Perspectives Test 3

Question 1

What assumptions are made regarding M, V, P, and y in the “money growth ==>inflation” view? [123 words]

Answer 1

M: That which is money is easily defined and identified and only the central bank can affect it’s supply, which it can do with autonomy and precision. V: The velocity of money is related to people’s habits and the structure of the financial system. It is, therefore, relatively constant. P: The economy is so competitive that neither firms nor workers are free to change what they charge for their goods and services without there having been a change in the underlying forces driving supply and demand in their market. y: The economy automatically tends towards full employment and thus y (the existing volume of goods and services) is as large as it can be at any given moment (although it grows over time).

Question 2

Given the assumptions of the “money growth ==>inflation” view, why is it that M ==> P is the only logical outcome? [47 words–I will help with this one in class]

Answer 2

P1. MV=Py P2. V is constant because people’s demand for money is constant P3. y is constant at the level associated with Say’s Law ∴ if the government raises M, the only possible result is a rise in P as people get rid of their excess money balances

Question 3

The Post Keynesian view argues that since V and y can and do vary in the real world, there is no reason to believe that changes in P can necessarily be linked directly to changes in m. However, the real nail in the coffin of the “money growth==>inflation” is what? Explain it briefly (be sure to mention the three means by which the Fed can affect the money supply). [99 words]

Answer 3

• The federal reserve can’t affect change in the money supply without a conscious and voluntary cooperation of the private sector.
• The federal reserve has no mechanism to alter money supply otherwise. Their options are Fed purchases of government debt from the public, Fed loans to banks through the discount window, or Fed adjustment of reserve requirements so that banks can make more loans from the same volume of deposits.
• Fed can’t force anyone to sell treasury bills in exchange for cash, can’t force a private bank to accept a loan, and private banks can’t force their customers to accept loans.
• Can’t supply money, unless corresponding demand exists

Question 4

Explain the three types of money that have been used.[72 words]

Answer 4

• Commodity money o The item used as money has the same value in use as it does in exchange. • Representative commodity money o The money itself has little or no value, but it can be exchanged for gold or silver equal to its face value. • Credit money o Any money, except representative commodity money, that circulates a value greater than the commodity value of the material from which it is made. o Credit money is the liability of the issuing bank, and is backed by borrowers

Question 5

It is in what act that banks create money? [4 words]

Answer 5

lending money to customers

Question 6

Why don’t banks like to keep reserves and how much are they required to keep?[14 words]

Answer 6

Because they do not earn interests on reserves, holding reserves results in a loss of revenue. They must hold 10%

Question 7

What two entries increase by exactly the amount of the loan whenever a loan is made and which is an asset and which a liability? [7 words]

Answer 7

Checking accounts (liabilities) and loans (assets).

Question 8

After a loan is made and the immediate adjustment to assets and liabilities is made, what other asset entry will banks need to make sure they adjust (although by how much may vary) and how long do they have to make that adjustment? [14 words]

Answer 8

They must adjust their required reserves and they have 14 days to do so.

Question 9

What are the two means shown in the article for a bank to adjust its reserves? [11 words]

Answer 9

It could sell treasury bills or borrow money on the federal funds market.

Question 10

If the entire banking system were increasing loan volume then the fed funds market would not be a useful source of reserves, leaving only sales of securities. Why is it likely that the Fed would passively accommodate? [21 words]

Answer 10

Because central banks target interest rates, they must accommodate a rise in the demand for loans or interest rates will rise.

