Fall 2010

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Group Members: Thursday Class: Javier Cobo, Justin Makil, Karina Dinershteyn, Kenny Zee, Vaid Ramachandran Saturday Class: Javier Cobo

Problem Set #5 Due: beginning of class December 8, 9, or 11

1. In a paragraph, describe how fiscal deficits can cause hyperinflations. Use the quantity theory to help frame your discussion. (15 points) The quantity theory equation is MV = PY. Countries that exercise poor fiscal discipline and have a non-independent central bank tend to run large government deficits and print additional money to pay off the deficits. Doing so increases the amount of money in circulation (M). With the velocity of money (V) and domestic output (Y) staying fairly constant, this means that prices (P) must increase for the quantity theory relationship to hold true. Therefore, prices can increase significantly based on how much additional money the government chooses to print in order to pay off deficits. A sudden increase in prices can cause hyperinflation. 2. In the 1990s, the U.S. experienced a period of high output growth, but low inflation growth, contrary to the Philips Curve view of the economy. In a sentence or two, give a likely explanation. (5 points) The Philips Curve states the lower the unemployment (higher output growth) in an economy, the higher the rate of inflation. Innovations in telecommunications and computer networking spawned a vast computer hardware and software industry and revolutionized the way many industries operate, which increased output growth due to an increase in TFP and also lowered the unemployment rate by introducing new jobs in these industries but inflation was left in check. However, in the 1990s, US output growth was high, unemployment was low, and yet inflation remained low. 3. Use a supply and demand diagram (like the one in the note on taxes) to address the following questions.

a. Draw a supply and demand diagram for electricity in the United States. Clearly label
the equilibrium quantity and price of electricity. (5 points)

AS Pc DWL P* Pf AD AD b. Suppo
s e the Congress seeking to reduce energy use places a tax of t dollars per kilowatt on all users of electricity. Show how this tax affects the market for electricity on your graph from part a. Clearly label the new price paid by users and the new price received by electrical utilities. (10 points) See Graph c. Carefully shade in the deadweight loss of the tax. (3 points) See Graph d. In words, describe why there is a deadweight loss. (5 points) Adding a tax on electricity increases the Price the consumer has to pay for electricity, which decreases the demand of electricity to be consumed. The decrease in demand of electricity results in electric utility companies producing less electricity than the equilibrium output. As a result, deadweight loss is created based on the difference in electricity output and increase in consumer price.

Y Y*

e. Is electricity a good thing to tax? Why or why not? (5 points)

YesIt depends. It depends on who you are and what your goals are. Below are some points for why its good (Yes) and why it isnt (No) Yes:

, becauseSince electricity is its considered a necessity, which is a low elasticity good. Therefore, increases in price will not reduce output as much. There will be less deadweight loss. Even though it has low elasticity, levying a tax on electricity may reduce usage in the long term as consumers turn to more energy efficient products or reduce heavy usage like air conditioning in summer. Reducing usage would be considered good to environmentalists and may be useful in heavy usage months like summer when shortages are an issue.

The Global Economy: Problem Set #5

No:

Since electricity is an input, adding a tax may negatively impact output because it cause firms to be less efficient in productivity due to the increased costs in inputs. Taxes on any necessity are regressive, which hurts lower income people. Overall,sincealmosteveryoneuseselectricity,thiswouldbeabroadbasedtax,whichisgenerallya bettertaxmethodbecauseitallowsthegovernmenttoraiseagivenamountoftaxrevenuewithalower rateandsmallerwelfarecosttosociety.

4.

