Questions about course content for Econ 102, Section 100, Winter 2005:

May 2:

> On question 31, you have the answer as being e), but I thought that when
> the expected inflation changes, the phillips curves shifts as would be
> illustrated in answer d).  Could you clear this question up for me so
> that I understand why it is answer e)?  Thank you

You are right that the short run Phillips curve shifts here, in this case 
from the one (not drawn) through point e to SRPC2.  But this question also 
says that there is an expansion of the money supply, which will stimulate 
the economy and lower unemployment, so we have to move not just up but 
also to the left.

Apr 27:

> I know this is kind of last min, but I really don't get this question,
> so any explanation you could give (no matter how short) would be
> greatly appreciated!
> 
> Winter 2002, #24:
> Government budget deficits tend to _______ in expansions because income
> tax  revenue tends to _______ while transfer payments tend to _______.
>    a.  Fall; increase; decrease
> b.  Fall; decrease; increase
> c.  Fall; decrease; remain unchanged
> d.  Rise; decrease; increase
> e.  Rise; increase; decrease
> 
> The right answer is a. and I put e.  I guess I just don't get what
> "Government budget deficits tend to fall in expansions" means.  Does
> that mean it's a contractionary policy? Because I thought increasing
> government spending was an expansionary fiscal policy...

This refers to the role of automatic stabilizers in the economy, and it 
asks about what will happen to the government budget if the government 
takes NO policy action.  Thus if something other than the government 
(such as an improvement in investor or consumer expectations) causes the 
economy to expand (AD to shift out and Y to rise), then with a fixed 
income tax schedule the government will collect more taxes, due to the 
rise in income.  Also, because some transfer payments, such as 
unemployment compensation, decline when more people have jobs, transfer 
payments will decrease.  Both of these imply that the government budget 
deficit is smaller as a result.

Apr 26:

> In looking over homeworks I realized that if Short run Aggregate supply
> shifts
> out, according to the AS/AS model, the amount of output increases and the
> price
> level goes down.  The homework also said that unemployment would go down in
> the
> short run. Isnt this contrary to the phillips curve which says because the pl
> goes down unemployment goes up?

What you say is correct, except for the last sentence.  The Phillips curve 
describes the effect of unemployment on the rate of inflation, not the other 
way around.  So it says that if unemployment goes down, then the rate of 
inflation will go up.  That will in turn mean that, over time in the AS/AD 
model, the SRAS curve will shift upward at a faster rate.  

But that actually agrees with what you were getting yourself in the AD/AS model 
if you had followed it through:  The downward shift of the SRAS curve does 
indeed increase Y and lower P.  But it lowers the intersection of SRAS with 
LRAS, which is the expected price level EP, even more.  So now P>EP, and EP 
will therefore rise over time.  So over time, as you move from the short run 
equilibrium to the long run, P rises as a result of this rise in Y and fall in 
u.

Apr 26:

> On the 2002 final exam, question number 17 says:
> 17. According to the sticky-wage theory, an increase in expected prices
> causes (in the short-run)
> a. wages to be set high, increasing the quantity supplied
> b. wages to be set low, decreasing the quantity supplied
> c. wages to be set low, increasing the quantity supplied
> d. wages to be set high, decreasing the quantity supplied
> e. none of the above
> 
> the answer is D.  could you explain why this is?  thanks.

Wages are sticky in part because they are set in contracts, and the 
contracts are based on expected prices.  So if the expected price level 
goes up, then labor contracts will be negotiated to include higher wages.  
But the expected price level is what anchors the SRAS curve, so this 
increase shifts it up (or you can just think of the higher wages as 
causing higher costs, shifting SRAS up).  And for a given actual price 
level, the SRAS curve then shows a lower quantity supplied.

Apr 26:

> Core inflation" is the rate of price increase excluding food and energy. By
> how
> much did the core rate of inflation in February exceed the core rate of
> inflation over the last year? (This will require some calculation, using the
> numbers in the article.)
> 
> If the core rate of inflation over the last year refers to the 12 months
> leading
> up to February, are you saying we should be calculating the core rate of
> inflation for that one month (February) and the core inflation of the 12
> preceding months?

Yes, both at annual rates, so that you can compare them.  

Apr 26:

> On problem #7 on the 2002 final, can you please explain why the
> correct answer is B.  I would think the "total change" in the
> investment account would be zero because this account went up with the
> purchase of the intermediate good (wine), and then it went back down
> when the wine was sold.  However, I'm surely missing something.

The wine was purchased 2 years ago, and that is when the inventory went 
up.  The only change in inventory this year is the fall in inventory when 
the wine is now sold.

Apr 26:

> (1) Concerning the huge budget deficit issue, this was a question in the
> Final
> exam of winter 2004 (short answers, Part 1 b).  It says that "because the
> govt
> is accumulating debt... upon repayment, we will have a decrease in AD which
> results in unemployment."

Are you asking why debt repayment would decrease AD?  Because to repay debt 
the government must run a surplus, and thus raise taxes and/or reduce spending.

> 
> I also have a second question. (2)  Does the SR Phillips curve shift whenever
> there is a change in any component that affects SRAS (e.g. labor, natural
> resources, capital..)?

I wouldn't say that.  The SRAS curve is anchored by the natural rate of output 
and the expected price level.  The short run Phillips curve is anchored by the 
expected rate of inflation and the natural rate of unemployment.  Changes in 
expected prices will therefore shift both curves, and so will a change in the 
natural rate of unemployment.  But other things can change the natural rate of 
output -- anything in the production function, for example -- without changing 
the natural rate of unemployment.

>  Is a "supply shock" only going to affect SRAS, but
> not
> LRAS?

I'm not sure that "supply shock" is all that well defined.  The term is 
usually used for changes in prices or expected prices and wages, which would 
shift SRAS but not LRAS.  But I'm not sure that the same term couldn't be 
used for changes that affect both curves.

>  Does the LRAS shift only when there is a change in natural rate of
> unemployment?

No.  See above.

Apr 26:

> 1.  For question #5 on the 2002 final exam, can you please explain why
> the answer is C.  If the central bank wants to keep unemployment lower
> than the natural rate, wouldn't this keep moving the Phillips curve up
> as people adjust to higher inflation?  This it seems to me, would make
> the answer E) accelerating inflation.

You are right.  Someone apparently typed the wrong answer into this answer 
sheet.  It should be E.

> 2.  Finally, for #32 in the 2004 final, can you tell me why an
> increased budget deficit would decrease consumption?  Is it just as
> simple as more taxes equals less spending?  What if the increase in
> the deficit is comprised of an increase in G rather than a change in
> taxes?

No, it is consumption that it says decreases, not government spending.  
An increase in the budget deficit causes the interest rate to increase in 
the long run, and this rise in the interest rate causes savings to 
increase (that's the reason for the upward slope of the SLF curve), and 
therefore causes consumption to decrease.

Apr 26:

> 1) in the LR, P clears the money market, in LF market, r changes. monetary
> neutrality says that a change in MS doest affect real variables, so when MS>0
> or MS<0, P changes. but in the LF market, r changes, but r is a real
> variable.
> i'm confused, can you help me clarify?

You seem to be correct until you say that a change in the money supply has an 
effect in the loanable funds market.  It does not.

> 2) how come a change in I caused by a shift in MD is a movement along the AD
> curve, but a change in I caused by a shift in MS is a shift in AD?

Not all changes in I due to shifts in money demand are movements along the AD 
curve.  That is only true of a change in the price level, which of course is 
the variable that AD is using as the determinant of Y.  Other things that cause 
MD to shift, as well as changes in MS, are done for a given price level and 
therefore give us shifts of the AD curve.

> 
> 3) is there an equaltion for chane in GDP for the crowding out effect? like
> the
> one for the multiplier effect?

We do not have such an equation in this course.  We could write one, if you 
wished, but I don't think it would be very helpful.  It would have to include 
several parameters, each of which would have to be learned.

> 4) is MPC = 1 - MPS? is there a relationship?

That's right.

> 5) Exam 2002 #12, one of the options is "investment spending is volatile."
> what
> does that phrase mean?

Volatile means "tending to vary often or widely."  We saw a graph of investment 
spending in the United States over the post-war period, and it did indeed move 
up and down rather a lot, which is what this refers to.

Apr 26:

> 1.  When NFI contracts, this lowers the interest rate because the DLF curve
> shifts left. This stimulates domestic investment, but how does this show up
> in
> the graph?  it seems like these two stimuli (contracting NFI and expanding
> domestic investment) cause the DLF curve to move both right and left
> simultaneously.

The rise in I does not show up in the graph, since I and NFI are combined in 
the DLF curve, and the two move in opposite directions here.  But we still 
know that I goes up, because it responds to the fall in the interest rate.  
The rise in I, as well as a partially offsetting rise in NFI itself, are both 
represented by the movement along the new DLF curve, not a shift of it.

> 2.  Winter 2004, #15.  15. While digging through the pockets of an old pair
> of
> jeans, you discover a $20 bill. Since you happen to be walking by an ATM
> machine, you decide to deposit it into your checking account. With fractional
> reserve banking, where the reserve ratio is 3%, your original $20 deposit
> eventually increases loans by ______ and the money supply by _______.
> a. $667, $667
> b. $667, $647
> c. $647, $647
> d. $19.40, $19.40
> e. $19.40, –$0.60
> 
> I understand how the money supply increases by $647, but not why loans only
> increase by $647.

The money multiplier is, as you know, 1/.03 = 33.33, so the $20 in new reserves 
of the banking system expands deposits by 33.33x20=667.  Since the cash portion 
of the money supply has simultaneously dropped by 20, this leaves the increase 
the money supply as $647, as you know.  Now in the bank balance sheets, they 
have $667 more of deposits, against which they are holding an additional $20 in 
reserves.  The rest, $647, they have lent out.  Thus loans increase by $647.

> 3.  Winter 2004, #21. Suppose that the central bank is required to stabilize
> prices. If the economy starts in long-run equilibrium and then experiences a
> cost-reducing supply shock, the central bank should respond by
> a. increasing the money supply, which causes output to move closer to its
> natural level.
> b. increasing the money supply, which causes the unemployment rate to rise.
> c. increasing the money supply, which causes output to move further from its
> natural level.
> d. decreasing the money supply, which causes unemployment to rise.
> e. decreasing the money supply, which causes output to move further from
> its natural level.
> 
> The answer is C, but I don't understand how you can end up with SRAS and AD
> intersecting at a point off of the LRAS curve.

Yes, that's a problem, but there is no problem with being there in the short 
run, which is what this central bank will apparently do.  If the LRAS curve 
has not shifted, then we are now in the situation that the expected price level 
has fallen, but the actual price level has not.  So expectations will be revised 
upward in response, shifting the SRAS curve back up over time.  As it moves up, 
this central bank will contract the money supply so as to remain at the same 
price level, and output will fall over time back to its natural level.

> 4.  Winter 2004, #22.  The banking system has $20 million in reserves and has
> a
> reserve requirement of 20 percent. The public holds $10 million in currency.
> If
> banks decide to increase reserves from 20 to 25 percent of deposits, by how
> much
> does money supply change?
> a. –$20 million
> b. –$10 million
> c. –$5 million
> d. –$1 million
> e. By none of the above.
> 
> The answer is A.  why?

When the reserve requirement is 20%, $20 million in reserves backs $100 million 
in deposits, since 20 is 20% of 100.  When the requirement rises to 25%, that 
same $20 million in reserves only backs $80 million in deposits, since 20 is 25% 
of 80.  So deposits fall from $100 million to $80 million.  The cash held by the 
public is irrelevant for this.  It is part of the money supply in both 
situations, however, which therefore falls from $120 milion to $100 million.

> 5.  Winter 2004, #30.  30. Suppose you expect the Fed to increase the money
> supply to a new higher level. Which of the following would it be better for
> you
> to do before, rather than after, the change in the money supply?
> a. Consolidate your student loans.
> b. Take out a mortgage.
> c. Sell stocks.
> d. Buy a car on credit.
> e. Buy bonds.
> 
> The answer is E.  Why?

In the short run the rise in the money supply lowers the interest rate.  If you 
are borrowing, you'd like to wait for the lower rate.  If you are lending, you 
want to lend at the current high rate.  Answers a, b, and d are all forms of 
borrowing, but answer e is a form of lending.  (Answer c is not really either, 
and I'm not sure it matters whether you sell stocks before or after the fall in 
interest rates.  But to the extent that the price of a stock reflects the 
present value of its future earnings and those earnings are positive and fixed, 
then the fall in the interest rate will increase that present value and thus 
the price of the stock.  So for it too, you'd rather wait to get this higher 
price.)

Apr 25:

> 2002 #3
> In the country of Edxico the marginal propensity to consume is 0.75 and there
> is
> no investment accelerator.  But, investment in Edxico is very peculiar: it
> does
> not change in response to a change in the interest rate.  Then if the Edxican
> government decides to increase spending by $10 billion and all this money
> makes
> its way to consumers, the resulting change in output in the short run is best
> represented by
> The answer is d. $0 to $40 billion
> but I thought that a. $40 billion would be better because it stated that "it
> (investment) does not change in response to a change in the interest rate"
> Then
> crowding-out effect wouldn't apply.  What else would change it? Do consumers
> consume less because of the higher interest rate? But if thats the case then
> I
> and S have to be equal so savings can't increase. Explain please.

If the question asked for the increase in aggregate demand at the initial price 
level (thus the size of the rightward shift of the AD curve), then $40 billion 
would be correct.  But with an upward sloping SRAS and a downward sloping AD, 
there will be a rise in the price level.  And this will reduce aggregate demand 
and therefore output.  (Of the three effects usually causing this to happen -- 
the wealth effect, the interest rate effect, and the exchange rate effect -- the 
second won't happen here because of the assumption about investment.  But the 
other two still will.)

> 
> 2003 #36
> "Disinflation" is caused by
> The answer is c. a rate of unemployment that is higher than the natural rate
> of
> unemployment.
> I thought a. expanding the money supply less rapidly than money demand would
> work. However, it could be because we don't know if it is disinflation or
> goes
> to deflation.  But the same can be said for answer C because the phillip's
> curve can go negative. Explain please.

Expanding the money supply less rapidly than money demand will cause the 
interest rate to rise in the short run and reduce aggregate demand.  While this 
will cause the price level to fall, it won't necessarily reduce the rate of 
inflation, which is what we mean by disinflation.  Also, in the long run, 
expanding money supply less rapidly than demand will cause prices to fall, but 
not necessarily fall more rapidly than they did before.