Question 11

Banks are always willing to make loans to what kind of customers (meaning that they are never constrained by a lack of saving)? [one word; HINT: 12 letters]

Answer 11

Creditworthy

Question 12

What are the four factors Post Keynesians say actually do cause inflation? Explain each very briefly, give an example, and tell to whom income is redistributed. [Not 38 Words]

Answer 12

: Market Power: the ability to avoid (at least to some extent) competitive pressures. The OPEC oil embargo was an example of inflation caused by market power and the winners were the OPEC countries and the oil industry. Demand Pull: a rise in demand relative to supply. If there is a boom in the housing industry then a shortage of bricks and lumber may develop, driving up prices. Manufacturers in those industries will get wealthier. Asset Market Boom: inflation can be injected from the asset market. If there is speculation in a commodity futures market, then producer of that commodity may restrict supply in hopes of earning more income later. This raises prices today. The winners here are the owners of the assets being bid up and the producers of that commodity. Supply Shock: Acts of God. If a storm knocks out a bunch of oil derricks, it could raise the price of oil. Who wins here is more complicated since it depends on the relative degrees of price rise vs. costs of reconstruction.

Question 13

Explain the process by which the inflation of the 1970s occurred and show how it is that a rise in the money supply may accompany a rise in prices, even though the former does not, indeed cannot, cause the latter. [95 words]

Answer 13

In 1973, the OPEC countries raised the price of oil by restricting its supply. This increased costs for entrepreneurs who therefore needed to borrow more cash to buy the inputs they used to produce their output. Bankers, knowing this was a reasonable demand, obliged. When they lacked sufficient reserves, the Federal Reserve accommodated by buying T Bills and other assets from banks. Once entrepreneurs’ output was produced, they had to sell for a higher price since their costs had risen. Both the money supply and prices had risen, but the latter had caused the former.

Question 14

Explain demand-pull inflation. [102 words]

Answer 14

One of the principle causes of inflation is is excess demand: too much money chasing too few goods. If demand rises faster than supply, prices rise. This is especially likely in a booming economy, where production is reaching full capacity.

Question 15

According to Neoclassical Keynesians and Monetarists, what are the costs of inflation (just the first two)? [106 words]

Answer 15

Uncertainty: If inflation keeps varying, then firms may be reluctant to invest as they may be unsure of what the government will do in the future. People may also be uncertain and reluctant to spend. Both could reduce long run growth. Income Distribution: many people have to live off fixed incomes, particularly the retired. The higher the level of inflation, the less their income is worth. This effect can also occur among people who are working as their incomes rise faster or slower than inflation. This redistribution of income is arbitrary.

Question 16

What factors probably contributed to the attractiveness of the Phillips Curve? [41 words]

Answer 16

The factors that contributed to its attractiveness are the remarkable temporal stability of the relationship, its ability to accommodate a wide variety of inflation theories, and that it offered policy makers a convincing rationale for their failure to achieve full employment with price stability.

Question 17

Briefly explain the pessimistic Phillips Curve and the “Cruel Dilemma.” Please illustrate with a graph. [19 words plus graph–have to work out yourself]

Answer 17

• The cruel dilemma refers to certain pessimistic situations where none of the available combinations on the menu of policy choices is acceptable to the majority of a country’s voters.

Question 18

What were the three innovations that led to the expectations-augmented version of the Phillips Curve? [35 words]

Answer 18

(1) The respecification of the excess demand variable as the gap between the natural and actual rates of unemployment (2) The introduction of price anticipations into Phillips curve analysis. (3) The incorporation of an expectations-generating mechanism into Phillips curve analysis

Question 19

What are the policy implications of the accelerationist hypotheses? [32 words]

Answer 19

The authorities can either peg unemployment or stabilize inflation, but they can’t do both. And the authorities can choose among alternative transitional adjustment paths to the desired steady state of inflation.

Question 20

According to rational expectations, what’s the only sort of policy that can lead to a movement away from the long run Phillips Curve? [one word, eight letters–have to work it out yourself]

Answer 20

Surprise

Question 21

What is a stop-go policy and upon what concept is it based? [62 words]

Answer 21

Stop-go policy attempts to used fiscal and monetary policy in periods of low GDP growth/recession and rising unemployment to achieve higher GDP growth and job creation, but this came with rising (demand pull) inflation. So the ‘go’ part of the policy ends as governments focus on reducing inflation. They deflate the economy by raising taxes and interest rates (the ‘stop’ part) reducing inflation - but creating lower growth and higher unemployment. It’s based on the boom-bust cycle.

