Friday, March 13, 2009


These problems sets correspond roughly to chapters in Greg Mankiw's Brief Principles of Macroeconomics 4th Edition, and material will be very similar to the 5th Edition as well. 


Wednesday, March 11, 2009


1 What role do interest rates play according to the liquidity preference theory?

A)when the interest rate increases, the opportunity cost of money increases, so people hold less money
B) Equilibrium in the money market is achieved by adjustments in the interest rate

2 What determines the money supply according to liquidity preference theory? What happens if there is an increase in the money supply? What happens if there is a decrease in the money supply?

The federal reserve determines the money supply .

If the Federal Reserve increases the money supply the money supply curve will shift right and interest rates will decrease. The Aggregate Demand curve will also shift right. If the Federal Reserve decreases the money supply, the money supply curve will shift left and interest rates will increase. The Aggregate Demand curve will shift left.

3. What effect does an increase in government spending have on the aggregate demand curve?

An increase in government spending initially shifts the aggregate demand curve to the right.

4. Explain the multiplier effect. Give an example:

With the multiplier effect, additional shifts in aggregate demand result when expansionary fiscal policy (government spending or tax refund checks) increases income and thereby increases consumer spending. Graphically there is an initial shift from the initial government spending, then an additional shift from the increases in consumer spending.

Example: The government spends money on roads and schools. The owners of the construction companies pay their workers and more teachers are hired to teach. The workers and teachers increase their spending. The firms that the workers and teachers buy goods from increase their production. Spending and income continues to increase, much more than the initial money spent by the government.

5. How does the crowding out effect impact the an increase in government spending?

According to the crowding out effect, an increase in government spending increases the interest rate and decreases investment spending. Graphically the aggregate demand curve may initially shift outward, but then may shift back in. As a result, the impact of government spending on ‘stimulating’ economic activity is less.

Note: The net effect of fiscal policy is uncertain. The multiplier effect increases the effects of an increase in government expenditures while the crowding out effect diminishes the effect of government expenditures. Both effects work against each other.

6. How might a tax cut affect the short run aggregate supply curve?

If the government cuts the tax rate, workers keep more of each dollar they earn, so they work more The quantity of goods and services supplied will be greater at each price level. As a result the short run aggregate supply curve shifts to the right and output increases.

Further, the cut in tax rates will stimulate enough additional production and income that tax revenue actually increases.

7. What is stabilization policy?

Stabilization policy is an attempt by policymakers and the federal reserve to control aggregate demand and stabilize the economy.

Ex: if there is a decrease in aggregate demand due to consumer and investor pessimism, the aggregate demand curve may shift left. A recession may result.
To combat this, the federal reserve may increase the money supply, or the government may increase spending in order to ‘shift ‘ the aggregate demand curve back out . The purpose would be to promote economic recovery from the recession or prevent it.

8. Why are many economists critical of stabilization policy?

A. There is a lag between the time policy is passed and the time policy has an impact on the economy.

B. The impact of the policy may last longer than the problem it was designed to offset

C. Policy can be a source of, instead of a cure for, economic fluctuations

Ex: During the Great Depression stabilization policies may have increased its severity and prolonged the time it normally would have taken to recover.


1 A recession can be described as:

A short period of falling incomes and rising unemployment

2 What role does investment (I) play in economic fluctuations?

It is only a small part of real GDP, but it actually accounts for a large share of the fluctuation in real GDP ( in fact ~ 2/3 of the decline in GDP during recessions)

3 If an economic contraction is caused by a downward shift ( or decrease) in aggregate demand, how would the economy respond on its own i.e. how would the contraction ‘resolve itself’ without government intervention?

(see 4 steps from notes Ch 15, slides, or class discussion/review)

Summary: With the reduction in AD, over time, there is a fall in the expected price level and costs decline. This leads firms to expand output, shifting the short run aggregate supply curve to the right.
The situation is resolved with a lower price level as output returns to its natural rate.

4 What happens when the short run aggregate supply curve shifts to the left?
(see slides ch15 notes, or graph in class discussion /review)

Summary: A decrease in the short run aggregate supply curve leads to decreased output and higher prices. This situation where there is increasing prices and decreasing output is referred to as ‘Stagflation’.


1) Write the equation for the market for loanable funds in an open economy:

S = I + NCO

2) In an open economy, the supply of loanable funds is determined by :

National saving, the same as in a closed economy

3) In an open economy, the demand for loanable funds is determined by: .

the sum of net capital outflow and domestic investment.



1) Write the equation for GDP for: a) a closed economy, b) an open economy

a) Y= C + I + G
b) Y = C + I + G +NX

2) What is the meaning and significance of the equation that NCO = NX?

Net capital outflow = net exports

If a country exports (sells) more goods than it imports (buys), it has a trade surplus, NX is positive. This means that Net Capital Outflow is positive.

If a country imports (buys) more goods than it exports (buys) it has a trade deficit, NX is negative, and NCO is also negative.

What Casued the Financial Crisis?

Did the Federal Reserve Cause the Housing Bubble and the Subsequent Financial Crisis?

