Perspectives in macro test 1

Question 1

Distinguish between validity and cogency.

Answer 1

An argument is valid if the conclusion is supported by the premises. An argument is cogent if it is valid AND the premises are warranted.

Question 2

Explain Say’s Law (both pro and con)

Answer 2

Pro- demand can never fall short of total supply since our desire for goods and services is insatiable. Unused resources we can already afford to employ are a waste, so we will put them to work doing even trivial tasks rather than leave them idle.
Con- demand may be insatiable, but when the future is uncertain, part of demand is a desire for a stock pile of purchasing power to meet unforeseen circumstances. Income diverted to this stockpile does not create employment.

Question 3

Show that the Classical labor demand function is actually a representation of the profit maximizing condition (MC=MR) in N and W/P space. What assumptions must be made to make the transformation?

Answer 3

assume perfect competition, allowing MR=P assume capital is fixed, allowing MC= W/MPN=Marginal labor cost

Question 4

Draw a labor market diagram with involuntary unemployment. Why is it that, given the Orthodox assumptions, the involuntary unemployment must disappear?

Answer 4

In the classical view, the involuntary unemployment at Wo/Po is a disequilibrium situation. Two groups are involved:

1. Firms are happy because they are on the labor demand curve
2. Willing to work: are sad because some will not get jobs. They will therefore compete among themselves for positions by offering to work for less. The process of competing W down will continue until the number willing to work is equal to the number of openings at W1/Po, N2.

Question 5

Derive the Classical aggregate supply curve from a labor market. Explain each step carefully.

Answer 5

Take a point on the labor market diagram and transpose the price and level of output created by that number of workers to the supply curve. Get a second point on the supply curve by raising price in the labor market. Note that this drives real wages down, creating an excess demand for workers. This in turn causes nominal wages to rise until no more excess exists. As we are at the original point, this means that the supply curve is vertical

Question 6

Using the Classical aggregate supply curve, why won’t firms offer more for sale when prices rise?

Answer 6

As price rises, firms are inclined to offer more for sale. To do so, they must hire more workers Unfortunately, since the price rise led to a fall in real wages, workers are less willing to offer their services at the current nominal wage and there is thus an excess demand for workers. Firms bid up wages and this continues until wages rise proportionately with prices. Therefore, the reason that firms offer no more for sale when price rises is that the rise in wages exactly offsets the possibility of higher profits.

Question 7

In what sense is money irrelevant in the Classical model?

Answer 7

Moey is irrelevant in that it never changes any real variables like Y or N. The latter are determined by resources, technology, and capital.

Question 8

Explain classical interest rate theory (aka the loanable funds theory of interest).

Answer 8

Underlying assumptions.
- Only households earn income, save, and consume, such that y=c+s
- Only firms borrow and invest
- investment s a negative Functiom of the interest rate - savings is a positive function of the interest rate -financial sector pays interest on household saving and earns interest when firms borrow to invest
-there exists a full employment level of tots. Spending: y*=c+I
Since y=c+sand y=c+I, s=I

Analysis:
Say So=Io corresponds to the full
Employment level of Y*=C+I. Now assume
A decrease in the desire to invest such
That we have an excess supply of funds
(S>I)at ro. This causes problems for the
financial sector since they are now earning
less money from firm borrowing but paying
the same on household saving. So they
Lower interest rates to encourage the former
And discourage the latter. Ultimately this leads
To s=I at s1=i1. Note that since the rise in consumption Implied by the move from s0 to s1 is identical to the
Fall in investment from I0 to I1, so total spending has not Changed and we are still at full employment.

Question 9

Show how unemployment can occur if there is a minimum wage on the labor market diagram. What kind of unemployment is it?

Answer 9

the minimum wage is set so that the associated real wage is above the intention on the labor market diagram, then involuntary unemployment will result. The excess supply is creating downward pressure on W, but it is socially unacceptable to allow that to occur

Question 10

According to Uncle Milty, what can monetary policy not do?

Answer 10

I) it cannot peg interest rates for more than very limited periods and II) it cannot bpeg the rate of unemployment for more than very limited periods

Question 11

What processes eventually cause a rising money supply to lead to higher, rather than
lower, interest rates?

