during expansions. c. There are clear similarities between the unemployment rates of the United States, Canada, United Kingdom, and Japan. They generally move up and down together. The outlier is Germany, which experienced much higher unemployment than the other countries but has had steady declines in their unemployment rate while many others have experienced high unemployment from the last recession.
.
Chapter 1
The Policy and Practice of Macroeconomics
9
Graph and table are shown below, from 2000 to 2012. The bold indicates a year in which the United States was in recession.
Date 2000-01-01 2001-01-01 2002-01-01 2003-01-01 2004-01-01 2005-01-01 2006-01-01 2007-01-01 2008-01-01 2009-01-01 2010-01-01 2011-01-01 2012-01-01
United States 4.0 4.7 5.8 6.0 5.5 5.1 4.6 4.6 5.8 9.3 9.6 8.9 8.1
Canada 6.1 6.5 7.0 6.9 6.4 6.0 5.5 5.2 5.3 7.3 7.1 6.5 6.3
4. a.
United Kingdom 5.5 5.1 5.2 5.0 4.8 4.9 5.5 5.4 5.7 7.6 7.9 8.1 8.0
Japan 4.4 4.5 4.9 4.6 4.2 3.8 3.6 3.6 3.7 4.8 4.7 4.2 3.9
Germany 7.8 7.9 8.6 9.3 10.3 11.2 10.3 8.7 7.6 7.8 7.1 5.9 5.5
The United States has the highest standard of living according to the data; China has the lowest among the five. b. South Korea’s standard of living has steadily improved over time and has closed a significant gap with Japan and the United Kingdom. In 1990, the gap was $17,694 per person compared to Japan and $12,794 per person compared to the United Kingdom; in 2011, the gap shrunk to $4,040 and $5,434 per person, respectively. c. Although China’s standard of living is much lower overall, it has grown rapidly during the last two decades, from around $674 per person in 1990, to almost $4,500 per person in 2011, a 563 percent increase; South Korea has the next highest growth over that period (152 percent),
.
10
Mishkin • Macroeconomics: Policy and Practice, Second Edition
followed by the United Kingdom (44 percent), United States (33 percent), and Japan (16 percent).
◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Nominal and Real GDP Data Sources Bureau of Economic Analysis: http://www.bea.gov/ . BEA is an agency of the Department of Commerce. Along with the Census Bureau and STAT-USA, BEA is part of the department’s Economics and Statistics Administration. BEA produces economic accounts statistics that enable government and business decision makers, researchers, and the American public to follow and understand the performance of the nation’s economy. To do this, BEA collects source data, conducts research and analysis, develops and implements estimation methodologies, and disseminates statistics to the public. Related Articles Henderson, David R., “GDP Fetishism”: http://www.econlib.org/library/Columns/y2010/HendersonGDP.html#. This article analyzes GDP’s methodology and economists’ reliance on such measure. Discussion Questions Do you think GDP is a good measure of individuals’ well-being? Why or why not? Answer: In general, there is some consensus about the fact that GDP is not a perfect measure of individual well-being. Many methodological (i.e., measurement) problems plague this approach to measuring economic activity (or a nation’s income). However, the GDP measure has some advantages, like allowing cross-country comparisons and being highly correlated with other measures of individual welfare.
.
Chapter 1
The Policy and Practice of Macroeconomics
11
B. For Information About Inflation and Unemployment Data Source Bureau of Labor Statistics: http://www.bls.gov/. The Bureau of Labor Statistics is the principal fact-finding agency for the federal government in the broad field of labor economics and statistics. BLS is an independent national statistical agency within the Department of Labor that collects, processes, analyzes, and disseminates essential statistical data to the American public, congress, other federal agencies, state and local governments, business, and labor. BLS also serves as a statistical resource to the Department of Labor. Related Article Summers, Lawrence H., “Unemployment”: http://www.econlib.org/library/Enc/Unemployment.html. This article discusses how unemployment is measured and how unemployment figures should be interpreted. Discussion Question Discuss the implications of a decrease in the official unemployment rate for teenagers. Answer: The official unemployment rate is an average for all participants of the U.S. labor force. Although a decrease in the official unemployment rate might seem like good news for teenagers, one should check the unemployment rate for teenagers. The latter is usually higher than the former, meaning that teenagers suffer from higher unemployment rates than the rest of the population.