Question 22

In general, what appears to be the effect of recessions on rates of inflation? During what decade did inflation significantly increase, even taking expansions and recessions into account? [6 words]

Answer 22

In the end it recessions lower inflation. The 1970s

Question 23

Know the name of each inflationary and the order they occurred (I’ll supply a complete chronology of years). Know, too, the overview of each.

Answer 23

Camelot: 1960-5 Overview: Moderate inflation and strong growth–nirvana! Wage-Price Spiral: 1966-72 Overview: Continued strong growth, but, at least by the standards of the day, accelerating inflation–oligopolies and unions? Oil Crises: 1973-81 Overview: Egypt and Syria invade Israel in October of 1973 and appear to be winning. After they ultimately lose, OPEC punishes the west with an embargo. Oil Glut: 1982-8 Overview: Industrial countries have time to shift away from oil, non-OPEC countries increase output, and OPEC countries cheat. Desert Storm: 1989-91 Overview: Saddam Hussein says Kuwait is selling too much oil and they should cut back–or else. Or else happens and UN intervenes. Peacetime Expansion: 1992-8 Overview: Longest peacetime expansion in US history, but no inflation? OPEC Production Cuts: 1999-2002 Overview: OPEC misses the old days and introduces a series of production cuts. Speculation: 2003-8 Overview: As stock market slows, speculative money drifts into oil (and other commodity) futures–until the bottom falls out in late 2008.

Question 24

Know the Post Keynesian, Monetarist, and Neoclassical Keynesian explanations and evidence for inflation.

Answer 24

Inflation Explanations and Evidence: Post Keynesian: Cost Push. Look for CPI to accelerate when oil prices rise and productivity falls. Monetarist: MV=Py. Look for CPI to accelerate when money grows faster than real GDP (in fact, excess growth should equal inflation). Neoclassical Keynesian: Demand Pull and the Phillip’s Curve. Look for inflation to accelerate when GDP accelerates, unemp falls, and cap util rises.

Question 25

Draw Keynes’ aggregate supply curve (Z). Explain carefully the relationship it represents. From what is it derived? Would the classicals object to the Z curve? [72 words and a graph]

Answer 25

Z is the profit maximizing condition written in Py & N space. The Z curve shows the level of nominal sales (Py) firms must expect to make hiring N workers a profit maximizing proposition. Since MNP falls faster than ANP, Py increases as an increasing rate as N rises. Classicals would have no problem with Z as it’s basically Nd. W/P=MPN W=MPN*P W/MPN=P W/MPN*y=Py W/MPN*y/1*N/N=Py W/MPN*y/N*N=Py WN(APN/MPN)=Py

Question 26

Macroeconomic equilibrium occurs when firms’ expectation of sales is not disappointed. In terms of Keynes Z-D diagram, what does this mean? Explain why none of the other points can be an equilibrium and where full employment is. [94 words and two graphs]

Answer 26

In the graph to the left, firms thought they could sell Py, so they hired N1 workers. However, N1 workers only generated Py2 sales. Firms will lay off workers till they reach N0. In this graph to the left, firms expected to sell Py2, so they hired N1 workers. However, N1 workers generated Py1 sales. Forms will add workers until they reach N0. Full employment may be at, but is probably to the right of the intersection of Z& D.

Question 27

What determines consumption in Keynes’ model? [1 word]

Answer 27

Income

Question 28

What determines investment in Keynes’ model? Does mec move to meet r, or vice versa? [66 words]

Answer 28

I=f(mec, r) + - Where mec is the present value of the expected stream of profits over the life time of a project as a percentage of the purchase price. Investment settles at the level where mec=r because firms will undertake project s until they are equal. For example, if mec>r, then there is an investment boom that causes decreased mec due to the rising stock of capital saturating that market.

