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Macroeconomics: Events and Ideas

1.
Since the crash of its stock market in 1989, the Japanese economy has seen little economic growth and some deflation. The accompanying table from the Organization for Economic Cooperation and Development (OECD) shows some key macroeconomic data for Japan for 1991 (a normal year) and 19952003.
Government budget deficit (percent of GDP)

Year

Real GDP annual growth rate

Short-term interest rate

Government debt (percent of GDP)

1991 1995 1996 1997 1998 1999 2000 2001 2002 2003

3.4% 1.9 3.4 1.9 1.1 0.1 2.8 0.4 0.3 2.5

7.38% 1.23 0.59 0.60 0.72 0.25 0.25 0.12 0.06 0.04

64.8% 87.1 93.9 100.3 112.2 125.7 134.1 142.3 149.3 157.5

1.81% 4.71 5.07 3.79 5.51 7.23 7.48 6.13 7.88 7.67

a. From the data, determine the type of policies Japans policy makers undertook at that time to promote growth. b. We can safely consider a short-term interest rate that is less than 0.1% to effectively be a 0% interest rate. What is this situation called? What does it imply about the effectiveness of monetary policy? Of fiscal policy?

1. Solution

a. From the annual real GDP growth rate, we can see the slow growth of the Japanese economy: the economy actually contracted in 1998 and 2002, with minimal growth in 1999 and 2001. We can also see that policy makers used expansionary monetary policy to spur the economy: short-term interest rates fell from 7.38% in 1991 to 0.04% in 2003. Finally, since government debt as a percentage of GDP rose from 64.8% in 1991 to 157.5% in 2003 and the government deficit as a percentage of GDP rose from 1.81% to 7.67%, we can conclude that they were also using expansionary fiscal policy. b. During 2002 and 2003, the short-term interest rate in Japan was effectively 0%, a situation known as a liquidity trap. In this case, monetary policy is ineffective since the interest rate cannot be driven any lower by expansionary monetary policy. In a case of a liquidity trap, the only effective tool is expansionary fiscal policythat is, Keynesian policy.

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MACROECONOMICS

33 17
ECONOMICS

chapter:

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MACROECONOMICS, CHAPTER 17 ECONOMICS, CHAPTER 33

2.

The National Bureau of Economic Research (NBER) maintains the official chronology of past U.S. business cycles. Go to its website at http://www.nber.org/cycles/ cyclesmain.html to answer the following questions. a. How many business cycles have occurred since the end of World War II in 1945? b. What was the average duration of a business cycle when measured from the end of one expansion (its peak) to the end of the next? That is, what was the average duration of a business cycle in the period from1945 to 2001? c. When and what was the last announcement by the NBERs Business Cycle Dating Committee, and what was it?

2. Solution

a. Answers will vary. But as of December 2008, there had been 11 business cycles since the end of 1945. This includes the recession that began in December 2007 and, at the time of writing, still continued. b. As of December 2008, the average duration of a business cycle for the period 19452005, when measured from the end of one expansion (peak) to the next, was 67 months. c. As of December 2008, the last NBER Business Cycle Dating Committee announcement was of the NBERs Determination of the December 2007 Peak in Economic Activity, on December 11, 2008.

3.

The fall of Americas military rival, the Soviet Union, in 1989 allowed the U.S. to significantly reduce its defense spending in subsequent years. Using the data in the following table from the Economic Report of the President, replicate Figure 33-3 for the 19902000 period. Given the strong economic growth in the U.S. during the late 1990s, why would a Keynesian see the reduction in defense spending during the 1990s as a good thing?
Year Budget deficit (percent of GDP) Unemployment rate

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

3.9% 4.5 4.7 3.9 2.9 2.2 1.4 0.3 0.8 1.4 2.4

5.6% 6.8 7.5 6.9 6.1 5.6 5.4 4.9 4.5 4.2 4.0

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3. Solution

The accompanying diagram replicates Figure 33-3 for the 19902000 period. It was fortunate that defense spending fell and the budget deficit declined during this period because additional spending at a time of strong growth (and low unemployment rates) is likely to have created inflationary pressure.
Unemployment rate, budget deficit (percent of GDP) 8% 6 4 2 0 2 4
98 19 92 94 96 19 19 19 19 00 90

Unemployment rate

Budget deficit

Year

4.