Apr 24:

> 1.  What does "Domestic Investment" mean? (as in questions 2, 6, 7, 10, etc.)
> Does it mean "All investments into the US by anyone?"  OR "All investments
> into
> the US by Americans?"  OR something else entirely?  And it means investment,
> like in the equation Y = C+I+G+NX, right?

Domestic investment refers to what we just called investment early in the 
course:  I (in C+I+G+NX).  Calling it "domestic investment" is just to 
distinguish it from net foreign investment.
> 
> 2.  Just a simple question for my own clarification:
> the governmetn can effect both AD and AS, but it can only effect the supply
> for
> loanable funds (at least in our loanable funds graph)?

I wouldn't say that government can't affect the demand for loanable funds.  
The standard example is the investment tax credit, by which the government 
encourages investment.  On the other hand, I have a harder time seeing how the 
government affects AS, though I suppose that by intervening in the price 
setting of markets, such as by a minimum wage, it does that.

> 3.  is labor considered to be a factor of production?

Yes.

> 4.  in our main models, (LR open economy, AD/AS, Money demand and supply,
> etc)
> do we always use real variables on the axes?  or do we ever find the nominal
> variables?

When we model the money market, both long-run and short-run, we put the nominal 
stock of money on the horizontal axis.  And of course the price level itself, 
on the vertical axis of AD/AS, is a nominal variable.  But the Y on the 
horizontal in AD/AS is real, as is the quantity of loanable funds, net foreign 
investment, and net exports.  

> 5.  Final from 2003, #6:  maybe this is connected to my lack of understanding
> of
> "domestic investment,"  but I don't understand this question.

This question is just about a leftward shift of the NFI curve, which by 
definition also shifts the demand for loanable funds to the left.  That lowers 
the interest rate and stimulates domestic investment.  What's happening is that 
by reducing our net foreign investment abroad, less of our saving is leaving 
the country and more is available to finance (domestic) investment, pushing 
down the interest rate and increasing investment.

> 6.  Final from 2003, #7:  I think I understand why (ii) isn't an option, but
> why
> isn't (i) one of the answers?  why doesn't domestic investment stimulate the
> economy in the short run?

It would.  But in the short run, incresing national saving doesn't lower the 
interest rate (that's the long-run, loanable funds model), and therefore doesn't 
stimulate investment.  Instead, if national savings goes up, national aggregate 
demand goes down (consumption, if it's private savings; government purchases for 
example if it is government saving), and that is contractionary, not expansionary.

  and about (iii).  I thought that FDI and FPI into
> a
> country were GOOD for its economy.  Can you explain this question?

Again, if funds coming in from abroad could lower the domestic interest rate, 
then this could simulate investment, etc.  But again, in the short run, the 
interest rate is determined by money demand and supply.  Meanwhile, an inflow of 
foreign capital is a demand for dollars on the market for foreign currency 
exchange, and this causes the dollar to appreciate.  The appreciation makes our 
goods more expensive and reduces NX, thus AD.  So answer (iii) works by reversing 
this flow, causing a dollar depreciation, and stimulating the economy through 
trade.

> 7.  If you're told that LRAS shifts, do you assume that SRAS shifts too?

Unless you have reason to think that the expected price level also changes by 
just the right amount, then yes.  Since SRAS cuts LRAS at the expected price 
level, a shift of the latter will have to be accompanied by an equal shift of 
the former.

Apr 24:

> 1. In the Money Market model we used in the last third of the course, we only
> talked about the price level shifting Money Demand.  However, in the long run
> model from the middle third there were other factors.  What shifts MD in the
> short run besides the price level?

Money demand is PY/V, where in the short run velocity, V, depends positively on 
the interest rate giving us the downward sloping demand curve.  So it shifts to 
the right with increases in P and/or Y.  It would also shift if something other 
than the interest rate were to change velocity.  (I don't now recall whether I 
said all this when I introduced the short-run money market in class.  But we 
certainly used the fact that income, Y, shifts it when we got the crowding out 
effect that dampens the rightward shift of AD due to a fiscal expansion.)

> 2. I was trying to understand the effect of a supply shock on the philips
> curve
> model and it seemed somewhat couterintuitive.  So my question is this: Is it
> correct to think that shifts in Aggregate Demand move along the short run
> philips curve (and then it shifts to adjust) and shifts in the Aggregate
> Supply
> shift the short run philips curve.

Yes, that sounds right.

Apr 24:

> Q: Does fiscal policy have to do with government spending in transfer
> payments,
> on top of tax / government purchases?
> 
> In speaking about aggregate demand in the AD/ AS model, are we only dealing
> with
> Govt Purchases (i.e. purchases included in GDP?)  Are we concerned also with
> government spending in terms of transfer payments?
> 
> So if govt increases its spending on unemployment benefits, does that
> increase
> G, and hence AD?

Fiscal policy refers to changes in any or all of:  government purchases, 
government transfer payments, and taxes.  In the definition of GDP (C+I+G+NX), 
G includes only government purchases, since only these are things (goods and 
services) that are produced.  Net taxes, T, is defined as taxes minus transfer 
payments, so transfer payments are included here, but negatively.  So an 
increase in unemployment benefits does not change G, but it does reduce T and 
therefore increase C because it increases disposable income (Y-T) on which 
consumption depends.

> If the govt budget deficit is reduced by increasing taxes, does it have any
> effect on G?   Or does it only cause C to decrease and so AD to decrease?

We assume that G does not respond automatically to changes in net taxes, but 
rather that the government has full control of G as a policy variable.  So an 
increase in taxes has no effect on G, but reduces AD as you say by reducing 
disposable income and therefore consumption.  (The assumption that G does not 
respond to T is not perfectly realistic in the U.S.  Purchases by state 
governments are in fact very much influenced by the state government budget, 
as we are feeling to our cost in Michigan right now.  And many anti-government 
conservatives advocate cutting taxes precisely because they think that this 
will force the federal government too to cut spending (they call it "starving 
the beast").  So far there is no sign that this works, at least in the Bush 
administration.)

Apr 24:

> I just want to clarify the effect of taxes on the AD/AS model.  If government
> reduces taxes that gives people more disposable income and consumption
> increases shifting AD right.  But, it the book says it also gives people more
> incentive to work because they can spend more of their income and shifts AS
> right.  Which effect dominates and how should we analyze a tax cut on the
> exam?

I would certainly expect the shift of AD to be larger.  In fact, I'm surprised 
that you say the book says that AS shifts right, and I'm wondering whether it is 
SRAS or LRAS that shifts.  I'm at home right now and won't be able to look it up 
until I'm back at the office.  If you could direct me to the page where Mankiw 
says this, I'd appreciate it.  I know that there are certainly people who think 
that cutting taxes will stimulate people to work more, though I did not realize 
that Mankiw shared that view.

> This also applies for an increase in government spending.  It shifts AD right
> but also shifts AS right because of improved roads etc.

Unlike the case of a tax cut, the effect here would only be valid for some 
particular kinds of spending, such as the roads that you mention.  Most 
government spending is not of that sort.  But I agree that government spending on 
infrastructure such as roads does increase the country's capital stock and shift 
the LRAS curve to the right.  Unless you are told that a spending increase is of 
that sort, you can ignore that effect.  (It too would be small compared to the 
shift in AD.)

Apr 24:

> One major question that I have had a question that Seb has not been able to
> answer is the issue with interest rates and investment. According to monetary
> policy, when the money suppy expands, interest rates decrease, and becasue it
> is cheaper to borrow money for investment, people borrow and investment
> increases. However, according to the Open Markets Economy Model, when
> interest
> rates in a country go up, people in other countries move their money into
> that
> country because interest rates reflect the return on a person's investment
> and
> reflects an opportunity cost of investment. To me, these seem like two
> contradictory statements becasue one says that when interest rates  go down
> investment goes up, and the other says when interest rates go down investment
> goes down because people invest in other countries becasue they have higher
> return on their investment. I would really appreciate if you could clarify
> this.

The confusion is because the word "investment" is being used in two different 
ways here.  In "I" (as a part of C+I+G+NX), investment is acquisition of 
physical capital (machines, etc.), and the interest rate is relevant because it 
is the cost of financing the investment.  In "NFI" (which the book calls NCO, 
or net capital outflow), the "investment" is financial.  In particular, in the 
case of an inflow, it refers to foreigners buying our financial assets, and 
here the interest rate is the return on those assets, not their cost.  So it 
has the opposite effect on the flow.  This may be part of the reason why Mankiw 
quit calling it net foreign investment, precisely to avoid this confusion.  In 
the future I will have to follow his lead.

(Strictly speaking, there is one component of NFI that is not financial.  NFI 
includes foreign direct investment, which IS the acquisition of real assets.  
For FDI coming into our country, our interest rate would presumably not matter 
at all, since it is neither the return on the asset nor the cost of acquiring 
it, since foreigners presumably can finance their FDI in their country, not 
ours.)

Apr 22:

> I was going over the study guide included with the book and on page 292
> after it lists what can shift long-run aggregate supply they say
> "Long-run growth and inflation may be depicted as a rightward shift in
> the long-run aggregate suppy curve..."  I understand the long-run growth,
> but how is inflation included in here? My only interpretation of this
> that works would be using the Philips Curve, so that if the natural rate
> of unemployment decreases (shifting the long-run philips curve left)  -
> long-run aggregate demand shifts right.  But even then, if the long-run
> philips curve shifts left, that doesn't impact inflation in the long run.
> What are they talking about here?

Very good question:  I have no idea.  This seems to be simply an error.  If 
there is an interpretation to make this statement correct, I can't think of 
what it may be.

Somewhat to my surprise, this is the first time that anyone has alerted me 
to an error in the Study Guide.  I don't know if that's because they 
haven't been reading it, or because the Guide is actually pretty good.  If 
this is the only mistake in it, that's impressive.

Apr 21:

> Thanks for responding to everything! it all makes sense too.. i just don't
> understand one of them..
> 
> > 37. Which of the following is greater in the long run than in the short
> > run? a) the effect of an increase in govenrment purchases on GDP
> > b) The effect of a tax cut on uemployment
> > c) The effect of an open market purchase of bonds on the price leel.
> > d) the effect of an increase in the preferences to holding money on
> > investment e) the effects of an increased prefrence for impots on the
> > trade deficit.
> 
> You say that, "An open market purchase of bonds, which expands the money
> supply, on the other hand, increases the price level a little (along the
> SRAS curve) in the short run, but even more in the long run as we move up
> the new AD curve to a higher price level.  So this is the answer." I'm
> not sure that I understand this. Increasing the money supply would shift
> the AD curve to the right, which increases output in the shortrun.
> However, in the long run, that only effects the price level, because the
> SRAS curve will shift left to bring the output back to the natural rate
> of output. So essentially, there is no effect in the long run... In
> addition, I thought that non-real variables (money supply) shouldn't
> effect real variables (output) in the long run.. Maybe I'm just not
> getting this.. Could you explain this a little bit more?

The shift of the SRAS curve, from short run to long run, does not bring the 
economy back to its initial position in all respects.  It brings Y back to 
where it started, but it bring P up to an even higher level.  That is, in 
the AD/AS diagram, in the short run you move up and to the right; then going 
to the long run you move UP (again) and to the left.  So you end at a higher 
price level.

Apr 20:

> Final exam 2002
> 21. Low-Tech Knotek is considering a new investment project in scooters.
> The intial cost of the investment will be $100,000 and it will pay back
> $125,000 in one year. If the interst rate is 20%, what is the present
> alue of the project? The answer is c)4166.67.
> I looked up the definition for present value, which is, "the amount of
> money today that would be needed to produce, using prevailing interst
> rates, a given future amount of money." Wouldn't this mean that the
> "project" itself's present value is d)104166.66? I understand how you
> would get 4166.67 if you subtract $100,000, (which is the cost of
> investment), but I don't understand why you would subtract that value,
> referring to the definition.

You are looking at the present value of just the future payback, not of the 
whole investment.  The whole investment includes a cost today and a payback 
in the future.  The present value of the cost today is just -100,000.  
Adding this negative value to the positive present value of the payback, 
you get the present value of the investment that is the answer.

> 28. In the sticky-wage model, an increase in the price level causes the
> real wage to ____ and the marginal productivity of labor to ______.
> The answer was D) decrease; increase.
> i just wanted to make sure if my logic was right. Because of sticky-wage,
> increase in price level would make the firms produce more, which leads to
> a decline in MPL because the marginal productivity of those extra labor
> declines as they are constrained with fixed capital. It leads to a
> decline in real wage because the MPL went down, and the inflation makes
> the real wage is lower by definition... Is my reasoning right?

Your reasoning is OK, but your typing isn't.  The answer is D) decrease; 
decrease.  An alternative (and equivalent) reasoning is that if P goes up 
and W doesn't, then that is a fall in the real wage by definition, as you 
say.  Firm's respond to that by expanding production, since now the initially 
unchanged MPL is higher than the real wage.  They expand production, hiring 
more labor, until the MPL falls (for the reason you state) to the level of 
the new lower real wage.

> 2003 Final exam
> 20. Money velocity in New Caledonia is constant. The money supply grows
> at 10% annually, the population grows at 2% a year, and the inflation
> rate is always 3%. The growth rate of nominal GDP per capita is ____%,
> and the growth rate of real GDP per capita is ____%.
> The answer is B) 8; 5.
> Using MV = PY equation, I got how nomianl GDP increases by 10% and real
> GDP increases by 7%. But I didn't understand why you subtract the
> population growth percentage from that to get the "per capita" ratio.

The growth rate of a ratio is (approximately, for small growth rates) the 
growth rate of the numerator minus that of the denominator.  So if PY grows 
at 10% and L grows at 2%, then PY/L grows at 10-2=8%.  Similarly Y/L grows 
at 7-2=5%.

> 22. Consider the AD/AS model, starting at a long-run equilibruim. Suppose
> that there is an increase in the money supply. When the economy reaches a
> new long-run equilibrium, the change in I will be ____, and the change in
> NX will be _____.
> a) negative;negative
> b)positive;negative
> c)negative;positive
> d)positive;positive
> e) none of the above
> The answer is E, which is none of the above alternatives is corrrect.
> My guess is that there will be no change in either of them because money
> supply doesn't effect real interest rate (and thus investment) in the
> long run... But, if the money supply decrease the interset rates in the
> short run, that would lead to more investment, so shouldn't that lead to
> more investment in the long run as well?

No, the rise in investment in the short run is only temporary, since in the 
long run the real interest rate goes back up.