You have been asked by your boss to explain the Taylor Rule and how it can be a useful tool for understanding how the Fed chooses monetary policy. a. Using the Taylor Rule workbook data on Blackboard, plot a Taylor rule and the federal funds rate on a graph from 1970 to 2010. (7 points)

b. What was the impact of keeping the federal funds rate well below the Taylor rule rate for much of the 1970s? Why might the Fed have chosen this policy? (5 points) We will answer these questions in reverse order.Since the Fed kept the fed funds rate below the Taylor rule for most of the 1970s, the fed was later forced to increase the fed funds rate well above the Taylor rule for most of the 1980s, hitting a peak of 17.78% in 1981. Rising prices in oil, due to the 1973 oil crisis, may have have forcedled the Fed to choose to keep interest rates low to encourage economic growth. According to the modern monetary policy, a supply shock like this one should instead be accommodated through a reduction in demand, which can be achieved through high interest rates. A federal funds rate well below the Taylor rule for much of the 1970s caused inflation to soar to over 9% in late 1974 despite the fact that it may cause inflation to rise. At the same time, it failed to stimulate growth, resulting in high unemployment. This high unemployment during a time of high inflation is called stagflation. To combat

The Global Economy: Problem Set #5

inflation, the fed was later forced to increase the fed funds rate well above the Taylor rule for most of the 1980s, hitting a peak of 17.78% in 1981. As a result, the US experienced stagflation in the 1970s with prices increasing while business activity remained stagnant and unemployment increasing.

c. Fed deviations from a Taylor rule were smaller and less persistent after 1985. What
was the impact on output and inflation? (5 points) Inflation became fairly stable at an average of 2.6% annually. Fluctuations in output also decreased during the time period after 1985. It only decreased significantly from 1992 to 1993. This change was most likely due to the increase in productivity that came with technological advancement. The output gap continued to change. Its changes were positively correlated with changes to the federal funds rate. See chart below.

The Global Economy: Problem Set #5

d. What can the Fed do if the Taylor rule rate is below zero? (5 points) The Fed cannot lower rates below 0 due to the zero lower bound because it would cause banks, firms, and people to hold cash rather than spend or invest the cash. However, the Fed can increase reserves to banks past the level for which the fed funds rate is 0 by lending money to companies. The additional quantity of reserves held by banks over and above the quantity of reserves that banks hold when the Fed rate is 0 , which is called quantitative easing. The Fed can also implement credit easing by changing the composition of the Feds balance sheet by swapping riskless assets such as treasury bills with more risky assets such as mortgage-backed securities and corporate loans.

The Global Economy: Problem Set #5

5.

Why does the short run aggregate supply curve have a positive slope? (10 points)

In the short run, as price increases, firms will want to produce more to take advantage of the higher prices that consumers are willing to pay. Keynesian Theory uses the production function to explain this phenomenon. It also assumes that Wages are very sticky in the short term, meaning they dont change since firms determine working conditions in the short term. If wages are constant while prices are increasing, the real wage (W/P) is decreasing. This decrease makes hiring more attractive to firms increasing L. With A & K constant and L increasing, Y (output) will increase as Prices increase. In the long term, wages will adjust leveling supply. <Add points from Business Cycle Theory Page 2 or lecture slides page 3 slide 3>

(Y=AK L1- )

6.

Deflationbroad and persistent decreases in the price levelcan be troublesome. Falling prices raise the expected real rate of interest, helping to discourage spending. For example, if consumers expect deflation to continue, they will put off purchases until the future, lowering their demand at any current price level. The economy is initially at the long run equilibrium, as shown in the figure below.

LRAS

AS

A PB P

YB Y*

AD

AD ADF Y a. How

does the figure above change when consumers expect deflation in the future? Label the new short run equilibrium (YB, PB). Are the consumers expectations correct? (10 points) See Graph. The AD curve will shift to the left if consumers expect deflation since they will have less demand at all price levels. Consumers will most likely put off purchases to the future. Their expectations are correct because even if all else stays the same, if consumer demand decreases, prices will decrease.

b. What can the Federal Reserve do to counteract this deflationary cycle? Show the
Feds response on the figure above. Label the new long run equilibrium (YC, PC). (10 points) The Fed can increase the money supply by cutting the Fed funds interest rate. This would cause the AD curve to shift back right (marked ADF). If the Fed cuts the interest rate just enough, it should cause the AD curve to shift back to almost the

The Global Economy: Problem Set #5

same level as before. The Fed will be careful not to increase the money supply so much that there is inflation.

The Global Economy: Problem Set #5