In the modern world, central banks are free to increase or reduce the money supply as they see fit. However, some people harken back to the good old days of the gold standard. Under the gold standard, the money supply could expand only when the amount of available gold increased. a. Under the gold standard, if the velocity of money was stable when the economy was expanding, what would have had to happen to keep prices stable? b. Why would modern macroeconomists consider the gold standard a bad idea?

4. Solution

a. For prices to remain stable when the economy was expanding and the velocity of money was stable, the stock of gold would have had to grow at the same rate as real GDP. b. Under the gold standard there is no room for activist monetary policy, which modern macroeconomists favor.

5.

Monetarists believed for a period of time that the velocity of money was stable within a country. However, with financial innovation, the velocity began shifting around erratically after 1980. As would be expected, the velocity of money is different across countries depending upon the sophistication of their financial systemsvelocity of money tends to be higher in countries with developed financial systems. The accompanying table provides money supply and GDP information in 2005 for six countries.
M1 (billions in national currency) Nominal GDP (billions in national currency)

Country

National currency

Egypt South Korea Thailand United States Kenya India

Source: Datastream.

Egyptian pounds Korean won Thai baht U.S. dollars Kenyan pounds Indian rupees

101 77,274 863 1,369 231 7,213

806,622 7,103 12,456 1,415 35,314

20

539

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a. Calculate the velocity of money for each of the countries. The accompanying table shows GDP per capita for each of these countries in 2005 in U.S. dollars.
Nominal GDP per capita (U.S. dollars)

Country

Egypt South Korea Thailand United States Kenya India

Source: IMF.

$1,270 16,444 2,707 41,886 572 710

b. Rank the countries in descending order of per capita income and velocity of money. Do wealthy countries or poor countries tend to turn over their money more times per year? Would you expect that wealthy countries have more sophisticated financial systems?

5. Solution
Country

a. The velocity of money is defined as nominal GDP divided by the quantity of money. For example, the velocity of money in Egypt is 539/101 = 5.3. The velocity of money for each of the countries is in the accompanying table.
Velocity of money

Egypt South Korea Thailand United States Kenya India

5.3 10.4 8.2 9.1 6.1 4.9

b. Rank in descending order of velocity: South Korea, United States, Thailand, Kenya, Egypt, India. Rank in descending order of per capita income: United States, South Korea, Thailand, Egypt, India, Kenya. According to the above rankings wealthy countries tend to have a higher velocity of money than do poor countries, but the relationship is not exact. One would expect that wealthy countries have more sophisticated financial systems.

6.

The chapter explains that Kenneth Rogoff proclaimed Richard Nixon the all-time hero of political business cycles. Using the table of data below from the Economic Report of the President, explain why Nixon may have earned that title. (Note: Nixon entered office in January 1969 and was reelected in November 1972. He resigned in August 1974.)
Government budget balance (billions of dollars) 3-month Treasury bill rate

Year

Government receipts (billions of dollars)

Government spending (billions of dollars)

M1 growth

M2 growth

1969 1970 1971 1972 1973

$186.9 192.8 187.1 207.3 230.8

$183.6 195.6 210.2 230.7 245.7

$3.2 2.8 23.0 23.4 14.9

3.3% 5.1 6.5 9.2 5.5

3.7% 6.6 13.4 13.0 6.6

6.68% 6.46 4.35 4.07 7.04

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Solution 6.

The data indicate that President Nixon may have used fiscal and monetary policy to aid his reelection efforts. From his first year in office, 1969, to his reelection year, 1972, federal spending grew by 27% but federal receipts grew by only 11%. Overall, the federal budget balance went from a $3.2 billion surplus to a $23.4 billion deficit as a result of these expansionary fiscal policies. Nixon also used expansionary monetary policy to increase his popularity. Both M1 and M2 grew increasingly rapidly from 1969 to 1972. In response, the three-month Treasury bill rate (a short-term interest rate) fell from 6.68% to 4.07% during this same time period. After his reelection, these expansionary policies were reversed and the budget deficit shrank by $8.5 billion, or by more than a third; the growth of M1 fell 3.7 percentage points, the growth of M2 fell 6.4 percentage points, and the three-month Treasury bill rate rose to 7.04%. The economy of Albernia is facing a recessionary gap, and the leader of that nation calls together five of its best economists representing the classical, Keynesian, monetarist, real business cycle, and modern consensus views of the macroeconomy. Explain what policies each economist would recommend and why.