> 26. This is a graph questions so I'm not able to type it, but it shows
> how the NFI curve is verticle, and NX curve is downward sloping. The real
> exchange rate at the intersection of the two curves is 1.
> The question asks, according to the graph below,
> a) PPP holds, becaue the real exchange rate is always equal to 1.
> b) PPP holds, because NFI is perfectly inelastic with respect to the ral
> interst rate.
> c)I cannot determine whether PPP holds, becasue the information given is
> insufficient (I don't know the value of X)
> d) PPP does not hold, because NX would be vertical if PPP held.
> e) PPP does not hold, because NX would be horizontal if PPP held.
> The answer is E,.. I had no idea how to approach this problem..

PPP is defined as having the real exchange rate always equal to one.  I 
pointed out in class, once, that the open economy model (which is what you 
are describing) does not assume PPP, since with its downward sloping NX curve 
it says that the real exchange rate can change in response to changes in NFI.  
However, this would not be the case if, contrary to what we normally assume, 
the NX curve were horizontal at the level of a real exchange rate equal to 
one.  For then if NFI were to change, the real exchange rate would not.

> 37. Which of the following is greater in the long run than in the short
> run? a) the effect of an increase in govenrment purchases on GDP
> b) The effect of a tax cut on uemployment
> c) The effect of an open market purchase of bonds on the price leel.
> d) the effect of an increase in the preferences to holding money on
> investment e) the effects of an increased prefrence for impots on the
> trade deficit. I wasn't completely sure how to answer this one as well..
> is there an easy way to do this?

Just compare what happens in the short and long runs, mostly using the AD/AS 
model.  An increase in G causes Y to rise in the short run but return to YN 
in the long run, so the effect in the short run is larger than the (zero) 
effect in the long run.  A tax cut does the same.  An open market purchase 
of bonds, which expands the money supply, on the other hand, increases the 
price level a little (along the SRAS curve) in the short run, but even more 
in the long run as we move up the new AD curve to a higher price level.  So 
this is the answer.  The change in preference for holding money, which is a 
shift in the demand for money, changes the real interest rate in the short-run 
money market, and thus investment, but not in the long run due to monetary 
neutrality.  The increased preference for imports leaves the trade deficit 
unchanged in both the short run and the long run, at least in the only model 
we have here, since NX equals NFI which is unchanged.

> 2004 finals
> 23. Initially, the naturla rate of unemployment in macro-Land is 5
> percent. Then union membership increasese. As a esult, it now takes
> longer to find a job in Macro-Land, What is the effect on the short-run
> Philips curvve and on the longrun Phillips curve?
> The answewr is b.Both LRPC and SRPC shift to the right... I understand
> how the SRPC curve would shift since it might take "longer" for people to
> find jobs, but why would the LRPC curve shift? The union membership
> increasing doesn't mean that the natural rate of unemployment will
> increase, does it? (since it just says it will take longer to find a job)

Yes, if you go back to the chapter on employment, you'll find that unions are 
one of the features of the economy that increase the natural rate of 
unemployment.  The reason given there, as I recall, was that unions raise the 
wage further above the market clearing wage, creating a larger excess supply 
of labor.  But if the union causes it to take longer to find a job, then the 
rate of "job finding" in our little model of the natural rate (where 
uN = s/(s+f)) goes down, which gives the same message.

> Finally, just a quick question..
> When the Government decreases spending, it would shift the AD curve to
> the left. The multiplier effect supposedly shifts it more to the left.
> Would you still call this a "multiplier effect?" and would the
> "crowing-out effect" (increase in Investment due to lower interest rate)
> still be called crowding out effect?

Yeah, we still call them that, even though the effects go in the other direction.

Apr 20:

(re. HW 9, #5b)
> Will this effect apply to all situations that shift SRAS because of price
> expectancy?  For example if producers expect the price of inputs to
> increase, SRAS shifts left, prices increase, so then expected inflation
> will increase and SRPC will shift up? Right?

Yes, I think so.  I'm always hesitant to agree to anything that is supposed 
to apply to "all situations," but barring something I haven't thought of, yes.

Apr 17:

> A few quick questions.  Assuming a positive rate of inflation from the
> Phillips curve, in the long-run AD-AS graph, won't the equilibrium
> price always keep increasing?  I was just wondering, because we don't
> usually show this when we draw one of these graphs.

Yes, that's right.  You'll only get a positive rate of inflation in the 
long run if something is continually shifting the AD curve up, most likely 
a rate of expansion of the money supply that is faster than Y is growing 
(which of course it isn't, in the diagram, if you don't shift LRAS to the 
right).  The positive expected inflation will mean that the SRAS curve is 
also continually shifting up.  All of this is true, but not really worth 
trying to draw, I think.

> Also, what is the cause of this continual inflation?  From the
> velocity equation, keeping money velocity and output constant as it is
> in the long-run AD-AS graph, wouldn't this mean that this inflation is
> solely caused by an increase in the money supply?  This matches up
> with an increase in price as seen in the AD-AS graph (from a shift in
> AD), but it just seems to me that the interest rates can't keep
> getting lower forever.  I would think there must be an equilibrium at
> some point, but if there is than wouldn't this imply that inflation
> would stop?

As I said above, the most likely reason for this happening is a continual 
growth of the money supply.  That will not, however, cause the interest 
rate to fall, because in the long run equilibrium the price level is rising 
right along with the money supply, so in the short-run money market, supply 
and demand are expanding at the same rate.

Apr 17:

> In the response you posted to a question regarding wheather the PC shifts
> or there is movement along it, is confusing.  I understand your reasoning
> that the PC will shift down, but then you say that the movement will be
> toward lower unemploymnet.  If the price level drops, that means actual
> inflation is lower than expected so wouldn't the movement be toward
> higher unemployment? Please clarify your response.

No, what I had in mind was that there is a fall in both the expected price 
level and the expected rate of inflation.  The fall in the expected price 
level appears as a downward shift of the SRAS curve, which causes the price 
level to fall, but by less than the expected price level (as must happen if 
you just shift the SRAS curve down without any shift of AD), so that Y rises 
and unemployment falls.  At the same time, the fall in the expected rate of 
inflation shifts the Phillips Curve down, but the movement to lower u is due 
to the increase in Y found from the AS/AS diagram.

Apr 14:

> On the last question in homework 9, question 5b. It is asked what would
> be the effects of a decline in price of imported oil do to the Phillips
> Curves..
> 
> Do i take the interpretation literally and read off the Phillips curve
> immedietly by saying consumer would expect a lower inflation since they
> know prices are going to fall due to decline in oil and therefore inward
> shift of SR Phillips Curve and no change to LR..
> 
> Or do i take the interpretation beginning with the ADAS by saying,
> decline in cost for firms therefore, outward shift in AS causing a drop
> in price levels. In this case i assume the Expected inflation to remain
> unchanged and therefore this is just a movement along SR Phillips Curve
> with dropping inflation causing increased unemployment? But this doesnt
> seem right because if AS shifts out, Y would increase in SR which should
> cause decrease in unemployment. So which is which? Am i missing something?

This is a place where the two models (AD/AS and Phillips Curve) do not fit 
together as nicely as we might like.  I would say that the fall in oil 
prices should be reflected in a fall in both the expected price level 
(in AD/AS) and the expected rate of inflation (in the Phillips Curve), so 
you'll get both a downward shift in the PC and also a movement along it to 
a lower rate of unemployment.

Apr 10:

> For the Wall Street Journal article about Consumer Prices rising 0.4% you
> ask us to calculate by how much the February core rate of inflation
> exceeds the core rate of inflation for the last year.  I read your
> response to a similar question and I see what they were doing wrong.  But
> I think that the February rate (.3%) does not exceed the rate for the
> past 12 months (2.4%).  Am I looking at the correct rates?

Yes, but .3% was the amount by which the CPI rose in just one month, not the 
annual rate.

Mar 31:

> for question 3 part c what does "pushes for tax cuts" mean? I am assuimg
> that it means the policy has not changed because he is only attempting to
> change it.  Am I correct?

I guess you are correct, but that's not what we intended.  We just wanted 
you to analyze a tax cut.  You are right that simply pushing for it would 
not have any effect, at least in any model that we've seen.

Mar 30:

> For the article in WSJ titled "Consumer Prices Rise .4%..." you ask us to
> calculate the change in core inflation rate over the last year. But in the
> article, it says CPI excluding Energy and Food rose by .3% in Feb and in
> the last 12 month the same price index went up by 2.4%. Does this mean
> that the core rate of inflation for last year was 2.4%/12= .2% and
> therefore, the core rate of inflation increased .1% from last year?

Inflation rates are always, I think, reported per year, not per month as you 
are trying to do here.

Mar 30:

> One of my student was going over the exam with me.
> in the form 1, question23
> He understood the choice 3, 'GSI having no savings at all', as the GSI's
> holding all our wealth in the form of cash, so he think that GSI will be
> hurt by unexpetedly high inflation.

For that to be a better answer than C (the professor with corporate bonds), 
the student would have to have more wealth in cash than the professor has 
in bonds.  That is not plausible.

Mar 25:

> In lecutre on Thursday, while explaining the interest rate effect you
> said that as price level increases the deamnd for money increases
> (domestic), and therefore the real interest rate increases.  So this can
> be interpreted as a right shift in the demand for loanable funds.  Then,
> you said that because the real interest rate increased, investment will
> decrease.  So this will decrease the demand for money, left shift in DLF.
> Does the DLF curve shift by equal amounts each time? What will be the
> overall effect on DLF and thereby on the real interest rate.

The loanable funds model is only meant to be relevant in the long run, in 
which the price level -- not the interest rate -- adjusts to clear the 
money market.  I don't think it is meaningful to think of the DLF curve as 
shifting in this context.  I will give you a different supply and demand 
model to use for this purpose next week.

Mar 23:

> I have a question about the subjective questions, number 1 part B:
> I can understand the rationale behind using the present value in terms of
> big Macs to evaluate which job offer is better, but I have a different
> interpretation for the question:
> 
> If I am in Ypsilanti:
> 
> When I get my pay for the first time, I can buy 1000 big Macs with that
> amount of money:
> 2000/2=1000
> When I get my pay for the second time, I can buy another 900 big Macs
> with that amount of money:
> 1800/2=900
> So the total number of big Macs that can be consumed is 1900.
> The reason why I did this was because I felt that the price of the big
> Macs mattered at the time when the pay was received, as in how many big
> Macs could be bought with that amount of pay, because consumption (eating
> big Macs) matters at that time of the good is being brought. Also, if the
> nominal interest rate goes up, it also could mean that inflation has
> occurred but at the same time the prices of big Macs have remained the
> same, so the prices of big Macs are relatively cheaper, so how many big
> Macs an amount of money could buy matters only at the time when a person
> wants to eat them. Because one would only get the money in the future, so
> how many big Macs a person can buy would depend on how much a big Mac
> costs at that moment in time.

I don't disagree with most of what you say here, except that it does not 
make sense to add together the number of Big Macs that you can consume 
this year and next year, since consuming at those two different times is 
different.  That's why we use present value to make them comparable.  In 
this case, for example, the maximum number of Big Macs you could consume 
TODAY in Ypsilanti is 2000/2 + (1800/1.05)/2 = 1000 + 857 = 1857.  The 
second term here is the number of Big Macs that you could buy today with 
the amount that you could borrow today against your next year's income 
of 1800.  This is what you would want to compare with the present value, 
in Big Macs, of an alternative income stream.  (You may object that you 
don't want to consume all of your income today, but that doesn't matter.  
For whatever path of consumption that you prefer -- consuming the same 
number of Big Macs each year, for example -- maximizing this present 
value will also maximize that.)

As a more minor disagreement, your mention of inflation is not relevant 
here.  The interest rate does not go up -- it's constant in both places 
-- and even if it did that would not imply inflation.  And even if it 
did, all that would matter would be the prices of Big Macs, which you 
are told. 

> So with that same thought I did the same if I were in French Riviera:
> 
> 1800/2.5=720
> 2200/2.5=880
> total big Macs consumed: 1600
> 
> And I would choose option 2.

Again the correct comparison would not be to the total number of Big Macs, 
but to the present value, which here is 1800/2.5 + (2200/1.06)/2.5.  For 
the numbers here, it turns out that you get the same answer either way:  
Option 2 gives you the smaller present value, and you should choose 
option 1.  I'm not sure why you conclude that you should choose option 2, 
even doing it in your incorrect way.  You got fewer burgers in option 2.

Mar 18:

> I just wanted to clear up one thing. For this question:
> 
> > > 5. In Winter 2004 Exam II, it asks which variables will be lower in
> > > the long run if the central bank decides to increase the requried
> > > reserve ratio. would "IV. the inflation rate" also be a valid answer?
> > > If M decrease and Y can't be affected, wouldn't P have to decrease?
> > 
> > Yes, P would have to decrease, but only to a new lower level.  Once
> > there it won't keep moving, and the inflation rate will be back at zero.
> 
> I thought the MV = PY equation only worked in the long run, thus wouldn't
> the decrease in M also mean a decrease in P in the long run as well,
> which means that the inflation rate will also decrease?
> The exact question is,
> Consider an economy which is in long run equiligbrium with all nomianl
> and real variables constant over time. Then, unexpectedly, the central
> bank decides to increase the required reserve ratio. Once the new long
> run equilibruim is reached, which variables will be lower in the new long
> run equilibrium compared to the initial equilibrium?
> I. The money supply
> II. The price lvel
> III. The real interest rate
> IV. The inflation rate
> V. The nominal exchange rate
> a) I only
> B) I, II only
> C) II, V only
> d) I, II, V only
> e) none of these variables is lower in the new equilibrium than initially.
> 
> The answer is b, and it's still correct even if the inflation rate is also
> lowered... I also asked my GSI and he thinks that it would decrease.. Are
> you saying that inflation rate is differnt than the change in P? I'm just
> a little confused on this one...

The inflation rate is the change in the price level over time.  In the new 
long-run equilibrium, like the old long-run equilibrium, the price level is 
constant and the inflation rate is therefore zero.  It is true that during 
the transition from the old equilibrium to the new one, the price level fell, 
and so the inflation rate must have been negative at some point during the 
transition.  But it can't be negative in the new long run equilibrium, because 
that would mean that the price level continues to fall, which it does not.

Mar 18:

> The answer about
> the costs of unexpected inflation.  You said a professor who puts his
> money into a stock will lose the most real wealth.  However, by investing
> his money into a bond, he is still getting some interest on it.  On the
> other hand, the GSI who only holds currency is not earning any interest
> on this money and his real wealth is decreasing with inflation.  It
> doesnt specify if his income is indexed with inflation.  Please take
> these concerns into account.

The professor gets the same interest on his bonds whether or not there is inflation, so the loss in wealth due to unexpected inflation is not made smaller by the fact of interest payments.  The GSI, on the other hand, has no wealth, and therefore loses no wealth as a result of the unexpected inflation.

