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2009 Winter Final Exam

2009 Winter Final Exam

Short Answer Questions (10 points each, 100 points total)

1. C + …… ≡ Y ≡ … + i + r + pi + δ + τindirect. Identify the missing components. Use to explain how lower car sales affect the economy. [Hint: why both the right and left hand sides?]

GDP = C+ Private domestic investment including new housing + I + Government purchases not transfers G + net exports of goods and service X-M = wages w + the rest. The right hand side reminds us that new final expenditure adds to incomes for someone through wages, dividends, profits and the like. Because income turns into disposable income, any change on the right hand side leads to an increase in income and an additional boost to GDP. That is the source of our multiplier.

An increase in new car sales shows up in C. This leads to additional wages as workers are rehired (w + …) which boosts disposable income and thence (after taxes, imports and savings) leads to an additional increase in G. We used a factor of 2 as the upper limit, but more realistically the multiplier for this sort of exogenous change is about 1.5.

2. Credit crunch. Explain why bad sub-prime loans lower car sales.

Banks (and ideally – once regulations are adjusted – shadow banks!) require capital as a cushion to protect depositors. If they suffer loan losses, then these are written off against capital. So then banks must either seek new capital or reduce total loans so that the ratio of assets to loans rises. Right now, they're not making loans. So consumers who want to buy a new car find it very hard to do so; leasing has almost totally collapsed. Of course sub-prime loan losses also mean lots of people are being pushed into bankruptcy, or at least can no longer "flip" their house to realize a capital gain. The recession also hurts expectations; consumers fearful for their job put off buying a new car if they can. At the moment this is particularly painful to car companies and other sellers of big-tickets items.

But in general a recession increases credit risk, making banks more selective in whom they lend to. So even without a credit crunch sales would fall. In addition, it cuts consumer confidence, so sales fall not because people can't buy, but because they don't want to. However, the centrality of credit in the normal car purchase – most people borrow to finance at least part of the cost – and the testimony of car dealers [not common knowledge to Econ 102 students] are arguments that the credit crunch is a factor.

3. "To maintain the stability of the financial system the US should insure deposits, but in return it ought to require that all institutions maintain minimum reserves and capital, and prohibit certain sorts of business, even if they only have transactions with other large financial institutions." Argue the merits of this proposition. [Feel free to refer to Krugman's arguments.]

We want to prevent bank runs (illiquidity) and bankruptcy (insolvency) of financial institutions; it's also nice to avoid credit crunches. Note that some large institutions have become so thoroughly enmeshed in our financial system that we (the Fed and Treasury) have judged them "too big to fail" and have been forced to insure deposits after the fact. That's very expensive, and hard to do, much less do well.

Insuring deposits up front is a way to prevent bank runs, but that creates moral hazard: financial institutions have less incentive to avoid risk. If they don't have to maintain capital, the upside from risk is greater. We thus can lessen moral hazard by forcing institutions to put more of their own money at risk (capital requirements), and by directly prohibiting gambling and other sorts of business with unusual risks or uncertainty. In addition, if banks have more capital, then they can cushion losses. When that is done, a bank run is less likely; forcing financial institutions to maintain reserves provides a cushion there as well. And charging a fee for insurance makes sense, too, and means that this system can be largely self-financing.

4. "Attempting macroeconomic policy is about as effective as trying to drive forward by looking in the rearview mirror: you are always going to miss the turns." Discuss the weaknesses (and strengths!) of MP and FP in terms of leads and lags, among other aspects.

Most of the time things don't change very quickly, and so we can potentially use MP to keep the economy on the road when there's a mild curve. But not when there's a sharp curve: the economy – as in 2008-9 – runs off the road. Even when we can sense problems ahead, and put on the brakes, we're likely to end up on the shoulder. We tend not to put on the brakes until we see we're quite a bit off course and we start out just touching the brakes, not slamming them on. Furthermore, we've got to contend with momentum: we don't stop right away.