7.

7. Solution

In response to a recessionary gap in Albernia, the economists representing the different views of the macroeconomy would make the following suggestions. Classical: Do nothing. The recessionary gap will exist only in the short run, and the only focus for policy makers is the long run. Keynesian: The best policies to alleviate the recessionary gap are fiscal policies. Although expansionary monetary policies can be effective in promoting economic growth, they will not be very effective when the economy is in a deep recession or depression, when the economy may face a liquidity trap. Monetarist: The government should not engage in discretionary fiscal or monetary policies because such policies can worsen economic fluctutations. GDP will grow steadily without inflationary pressure if the money supply grows steadily. Real business cycle: The government should engage in policies that increase total factor productivity. Changes in monetary or fiscal policy that simply stimulate demand will have no effect on the economy because the aggregate supply curve is vertical. Modern consensus: Both monetary and fiscal policies can reduce a recessionary gap, although if a liquidity trap exists, it will reduce or eliminate the effectiveness of monetary policy. Discretionary monetary policy is generally preferred over discretionary fiscal policy.

8.

Which of the following policy recommendations are consistent with the classical, Keynesian, monetarist, and/or modern consensus views of the macroeconomy? a. Since the long-run growth of GDP is 2%, the money supply should grow at 2%. b. Decrease government spending in order to decrease inflationary pressure. c. Increase the money supply in order to alleviate a recessionary gap. d. Always maintain a balanced budget. e. Decrease the budget deficit as a percent of GDP when facing a recessionary gap.

8. Solution

a. Monetarists would support such a policy; they believe in a monetary policy rule that allows the money supply to grow at the same rate as GDP. Since classical economists focus on long-term policies, they would also recommend such a policy. Keynesians and followers of the modern consensus believe that discretionary monetary policy can be useful in addressing short-run problems and would not recommend a monetary policy rule.

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b. Classical economists would see the inflationary pressure as a short-run problem and would not advocate any policy; their view would be that the inflationary pressure will not exist in the long run. Monetarists would also be reluctant to endorse fiscal policy in the short run; they believe discretionary fiscal policy actually makes the economy worse. Contractionary fiscal policy, such as a decrease in government spending, would definitely be recommended by Keynesians and, only in very unusual circumstances, by followers of the modern consensus. c. Classical economists would see a recessionary gap as a short-run problem and would not advocate any policy; their view would be that the recessionary gap will not exist in the long run. Monetarists would also be reluctant to endorse a shortrun discretionary monetary policy because they believe it will make the economy worse. Expansionary monetary policy, such as an increase in the money supply, would be recommended by Keynesians and by followers of the modern consensus if the economy is not suffering from a liquidity trap. d. Keynesians and followers of the modern consensus would disagree with this policy recommendation. A balanced-budget rule would eliminate the possibility of using discretionary fiscal policy whenever a recessionary or expansionary gap exists. In fact, a balanced-budget rule would require that the government employ contractionary fiscal policy during recessions (making the recession worse). Monetarists would be sympathetic to a balanced-budget rule because of the problem of crowding out. Given classical economists focus on the long run, they would probably favor such fiscal conservatism. e. No one would agree with this policy recommendation. Decreasing the budget deficit as a percent of GDP when facing a recessionary gap would be using contractionary fiscal policy (a decrease in government spending or an increase in taxes) and that would make the recession worse.

9.

Using a graph like Figure 33-4, show how a monetarist can argue that a contractionary fiscal policy need not lead to a fall in real GDP given a fixed money supply. Explain.

9. Solution

As you can see in the accompanying figure, contractionary fiscal policy shifts the aggregate demand curve leftward, from AD1 to AD2, in panel (a). Correspondingly, there is a decrease in money demand, and the money demand curve shifts leftward, from MD1 to MD2, in panel (b). This leads to a fall in the interest rate from r1 to r2, which has the effect of increasing investment spending and expanding the economy. If the increase in investment spending is sufficient to counteract the effect on real GDP of the contractionary fiscal policy, then the monetarist is indeed correct.
Panel (a) Panel (b)
SRAS
Interest rate MS

Aggregate price level

P1 P2

E1 E2 AD2 AD1
Real GDP

r1 r2

MD1 MD2

Y2

Y1

Quantity of money