Mar 16:

> WINTER 2002
> 4.  Which of the following is most likely to cause a real appreciation of
> the US dollar relative to the yen (Japan's currency)?
> You said the answer was c, but if Japanese banks begin to invest heavily
> in US real estate, then US NFI would increase, and that would shift our
> NFI curve out to the right, and our demand for loanable funds by the same
> amount.  In the open economy model, wouldn't this lead to a drop in the
> real exchange rate, meaning that US currency is depreciating?

No, if Japanese are buying US real estate, that is a fall in NFI, not a rise.  
Foreigners are acquiring more US assets, and that is foreign investment into 
our country, not out.

> 14.  Assuming velocity is constant, an inflation rate of 10% implies
> that... I don't understand how the money growth would have to be greater
> than real GDP growth.

From the quantity theory equation, MV=PY, we see that, with V constant, 
gM = gP + gY or gM = gY + 10.  So gM > gY.

> 17.  President Bush recently announced that the US would put tariffs on
> imported steel.  According to our model of the open economy, this action
> will... Shouldn't a tariff on imported steel DECREASE net exports because
> imports would decrease?  Thus, why isn't the answer a.?

Net exports are (exports minus imports).  When imports decrease, 
(exports minus imports) increases.

> WINTER 2004
> 6.  Which of the following could cause a leftward shift in the supply of
> loable funds curve?
> Why would a decrease in taxes with no change in gov't expenditures cause a
> decrease in the supply of loanable funds?  Is it because government
> savings decreses?

Yes, together with the fact that private savings, though it will increase 
due to the tax cut, will increase less than government savings has decreased.  
Or, more simply perhaps, SFL = Y - G - C, and the tax cut increases C.

> 9.  A risk-averse individual should...
> Wouldn't a risk-averse individual want all of the above?

No.  If the return on a risky option is large enough, even a risk averse 
individual will choose it.

> 16.  Japan reduces its budget deficit by reigning in its spending.
> According to the long run open economy model, the quantity of US domestic
> investment will _____ and the quantity of US national saving will _____.
> I don't understand in which open economy model do you consider the
> changes.  Do you look at the US and say that NFI will increase because
> Japanese investment in the US decreases, or do you look at Japan's open
> economy model and say that the supply of LF increases because they are
> spending less?

Here you need to first use the open economy model for Japan, then for the US.  
Applied to Japan you'll find that by reducing its budget deficit it will 
push down its interest rate and increase its NFI.  Then, looking at the open 
economy model for the US, this means that US NFI is shifted left (Japan's 
capital outflow, induced by its lower interest rate, is a capital inflow for 
the US).  Since this also shifts US DLF to the left, the US interest rate 
falls, increasing US investment and decreasing US savings.

> 17.  The prime minister of Tuvalu is considering the following policies to
> increase net exports in the long run. I. Export Subsidies, II. Import
> Quotas, and III. Decrease in government expenditures.  According to the
> open economy model, which of these policies will accomplish the goal?
> Is it only three because I. and II. are short term impacts?  And why
> would a decrease in gov't expenditures increase NX?

I and II shift the NX curve, which in the open economy model does not change 
the level of NX, since in equilibrium NX=NFI, and NFI has not changed.  It's 
true that this is a long-run effect, because the model that tells us this is 
a long-run model.  We have not studied what these changes would do in the 
short run.

A decrease in government expenditures, on the other hand, is an increase in 
savings and thus a rightward shift in the supply of loanable funds.  This 
reduces the interest rate, increasing NFI, and causing a depreciation of the 
exchange rate that increases the level of NX.

Mar 16:

> I have a quick question about a problem in chapter 14. The problem asks
> what would happen when the quality of US exports decreases. So, assuming
> this would lower US exports I assumed that imports would increase and
> thus Supply of $US for exchange would increase (shift right). If that's
> correct, I then thought that NX would also shift outward b/c we are
> importing more. Are my assumptions correct??? Can you shift both Supply
> and Demand for  foreign currency???

The fall in quality of exports causes, as you say, a fall in exports.  I 
don't know why you think that would increase imports, but in either case, 
this shifts the NX curve, which is the demand for dollars in the foreign 
exchange market, to the left.  That's all that shifts:  the NX curve shifts 
left.

Mar 16:

>      I was confused on the abbreviation for the real exchange rate.  In
> the book the abbreviation is capital "E", but Seb told us that it is
> lower-case "e"...  Which is the real exchange rate, and which is the
> nominal exchange rate.  Thank you.

The way that I have used those symbols has been that e is the nominal 
exchange rate, defined as the foreign-currency price of the domestic 
currency, and E is the corresponding real exchange rate.  I think that 
is the same way the book uses the symbols.  Of course there is nothing 
in economics to say which symbol should be used for which exchange rate.

Mar 16:

> (1) Can NX and NFI move independently (i.e. NX increases, but NFI remains
> unchanged)?  I understand that NX = NFI, and so wonder if when US imports
> a car NFI will automatically decrease.

In equilibrium NX must equal NFI.  But it doesn't follow that something that 
changes NX will in turn change NFI.  In fact, what usually happens is that 
the exchange rate changes to cause a reversal of the change in NX, leaving 
both NX and NFI unchanged.  So in your example, if the US decides to import 
more cars, thus reducing NX at the current exchange rate and thus also 
reducing demand for dollars (on the market for foreign currency exchange) 
below supply, the exchange rate will depreciate (the dollar becoming 
cheaper) so as to stimulate exports and reduce (other) imports until NX is 
back where it was before.  If that didn't happen, some of the people 
supplying dollars to the market (in order to buy foreign assets) would find 
nobody to buy them.

> (2) if NX does not change, does that mean that NFI does not change either?

If you are asking whether, if the NX curve does not shift, then does that 
imply that the NFI curve does not shift, then certainly not.  We often have 
the NFI curve shift (due to a rise in the foreign interest rate, for 
example) without any shift in NX.  

If you are asking whether, if the level of NX does not, in the end, change, 
can one infer that NFI must not have changed, then yes, since NX=NFI in 
equilibrium.  But of course the causation in this model actually goes from 
NFI to NX, not the reverse.

> (3) according to the law of constant marginal returns, is it true that
> only if ALL factors of production increase by the same proportion, will Y
> increase by the same proportion?

There is no "law of constant marginal returns."  The property you are 
thinking of is "constant returns to scale," and it is not a law, but rather 
just a property of production functions that we assume to hold of the 
aggregate production function, Y=AF(L,K,H,N).  That property says that if 
L,K,H, and N all increase in the same proportion (and if A is fixed), then Y 
will increase in that proportion as well.  The reverse of this, which you 
state, does not hold.  For example, if A were also to increase, then Y would 
rise by more than the increases in the factors.  And if the factors 
increased by different amounts, then we wouldn't even know what was meant 
by "the same proportion."

> (4) is it true that if only ONE of those factors of production increases,
> Y will increase less than proportionately, and also at a decreasing rate?
> (i.e.--does the law of diminishing marginal returns apply to K, L, H, N,
> not only H?

Yes, the law of diminishing marginal returns is what you say, and it applies 
to each of the factors L,K,H,N individually.

> (5) will a DECREASE IN DEMAND FOR MONEY cause inflation?

A decrease in the demand for money (in the sense of people wanting to hold 
less money for a given value of P) will, if the supply of money is 
unchanged, in the long run cause the price level to increase to a new 
higher level.  In getting to that higher level, the rate of inflation would 
have to increase, but only temporarily since once at the higher level the 
price would stop rising.

> (6) does inflation cause people to save more? It was discussed in the
> book that a HIGH inflation rate will DEPRESS savings

To the extent that people can hold their wealth (the results of their saving) 
in assets that rise in value with the price level, then inflation does not 
need to discourage saving.  But in fact a great many of the assets that 
people hold are not indexed to the price level and do fall in real value when 
there is unexpected inflation.  That could well depress savings.

> (7) if a bank holds $600 excess reserves, and $400 required reserves,
> what does "all currency end up in the bank again" mean, causing the total
> amount of reserves held by the bank $1000?

The phrase "all currency ends up in the bank again" simply means that people 
other than banks do not hold any currency -- so that all money is bank 
deposits.  That's an assumption (obviously a very unrealistic one) that we 
often make in order to simplify the operation of the monetary system so that 
you will be able to analyze it.  It is completely separate from the issue of 
whether banks hold more reserves than they are required to -- i.e., excess 
reserves.

> (8) when a change in the real exchange rate E causes the level of NX to
> change, does this also change NFI?  (i.e.  can we go "backwards" with the
> open economy model?)

No. 

Mar 16:

> 1) i am having a hard time understanding FPI vs FDI. i know FPI is money,
> and FDI is physical assets, but in Q#6 on the winter 2003 exam it talks
> about bonds being bought by euros then these euros are used to buy french
> wine. what i did for this problem is:
> 
> NFI (FDI) dec = purchase of bonds
> NFI (FPI) inc = euros paid for bonds
> NX dec = french wine
> NFI (FPI) dec = euros bought wine
> 
> the FPIs cancle so [FDI dec and NX dec]. but the answer is [FPI dec, NX
> dec]. where did i misunderstand this?

FPI is not necessarily money, but holdings of any financial assets.  In this 
question, there is no change in holdings of money as an asset, since the 
euros that are paid for the bonds are then used to buy goods, so the euros 
are out of the picture.  What matters are just the foreign purchase of our 
bonds, which is a fall in NFI and FPI (bonds are financial, and therefore 
part of portfolio investment), and our purchase of wine, which is a fall in 
NX.
> 
> 
> 2) W03 #10: talks about when the LRAS curve shifts, i thought that it
> didnt shift, since it is vertical it doesnt depend on the price level. so
> why, how and when does it shift?

LRAS is vertical at the level of Y=AF((1-uN)LF,K,H.N), so it shifts in 
response to changes in any of A,uN,LF,K,H, or N.

> 
> 3) W03 #24: asks the effects on CPI due to a shift in NFI. first i drew
> the open economy model, and see that an inc in NFI => depreciation in
> real exchange rate. also knowing E = eP/P*, this can relate to the CPI.
> since E dec, why doesnt P decrease? why does it rise as the answer
> suggests?

The fall in E in this case is also a fall in e, since the prices of goods 
produced in both countries are said to be fixed.  US consumers must now 
pay more (in dollars) for their imports of imported clothing, thus 
increasing the CPI.

Mar 16:

> 17. Suppose that consumers in China develop a taste for American blue
> jeans, desiring to import more of them than before at any given real
> exchange rate. This change
> will affect the equilibrium levels of which of the following variables in
> the US?
> a) The real exchange rate.
> b) NX.
> c) r.
> d) NFI.
> e) All of the above.
> 
> *if the real exchange rate changes, don't all the rest variables change
> as well?

No, they don't.  r is determined in the loanable funds market based on 
behaviors (I, NFI, S) that do not depend on the exchange rate.  NX does 
depend on the exchange rate, but in equilibrium NX=NFI, and since NFI 
doesn't change here, NX also does not.  That is, the exchange rate must 
change so as to bring NX 
back to its initial level.

> 18. Consider the sequence of events depicted in the diagram below.
> 
> *The diagram shows that the SLF shifts to the right, and the Supply of
> Dollars shifts to the right.
> 
> Which of the following could NOT potentially cause these events to occur?
> a) Government reduces purchases.
> b) Foreigners increase purchases of our exports, for given prices and
> exchange rate.
> c) Households reduce consumption, for given levels of income and the
> interest rate.
> d) Government increases taxes on income.
> e) None of the above; that is, all of the above are plausible
> explanations for the
> diagram.
> 
> *The tax doesn't change the National saving since Ns= Y-G-C. But if
> foreigners decided to buy more from US, then the NX increases, which
> shifts the supply of dollar curve to the right. Therefore, shouldn't the
> answer be D instead of B?

No.  When foreigners decide to buy more goods from the US this changes 
NX for given E, thus shifting the NX (or demand for dollars) curve.  It 
does not shift the supply of dollars curve, which is just the level of 
NFI determined in the panel above it.  As for taxes, when these go up 
households have less disposable income and so they reduce consumption.  
So Y-G-C goes up.

Mar 16:

> 26. The long-run aggregate supply curve is vertical, because
> a. the natural rate of unemployment does not vary over the business cycle.
> b. a rising price level raises marginal cost along with price of output.
> c. net foreign investment does not depend on the real exchange rate.
> d. the central bank controls the money supply.
> e. perfectly competitive firms increase output when price rises.
> 
> *The answer is b, but I just don't understand what it means. Could you
> explain it to me?

Look at your notes from my lecture of last Thursday, where I went through this.  
The point is that the price level includes all prices and wages, and so when 
it goes up that means that both wages of labor and prices of intermediate 
inputs are going up along with the price of a firm's output, and therefore 
that marginal cost is shifting up.  As I showed in class, if marginal cost 
and price of output both rise by the same amount, then output will not change.  
And that's what the vertical long run aggregate supply curve shows.

Mar 16:

> 1. On the Bureau of Labor Statistics reading, you ask, "If you hold two
> paying jobs, under what circumstances will you be counted as two employed
> persons?" The reading says that "Each employed person is counted only
> once, even if he or she holds more than one job." So is the answer to
> this question "never"? 

That would be my interpretation of what you quote.

2. On the "Payrolls Rise, Passing Milestone as
> Unemployment Slips to 5.2%" WJS article, you ask, "what two numbers did
> January employment surpass?" Is one of them payroll employment? And what
> would be the second statistic that you want us to know?

I didn't mean that you had to know a particular number.  What I meant was 
that the employment in January surpassed what employment had been at two 
notable times before.  One was its pre-recession peak in Feb 2001, and the 
other was its level when George Bush first took office, in Jan 2001.  The 
article mentions both of these, and it calls at least one of them a 
milestone, as I recall.

> 3. On Winter 2004 Midterm II, question #9, it asks,
> A risk-Averse individual should
> a) always prefer a sure payment of $100 over a gamble in which she can
> win $110 with 90% probability and $10 with 10% probability
> b) Always invest in bonds rather than stocks
> c) always prefer a less risky stock over a more risky stock
> d) always prefer an investment with lower return and less risk to one
> with a higher return and more risk.
> e) always be insured.
> -I understnad how a is true, but I don't understand why a risk averse
> individuals won't also do b, c, or d.

I think I answered this one earlier.  Basically it is that risk aversion 
doesn't mean that you avoid risk at all cost, only that you will give up 
some return to get reduced risk.  But if the expected return of a risky 
choice is high enough, you'll take it.

