ISL244E Macroeconomics Problem Session-5 by Research Assistant Serkan Değirmenci D202/12-14.03.2012

# Today # GNH (2009), Macroeconomics in Context - Chapter 11: Money and Monetary Policy Review Questions (RQ): 14-15-16-17-18 (Page: 285) Exercises (E): 4 (Page: 286) Blanchard (2009), Macroeconomics: #THE SHORT RUN# (CHP. 3 + CHP. 4 = CHP. 5) - Chapter 3: The Goods Market: (btw pages: 65-84) Quick Check (QC): 1-2-3 (Page: 82) Dig Deeper (DD): 4-5-7 (Page: 82-83)

GNH-Chapter-11-RQ-14 (Page: 285) 14. What is the quantity equation? ANSWER: (pages: 278-280) *quantity equation: MV=PY, where M is the money supply, V is the velocity of money, P is the price level and Y is the real output. MV=PY Y: real output or GDP (REAL GDP) P: price level as measured by the (GDP deflator) PY: nominal output (NOMINAL GDP) M: level of money balances (M1 measure) V: velocity of money

GNH-Chapter-11-RQ-15 (Page: 285) 15. What is the quantity theory of money? ANSWER: (pages: 278-280) *quantity theory of money: the theory that money supply is directly related to nominal GDP, according to the equation MxVbar=PxY. MV=PY with V assumed constant. Y: real output or GDP (REAL GDP) P: price level as measured by the (GDP deflator) PY: nominal output (NOMINAL GDP) M: level of money balances (M1 measure) V: velocity of money

GNH-Chapter-11-RQ-16 (Page: 285) 16. Describe classical monetary theory. ANSWER: (pages: 280) *Classical monetary theory is based on the quantity theory of money, plus the assumption that output is always constant at its full-employment level. MV=PY with V constant and Y=Y*. Y: real output or GDP (REAL GDP) Y*: FULL EMPLOYMENT OUTPUT P: price level as measured by the (GDP deflator) PY: nominal output (NOMINAL GDP) M: level of money balances (M1 measure) V: velocity of money In this case, changes in the money supply can have NO effect on the level of output. The inability of changes in the money supply to affect real output is called MONETARY NEUTRALITY. The only variable on the left side that is not constant is the money supply, while the only variable on the right side that is not constant is the price level. Thus, all that a change in the money supply can do is change prices. Rather than an increase in the money supply increasing output, in this model the only thing an increase in the money supply does cause inflation.

GNH-Chapter-11-RQ-17 (Page: 285) 17. What is monetarism? ANSWER: (pages: 280-281) *monetarism: a theory associated with Milton Friedman, which claims that macroeconomic objectives are best met by having the money supply grow at a steady rate. MV=PY, with V constant and a claim that a decrease in M can cause both P and Y to decrease. Y: real output or GDP (REAL GDP) P: price level as measured by the (GDP deflator) PY: nominal output (NOMINAL GDP) M: level of money balances (M1 measure) V: velocity of money

GNH-Chapter-11-RQ-18 (Page: 285) 18. Discuss how monetary expansion can lead to high inflation, using the quantity equation. ANSWER: (pages: 281-282) If M rises and V and Y are constant or do not rise much, P must rise. Y: real output or GDP (REAL GDP) P: price level as measured by the (GDP deflator) PY: nominal output (NOMINAL GDP) M: level of money balances (M1 measure) V: velocity of money

GNH-Chapter-11-E-4 (Page: 286) 4. Suppose the level of nominal GDP in Estilvania is $30 billion, and the level of the money supply is $10 billion. What is the velocity of money in Estilvania? Suppose that the money supply increases to $15 billion and nominal GDP rises to $45 billion. Which theory is supported? Suppose that the money supply increases to $15 billion and nominal GDP rises to $40 billion. Which theory is supported? Suppose that the money supply decreases to $5 billion and as a result both the price level and real GDP fall, so that nominal GDP falls to $15 billion. Which theory is supported? Suppose that the money supply increases to $15 billion. Real GDP stays the same, at its full-employment level, but the price level rises so that nominal GDP becomes $45 billion. Which theory is supported?