To rephrase, policy change lags reality, because economists have to rely on data reflecting the state of things 1-3 months earlier, and the data are noisy and so are hard to interpret; two bad months may not indicate actual problems. While with hindsight we know the recession started at the end of 2007, that was not apparent even in March 2008. The Fed then cut interest rates a bit; they weren't certain how deep the recession would be, or how much impact cutting interest rates would have. Their bias is to not overdo it, as a drop in interest rates only works as home construction and new investment pick up, which occurs over the course of many months. (And rates can't be cut below zero.) Because expectations are very important, a cut may not work, or it may coincide with a return of optimism. So if the Fed cuts rates, and this produces a turnaround, the Fed may not know that until 9 months later. Moving slowly lessens the danger of overcorrecting.

Fiscal policy requires even greater lead time, because there is normally only one set of budget bills a year; putting together an emergency stimulus bill, such as was passed in February 2009, is highly unusual, and that effort began only after months of horrendous data indicating a very deep recession. Once Congress approves tax and expenditure changes, we're still not done, because they take a while to implement; the full impact of the February 2009 stimulus package won't likely be felt until over a year from now and we may not know that until the budget for 2010 has already been drafted. As with monetary policy, it isn't always effective. As we've analyzed using our life cycle consumption model, a temporary tax cut tends to be saved, not spent – and for those just short of retirement age, an income tax cut must always be temporary. Spending programs are more reliable creators of jobs.

We can also note side effects. Expansionary fiscal policy tends to push up interest rates and when the economy is near capacity, can crowd out investment or lead to a strong dollar and a trade deficit. "Tight" monetary policy operates through higher interest rates and so has the same side effects. Hence we'd prefer that "tight" fiscal policy be used to fight inflation and stimulative monetary policy to fight recessions. But the unpredictable nature of the legislative process means that since WWII the US has depended almost entirely on monetary policy.

In sum, we cannot fine-tune the economy, though reduced volatility fooled many into thinking the business cycle had been tamed. As Krugman pointed out in his book, that position is possible only if economists refused to look at the recent experience of other countries. Big swings in performance (including inflation) are unusual – in the US we've not seen anything like this for 70 years. In the same vein, if we look at the 30-40 largest economies, we find only scattered crises. But they've not disappeared, and so "depression" economics must remain part of the realm of macroeconomics. This is in tension with "cutting edge" research, which for technical reasons borrows heavily from the mathematics of "classical" models, whatever the ideology of the economist. In modern models change is smooth; crises cannot occur. In effect, leading macroeconomists confused their simplified models of the economy with the economy itself.

5. Endogeneity (I): Phillips Curve. As we increase aggregate demand, what happens to real GDP? to the multiplier?

The Phillips curve, showing a tradeoff between GDP and prices (or better, the link between GDP growth and changes in the growth of inflation), is the technique macroeconomists use to endogenize prices. In our AD - AS framework we can do that by introducing a curved AS that is flat at low levels of output and rises towards vertical at higher levels of output. (We can also use a potential GDP curve, but that adds complexity without shedding additional light on what happens.)

The answer is, "it depends." At normal levels of GDP, with unemployment at low levels, an increase in aggregate demand (a "nominal" government expenditure) leads to a modest boost in real GDP (some job creation) and a modest increase in prices (some inflation). In other words, we don't get the full multiplier effect because some of the boost in demand is eaten up by higher prices rather than higher quantity, leading to a smaller multiplier effecdt. If unemployment is very low – the economy is booming – the multiplier can be zero. But if we are in a situation such as today's deep recessions, AS is flat and there are no such issues.

Now the Phillips Curve is not a stable relationship; whatever the rate of inflation, it tends to be perpetuated. We can also have crowding out (so that G ↑ ⇒ X-M ↓ with no net change to Y, that is, a zero multiplier) where a boost in AD does not lead to a price increase. But that is not due to the Phillips Curve itself.

6. Endogeneity (II): Taylor Rule. As we increase aggregate demand, what happens to interest rates? to the multiplier?

We can also make the interest rate endogenous using a Taylor Rule. That is because short term interest rates are (at least for the past quarter century) explicitly set by the Fed, and we know that the Fed tends to raise interest rates in response to inflation and (with less "oomph") to changes in GDP growth. So ceteris paribus when GDP grows more strongly, the Fed raises (short-term) interest rates; long-term rates tend to follow. That means that while we had (say) G ↑ we now have a partially offsetting decrease in I and X-M. As a result we have a smaller multiplier effect. This ought to work in reverse, too: if fiscal policy is "tightened" (G ↓) so that the Fed anticipates slower growth, then it will tend to cut interest rates, which will raise I and X-M, offsetting some of the change in policy. Again, that shows up as a smaller multiplier.