> 4.Is cyclical unemployment rate an absolute number? The definition in the
> book defines it as "deviation from natural rate of unemployment" but in
> 2004 Midterm II, question #25, you seem to assume that it's not an
> absolute number... If it says that the cyclical rate of unemployment is
> 2.5%, does that mean that it is 2.5% less than or greater than the
> natural rate?

No, it's not at all an absolute number.  It is actual unemployment minus 
the natural rate of unemployment, so it certainly moves around, being 
positive sometimes and negative others.  That's why it's called "cyclical."  
It goes up and down.

> 5. In Winter 2004 Exam II, it asks which variables will be lower in the
> long run if the central bank decides to increase the requried reserve
> ratio. would "IV. the inflation rate" also be a valid answer? If M
> decrease and Y can't be affected, wouldn't P have to decrease?

Yes, P would have to decrease, but only to a new lower level.  Once there 
it won't keep moving, and the inflation rate will be back at zero.

> 6. In 2003 Midterm II, Short answer number 1. part b), we are suppose to
> determine what happens to domestic investment when congress passes an
> investment tax credit. I understand that an investment tax credit would
> increase domestic investment, but when this happens, the interest rate
> increases. Wouldn't the increase in interest rate decrease domestic
> investment, thus the answer is ambiguous? (Is the answer increase because
> the former is a shift in the curve and the latter is a movement along the
> curve?)

You are right that there are two offsetting things happening to investment, 
the shift of the curve that would increase it if the interest rate did not 
change, and the rise in the interest rate that tends to decrease it.  So 
based just on that, it looks like the answer is ambiguous.  But in 
equilibrium, I+NFI=S, or I=S-NFI.  The rise in r raises S and lowers NFI, 
thus necessarily raising S-NFI, so I must rise.

Mar 16:

> 1.  For number 16 on the Winter 2004 exam: If Japan's savings goes up,
> its NFI will go down.  This will end up causing our NFI to go up, which
> in turn causes our  interest rate to go up.  Therefore, it makes sense to
> me that domestic investment will decrease and savings will increase, but
> for the answer it is the other way around.

You are starting wrong.  Why do you think that Japan's increase in saving 
will cause Japan's NFI to go down?  By saving more they push down their 
interest rate, making their assets less attractive and causing their NFI 
to increase, not decrease.  So our NFI goes down (as capital flows in, 
fleeing their lower interest rate), reducing our demand for loanable funds 
and pushing down our interest rate.  That increases our investment and 
reduces our saving.

Mar 15:

> Hi Professor Deardorff,  I have some questions about Winter 2002 Exam.
> 
> 11.  Here's what I did:
> 
> (%change in e) + (%change in p) - (% change in p*) = (%change in E) = 0.
> 
> I got that (%change in e) would be 16, which led me to choose answer A,
> because 69 is approximately 16% higher than 60.  This is the wrong
> answer.  What should I have done?

The definition E=eP/P*, which you've used, is only correct if you define e 
as the foreign currency price of domestic currency, not the other way 
around.  That is, the currency that is in the denominator of e should also 
be the one whose prices are captured by P, while the currency in the 
numerator is the one whose prices are captured by P*.  From the difficulty 
that another student had with this problem, my guess is that you got e 
upside down.

> 
> 25.  Can you explain to me why the trade deficit equals government budget
> deficit plus investment minus private savings?

Well, I can derive it from the definition of GDP:
  Y=C+I+G+NX
  -NX=C+I+G-Y
  -NX=G+I-(Y-C)
  -NX=(G-T)+I-(Y-T-C)
But if you want an explanation in words, try this:  The trade deficit is the 
amount that our country spends in excess of its income. (If we buy more than 
what we produce, we have to import the difference.)  The amount that we spend 
in excess of our income includes the amount that our government spends in 
excess of its income (the budget deficit) plus the amount that the private 
sector spends in excess of its income, which is investment minus private 
saving.  Does that help?

Mar 14:

> I seem to be confused about question #7 on the Winter 2003 practice
> exam.  I do understand that the question implies a leftward shift in
> the supply of money and a reduction in net exports.  However, I do not
> see how specific conclusions can be made about exports and imports. 
> Are these conclusions drawn because of the increased real rate of
> exchange?  However, couldn't exports and imports both decrease, but
> exports just decrease more?

First, this is not a "leftward shift in the supply of money."  It is a 
leftward shift in the supply of dollars on the market for foreign 
currency exchange.  You should reserve the term "supply of money" for 
the quantity of money controlled by the central bank, which is quite 
different, or you will get confused at some point.

As we discussed in explaining why the NX curve slopes down, both exports 
and imports individually depend on the real exchange rate, exports 
negatively and imports positively.  So yes, we do know how each of them 
change in this case.  (You're right that if all we knew was that NX 
declines without knowing why, then we wouldn't know the changes in 
exports and imports separately.  But here we do know that the decline 
in NX is due to the real exchange rate, so we know how it affects them.)

> Also, along the same lines, can you please explain the effect on trade
> of an import quota?  I understand that net exports would remain
> unchanged, but can any specific conclusions be drawn about exports and
> imports?  (i.e. both imports and exports increase by the same amount,
> or both would stay at the same level).

If an import quota reduces the quantity of certain imports, then this 
increases NX for a given exchange rate.  This causes the real exchange 
rate to appreciate, which in turn reduces exports and increases those 
imports that were not constrained by the quota.  Since NX must end up 
where it started (equal to unchanged NFI), the end result must be that 
both exports and imports fall by the same amount, imports having fallen 
by more due to the quota and then risen somewhat due to the appreciation.

> Finally, question #17 on the same practice exam refers to consumers in
> China developing a taste for American blue jeans, which shifts the
> demand for dollars up.  However, how do I distinguish this change from
> an increased "attractiveness of domestic assets," which leads to the
> NFI curve shifting left?

Bluejeans are a good that people consume, not an asset.

Mar 14:

2.  Does inflation cause people to save more or less? In
> your office I believe we concluded that inflation erodes the value of
> currency more than it erodes the value in a savings account,so they would
> want to save more,but am i thinking about this correctly? It seems to go
> against the book in the section which talks about "inflation-induced tax
> distortions", where it says that inflation discourages people from
> saving... then if this is true, why? 

To the extent that a portion of savings is held in assets that do not rise 
in value with inflation, inflation reduces their value and thus discourages 
saving.  That certainly includes the portion of saving that is held as money.  
You seem to be thinking that all saving goes into "savings accounts," but 
that is not the case.

3.  for the relationship between
> government budget deficit and trade deficit, I understand that tax cuts,
> which increases budget deficit reduces NX because of how it fits into the
> model, is there anything else we need to know? 

That plus how the sizes of the changes in the two deficits compare, which 
you also should be able to figure out from the model.

4.  Why doesn't NCO depend
> on the real exchange rate? The real exchange rate is defined as "the rate
> at which a person can trade the goods and services of one country for the
> goods and services for another." If NCO is the outflow of money, wouldn't
> the real exchange rate, by definition, effect whether people want to
> invest domestically or abroad?

No, what matters in holding domestic versus foreign assets is the percentage 
return that you expect to get on each, and that does not depend on the level 
of the exchange rate so long as the exchange rate is the same both when you 
buy the asset and when you sell it.  This is something I talked about in 
class.

Mar 13:

> I have several questions about the second midterm from winter 2004.
> 
> 9.  I guess I understand why A is the answer, but I don't understand why
> C, D, and particularly E are not also possible answers.

Risk averse doesn't mean that you avoid risk no matter what, only that you 
are willing to sacrifice some amount of expected return to get less risk.  
But if a more risky stock gives you enough of a higher return, then you 
will still buy it, which is the reason that both C and D are wrong.  And 
for E, it depends on the cost of the insurance.  A risk averse person will 
always pay some amount for insurance, but maybe not as much as it costs.

> 15.  Is the answer A becuase only the demand for $ curve shifts down?

Yes.  Our sales to foreign tourists are part of our exports, so in this 
example we are exporting less for any given value of the exchange rate.  
So the NX curve (i.e., demand for $) shifts down and to the left.

> 16. It seems like, for starters, when Japan shrinks its deficit, it's real
> interest rate decreases, making Japanese assets less attractive everyone.
> Then American NCO shifts left, decreasing our interest rate, encouraging
> doemstic investment and discouraging saving?

Yep.  Except I don't know what NCO is.  If you mean NFI and therefore DLF, 
then I agree.  (Boy, I sure don't remember that we asked this question.  And 
I can't believe I let that misspelling through.)

> 18. How do you read/interpret the nominal exchange rate on the long run
> open economy model?

By combining it with the other long run model of the quantity theory of 
money.  The open economy model tells you that the real exchange rate does 
not change (since the money supply does not enter that model).  The decrease 
in money supply then, when it causes the price level to fall, has to cause 
the nominal exchange rate to appreciate in order to keep the real exchange 
rate constant.

> 25.  Confused!  If the rate of job-finding is 7x larger than the rate of
> job-separation, why is there any unemployment at all?

This is from the model of job finding and separation that I gave in class 
and that was in homework 4.  There the natural rate of unemployment is 
s/(s+f) = 1/(1+f/s).  So if f is 7x s, unemployment is 1/(1+7)=1/8=12.5%.

> Short 1a.  I always get confused about exactly which number to multiply
> by the money multiplier.  In the text book, it says "the money multiplier
> is the amount of money the banking system generates with each dollar of
> reserves."  However, it seems to me that it's more like the  "the money
> multiplier is the amount of money the banking system generates with each
> dollar NOT HELD IN reserves."

Well, no.  I don't see why you think that.  If money is held as currency in 
people's pockets, and thus not as reserves in banks, then it just counts as 
part of the money supply directly and does not support any multiple 
expansion of the money supply.  But each dollar that is held in banks, and 
thus is part of reserves, supports deposits equal to the money multiplier 
times the amount of reserves.

> ALSO, questions regarding the text book.
> 
> If currency is "in the hands of the public," does that include the
> goverment?   In what capacity?  (page 223)

Yes, it would include the money that various parts of government are holding 
to use for transactions.  It would not include money that the government has 
printed but has not put into circulation yet.

> Where does it show up in the market for loanable funds graph if someone
> wants to invest, but they're not actually borrowing funds in order to do
> it?  (page 292)

All (domestic) investment is part of the DLF curve.  If a firm is using its 
retained earnings for that purpose, the retained earnings are also part of 
saving and therefore also part of the SLF curve.  It's as though they borrow 
from themselves.

> In terms of NX=NCO, I'm a little confused.  When Americans get foriegn
> currency from selling exports, why do they HAVE TO buy foreign assets?
> Couldn't they save?  or buy domestic assets?  (page 292)

The people who export don't have to buy foreign assets themselves, but they 
have to do something with the foreign currency that they acquire.  If they 
hold onto it, then that IS acquiring a foreign asset.  If (as would be more 
normal) they use it to buy dollars on the exchange market from someone else, 
then the question is why that other person wanted to sell dollars.  It may 
have been to buy imports, in which case our net exports didn't go up after 
all.  Or it may have been to buy foreign assets.  Or maybe they just wanted 
to hold more foreign currency, but that is foreign assets also.  Whatever 
the reason, we end up with NX=NFI.  (I'm still trying to figure out where 
you're getting NCO instead of NFI.)

> Why doesn't NCO depend on the real exchange rate?  NX certainly depends
> on the real exchange rate, and NX = NCO.  (page 293)

You're right that NX depends on the exchange rate, because it determines the 
relative prices of domestic and foreign goods.  And its true that NC=NFI, but 
only in equilibrium.  Since NFI represents the net change in holdings of 
assets, and as the level of the exchange rate does not matter for that (as I 
explained in class), NFI does not depend on it.

> I'm having a really basic problem understanding the market for foreign
> currency exchange.  Do the Supply and Demand curves represnet total
> world-wide supply and demand of dollars?  I don't really understand what
> those two curves represent.

The basic idea is for the demand for dollars on this market to represent all 
of the dollars that anybody in the world wants to buy, in a given time period, 
in exchange for foreign currencies, and the supply to represnet all of the 
dollars that anybody in the world wants to sell, also in exchange for foreign 
currencies.  Logically, the demand for dollars would then include both total 
exports and total capital inflows, since both of these transactions require 
that people exchange foreign currency for dollars, and supply of dollars would 
include total imports and total capital outflows, since these involve selling 
dollars.  However, for simplicity, Mankiw treats imports as negative demand 
rather than positive supply, and capital inflows as negative supply rather than 
positive demand.  That may not seem simple, but it means that we can represent 
demand with one kind of behavior (trade) and supply with another (capital flows, 
or NFI), which really is simpler.

> What would cause a shift in NCO vs movement along that curve?  What would
> cause a shift in demand and supply for $ vs movement along those supply
> and demand curves?

Ah, I just figured out what you mean by NCO:  Net capital outflow.  Is that in 
the book?  Or is your GSI using that?

Anyhow, I'll keep calling it NFI.  Changes in capital flows due to a change in 
the domestic interest rate are movements along the curve (as you can tell from 
the fact that the interest rate is on the axis of the diagram).  Changes in 
capital flows for any other reason, such as a change in the foreign interest 
rate or changes in the policies or risks associated with domestic or foreign 
assets, will shift the curve.

> what is the difference between money stock and money supply?

No difference.  They're the same.

> I understand why long run aggregate supply is vertical, but why is short
> run aggregate supply sloping?

I haven't explained that yet.  We'll have several reasons that we will go 
through after the exam.

Mar 13:

> This question is from #6 HW 5.  For part (a), I understand that PY is
> nominal GDP, and we can use that value to find V.  However, I used Real
> GDP for Y and GDP deflator for P?  I know that doing that way gives a
> different answer, but why can't I do that?

You can do that, as long as you remove the 100 from the GDP deflator first.  
In the definition of the GDP deflator as ( Nominal GDP divided by Real 
GDP ) times 100, the 100 is just to make the number comparable to a price 
index, but if you multiply it times real GDP as is, you get 100 times the 
actual value of nominal GDP.

  Also for part (c), you state
> that % change in money sypply is approximately equal to the sum of the %
> change in real GDP and the inflation rate.  But they come out to be 40%
> and 29%.  Is that considered approximately the same?

No, not really.  The approximation (that the % change in a product is the 
sum of the % changes) is only valid for small changes.  These are not small.

  Also how does
> calculating % changes in money supply, real GDP, and inflation rate
> explain the neutrality of money?

It doesn't explain it.  But you do observe here that the growth of the money 
supply has not had any affect on the growth of real GDP.  That is all that 
is meant by the neutrality of money.

> Lastly, what is the exact difference between monetary policy and fiscal
> policy?

Monetary policy consists of using the money supply to affect the economy.  
Fiscal policy consists of using government purchases and/or net taxes (taxes 
and transfers) to affect the economy.