GNH-Chapter-11-E-4 (Page: 286)-answer a. V = 3 (That is, according to MV=PY, 10V=30). b. Quantity theory of money. (V is constant) c. Keynesian theories (V is variable) (page: 280) d. Monetarism (V is constant, and a drop in M causes a drop in both P and Y) e. Classical theory (V is constant and Y is constant at full employment). (This might arguably be a Keynesian theory with output happening to be at its full employment level, but for the fact that V is constant.)

B-Chapter-3-QC-1 (Page: 82) Using the information in this chapter, label each of following statements true, false, or uncertain. Explain briefly. The largest component of GDP is consumption. (T) (page: 67-table 3-1) Government spending, including transfers, was equal to 19% of GDP in 2006. (F)-Government spending excluding transfers was 19% of GDP. The propensity to consume has to be positive, but otherwise it can take on any positive value. (F)- The propensity to consume must be less than one for our model to make sense. (page: 69) Fiscal policy describes the choice of government spending and taxes and is treated as exogenous in our goods market model. (T) (page: 70) The equilibrium condition for the goods market states that consumption equals output. (F) (page: 71) An increase of one unit in government spending leads to an increase of one unit in equilibrium output. (F)- The increase in output is one times the multiplier. (page: 72) An increase in the propensity to consume leads to a decrease in output. (F) (page: 72)

B-Chapter-3-QC-2 (Page: 82) 2. Suppose that the economy is characterized by the following behavioral equations: C = 180 + 0.8YD I = 160 G = 160 T = 120 Solve for the following variables. Equilibrium GDP (Y) Disposable income (YD) Consumption spending (C)

B-Chapter-3-QC-2 (Page: 82)-answer (pages: 70-72) a. Y = C + I + G Y = 180 + 0.8(Y-120) + 160 + 160 Y = 2020   b. YD = Y – T = 2020 – 120 = 1900 c. C = 180 + 0.8YD C = 180 + 0.8(1900) = 1700

B-Chapter-3-QC-3 (Page: 82) 3. Use the economy described in problem 2. Solve for equilibrium output. Compute total demand. Is it equal to production? Explain. Assume that G is now equal to 136. Solve for equilibrium output. Compute total demand. Is it equal to production? Explain. Assume that G is equal to 136, so output is given by your answer to (b). Compute private plus public saving. Is the sum of private and public saving equal to investment? Explain.

B-Chapter-3-QC-3 (Page: 82)-answer (pages: 67-75 + 78-79) 3. a. Equilibrium output is 2020. Total demand = C + I + G = 1700 + 160 + 160 = 2020. Total demand equals production. We used this equilibrium condition to solve for output. b. Output falls by (24 times the multiplier) = 24/(1-.8) = 120. So, equilibrium output is now 1900. Total demand = C + I + G = 180+0.8(1780) + 160 + 136 = 1900. Again, total demand equals production. c. Private saving = Y – C – T = 1900 – 180 - 0.8(1780) – 120 = 176. Public saving = T – G = 120 – 136 = -16. National saving (or in short, saving) equals private plus public saving, or 160. National saving equals investment. This statement is mathematically equivalent to the equilibrium condition, total demand equals production. In other words, there is an alternative (and equivalent) equilibrium condition: national saving equals investment. (READ: 78-79)

B-Chapter-3-DD-4 (Page: 82) 4. The balanced budget multiplier. For both political and macroeconomic reasons, governments are often reluctant to run budget deficits. Here, we examine whether policy changes in G and T that maintain a balanced budget are macroeconomically neutral. Put another way, we examine whether it is possible to affect output through changes in G and T so that the government budget remains balanced. Start from equation (3.8).