Some economists think that the Fed played a role:

( Recall the application of the supply and demand for loanable funds from Chapter 8 relates to this point of view)

See here ( Wall Street Journal) here ( WSJ)
and here ( Ludwig von Mises Institute)

Alan Greenspan, Former Federal Reserve Chairman doesn't think so:

see here ( Wall Street Journal)

For a visual explanation see the following video:

Part 1

Part 2

Austrian Business Cylces Using Supply and Demand for Loanable Funds

Austrian Business Cycles and the Market for Loanable Funds

•Figure 1(b) shows the effect of an increase in credit creation brought about by a monetary expansion from the Federal Reserve. This results in a shift in the supply curve from S to S+ MS’.

•This increase is not based on real households savings; only the injection of new money created by the Federal Reserve.

•As the market-clearing rate of interest falls from I’ to i, businesses increase investment by the amount AB, while genuine saving actually falls by the amount AC.

•Inflating the supply of loanable funds with new money keeps the interest rate artificially low. This drives a wedge between saving and investment.

•This has stimulated temporary vs. sustainable growth, or an artificial boom. The result is unsustainable. A bust follows, and investment falls back into line with saving (not shown in figure 1(b).

Adapted from : David Glasner, ed., Business Cycles and Depressions
New York: Garland Publishing Co., 1997, pp. 23-27

Taxes, Spending, and Unemployment

Government interventions such as unemployment insurance may explain the chronic unemployment issues in Europe. Below are some additional resources that look at employment levels as they relate to government policies in European countries.

Economic Inquiry, 2008, vol. 46, issue 2, pages 197-207

Abstract: "We develop and calibrate a theoretical model that explains per capita hours worked and output growth as a function of three fiscal policy variables. differences in income taxes, productive government expenditures, and nonemployment transfers are sufficient to answer the question why Europeans work (much) less than Americans and why some Europeans work less than others. Differences in taste for leisure have little role to play given the actual variation of these three policy variables." ("JEL" E24, E62, J22, O41) Copyright (c) 2007 Western Economic Association International.


Why Do Americans Work So Much More Than Europeans?
Federal Reserve Bank of Minneapolis Quarterly Review
Vol. 28, No. 1, July 2004, pp. 2–13

Americans now work 50 percent more than do the Germans, French, and Italians. This was not the case in the early 1970s, when the Western Europeans worked more than Americans. This article examines the role of taxes in accounting for the differences in labor supply across time and across countries; in particular, the effective marginal tax rate on labor income. The population of countries considered is the G-7 countries, which are major advanced industrial countries. The surprising finding is that this marginal tax rate accounts for the predominance of differences at points in time and the large change in relative labor supply over time.


Some Observations on the Great Depression


The Great Depression in the United States was largely the result of changes in economic institutions that lowered the normal or steady-state market hours per person over 16. The difference in steady-state hours in 1929 and 1939 is over 20 percent. This is a large number, but differences of this size currently exist across the rich industrial countries. The somewhat depressed Japanese economy of the 1990s could very well be the result of workweek length constraints that were adopted in the early 1990s. These constraints lowered steady-state market hours.


The Marxian view is that capitalistic economies are
inherently unstable and that excessive accumulation of
capital will lead to increasingly severe economic crises.
Growth theory, which has proved to be empirically successful,
says this is not true. The capitalistic economy is
stable, and absent some change in technology or the rules
of the economic game, the economy converges to a constant
growth path with the standard of living doubling
every 40 years. In the 1930s, there was an important
change in the rules of the economic game. This change
lowered the steady-state market hours. The Keynesians had
it all wrong. In the Great Depression, employment was not
low because investment was low. Employment and investment
were low because labor market institutions and
industrial policies changed in a way that lowered normal


Saturday, March 7, 2009


#1 . The Federal Reserve has _____ regional banks. The Board of Governors has ____ members who serve 14-year terms.

ANS: 12, 7

#2 List the 3 primary functions of the Fed.

Regulates banks to ensure they follow federal laws intended to promote safe and sound banking practices.

•Acts as a banker’s bank, making loans to banks and as a lender of last resort.

•Conducts monetary policy by controlling the money supply.

#3 How might the fed increase the money supply?

1-make open market purchases (which lowers the federal funds rate), 2-lower the discount rate 3 - lower the reserve requirement

#4 What is the federal funds rate, and how is it involved in monetary policy?

The interest rate banks charge each other for short-term loans of reserves. By increasing the money supply with open market purchases the fed lowers the federal funds rate. By decreasing the money supply through open market sales the fed increases the federal funds rate.

#5 If the reserve ratio is 5 percent, the money multiplier is _________________________.

(1/5)*100 = 20

The Mystery of Capital: Property Rights and Economic Development

In the last 2 weeks I discussed the importance of a sound legal system and property rights with regard to economic growth. In his book The Mystery of Capital Hernando De-Soto explains why these are so important, especially to developing countries. It also explains why capitalism has struggled to provide developing countries with many of the benefits we enjoy in the United States.