Mar 13:

> This question is #11 on 2003 Midterm 1.  Choice (c) states that "The
> public decides to use credit cards to make a greater proportion of their
> transactions in order to earn points towards air travel."  I think this
> would not decrease the value of money since using creadit cards does not
> affect the money supply.  Is that right?

You are right that it does not affect the money supply, but it does affect 
the money demand.  If people are using credit cards instead of cash, then 
they need to hold less cash and the demand for money is shifted left.  
(Equivalently, the velocity of money is increased.)  So it does reduce 1/P.

> For #5 on HW 5, I don't understand why deposit is $5000.  Is it because
> people do not use the currency for transaction?

Yes, they end up depositing all the wheels in the bank, and since the bank 
keeps 10% of deposits as reserves, and reserves are 500, deposits must be 
5000. (Not $ though.  fei)

  Also if I have to
> multiply the initial amount by the money multiplier, why don't I do the
> same thing for $100 that Colobos deposits?

You can.  100 times 10 is 1000, which is the new amount of deposits and money.

  Also for part (c), why does
> the banker have to recall the loans by 300?  Can it be any other number?

Yes, it could be some other number, I suppose, if the banker were to anticipate 
what the result of this whole process will be, and since this is the only bank 
on the island.  But the number 300 comes from the banker looking just at his 
current deposits and how much more reserves he'd like to have to back them, 
ignoring the fact that by calling in loans he will also cause deposits to fall.  
With deposits of 6000, and reserves of 600, but wanting to now hold 15% of 6000 
as reserves (which is 900), he will recall 300 in loans to try to achieve it.  
This is therefore the answer you would get if there were lots of banks, each 
of which would be right to ignore the effects of its own recalling of loans on 
its own deposits.


> What is the difference between discount rate and federal funds rate?  My
> understanding is that discount rate is interest rate between the Fed and
> banks, and federal funds rate is between banks?  Is that right?  And why
> is federal funds rate important?

Yes, that's right.  The federal funds rate is important because more borrowing 
of reserves is done among banks than by banks from the Fed, so it is really the 
federal funds rate that influences bank behavior.  But the two rates are always 
almost exactly the same.

Mar 10:

> I was doing this week's homework and have a couple of questions.
> 
> For #2 (a), When I calculate the value of US exports using the formula
> Y=C+I+G+NX, does "I" include US investmen abroad?  I thought no, but just
> wanted to check.

No.  I stands for domestic investment, and it is included in the definition 
of GDP because it represents goods that have been produced in the country 
that are not included in C.  Net foreign investment includes, as FDI, goods 
that have been produced, but not in this country.

> Also, I don't know where to strat for part (c).  Do you have any hint?

Use the equations that define the various variables, and among those 
equations, look for ones in which you know all but one of the variables.  Then you can solve for the one you don't know.  In this way you should be able to solve for 
the level of net taxes, and then its deficit or surplus.

> For #3 (c), I am not sure about the last part.  If euros are deposited in
> euro-dominated bank accounts in NY, is it a part of NFI? or does it have
> nothing to do with NFI?

These euros are a financial liability of the Europeans, now held by 
Americans, so yes it does matter for NFI.

> For #6 (a), I thought that I should shift the NFI curve of the second
> graph to the right.  Is that right?

No, you need to think more carefully about what NFI represents (perhaps 
look again at the handout I posted on this subject), and also remember 
what the DLF curve now represents.

Mar 9:

> On question 6 of hw#6
> 
> I know that the riskiness of foreign assests will cause the NFI curve to
> shift left.  But, I recall from lecture that when the rise in foreign
> interest rate caused it to move right, the Loanable funds curve moved as
> well.  Will the shift left due to riskiness move the LF curve left, or
> was that specific to the interest rate?

Yes, it definitely will shift the DLF curve also.  The DLF curve is defined 
as measuring (horizontally) I+NFI, so anything that shifts the NFI curve 
also shifts the DLF curve by the same amount.

Mar 7:

> My GSI told me that
> the PY portion of the equation MV=PY, is equal to the nominal GDP. But
> the textbook claims that P=the GDP Deflator and Y=the real GDP.

Both are right.  If you'll recall, the GDP deflator is defined as nominal 
GDP divided by real GDP.  Therefore, when it is multiplied by real GDP, as 
in P times Y, the result is nominal GDP.  (OK, I guess I'd actually say 
that the textbook is not quite right, since the GDP deflator is defined to 
include multiplication by 100, which would mess this up.  In that sense, P 
can't really be the deflator, but rather the deflator divided by 100.)

Mar 2:

> I'm having trouble with question 6c on homework 5.  In fact, I don't even
> know where to start.  Any advice?

Start, if you haven't already done that, by filling in both columns of the 
table.  (Reread the question if you're having trouble with part of that.)  
Then use the definition of the deflator to calculate that for each year.  
From that you can calculate the rate of increase of prices.  Now use the 
quantity equation, in growth form, to see whether all of these growth rates 
match up.

Feb 19:

> For number 2(f), you wrote "suppose that unemployment in 1985 was at its
> natural rate.  Define and calculate the cyclical unemployment in years
> 1990 and 1995."  But I think you meant to put 1995, 2000, and 2005 for
> the years.  Is that right?

Yes, that's what I meant.  By now you've received a correction that I sent 
to the class.

> Also for number 4(c), where are we supposed to look up for the data?  Is
> it the same data as the one for 4(b)?

Yes, you're supposed to look up the data, but it won't be in exactly the 
same place as 4(b).  You'll need to do a little searching on the BLS website.

Feb 18:

> I was reading an article about Greenspan's comment on the Social Security
> on Thursday's WSJ.
> Greespan said that instiling private account in Social Security still
> wouldn't solve the problem of low private saving rate, and the government
> will need to borrow money to support the social security even if it is
> reformed the way the president proposed.
> If that is the case, wouldn't it cause a problem in the long run because
> of the increasing government defincit and low saving rate?

It certainly causes a problem in the short run, because the government 
borrowing that he said was necessary is most obviously needed only in the 
short run, during the switch from one system to the other (which will take 
a generation or so).  As for the long run, I presume the expectation is 
that once people start earning good returns on their individual accounts, 
then the government will be able to cut back on what it hands out.  The 
administration's proposal to switch indexing from wages to prices is 
designed to do exactly that.

Feb 17:

> For question #3, it says 10 out of 1000 people leave their jobs. Is the
> labor force in the problem that 1000, or is 1000 for the employed workers
> and 111 unemployed workers(1000/.9=1111)?

I guess it should have said "6 in every 1000 employed workers quits" and so 
forth.  I took it for granted that workers who quit would have previously 
been employed.  All this is doing is telling you the percentages of employed 
workers who quit and are fired each week.

Feb 16:

> I was concerned with what you said in lecture yesterday about the exam.
> You stated that for two questions, you would be giving credit for two
> additional answers.  I understand giving credit for the Hymans article
> question, as some students read a different version of the article the
> day of the exam, but I don't understand giving credit for the question
> about GDP.
> 
> When taking the exam, I understood the "babysitting answer" to be wrong
> because babysitting is a service consumed by a household.  Albeit the
> person babysitting was Kate's sister, she was still paid for her
> services, which would make it count towards GDP.  If Kate's sister wasn't
> paid, then the babysitting service wouldn't be counted towards GDP, but
> that isn't the case.  I believe the textbook makes it clear that GDP
> includes intangible services such as babysitting.  "Bob buys $2000 of
> bonds issued by the US Government" does not count towards the GDP because
> it is part of Financial Market, which does not count towards GDP.
> Students may have taken this to be part of investment, but that would
> clearly be wrong.
> 
> Yes, the question was tricky, but not tricky enough to grant credit for a
> wrong answer.  My take is that the students weren't tricked by the
> question, but by the meaning of GDP.  By giving credit to those who chose
> a wrong answer, you are in fact punishing those students who understood
> the question, and the meaning of GDP.  The majority of students who gave
> the correct answer heavily outweighs the handful of students who
> misinterpreted the meaning of GDP.

I certainly see your point, but having now read carefully what Mankiw says 
about this kind of payment, I think it really is unclear whether such 
payments are or are not included in GDP.  What he says, on p. 94, is the 
GDP "excludes most items that are produced and consumed at home and, 
therefore, never enter the marketplace."  From this, you could either infer 
that a payment by one family member to another for a service is something 
that is produced and consumed at home and never entered the marketplace, 
because the "marketplace" is outside the home.  Or one could assume that 
the fact of a monetary payment is enough to make it a market transaction.  
The latter is what you and I assumed, but there is nothing I can find in 
the text to say that it is right.  Since a student who had memorized this 
passage of the text perfectly could reasonably have concluded that answer 
(b) was right, I think I have to give credit for it.

Although it wouldn't matter for grading this question, I decided to try 
to find out what our government actually does on this issue when measuring 
GDP.  What I found was the following (from the website of the Bureau of 
Economic Analysis):  Personal Consumption Expenditures includes purchases 
of "services of paid household workers."  However, "purchases from other 
individuals are not included."  So I'm still a bit unsure.  I think that 
"paid household workers" only refers to people who make part of their living 
doing housework, such as cleaning, gardening, or child care, and would not 
include paying a relative for babysitting.  And saying that purchases from 
other individuals are not included surprises me, since it does seem to 
exclude this kind of transaction.  So based on this, I now think that I 
should give credit for answer (b) not just because Mankiw was unclear, but 
because answer (b) seems actually to have been correct.

Feb 14:

> There was a question on the exam that asked which one of the following
> would NOT change the GDP.  I understand why the correct answer is
> correct, but I do not understand why the answer that deals with
> babysitting is incorrect.  The book explicitly says that jobs in the
> family like this are not included in the GDP and you also said this
> yourself in lecture.

This was not unpaid work around the house, but work that was paid for.

Feb 13:

> I am a bit confused about the question #7 on the first exam: "Country A
> is a closed economy. Its GDP is $15 billion. Its government purchases $4
> billion in goods and services, collects $5 billion in taxes, and provides
> $2.5 billion in transfer payments to households. Private savings in
> Country A is equal to $5 billion. What is investment in Country A?" 
> 
> I tried to solve the problem the following way: 
> 
> National saving is: private saving (Y-T-C) plus government saving (T-G).
> Since private saving is $5 billion and government saving is $1 billion
> (T-G: $5-$4=$1), national saving for country A equals $6 billion. Since
> national saving equals to national investment, the country's investment
> is also $6 billion. 
> 
> Obviously, since the correct answer is $3.5 billion, the $2.5 billion was
> deducted from the total national saving. I was wondering why are the
> transfer payments to households included in the equation. The payments
> are transfer payments, and as such, they would not be included in the GDP
> equation (Y=C+I+G). Moreover, since national saving equation derives from
> the GDP equation, is it correct to include transfer payments into it? 

You are correct that transfer payments do not belong in the equation for 
GDP (and neither do taxes).  But they definitely belong in both the 
government's budget (negatively) and the private sector's budget 
(positively), which is why T stands for net taxes, not just taxes.  That 
is, as I know I stressed in class, T is taxes minus transfer payments.

Feb 10:

> I have a question regarding the last problem in Part II of the Econ 102
> exam. We're asked to record the changes caused by an increased in the
> government purchases.
> 
> I do not understand why private saving rises. With reference to the
> question, I believe that's the consequences of the increase in interest
> rate and not because of the increase in government purchases. Therefore
> the private saving should remain unchange. If indeed private saving rises
> and public saving falls, then there might not be a shift on the supply
> curve after all.

The rise in private saving is indeed due to the rise in the interest rate, 
which is in turn due to the market adjustment necessitated by the rise in 
government purchases.  The rise in private saving is a movement along the 
SLF curve, not a shift of it, so it cannot undo the shift that was caused 
by the increase in government purchases.  Recall that the reason that the 
SLF curve slopes up is that private savings rises as the interest rate rises.

Feb 10:

> I just wanted to let you know that there was a problem with one of the
> questions on today's exam. The question about the Chinese GDP article
> (question 7 on form 3) said that Chinese per capita income would catch up
> to the US later this century. At the end of the article, however, it says
> specifically that Chinese people will still not be rich, because the GDP
> per capita of China will still only be 1/3 that of the US in 2040. I'm
> not sure if that affects the exam question though, because assuming the
> given information is correct would lead to only one of the answers. I
> just thought I would let you know, because I'm sure I wasn't the only one
> who was confused.

Oops.  You are right that I misquoted the article, which said that China 
will surpass the US in total income, not per capita income.  I think you 
are also right, though, that the intended answer is correct given the 
statement made, and if there is a way that another answer becomes correct 
based on correcting the statement, then I don't see it.

For what it's worth (and that's not much), the numbers in the article do 
suggest that Chinese per capita GDP would surpass that in the US, if growth 
rates don't change (which is what all of the other answers are about, of 
course).  As you say, it predicts that by 2040 Chinese per capita GDP will 
be 1/3 of US per capita GDP.  It also gives the real growth rates of 8% 
for China and 3% for the US.  If the two countries have the same population 
growth rates (they don't; China's is smaller, I think, due to their one-
child policy), then these translate into 5% faster growth of per capita GDP 
in China than the US (and even faster if their population grows more slowly), 
which from the rule of 70 will double the ratio of their per capita GDP to 
ours every 14 years.  So that 1/3 ratio becomes 2/3 by 2054 and 4/3 by 2068, 
definitely surpassing us within the century.

Feb 9:

> Could you please explain #18 from the Winter 2003 exam?

The US GDP deflator is an index of the prices of goods produced in the 
US.  The prices of snowmobiles produced in Canada do not affect that.  
(Actually, these imported snowmobiles enter GDP, and the GDP deflator, 
both positively through consumption and negatively through imports in 
net exports, thus canceling out.)  The imported snowmobiles do however 
enter positively in the US consumption basket for the CPI (according 
to the question), so a rise in their prices will increase the CPI.

Feb 9:

> Thank you for your quick reply. I still am wondering about question 16.
> If that is the case, why does an accumulation in capital lead to a higher
> GROWTH RATE? For example, on HW 2 Question 6, you mention that increase
> in investment to Dian of 100 million dollars will lead to an increase in
> growth rate in the short run. Am I just misinterpreting what you said in
> the HW solution? (I understand that increase in capital leads to an
> overall growth, but how does it also increase growth rate? Doesn't it
> decrease the growth rate?)

In the Nicaragua question we are holding the rate of investment constant, 
and the drop in the capital stock means that a given amount of investment 
produces a higher growth rate (for a while, until the capital stock grows 
back to what it was before).  In the Dinan question, we are increasing 
investment for a given capital stock, and this increases GDP.  In the year 
that this happens, that is an increase in the growth rate.

