Test 1

Question 0

2. What is the fallacy of composition? Give an example related to macroeconomics. [58 words]

Answer 0

The fallacy of composition arises when one infers that something is true of the whole from the fact that it is true of some part of the whole. For example, while it is possible for an individual to spend more than she earned, a closed economic system cannot, since a surplus unit must offset every deficit unit.

Question 1

1. Distinguish between validity and cogency. [25 words]

Answer 1

An argument is valid if the conclusion if supported by premises. An argument is cogent if it is valid and the premises are warranted/reasonable.

Question 2

Explain why injections must be equal to leakages in a closed system. [127 words]

Answer 2

Total expenditures in the macro economy are defined as follows: AE= C+ I+ G+ (X-M). Total income is defined as follows: Y= C+ S+ T. Since every time one makes an expenditure it becomes someone else’s income, AE=Y and C+I+G+(X-M)=C+S+T. Cancelling C and rearranging, we get: I+G+X=S+T+M. In other words, injections= leakages. How they move to equality, varies by school of thought. But from the Keynes/Keynesian perspective, the process hinges on the fact that S, T & M are all a direct function of Y. Therefore, if injections are greater than leakages, this raises Y, which raises leakages until they are equal again. If Injections are less than leakages, this lowers Y, which lowers leakages until they are equal once more.

Question 3

Derive the simple income multiplier

Answer 3

a. Y=C+I+G+(x-m)
    C=a+bY
    Y=a+bY+I+G+(x-m)
    Y-bY= a+I+G+(x-m)
    Y(1-b)=a+I+G+(x-m)
    Y=1/(1-b)*(a+I+G+(x-m) where 1/(1-b)is the multiplier

Question 4

5. How does, ceteris paribus, a more even distribution of income create a higher level of GDP? [56 words]

Answer 4

The wealthy spend a smaller percentage of their income than the poor do. For example, in 2010, the top quintile spent roughly 60%, while the bottom four quintiles spent around 90%. This means that as income is concentrated closer to the top, spending per dollar declines, as does the marginal propensity to consume and the multiplier

Question 5

Derive the income multiplier with imports as a function of income. Is this multiplier higher or lower than the simple income one and why? [Equations and notes]

Answer 5

Y=C+I+G+(x-m)
C=a+bY
M=d+mY
Y=a+bY+I+G+x-d-mY
Y-bY+mY=a+I+G+x-d
Y(1-b+m)=a+I+G+x-d
Y= 1/(1-b+m)*(a+I+G+x-d)
It is lower because every round, some spending does not raise domestic income as it leaves the country for imports.

Question 6

Derive the income multiplier with taxation. Is this multiplier higher or lower than the simple income one and why? [Equations and notes]

Answer 6

Y=C+I+G+(x-m)
C=a+bYd
Yd=Y-tY (disposable income= income- taxes)
Y=a+b(Y-tY)+I+G+(x-m)
Y=a+bY-btY+I+G+(x-m)
Y-bY+btY=a+I+G+(x-m)
​Y - b(1 - t)Y = a + I + G + (X - M)
​Y(1- b(1 - t)) = a + I + G + (X - M)
​Y = (1/1-b(1-t))(a + I + G + X - M)
This equation will be smaller than the simple income equation because some money escapes in taxes

Question 7

Give an example to show how even a balanced government budget boosts GDP. Why is this so? [equations and notes]

Answer 7

a. Y=C+I+G+(x-m)
C=a+bYd
Yd=Y-T 
Y=a+bYd+I+G+(x-m)
Y=a+bY-bT+I+G+(x-m)
Y(1-b)=a-bT+I+G+(x-m)
Y=
example: b=0.8. a=10, T=0, I=50, G=0, (x-m)=0
Y=
Y=300
Now, set T=G=10
Y=
Y=310
Agents would have saved some portion of the 10 taxed away (2), but the government spent the entire amount.

Question 8

10. What is the most critical fact one needs to know in order to understand the role of the 
federal budget? [23 words]

Answer 8

The most critical is the fact that the private sector is incapable of consistently generating sufficient demand to hire all those willing to work.

Question 9

11. What is the only entity capable of creating demand from thin air? [1 word]

Answer 9

Government

Question 10

Why is it that cutting the deficit by reducing spending does not put money in the pockets 
of those in the private sector (two reasons)? [34 words]

Answer 10

a. You weren’t being taxed to finance the deficit in the first place
b. Government spending is money in someone’s pocket.

Question 11

You can spend your way out of a recession because a recession is caused by a lack of 
what? [1 word]

Answer 11

Spending

Question 12

When would cutting government spending free up resources for the private sector to grow; 
and why is this not the case in the midst of the worst recession since the Great Depression (in terms of what is available to the private sector and what they were choosing to do)? [29 words]

Answer 12

If we were already at full employment and using all our productive capacity. However, we currently have plenty of idle resources, the private sector is simply choosing not to employ them.