Below are a few excerpts:


“With the help of facts and figures that my research team and I have collected, block by block and farm by farm in Asia, Africa, the Middle East, and Latin America, that most of the poor already possess the assets they need to make a success of capitalism. Even in the poorest countries, the poor save. The value of savings among the poor is, in fact, immense—forty times all the foreign aid received throughout the world since 1945. In Egypt, for instance, the wealth that the poor have accumulated is worth fifty-five times as much as the sum of all direct foreign investment ever recorded there, including the Suez Canal and the Aswan Dam. In Haiti, the poorest nation in Latin America, the total assets of the poor are more than one hundred fifty times greater than all the foreign investment received since Haiti’s independence from France in 1804. If the United States were to hike its foreign-aid budget to the level recommended by the United Nations—0.7 percent of national income—it would take the richest country on earth more than 150 years to transfer to the world’s poor resources equal to those they already possess.”


“Because the rights to these possessions are not adequately documented, these assets cannot readily be turned into capital, cannot be traded outside of narrow local circles where people know and trust each other, cannot be used as collateral for a loan, and cannot be used as a share against an investment.”
“They lack the process to represent their property and create capital. They have houses but not titles; crops but not deeds; businesses but not statutes of incorporation. It is the unavailability of these essential representations that explains why people who have adapted every other Western invention, from the paper clip to the nuclear reactor, have not been able to produce sufficient capital to make their domestic capitalism work.


It takes 168 steps and 13 to 25 years to gain a formal title to urban property in
the Philippines; 77 steps and 6 to 14 years to do the same in the desert lands in Egypt; and 111 steps and 19 years in Haiti. If you wanted to open a one-worker garment shop legally in Lima, Peru, it would take you 289 days, working 6 hours a day, to obtain the business license.

In Brazil, 60 percent of new rental housing is in the underground economy. In Egypt, 92 percent of urban dwellers and 83 percent of rural dwellers live in homes without clear legal title.

I also shared some peer reviewed research related to economic growth. Below you will find some additional resources.

Aaron Tornell & Philip R. Lane, 1999.
"The Voracity Effect," American Economic Review, American Economic Association, vol. 89(1), pages 22-46, March.

Lucas (1988). ‘On the Mechanics of Economic Development.’ Journal of Monetary Economics 22 (July) 3-42.

Krueger (1993) ‘Virtuous and Vicious Circles in Economic Development.’ American Economic Review 83 (May) 351-355.



#1 . The natural rate of unemployment is the
a. unemployment rate that would prevail with zero inflation.
b. rate associated with the highest possible level of GDP.
c. difference between the long-run and short-run unemployment rates.
d. amount of unemployment that the economy normally experiences.


#2 T/F Cyclical unemployment is closely associated with long term economic growth;

FALSE It is associated with fluctuations in the business cycle.

#3 Give an example of frictional unemployment associated with a sectoral shift.

The decrease in jobs in cassette manufacturers due to the introduction of CD’s.

#4 Why might European countries( like Germany) have higher rates of unemployment in the United States

Due to high levels of unemployment insurance.

#5 Why do firms pay efficiency wages? (SKIP)

#6 ) A minimum wage set above equilibrium results in?

INCREASE the quantity of labor SUPPLIED and DECREASE the quantity DEMANDED. This results in a SURPLUS or UNEMPLOYMENT. You should be able to demonstrate this with a graph


# 1 What causes a government budget deficit? How does if affect interest rates and investment? What is this result referred to as?

A budget deficit occurs when the governments spending exceeds tax revenue.
By decreasing the supply of loanable funds, a budget deficit leads to a leftward shift in the supply curve for loanable funds, leading to an increase in the equilibrium interest rate.

This increase in the interest rate results in a decrease in the quantity of investment. This is referred to ‘crowding out.’

#2 What would be the result if instead of a budget deficit, the government had a budget surplus? Use a graph.

As shown in the graph below, the economy starts in equilibrium at point E0 with interest rate r0 and equilibrium quantity of saving and investment at q0. If the government succeeds in obtaining a surplus, there will be more public saving in the economy and so more national saving at each interest rate, and the supply of loanable funds curve will shift from S0 to S1. The new equilibrium will be at E1, with a lower interest rate, r1 and a higher quantity of saving and investment, q1. Hence, if the federal government succeeds in having a surplus, interest rates will fall and investment will increase.

#3 What happens if there is an increase in the demand for loanable funds?

An increase in the demand for loanable funds shifts the demand curve for loanable funds to the right, leading to an increase in the equilibrium interest rate.


#2What are the 4 determinants of productivity?

A = Technology
K/L = physical capital per worker
H/L = human capital per worker
N/L = natural resources per worker

#3 Which of the following policy proposals would lead to increased growth in a poor country?

1. Reduce corruption in the legal system;

2. Reduce reliance on market forces because
they allocate goods and services in an unfair manner;

3. Restrict investment in domestic industries by foreigners
because they take some of the profits out of the country;

4. Encourage trade with neighboring countries

5. Increase the fraction of GDP devoted to consumption

ANS: #1, #4

#4 In a market economy, we know that a resource has become scarcer when :

ANS: The price of that resource has increased

#5 True or False: Historically, the market prices of most natural resources (adjusted for inflation) have

False-they have remained stable or decreased.