Feb 9:

> I was working on the old exams in the
> Course Pack 4. Could you explain the question 13 on the first winter
> exam, 2004? I have no idea how to do it and am really concerned.

Just plug the numbers into the formula that I gave you in class 
yesterday.  But since that's on a topic (unemployment) that is not 
covered on this exam, there is no need to be too concerned.

> Also, for the second short answer question, the answer says that the
> investment decreases due to the decrease of investment on residential
> properties. But How do you know whether or not the increase in Business
> Investment outweighs the decrease in the investment for residential
> properties?

Because total investment equals saving in equilibrium and you know 
from the fall in the interest rate that savings falls.

Feb 9:

> Could you please explain to me what would be the affect on national
> savings from lowering or raising taxes?  I understand that if you raise
> taxes: gov. savings increase, private decrease, and that if you lower
> taxes: gov. savings decrease and private savings increase, but how can I
> figure out the overll affect?

Any change in the amount that the government collects in taxes is added, 
in its full amount, to government savings.  But an increase in taxes reduces 
household income, out of which households both save and consume.  So the 
private sector's change in savings must be less than the change in income, 
and therefore less than the change in taxes and government savings.  More 
formally, if we let MPS be the marginal propensity to save (the change in 
private saving per dollar of income), then 0 < MPS < 1.  A change in taxes 
of dT then increases government savings by dT but reduces private savings 
by MPS times dT, so the change in national savings is (1-MPS)dT.

Feb 9:

> I am having trouble answering this question from the W02 exam:
> 
> 9. If we initially have GDP of Y=3000, and if we now triple the amount of
> capital and labor employed in this economy when we have a production
> function of Y=3000K1/2 L1/2.
> What will the new amount of output be?
> a. 6000
> b. 8000
> c. 9000
> d. 3000
> e. can’t answer this without specific numbers for K and L
> 
> For #9, i dont understand how the answer is c, the production function is
> Y = AF(L,K,H,N) and if K and L is tripled, what about the other factors?
> i dont understand how Y=3000K1/2 L1/2 was derived, or what it means.

In general we have that Y = AF(L,K,H,N).  However, in this particular case 
you are told that the production function takes the special form of 
Y=3000K1/2 L1/2, so H and N do not, in this case, matter for production.  

The function Y=3000K^(1/2)L^(1/2) has the property of constant returns to 
scale, as you can verify algebraically as follows:  For any x>0, 
3000(xK)^(1/2)(xL)^(1/2) = 3000(K)^(1/2)(L)^(1/2)x^(1/2+1/2) 
= x3000(K)^(1/2)(L)^(1/2).  (Sorry about the messiness; it's hard to do 
exponents in e-mail.)  

Using  constant returns to scale, you then know that if you triple all 
inputs, this will triple the output.

Feb 9:

> > From the Winter 03 Exam
> 1. On the short answer question number 1b, i understand all the
> computations and everything, but I have noticed a difference with my
> notes and the answer key.  In my notes it says you compute the value in
> terms of year one's dollars you compute the Value in year two multiplied
> by the CPI of Year two over the CPI of Year one.  However, the answer key
> says it the other way around. Which is correct?

I remember our talking about this in my office, and I had trouble following 
which way we were going when you read it off.  So I apologize if I 
confirmed what was in your notes when it was wrong.  The correct statement 
is what you say is in the answer key:  to compute the value in year 1's 
dollars of an amount from year 2, you divide by year 2's price index and 
multiply by year 1's price index.  By doing that, if for example prices in 
year 1 are higher than in year 2, you are scaling up the value from year 2 
to reflect that price increase, since the ratio of year 1's price index to 
year 2's price index is greater than one in this case.

> 2.  For multiple choice 19, why isn't the GDP growth affected in the next
> five years.  Is it just because it takes awhile to take affect? So, if it
> doesn't grow in the short run and in the long run we have to consider
> diminishing returns, so when does the rate of growth rate actually grow?

GDP growth IS affected in the next five years.  The question asks for which 
statement if FALSE.

> > From the Winter 02 Exam
> 1.  For short answer B2 part c, i understand within a closed economy what
> is going on, but for the open economy i am a bit confused.  Why does the
> NX go into the equation on the I side?

Because Y = C + I + G + NX, which if you rearrange it gives 
Y - C - G = I + NX.  As I recall, this is something that you derived in 
one of the homeworks.

> 2.  For multiple choice 9, I am not exactly sure what it is asking.
> Perhaps you can clarify what we are supposed to do? Can't we just triple
> the 3000 to get 9000  because in order for Y= 3000 and the production
> function to be that, everything else must not affect it? I'm also very
> confused on what the exponents of 1/2 mean and what we do with them?

You CAN just triple the 3000 to get 9000 in this case.  The reason you can 
do that is that the production function shown has constant returns to scale, 
and the question refers to a proportional increase in all factors.  
Unfortunately, in order to know this, you need to know how to use algebra 
to confirm that this function has constant returns to scale.  As I recall, 
I didn't much like this question, but my GSIs assured me that their 
students would be able to do it.  The exponent of 1/2 just means square root.  

> 3.  For multiple choice 23, I understand why the answer is A, but I am
> not sure why it isn't C.  As CPI increases, doesn't this mean that the
> cost of living increases within the US and therefore consumers would
> substitute toward cheaper imported goods? I understand that the CPI
> doesn't account for substitution, but this is in reaction to a higher
> CPI, not the cause of it.

No, the CPI includes the prices of imported consumer goods, and the 
rise in the CPI could be the result of rising prices of imports.  You 
don't know, here, whether domestic goods have risen in price more or 
less than the prices of imports.

Feb 9:

> WINTER 2002
> Question 3:  I know that it is a matter of unmeasured quality change, but
> I don't know why it is overstated, because in order to say that, this
> would imply that the price of tomatoes was decreasing.  How do you know
> this?  Is it not possible that after such technological improvements,
> tomato sellers would want to charge more for a better product?

Yes, but if they do, we will treat that as a price increase, when it is 
really not (since you may be paying the same amount per unit of quality).  
This upward bias does not depend on any assumption about how prices change 
when quality changes.

> Question 4:  I understand that the interest rate must be higher, because I
> thought the answer was A.  However, how can the quantity not be higher?
> With a deficit, the government is going to increase demand for loanable
> funds (right shift of the demand curve) and with a tax credit, there is
> more incentive to save on behalf of private citizens, and therefore, an
> increase in supply (right shift of the supply curve).

You've got things backwards here.  First, the tax credit does not change 
private savings, since it is a credit for investment, not for saving.  It 
is firms that will respond to this incentive, by increasing investment, 
and this shifts the demand for loanable funds to the right.  As for the 
government, remember that we include the government's budget, positive or 
negative, as part of the supply of loanable funds, not the demand.  So 
when the government increases its deficit, this reduces national saving 
and shifts the supply curve to the left.  That's why the quantity may fall.


> Question 7:  I did not know how to do this problem.  Could you please
> explain? 

Just calculate the present value of the payments in option (1).  That is, 
PV is 30,000 divided by 1.05 plus 30,000 divided by 1.05 squared.

> Question 9:  How can you calculate Y without knowing L and K?

This production function has the property of constant returns to scale, 
which we discussed in class.  It then follows that if all inputs triple, 
then so does output.

> Question 26:  Since the CPI is based on a fixed basket of goods, how are
> we able to determine which goods-services will impact the CPI the most?
> Wouldn't we need a breakdown of what CPI accounts the most for?

Yes, that's exactly what you need.  And you were shown a graph of that 
(for the U.S. CPI) in the book and in lecture.

> WINTER 2003
> Question 11:  Could you please explain what "velocity" is in terms of
> money?  Was this covered in class lecture or Mankiw?  I did not think so.
> Will we encounter problems like these on Thursday?

No, that's from the material we will be covering next week.  The coverage 
of the exam in Winter 2003 was different than it is this year.

> Question 14:  What is the discount rate when referencing to Fed actions?
> Why wouldn't the sale of government bonds increase the money supply?

Again, we haven't gotten to that yet.

> Question 25:  An income tax would create discouragement for people to
> save, so supply would decrease (supply curve shifts to the left).  If
> supply shifts to the left, wouldn't the equilibrium interest rate
> increase and the amount saved decrease?

You are forgetting that the supply curve include both private and government 
savings.

> Question 26:  I did not know what to do for this question.  Could you
> please explain?

No, that's another one from the part of the course we have yet to do.

> 1) Do we need to know the money multiplier?  I have seen it on a few
> exams, but I do not believe we were assigned to read that section in
> Mankiw. 

No

Feb 9:

> 1.  In the Mitchell article, he refers to "marginal tax rates."  What are
> they?

That's the increase in tax that you pay per dollar increase in your income.  
Because the tax schedule is not just a simple proportion of your income, 
and in particular you don't pay tax at all on income up to a certain level, 
the marginal tax rate is typically higher than the average tax rate (defined 
as the ratio of your total tax to your total income).

> 2.  When computing future or present value, would you ever do it without
> compounding interest?

No

> 3.  Are interest rates (in general) dictated by the Federal Reserve
> Board?  Or are they organic, stemming from the intersection of supply and
> demand of loanable funds in the marketplace?

That depends on which interest rate you mean.  There is one interest rate, 
called the Discount Rate, that the Fed charges to banks that seek to borrow 
from it.  It controls that directly.  There is also another interest rate 
that the Fed almost controls, called the Federal Funds Rate, which is the 
rate that banks charge each other for very short-term (overnight) loans.  
By intervening in the short-term bond market, the Fed is able to "target" 
that rate and influence it so precisely that it essentially controls it.  
All other interest rates, and in particular the interest rates on long-term 
bonds, are determined in the bond market by the forces of supply and demand.  
The longer the term, the less influence the Fed has on these rates.  The 
loanable funds model is, like everything we've done so far, about long-term 
behavior in the economy, and the Fed plays no particular role in that.  But 
as we'll see later in the course, in the short run the Fed's policies are 
very important for determining interest rates, in a way that the loandable 
funds model does not capture.

> 4.  The total income in the economy must equal the total expenditure in
> the economy.  Within what time frame?  And where is personal savings
> included?

Total actual income must equal total actual expenditure in any time frame, 
since it is true by definition.  The portion of income that consumers and 
government don't spend is what they save, part personal and part government 
(perhaps negative).  The portion of the production that generated that 
income but was not sold to consumers or government is kept (in a closed 
economy) by the firms, either as new capital or as increases in inventories, 
and is thus investment (which is part of "expenditure").

> 5.  Can you briefly explain standard deviation and how it measures the
> riskiness of a stock portfolio?

It is a statistical measure of riskiness that you don't need (for this 
course) to know the formula for.  What's important here is that, in graphs 
like the ones I showed in my Diversification handout, it measures how wide 
these are.  The formula is, if you are interested, the square root of the 
sum of the squares of the differences between each possible outcome and 
the mean outcome, each weighted by their probabilities.

> 6.  Would a PPF curve ever not be bowed out, i.e., a straight line?  In
> what scenario?  When there are not increasing opportunity costs?

Where are you getting this question?  It is not in the material for this 
course, is it?  

The answer is that the PPF will be a straight line if there is only one 
factor of production (e.g., labor) needed to produce output, with constant 
unit-labor requirements for doing so.  (This is the "Ricardian Model" of 
international trade theory, for example.)  It would also be a straight line 
if there are multiple factors of production but all sectors (with constant 
returns to scale) use them in the same proportions.  The PPF can even be 
"bowed in" instead of out, if there are increasing returns to scale.

> 7.  The textbook says (pg 94) that GDP includes the market value of
> housing by estimating the rental value of a house and then assuming that
> the owner of a house pays rent to himself.  This is not production.
> Why/how would it be included in GDP?

Because it IS production.  The house is a piece of capital that is being 
used to provide a service: housing.  If one person owns the property and 
rents it to another, the rent is part of the consumption of the tenant, and 
gets into GDP that way.  For owner-occupied housing, as you say, the folks 
who measure these things "impute" such a rental value and treat household 
consumption as including the rent that they "pay" to themselves.

What could certainly be confusing here, and may not be handled in the text, 
is that a new house, when it is built, is also included in GDP as investment, 
and therefore it seems that the value of the house is being included twice, 
once in the year when it is built and again each year that somebody lives 
in it.  And that's true.  In fact, it is true not only of houses, but of 
all forms of physical capital.  An accurate measure of production would 
therefore deduct the portion of the value of a piece of capital (or house) 
that is used up each year as it contributes to production.  That is called 
depreciation (or sometimes "capital consumption allowance"), and indeed it 
IS allowed for in what is called Net Domestic Product (NDP), as opposed to 
GDP.  NDP is the more correct measure of production, for this reason.  
However, because measuring (and even defining) depreciation is so difficult, 
the custom is to pay more attention to GDP.

> 8.  DO you calculate inflation with the GDP deflater essentially the same
> way you would with CPI?  ((year2-year1)/year1)

Yes

> 9.  Can you please explain #9 from the Winter, '02 exam?

I never much liked that question, since it seemed to be more about 
mathematics than about economics.  The point is first to recognize that 
the production function written there displays constant returns to scale.  
Figuring that out is a piece of mathematics that has little to do with 
this course.  But once you know it, then you do know from this course what 
happens in a production function with constant returns to scale when all 
inputs increase in the same proportion, as they do here:  Output rises in 
the same proportion as well.  So in this case, output triples, and the 
answer is c.

Feb 9:

> on 2004's past exam, #16, it says,
> 
> 16. Suppose Nicaragua suffers a massive earthquake that destroys 10% of
> its stock of physical capital. Its productiviuty will initially fall by
> _______, and over the next few years its productivity growth rate should
> be _______ it was before the earthquake
> 
> a)10%; higher than
> b)10%; lower than
> c)10%; the same as
> d)less than 10%; lower than
> e)less than 10%; higher than
> 
> the answer given was e). I undertand that the productivity will initially
> fall by less than 10%, but I don't understand why its productivity growth
> rate should be "higher than" it was before earthquake over the next few
> years. We learned that increasing the capital would increase the growth
> rate in the short run. Why would decreasing the capital increase the
> growth rate as well?

That's the "catch-up" effect mentioned in the text.  Countries with less 
capital per worker have, as a result, a higher marginal product of 
capital, so that a given amount of investment will cause a larger increase 
in output.

> Also on the 2004 exam, #17 it says
> Suppose Moe owns only one stock: Springfield Power and LIght, which ahs a
> relatively low level of risk. If he buys some shares of Duff beer, a
> relatively risky stock, what will happen to the overall level of risk in
> his stock portfoilo?
> a) It will fall, because diversifying the portfolio always reduces risk
> b) it will rise, because Duff is riskier than SP & L.
> c) It will fall as long as the total value of his SP & L shares equal or
> exceeds the total value of his Duff shares.
> d) It could rise or fall, depending on whether the stocks' prices tend to
> move together.
> e) None of the above.
> 
> the answer key says the answer is d), and I'm not sure why that'll be the
> case. Could you explain why the risk wouldn't rise overall?