C. For Information About the Policy and Practice of Macroeconomics Data Source Information about macroeconomic variables (e.g., GDP, inflation, unemployment, savings rate) can be found at: http://research.stlouisfed.org/fred2/. This is a comprehensive database created and updated by the Federal Reserve Bank of St. Louis. Related Articls Library of Economics and Liberty search page: http://www.econlib.org/cgi-bin/searchbooks.pl?query=scientific+method&andor=and (check the following authors: Mill, Marshall, and Say). Discussion Question What is the object of studying the science of economics in general and macroeconomics in particular? Answer: In general, the science of economics studies how individuals (or societies) allocate scarce resources to multiple ends. This implies identifying the relevant constraints and preferences (including incentives) that guide our decisions. Macroeconomics deals with topics that affect the whole economy (e.g., the role of the government, economic growth, monetary economics, unemployment, and inflation). Macroeconomics’ methodology is mostly borrowed from microeconomic analysis.
D. For Information About the Dating of Business Cycles Data Source The National Bureau of Economic Research: http://www.nber.org/. Founded in 1920, the National Bureau of Economic Research is a private, nonprofit, nonpartisan research organization dedicated to promoting a greater understanding of how the economy works. The NBER is committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community.
.
12
Mishkin • Macroeconomics: Policy and Practice, Second Edition
Related Article Krugman, Paul, “The Third Depression”: http://www.nytimes.com/2010/06/28/opinion/28krugman.html. In this article, Nobel Prize winner Paul Krugman describes the effects of the most recent recession and comments on the policy measures designed to reduce its adverse effects. Discussion Question Using data from the NBER, the BLS, and the BEA, characterize the 2007–2009 recession in terms of duration, changes in unemployment, inflation, and real GDP. Answer: According to the NBER, the last recession lasted for 18 months: December 2007 until June 2009. During this period, unemployment increased from 5.0 percent to 9.5 percent, monthly inflation rates remained low (around 0.4 on average) and were negative at some point. Finally, real GDP dropped by 4.1 percent during the 18-month period.
.
Chapter 2 Measuring Macroeconomic Data ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline Measuring Economic Activity: National Income Accounting Measuring GDP: The Production Approach Market Value Final Goods and Services Newly Produced Goods and Services Fixed Period of Time Policy and Practice: Can GDP Buy Happiness? Measuring GDP: The Expenditure Approach Consumption Expenditure Investment Government Purchases Net Exports Changes in the Spending Components of GDP over Time Measuring GDP: The Income Approach Categories of Income Income Measures Real Versus Nominal GDP Nominal Variables Real Variables Chain-Weighted Measures of Real GDP Measuring Inflation GDP Deflator PCE Deflator Consumer Price Index Policy and Practice: Policy and Overstatements of the Cost of Living Inflation Rate Percentage Change Method and the Inflation Rate Measuring Unemployment Macroeconomics in the News: Unemployment and Employment Measuring Interest Rates Types of Interest Rates
.
14
Mishkin • Macroeconomics: Policy and Practice, Second Edition
Macroeconomics in the News: Interest Rates Real Versus Nominal Interest Rates The Important Distinction Between Real and Nominal Interest Rates
Chapter Overview and Teaching Tips This chapter examines how economists define and measure the most important data in macroeconomics. Some instructors will want to cover this material in detail in class, but others will prefer to just cover the main points and let students read the chapter on their own as background. There is no way around it: National income accounting is not the most exciting of topics. Yet it is important, as the preview to the chapter indicates. Students need to be exposed to a basic concept like Gross Domestic Product and how it is measured. Similarly, they need to understand what the data on unemployment, the consumer price index (CPI), inflation, and real interest rates means and how measurement of this data is not always completely straightforward. Although the material in this chapter can be dry, discussing in class the Policy and Practice cases in the chapter, “Can GDP Buy Happiness?” and “Policy and Overstatements of the Cost of Living,” liven up the material. It also helps students recognize that understanding and measuring macroeconomic data is important to getting policy right. This chapter introduces “Macroeconomics in the News” boxes, which contain news items and data that are reported daily in the press. These boxes help explain what data are reported on regularly, how to find it, and how to read it. They encourage students to start paying more attention to the data that feature so prominently in macroeconomics.