Question 13

15. When might deficit spending create inflation? [6 words]

Answer 13

a. If we were already at full employment

Question 14

16. Government surpluses do not help the economy grow because they represent what? [7 words]

Answer 14

Government surpluses represent a net drain on private-sector income

Question 15

17. What is the chance that the US could be forced to default on the debt and why is that so? [16 words]

Answer 15

a. The chance is 0% because the American government is authorized to print its own money.

Question 16

18. What was quantitative easing meant to do and why was it an utter waste of time? [44 words]

Answer 16

Quantitative easing was meant change the form in which financial assets were held in the banking system so that it would easier for institutions to loan money. It created absolutely no new income whatsoever, which is why it was an utter waste of time.

Question 17

19. That we owe money to China has nothing to do with what and everything to do with what? [17 words]

Answer 17

a. That we owe money to China has nothing to do with Budget Deficit and everything to do with trade deficit.

Question 18

19. Say’s Law implies what because the very act of production does what? [26 words]

Answer 18

​a. Say’s law implies that a recession or depression will never occur because the very act of production creates enough income and demand to purchase everything produced.

Question 19

20. Draw Keynes’ expected sales proceeds/planned spending (Z-D) diagram and explain why points to the right or left of the intersection cannot be equilibrium. Where is full employment? [graph plus 94 words]

Answer 19

a. In the graph on the top, firms thought they could sell Py1 so they hired N1 workers. But, N1 workers, in combination with investment, only generated Py2 sales. Firms will lay off workers until they reach N0.

In the graph on the bottom, firms expected to sell Py2 so they hired N1 workers. But, N1 workers, in combination with investment, generated Py1 demand. Firms add new workers until they reach N0.

Full employment may but be at but is probably to the right of the N associated with the intersection of Z and D.

Question 20

Keynes’ approach does not lead to the conclusion that flexible wages will assure full employment because Keynes’ parameterization of the money wage forces the analyst to do what? [18 words] 


Answer 20

A. Keynes’s parametrization of the money wage forces the analyst to evaluate how any change in the money wage works through the D1 and D2 components of aggregate demand.

Question 21

The rejection of the ergodicity axiom and the assumption of uncertainty by Keynes was critical to his analysis. Keynes rejection of the ergodic axiom means that realistic theories of our economic system cannot demostrate what and instead his analysis suggests that the primary function of financial markets is what (and not what)? [56 words]

Answer 21

a. Keynes’s rejection of the Ergodic axiom means that realistic theories of our economic system cannot demonstrate that unregulated financial markets can optimally automatically assure full employment and allocate resources and finance into those projects that in the future will earn the greatest return. In non-ergodic circumstances, Keynes’s analysis suggests that the primary function of financial markets is to provide liquidity and not to optimally allocate capital as classical theory contends.

Question 22

On pages 51 to 53, Davidson explains the problems inherent to economic modeling, particularly as related to the fact that the ceteris paribus assumption that is absolutely necessary in formalizing our analysis will never hold in the real world. How does he relate this to stimulus spending in 2009 (what is the problem and from what was this no doubt a result?)? [38 words]

Answer 22

a. When some economists tried to measure the multiplier effect of the Obama stimulus spending in 2009, they did not get the large magnitudes that they claimed would occur. Part of the problem might be that not all things were equal from 2008-2009

Question 23

Read the section discussing the two essential properties of liquid assets in the appendix to chapter 3. Summarize how these create the possibility of involuntary unemployment even when there are perfectly flexible wages and prices. [72 words]

Answer 23

The first, regarding the elasticity of production being zero or negligible, means that as agents desire more liquidity, it does not follow that this sets into motion the hiring of new workers to create more liquid assets. The second, regarding the zero or negligible substitutability between liquid and reproducible goods, means that when the price of liquidity rises, agents will not shift demand towards goods that WILL raise the level of employment.

Question 24

27. Davidson argues that the decision to invest is a weighty one because one is very unlikely to be able to find a new buyer for a sausage machine, and certainly not at a price that would recoup costs. He further argues that the key to understanding investment behavior is the knowledge that entrepreneurs will order new capital goods (i.e., invest) whenever the demand price for plant and equipment (i.e., the price those demanding investment goods are willing to pay) exceeds the flow supply price (i.e., the price firms producing investment goods require to supply them). Write Davidson’s stock demand quantity for capital (equation 4.2), define each variable, and tell the sign of the independent variables with respect to the dependent. [79 words]

Answer 24

a. Dk= f1(Φ,Pk,I,E)

Φ- expectations regarding the growth in demand for the products produced BY CAPITAL:+

Pk- The expected price of the investment: -

I- The discount rate of future income: -

E- The number of entrepreneurial investors who can obtain finance for their demand for capital goods: +