Question 29

In Keynes’ model, what maintains the equality of investment and saving? [79 words]

Answer 29

Changes in income restore the equality of I and S. S=Y-C C=a+bY Y=(1/1-b)(a+I) Whenever I changes, Y will change to compensate and S will follow. For example: I=50 b=.8 a=10 Y=(1/1-.8)(10+50)=5*60=300 C=a+bY=10(.8)300=250 S=Y-c=300-250=50 All at equilibrium and full employment. Lower I to 40: Y=5(10+40)=250 C=10+.8(250)=210 S=250-210=40 S and I are equal again, but at the cost of the level of economic activity.

Question 30

How are interest rates determined in the General Theory? [107 words]

Answer 30

Interest determines how you save, not how much. It is the price of parting with liquidity rather than the reward for abstaining from consumption. There are three reasons to want to hold cash. (1) Transactions motive: the need for cash for current personal and business transactions (varies positively with income.) (2) Precautionary motive: a desire for security as to the future cash equivalent of assets (varies negatively with optimism) (3) Speculative motive: holding cash because you think current interest rates are a bad deal (varies negatively with R.) When compared to the supply of money, this determines the interest rate.

Question 31

Why would any one in their right mind put down money at a game where they had no idea of the odds and what, at any given moment, determines whether or not US corporations are opening new facilities or laying off workers? [20 words]

Answer 31

Animal Spirits! It it is this balance between uncertainty and our animal spirits that determine whether or not U.S. corporations are opening new facilities or laying off workers.

Question 32

Keynes’ Chapter Twelve: What does Keynes mean by speculation? By enterprise? [24 words]

Answer 32

Speculation: activity of forecasting the psychology of the market Enterprise: activity of forecasting the prospective yield of assets over their whole life

Question 33

Keynes’ Chapter Twelve: What does Keynes think could be accomplished by his half sarcastic, half serious, suggestion that we should make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause? [17 words]

Answer 33

Keynes thinks it would force the investor to direct his mind to the long-term prospects and to those only.

Question 34

Know the Post Keynesian, Monetarist, and Neoclassical Keynesian explanations and evidence for the business cycle.

Answer 34

Post Keynesian: saturation of investment demand. Look for positive investment growth to cause accelerating real GDP growth and negative investment growth to cause decelerating real GDP growth (maybe consumer durables, too). Monetarist: unexpected inflation (caused by money growth) leads to a fall in unemployment. Look for lower unemployment when money growth accelerates and higher unemployment when it decelerates. Neoclassical Keynesian: monetary and fiscal policy cause fluctuations in output and employment. Look for rising fiscal impulse and falling interest rates to cause falling unemployment.

Question 35

Distinguish between validity and cogency. [25 words]

Answer 35

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 36

Explain Say’s Law (both pro and con). [94 words]

Answer 36

• Say’s Law argues that the economy always tends toward maximum growth in full employment • Pro’s o Demand can never fall short of total supply since our desire for goods and services is insatiable. Unused resources we already afford to employ are a waste so we will put them to work even doing trivial tasks rather than leave them idle. • Anti- o Demand may be insatiable, but when the future is uncertain part of demand is a desire for a stockpile of purchasing power to meet unforeseen circumstances. Income diverted into this stockpile does not create employment.

Question 37

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? [18 words]

Answer 37

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

Question 38

Draw a labor market diagram with involuntary unemployment. Why is it that, given the Orthodox assumptions, the involuntary unemployment must disappear? [graph plus 64 words]

Answer 38

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 39

Derive the Classical aggregate supply curve from a labor market. Explain each step carefully. [87 words plus graphs]

Answer 39

Assume Y is a function of N. 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 40

Using the Classical aggregate supply curve, why won’t firms offer more for sale when prices rise? [113 words]

Answer 40

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 41

In what sense is money irrelevant in the Classical model? [24 words]