Well, if Duff beer had exactly the same level of risk as SPL, then the 
effect of diversifying (if the two stock prices do not move perfectly 
together) will cause risk to fall.  So if Duff beer has a higher level of 
risk, but not by too much, risk will still fall.  Only if the risk of Duff 
beer is sufficiently higher to offset the benefits of diversification will 
the overall risk rise.

Feb 7:

> Also, are cost of living and inflation the same thing?  If not, how are
> they different, and how do you calculate cost of living?

The cost of living is synonymous with the Consumer Price Index.  The rate 
of inflation is the rate of change over time in the CPI.

Feb 7:

> For #25 on the winter 2003 first exam, why is the answer E for this
> question?  It seems to me that an income tax increase would lead to
> reduced savings and correlate to increased interest rates and reduced
> investment.

It reduces private savings (by a fraction of the tax increase equal to 
the marginal propensity to save), but it increases government saving 
(surplus) even more, by the full amount of the tax increase.

Feb 6:

> I was going over HW #1, and I could not understand some of the answers in
> the solution.
> 
> For 1 vi, I understand how you get the chage in GDP in each country.  But
> since the event happened in 2003, should it not count for GDP this year?

Right.  All this is in 2003.

> Also for 1 vii, I understand how Mexico GDP changes.  But I do not
> understand why a Canadian buying a TV in America count as an export for
> the US and import for Canada.  I thought that GDP does not matter of the
> nationality of the person, but the geographical boundary.  Should not it
> count as consumption for the US?

Money spent by tourists in another country is regarded as exports of that 
country and imports of the tourists' home country.  You're right that it 
counts as part of the GDP of the country where it is produced, but this is 
consistent with that.

Feb 3:

> 1) in lecture while talking about the orzag and mitchell articles, you
> said that the budget deficit is the same as tax cuts. i dont understand
> how that is true. is it because if there is a tax cut, the governemnt
> will in turn borrow more and thus increase it's deficit? i dont quite
> understand how tax cuts and budget deficits are similar or related.

The budget surplus is T-G (net taxes minus government purchases).  The 
deficit is G-T.  If T falls, G-T goes up.  That's all.

> 2) for hw 3, #3c) it asks to write an equation for national saving and
> how it depends on r. we are given private saving, governemt purchases, T,
> Y, and I. S = private + public, private is given but where did that
> equation come from? is public saving still T- G? how should it relate to
> r ?

The equation for private saving is new information that we are giving you 
in the problem, but it embodies the assumption that we made in class: that 
private savings rises with an increase in the interest rate (that's what 
the term in the equation, 1,500r, does).  Yes, public saving is still T-G.  
And the question does not ask you to relate public saving to r, only 
national (i.e. total) saving.

Feb 3:

> I was reading the WSJ news about Fed raised interest rates. In
> the news, it says, slower productivity growth will force Fed to raise the
> federal funds rate. My question is, does this mean that increasing
> interest rates will increase the productivity? I'm not sure if this is
> right, but my understanding is slower productivity will drive up the
> prices of goods and therefore cause inflation, and that's why Fed will
> eventually raise the interest rates to controll the inflation. Could you
> please explain the relationship between productivity and interest rates?

I think you've got it right.  The interest rates are not being raised in 
order to increase productivity, but to prevent inflation.  The connection 
with productivity is, as you say, that with slower productivity growth and 
hence slower growth in output, a given rate of growth in demand will lead 
to more inflation (because demand will exceed supply, in essence).  By 
raising interest rates they reduce investment, which is a component of 
demand, and that helps to prevent that.  All of this will be part of our 
course during the last third of the semester, when we look at such short-run 
effects.  

If there is any connection with productivity as an effect (rather than a 
cause) of raising the rates, then it is probably negative, not positive.  
By deterring investment they reduce the growth of the capital stock, and 
this will cause productivity to rise even slower.  What they are counting 
on is that this effect on productivity will take a long time to happen, 
and by then other things will have happened to make today's interest rates 
less important.

Feb 1:

> Hi. I have a question about homework 3, question 4c.
> 
> 4c)Analyze the effects of the following events on investment and on the
> real interest rate. Event : A decrease in the income tax rate.
> 
> Since it is not mentioned, I think that the revenue is not neutral.

Right.

> Anyway, this is my thinking. A decrease in income tax rate increases the
> private savings, but decreases the public savings, as the increase in
> private savings compensate the decrease in public savings, the national
> savings remain the same. However, since supply of loanable funds depends
> on household savings, if based on the assumption that with higher income,
> people will save more, then the decrease in income tax rate with cause a
> rightward shift on the Supply of LF curve. On the other hand, this policy
> might lead to a budget deficit, which will then cause a leftward shift on
> the Supply of LF curve. So, in the end, the Supply of LF curve remains
> the same. Is this true?

No, because when people's disposable incomes rise due to a tax cut, they 
both consume more and save more.  That means that their rise in savings cannot 
be as large as the fall in taxes.

> Now to the Demand of LF. A decrease in income tax rate is like an
> investment incentives. (Is this true?) As a result, an increase in the
> Demand for LF. Thus, the demand curve for LF would move to the right.

No, I don't see why a decrease in the income tax (paid by households) should 
have anything to do with investment (done by firms).

> Finally, looking at the new intersection of both curves, we find that the
> equilibrium interest rate(real interest rate) increases, the Investment
> increases, and the equilibrium quantity of LF increases.

The last step is right, given the previous two.

Feb 1:

> I have a couple of quick questions for this week's homework (#3):
> 
> 2b.  Is NX included as private or government savings?  Is it + or ? in the
> equation for national savings?

NX is not part of the definition of savings of any kind.

> 3a.  “Give some intuition on why private saving might be increasing in
> the real interest rate.”
> 
> What does this mean?   “IN” the real interest rate??  I don’t understand
> the 	question.

The phrase, "increasing in the real interest rate" means "an increasing 
function of the real interest rate."  That is, you are supposed to give 
an intuitive reason why people might save more in response to a rise in 
the real interest rate.

> 4c.  Are capital gains taxed under “income tax?”

Yes and no.  In the United States the capital gains tax is collected as 
part of the income tax.  However, in terms of economic models, we would 
not regard a capital gains tax as being the same as an income tax, since 
it is not a tax on the real income of the economy, but rather is levied 
on the change in value of assets.

Jan 29:

> One quick question: would the government purchase of a building
> constitute investment or government expenditure regarding GDP?  Mankiw
> says "structures" are investment, while he also says government purchases
> include "spending on goods and services."

My understanding is that, in measuring GDP, anything that the government 
spends on goods and services is classed as part of G, even when logically 
what they are doing is adding to the country's capital stock, as would be 
the case you mention.  Within the category of G, I'm sure they report 
separately their different kinds of expenditures, including this one.  But 
in Y=C+I+G+NX, government purchase of a building is part of G, not I.

Jan 27:

> Hello. It's me again. I didn't quite understand something I read from
> WSJ's Jan 20 issue. The title of the article is "Fed Officials Weigh the
> Effects Of Slower Productivity Growth."

In both of your questions you are getting quite a bit ahead of what we 
have studied in the course so far, so it is not surprising, at all, that 
you don't understand what they are saying.  But I'll try to explain.

> 1. In the first paragraph, it says higher productivity is the key to
> inflation-free economic expansion. After reading the article, I still
> can't comperehend how higher productivity can lead to an inflation-free
> economic growth. Can you elaborate for me?

I'm not sure that I agree with them on this, but here is the argument.  
As we'll see in a few weeks, in the long term inflation results when the 
supply of money is expanded faster than the amount of real output.  
Therefore, if real output grows faster due to productivity growth, then 
there will be less inflation for a given rate of monetary expansion.  
Also, as we'll see later in the course, in the short run inflation results 
when demand for labor rises relative to supply.  Again, if productivity 
is growing, then you don't need as much labor for a given output, and 
that reduces inflationary pressure.

> 2. In the 8th paragraph, it implies that the Fed has to raise interest
> rates our of fear of inflation. Why is this? And also, what kind of
> interest rates are we talking about?

As we will study in the last third of the course, in the short run 
inflation occurs when aggregate demand rises relative to aggregate supply.  
A rise in interest rates tends to reduce aggregate demand by reducing 
investment.  The relevant interest rate for that purpose is the interest 
rate that firm's pay if they borrow to finance investment.  The Fed 
doesn't control that directly, but it does control another interest 
rate (among banks) that turns out to influence it almost directly.

Jan. 26:

> i have a qn about homeowrk 2 qn 2a.
> it says an increase of foreign direct investment into the US from europe
> is caused by the decline in the value of the european currency, euro..
> 
> however shouldnt it be that the decline of US currency or the rise in
> value of the euro compared to the greenback then causes increase in
> foreign direct investment from Europe?  Not the other way round where the
> euro declined..so there is more investment into the US.

Well, the decline in the value of the dollar, and the reason for the inflow 
of FDI, are both irrelevant to the question, which is really just about the 
effects of FDI on GDP and GDP growth.

But since you ask, I would say that it is not obvious how a fall in the 
exchange-market value of the euro would affect FDI.  On the one hand, it 
makes any real investment in the US (such as building a factory) more 
expensive for a European, which might be unattractive, especially if they 
will use the factory to produce for export back to Europe, and presumably 
that is what you are thinking.  On the other hand, if the falling euro is 
taken as a signal that it will continue to fall, then they might want to 
move their assets out of Europe to avoid that capital loss.  I suspect 
that is what the writer of this question may have had in mind, although 
it is hard to know.  (This question was written some years ago, when the 
euro was actually falling.)

I think I would probably agree more with your reasoning than theirs.  But 
as I said, it really has nothing to do with the answer you are being asked 
to provide.

Jan. 23:

> Since the CPI includes the cost of foreign goods, would there be a larger
> difference between the CPI and GDP deflator due to the declining value of
> the dollar?

Yes.  Very good.

Jan. 23:

> In discussion we defined consumption for the US as being private US
> resident consumption on US soil. However I am confused about this because
> in an example where a French tourist buys a hamburger in the US, we said
> that this transaction would count toward French consumption. By
> definition, French consumption should only occur when the transaction
> occurs on French soil. Also when going over the homework, in the question
> where the Canadian buys a television in the united states, we said that
> the transaction would count toward Canadian consumption. Can you please
> clarify this? thank you.

I would say that the definition given you in discussion is not right.  It 
shouldn't include the "on US soil" part.

Jan. 22:

> I'm having some problems in knowing how to view the questions in HW 2. For
> example, for question 2, can we see US per capita GDP growth as increase
> in the rate of productivity? Which factors do we consider, the factors of
> GDP like consumption, investment etc? And also, do we look at it as a
> form of chain reaction like how foreign direct investment can lead to
> increase in productivity, and this causes GDP to increase since more
> products are produced and consumption can hence increase? Are these
> effects different on per capita GDP and in a nation's GDP?
> 
> For 102, do we see things as word for word like how 101 is mainly like,
> or do we have to think out of the scope and consider the many effects
> that influences the economy?

Well, first, I doubt that Econ 101 even addressed a question like this, 
since it didn't deal with the GDP of a country.  For this, you want to use 
the material that was in the chapter on growth and the lecture on that topic 
that I gave on Thursday.  Specifically, per capita GDP is basically Y/L, 
which we saw in class to be equal to AF(1,K/L,H/L,N/L).  That's what you 
should be looking at for this question.

Jan. 22:

> Hi Professor, I was reviewing my work on homework 1 and I got a little
> confused on one part which I hope you can clarify. On question one part
> iii, it states
> 
> The US Steel Corporation purchases a new 10 million steel rolling machine
> for its factory. Assume the steel rolling machine was produced in Japan.
> 
> My question is, can I double count in this situation? Would this example
> affect both I and NX and therefore the overall affect on GDP is zero?

It does effect both I and NX (the latter negatively), because it is indeed 
both an investment and an import of the US.  That is not what we mean by 
"double counting" however. Double counting would occur if you somehow caused 
a particular act of production to contribute twice, both positively, to GDP.  
In this case, the occurrence of this amount as both investment and imports 
cancels out, and you get no effect on GDP at all, as you said.  Which is 
exactly what it should be, because in this example nothing was produced in 
the US.

Jan. 20:

> Hi, I'm really confused on how to calculate GDP.  I'm getting hung up on
> number 1 of the homework thats due soon.  Can you tell me if I'm on the
> right track with this, or if I'm missing something?
> 
> For problem 1 vii)  A TV assembly plant in Mexico buys $150 worth of
> components from US factories, assembles a TV, and sells it to the Ann
> Arbor Best Buy for $300.  A Canadian buys it in Ann Arbor for $400 while
> on his vacation.
> 
> What I have right now is:  the $150 is in intermediate goods so that
> doesnt count towards any GDP.  Mexico has an export value for the TV so
> that adds $300 to their GDP.  Then the US has an import of $300 so they
> have -300 in NX but then there is consumption for $400 so the US gets the
> other $100 added to the GDP.  As far as I can tell the Canadian GDP
> should be unchanged.
> 
> This doesn't really seem logical though because the components should
> factor in because they are an export.  So US gets +150 for NX in parts,
> mexico -150 for NX in parts.  Mexico +300 for NX for the TV, US -300 for
> NX for the TV.  US +400 in NX for sale to Canada.  Canada -400 NX +400 C.
> NET RESULT:  Mexico +150   US +250  Canada 0
> 
> If this second method is correct, then is it true that anything whether
> final or not that is exported to a different country counted towards the
> GDP.  If so this would mean that the for part vi the bricks produced in
> Canada add to their GDP, right?

Right.  That is, your second approach is the correct one.  The only reason 
for not including intermediate goods directly in measuring GDP is that their 
value is included in the final goods they help to produce that also goes 
into GDP.  But intermediate goods that are exported are NOT included in any 
other way, so they DO appear in GDP.  In short, exports and imports include 
all goods (and services) that flow out and into the country respectively, 
whether or not they are intermediate or final.

Jan. 18:

> I just have a question about homework 1.  On problem 3 part A at the end
> of the paragraph, it says in parenthesis real rate of return.  But for
> the purposes of part c, isn't that actually the nominal rate and part b
> calculates the real interest rate?

Part (a) is a real rate of return because it is being measured here in units 
of a real good, ice cream.  Of course since price is constant in part (a), 
the real return is also the nominal return.

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