Answer 11

The more rapid rat of monetary growth will stimulate spending, both through he impact on investment of lower market interest rates and through the impact on other spending and thereby relative prices of
higher cash balances than are desired. But, one man’s spending is another man’s income. Rising oncoming will raise the liquidity preference schedule and the demand for loans; it may also raise prices, which would reduce the real quantity of money. These three effects will reverse the initial downward pressure on interest rates fairly promptly and together, they will tend after a longer interval to to raise interest rates temporarily.

Question 12

How long is “temporary,” according to Friedman?

Answer 12

two to five years; a couple of decades

Question 13

What is it that monetary policy can do?

Answer 13

avoid major mistakes, provide a stable background for the economy, contribute to offsetting major disturbances in the economic system arising from other sources

Question 14

What are the requirements for monetary policy to follow?

Answer 14

I) monetary authority should guide itself by magnitude we that it can control. II) monetary authority should avoid sharp swings in policy

Question 15

How is new money introduced in this fictitious economy?

Answer 15

Helicopter

Question 16

Why, in his simple, hypothetical economy, should people want to hold money?

Answer 16

to serve as a medium of circulation or abode of purchasing power in order to avoid the need for a double coincidence of barter.

Question 17

Assuming no change in the desire of people to hold cash, what is the only lasting effect of
an increase in the money supply?

Answer 17

A rise in the price level

Question 18

Friedman lists thirteen assumptions for his fictitious economy. He does not explicitly
mention full employment of resources. Is he assuming it implicitly? Explain.

Answer 18

He must be if rise in Ms leads to nothing but rise in P

Question 19

What is the policy ineffectiveness critique that represents one of the distinguishing features between Monetarist and New Classical economics?

Answer 19

It says that because they are armed with rational expectations, economic agents will correctly anticipate the effect of monetary policy that changes price levels. This means that so long as the government does not manipulate the money supply in secret, economic agents will never suffer from the money illusion that causes fluctuations in employment in the netariat model

Question 20

How does New Classicism’s Ricardian Equivalence argue that fiscal policy is ineffective?

Answer 20

Government deficits are supposed to inject new income into the macroeconomy that agents then spend, increasing demand. However, if those agents rationally assume that they will one day be forced to pay higher taxes, to repay those deficits, they will not spend the windfall and aggregate demand is unaffected

Question 21

Show how unemployment can occur if coordination problems occur on the labor market diagram. What kind of unemployment is it?

Answer 21

Nd is the actual demand curve while Nd* is what firms expect, the vertical portion of which is a function of how much firms think they can sell. In fact, firms could have hired N0 workers and sold everything they produced, but they don’t know that. Thus, firms hire no more than N1 workers. Wages are left undetermined, but at every one except W0/P0, there will be involuntary unemployment.

Question 22

Draw a labor market diagram with involuntary unemployment. Why is it that, given Keynes’ assumptions, there exists no tendency for the involuntary unemployment to disappear

Answer 22

In Keynes’ views, the unemployment at W0/P0 is an equilibrium situation. Why? Firms are happy because on They are on Nd and reluctant o lower W as it may lower morale and productivity
Workers are very happy as they would have worked for less (W1/P0)
Involuntarily unemployed are sad because many may be willing to work for less but no one asked them because firms are not hiring. Thus, though there may be some downward pressure on wages, it is insufficient to create the adjustment described in orthodoxy/ classicism.

Question 23

Why is it that Keynes argues that wage flexibility should not even be a goal in terms of finding means to lower unemployment?

Answer 23

!) Too many payments in a modern capitalist economy contracted in nominal terms. Lowering nominal wages may leave people unable to pay mortgages, car loans, etc. and lead to financial distress.
!!) The livelihood of here worker is the raison d’être of the economy. All other prices should adjust to wages not the other way around
III) Wages are an important component of aggregate demand. Lowering them may push he economy even cuter into recession and make unemployment worse
IV)Most fundamentally, a rise in wages is not the cause of economy downturns, decreases in aggregate demand are. The latter should be raised rather than the former lowered.