◼
Answers to End of Chapter Review Questions and Problems
Answers to Review Questions Measuring Economic Activity: National Income Accounting 1. The fundamental identity of national income accounting states that Total Production = Total Expenditure = Total Income. Its significance is that macroeconomists can define and measure gross domestic product in three ways: by totaling either the value added in production or the expenditures to buy goods and services or the incomes earned by households, business firms, and government. Measuring GDP: The Production Approach 2. GDP is defined as the market value of all final goods and services newly produced in the economy during a fixed period of time. When a market value or price is not available for a good or service, its contribution to the value of total output is either ignored—as in the case of most household services and underground economic activity, imputed—as with the value of the services homeowners enjoy by living in their houses, or considered to be equal to its cost of production—as is the case with the provision of government services, such as national defense and education. The value of intermediate goods and services that go into the production of final goods and services is included in value of the final products and, therefore, is not counted separately because doing so would result in double counting and cause GDP to overstate the amount of economic activity. GDP likewise omits purchases of used goods and imports, again to avoid overstating the value of the current time period’s production of goods and services. 3. A flow measure is a quantity per period of time and a stock measure is an amount at a given point in time. For example, your car’s speedometer, by telling you how fast you are driving in miles per hour, provides you a flow measure associated with a period of time. Its odometer gives you a stock measure
.
Chapter 2
Measuring Macroeconomic Data
15
of how many miles the car has been driven up to a particular point in time. GDP measures the value of final goods and services produced during a given time period; thus, it is a flow measure that indicates how much economic activity occurred per period of time. 4. Intermediate goods and services are used up completely in the production of final goods and services during a given time period. Because this is so, their value is completely incorporated into the value of those final goods and services and is not counted separately. This is not the case with capital goods and inventories. A capital good is a final good that is produced during a given time period and is then available to use in the production of other goods and services during one or more future time periods. It is not completely used up during the time period in which it is produced, and therefore, it is not treated the same way an intermediate good is. Inventory investment, the change in business firms’ holdings of raw materials, unfinished goods, and unsold finished goods, represents the current production of both intermediate and final goods and services during a given time period that, like capital goods, will be available to help produce more goods and services in future time periods. Because both capital goods and investment in inventories represent production in the current time period that can be used to assist in future production of goods and services, they are counted in the current time period’s GDP. Measuring GDP: The Expenditure Approach 5. According to the national income identity, GDP (Y) can be measured by summing consumption expenditure (C), investment expenditure (I), government purchases of goods and services (G), and net exports (NX). Consumption expenditure includes consumer durable goods, nondurable goods, and services. Investment expenditure includes business fixed investment (capital goods), inventory investment, and residential investment. Government purchases include spending on currently produced goods and services by federal, state, and local governments but do not include transfers such as payments for Social Security and unemployment insurance benefits. Net exports equal exports minus imports, so goods and services that domestic households, business firms, and governments purchase that are produced elsewhere are subtracted from GDP and not counted as domestic production. Measuring GDP: The Income Approach 6. The major income items in national income are employee compensation, proprietors’ income, rental income of persons, corporate profits, and net interest. The total of these income categories does not equal the GDP because depreciation, which is treated as an expense and therefore reduces proprietors’ income and corporate profits, is not income for anyone else. The same is true of indirect business taxes. Furthermore, a country’s national income includes income its residents earn from productive activities in other countries, which do not contribute to the country’s GDP and excludes income nonresidents earn from their productive activities in the country that do contribute to its GDP. Adjusting national income by adding in depreciation, indirect business taxes, and factor income paid to the rest of the world, subtracting factor income received from the rest of the world, and adjusting for the (relatively small) statistical discrepancy that arises from measuring GDP in two different ways—the production approach and the income approach—reconciles the two approaches. Real Versus Nominal GDP 7. Variables measured in terms of dollars or other monetary units, such as GDP and its various income and expenditure components, can be measured using either current market prices or the prices of a base year. The nominal value of a variable is measured using current market prices and will change when either current market price or quantity changes. Therefore, a change in a variable’s nominal value gives no information about whether or how much market price or quantity has changed. The measure of a real value, however, always uses the prices of a base year. Thus a variable’s real value changes only when quantity changes and is unaffected by changes in current market prices. For that
.