B-Chapter-3-DD-4 (Page: 82)-cont. 4. By how much does Y increase when G increases by one unit? By how much does Y decrease when T increases by one unit? Why are your answers to (a) and (b) different? Suppose that the economy starts with a balanced budget: G=T. If the increase in G is equal to the increase in T, then the budget remains in balance. Let us now compute the balanced budget multiplier. Suppose that G and T increase by one unit each. Using your answers to (a) and (b), what is the change in equilibrium GDP? Are balanced budget changes in G and T macroeconomically neutral? How does the specific value of the propensity to consume affect your answer to (a d)? Why?

B-Chapter-3-DD-4 (Page: 82)-answer 4. a. Y increases by 1/(1-c1) b. Y decreases by c1/(1-c1) c. The answers differ because spending affects demand directly, but taxes affect demand indirectly through consumption, and the propensity to consume is less than one. d. The change in Y equals 1/(1-c1) - c1/(1- c1)=1. Balanced budget changes in G and T are not macroeconomically neutral. e. The propensity to consume has no effect because the balanced budget tax increase aborts the multiplier process. Y and T both increase by one unit, so disposable income, and hence consumption, do not change.

B-Chapter-3-QC-5 (Page: 82-83) 5. Automatic stabilizers So far in this chapter, we have assumed that the fiscal policy variables G and T are independent of the level of income. In the real world, however, this is not the case. Taxes typically depend on the level of income and so tend to be higher when income is higher. In this problem, we examine how this automatic response of taxes can help reduce the impact of changes in autonomous spending on output.

B-Chapter-3-QC-5 (Page: 82-83)-cont. 5. Consider the following behavioral equations: C = c0 + c1YD T = t0 + t1Y YD = Y – T G and I are both constant. Assume that t1 is between 0 and 1. a. Solve for equilibrium output. b. What is the multiplier? Does the economy respond more to changes in autonomous spending when t1 is 0 or when t1 is positive? Explain. c. Why is fiscal policy in this case called an automatic stabilizer?

B-Chapter-3-QC-5 (Page: 82-83)-answer 5. a. Y=c0+c1YD+I+G implies Y=[1/(1-c1+c1t1)][c0-c1t0+I+G] b. The multiplier=1/(1-c1+c1t1)<1/(1-c1), so the economy responds less to changes in autonomous spending when t1 is positive. After a positive change in autonomous spending, the increase in total taxes (because of the increase in income) tends to lessen the increase in output. After a negative change in autonomous spending, the fall in total taxes tends to lessen the decrease in output. c. Because of the automatic effect of taxes on the economy, the economy responds less to changes in autonomous spending than in the case where taxes are independent of income. Since output tends to vary less (to be more stable), fiscal policy is called an automatic stabilizer.

B-Chapter-3-QC-7 (Page: 83) 7. Investment and income This problem examines the implications of allowing investment to depend on output. Chapter 5 carries this analysis much further and introduces an essential relation-the effect of the interest rate on investment-not examined in this problem.

B-Chapter-3-QC-7 (Page: 83)-cont. 7. a. Suppose the economy is characterized by the following behavioral equations: C = c0 + c1YD YD = Y – T I = b0 + b1Y Government spending and taxes are constant. Note that investment now increases with output. (Chapter 5 discusses the reasons for this relation.) Solve for equilibrium output. b. What is the value of the multiplier? How does the relation between investment and output affect the value of the multiplier? For the multiplier to be positive, what condition must (c1 + b1) satisfy? Explain your answers. c. Suppose that the paramater b0, sometimes called business confidence, increases. How will equilibrium output be affected? Will investment change by more or less than the change in b0? Why? What will happen to national saving?

B-Chapter-3-QC-7 (Page: 83)-answer 7. a. Y=C+I+G Y=[1/(1-c1-b1)]*[c0-c1T+b0+G] b. Including the b1Y term in the investment equation increases the multiplier. Increases in autonomous spending now create a multiplier effect through two channels: consumption and investment. For the multiplier to be positive, the condition c1+b1<1 is required. c. Output increases by b0 times the multiplier. Investment increases by the change in b0 plus b1 times the change in output. The change in business confidence leads to an increase in output, which induces an additional increase in investment. Since investment increases, and saving equals investment, saving must also increase. The increase in output leads to an increase in saving.

to be continued…