Answer 41

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 42

Explain classical interest rate theory (aka the loanable funds theory of interest). [227 plus graph]

Answer 42

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 43

Show how unemployment can occur if there is a minimum wage on the labor market diagram. What kind of unemployment is it? [47 words plus graph]

Answer 43

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 44

According to Uncle Milty, what can monetary policy not do? [13 words]

Answer 44

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 45

What processes eventually cause a rising money supply to lead to higher, rather than lower, interest rates? [35 words]

Answer 45

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 46

How long is “temporary,” according to Friedman? [mention both the time period necessary for initial effects to be reversed and that for full adjustment; 8 words]

Answer 46

two to five years; a couple of decades

Question 47

What is it that monetary policy can do? [23 words]

Answer 47

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

Question 48

What are the requirements for monetary policy to follow? [17 words]

Answer 48

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

Question 49

How is new money introduced in this fictitious economy? [1 word]

Answer 49

Helicopter

Question 50

Friedman lists thirteen assumptions for his fictitious economy. He does not explicitly mention full employment of resources. Is he assuming it implicitly? Explain. [14 words]

Answer 50

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

Question 51

Why, in his simple, hypothetical economy, should people want to hold money? [10 words]

Answer 51

To serve as a medium of circulation and as a reserve for future emergencies

Question 52

Assuming no change in the desire of people to hold cash, what is the only lasting effect of an increase in the money supply? [couple of words–have to work it out, but not terribly difficult; 4 words]

Answer 52

A rise in the price level

Question 53

What is the policy ineffectiveness critique that represents one of the distinguishing features between Monetarist and New Classical economics? [59 words]

Answer 53

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 54

How does New Classicism’s Ricardian Equivalence argue that fiscal policy is ineffective? [51 words]

Answer 54

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 55

Show how unemployment can occur if coordination problems occur on the labor market diagram. What kind of unemployment is it? [73 words plus graph]

Answer 55

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 56

What is the quick explanation of why real business cycle theorists believe that markets must clear and, in the absence of such a possibility, how do they explain the fluctuations in business activity that have been obvious for over two centuries and how does this create the pattern we observe as booms and recessions? [161 words]

Answer 56

If a market does not clear, there is a profit opportunity for someone, and someone will take it. Hence wages and prices should not be sticky, but should adjust quickly. The real-business cycle theorists say that an important cause is fluctuation in the rate of technology change. Suppose, for example, the rate of technology slows down. As a result, people’s marginal productivity will drop, and as it does, the real wage will drop. People will react to that change in real wage in a rational manner by shifting their work and leisure decisions over time. Suppose that in some weeks you get paid $15 per hour, and in other weeks you only get paid $5 per hour. If you can work as many hours per week as you want, what kind of pattern will there be to your work? Although some people undoubtedly would work the same in all weeks, most people would work longer in the higher-pay weeks and less in the lower-pay weeks. They will take their leisure in the lower-pay periods, and move their work to the higher pay periods.

Question 57

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 (be sure to reference your graph in the explanation)? [89 words plus graph]

Answer 57

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 58

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

Answer 58

!) 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.

Question 59

Did unemployment ever trend down during a recession? Does the trend up in unemployment associated with recessions tend to lead, lag, or be coincident? What do you notice about unemployment after the end of the last two recessions before our current one (and actually to a small extent after the last one)? [10 words]

Answer 59

There was no trend up; unemployment didn’t fall during recessions and typically leads a little. Unemployment continued to rise after the end of the last two recessions

Question 60

If you had to generalize, what would you say that interest rates do during recessions? How would you describe interest rate since the last recession? [3 words]

Answer 60

Interest rates typically fall during recessions and rise during expansions.

Question 61

Generally speaking, what does investment do in recessions? In the majority of instances, does it appear to begin to do what you suggested in the previous answer as a lead, lag, or coincident with recessions? [2 words]

Answer 61

Investment generally falls during recessions. It typically is a leading indicator of recessions.