7. Law of Comparative Advantage. Exporters and importers around the world can't get banks to lend them money to finance shipments of goods.

The LofCA urges us to specialize, in line with comparative advantage, and to trade to enable that to happen. The result is that our incomes should on average rise (ditto for those of our trading partners).

The current credit crunch interferes with that process. If shippers can't get finance to open "letters of credit" then the net effect is like that of an across-the-board increase in tariffs. Total trade falls, hurting exporters and importers, and undoing some of the benefits of trade. That was one complicating factor in the Great Depression of the 1930s; let's hope it does not become a problem this time around.

8. Expectations: How powerful is Ben Bernanke right now? What can he (and can he not) do?

Investment is governed first and foremost by expectations, not interest rates. Presently investors (those building factories, office buildings, shopping malls and houses) are gloomy in the extreme. No amount of cuts in interest rates will offset that (particularly since inflation is nearly zero, so that real interest rates can't be pushed below zero).

The same is true to some extent for consumption, particularly of durable good but also for other discretionary items, e.g., restaurants. That shows up as an increase in precautionary saving. Would that Americans had saved during the "bubble", cashing out (and extra sales, more houses and stocks on the market, would have restrained prices and hence muted the bubble). Now we face the paradox of thrift.

9. "X has a large budget deficit, a lot of debt and an unstable banking system." Should we fear a meltdown? Does it matter if X is California? Mexico? the US?

The US has its debt in dollars, and can "roll over" bonds. The Fed can also in effect "print" money to bail out banks. And right now the deficit is not an issue as few others want to borrow money (and many of those who would like to borrow are not good credit risks). Fiscal policy works to some extent: the multiplier is fairly high. Finally, we are a whale in the global economy, so capital flight is not possible: there is nowhere to which investors in the US can flee. We are (ouch) too big to fail…

California can't bail itself out; it can't print money and currently people demand very high returns on California's debt. Interstate banking means it also has a hard time addressing banking problems on its own. So the level of debt matters, it has a hard time running deficits and it can't cure banking problems. In addition, the multiplier is low, so in any case it wouldn't find fiscal policy attractive.

Mexico has historically borrowed from non-residents, and it remains a modest-sized component of a large global economy. It can thus suffer from short-term capital flight, and from exchange risk. It thus matters a great deal if it has a lot of debt, because that amplifies the downside from any negative shock and in general makes capital markets nervous. It can run budget deficits, as long as investors aren't nervous, but can't 100% rely on them. However, as domestic peso-based capital markets have grown in size, the potential to borrow in pesos is now greater, so Mexico has a degree of freedom it did not in the 1990s. Now fiscal policy has potency, though less than in the US because trade is more important to Mexico so the multiplier is smaller.

10. At the start of the Reagan Administration household savings were above 10%, but then declined almost monotonically to below zero in 2006. What are the costs and benefits of boosting savings rates to (say) their average postwar level of 8%-10%?

First we need to remember the paradox of thrift: s ↑ ⇒ G ↓ which is unpleasant. Over time any such effect should wear off, but a short-term swing in savings is not desirable. In addition, we have no guarantee that it will be channeled into productive investment and hence greater long-run growth.

But in general we would expect a large supply of savings to produce slightly lower real interest rates, which would lead to I ↑ and e ↓ (hence X-M ↑) and undo the crowing out we see at present. That would be good as we are running up lots of liabilities to the rest of the world. It would also boost LR growth.

One way to summarize this is using (S-I) + (T-G) ≡ (X-M). As long as we don't start running up bigger deficits, then S ↑ should lead to offsetting changes in other components of our global savings-investment balance.

Note that this does not guarantee that at the household level dis-saving in retirement would go smoothly; it does not get around the pay-as-you-go nature of retirement at the macroeconomic level. Hence we still are likely to see an increase in taxes in the not-so-distant future. But if we start saving now, we would be splitting a larger pie with the baby boomers, potentially one large enough to "pay back" the savings made up front with a decent increase in consumption.