ECON 332: Fall, 2011 Things to Know for Test 1 1. Nominal vs.

Real Variables What is the difference between a nominal variable and a real variable? A nominal variable is expressed in $ amounts, while a real variable is expressed in terms of goods or purchasing power (pp). b. How do you deflate a nominal variable to obtain the corresponding real variable? Divide the nominal variable by the price level, c. If the nominal wage rate is $20/hour and the price of a (single) good is $4/good, what is the real wage rate? What does this mean? The real wage rate is 5. This means that despite a nominal wage rate of $20/hour, people can only afford to buy 5 goods per hour. d. What are the units of measurement of the real money supply? Goods. e. What nominal variable is an exception to the general rule for deflating to obtain the corresponding real variable? nominal interest rate: i
a.

2. Bonds and Interest Rates What is a bond? What is it that a borrower is promising to do when he/she sells a bond? A bond is a financial instrument sold by a borrower to the highest bidder (bond buyers are lenders). A bond represents a promise to the lender to pay a specified sum of money (Face Value) at a specified future date (maturity date) and in the meantime, to make regular payments of interest (coupon payments). b. What are the four characteristics of a bond? 1. Face Value (F) 2. maturity date => term to maturity (n) 3. Coupon payment (C) 4. Present value of the bond (Pb) AKA the Price c. What is the nominal interest rate on a bond? That is, what does the nominal interest rate tell you? The nominal interest rate on a bond tells you the $ amount of how much will be paid out each year by the borrower, % rate of return in terms of $, or per year per $ invested. d. How is the nominal interest rate calculated (using the approximation formula)? I [C+(FPb/n)]/(Pb+F/2) where (Pb+F/2) = Avg. Amount invested e. Calculate the nominal interest rate on a bond with the following characteristics: C = $60/yr, n = 5 years, F = $1000, PB = $980. [.0646 or 6.46%] Repeat for the following bond: C = $70/yr, n = 5 years, F = $1000, PB = $1023. [.0646 or 6.46%] How is it that these two bonds (one selling at a discount, the other selling at a premium) could yield the same nominal interest rate? The difference in C.
a.

3. Inverse Relationship Between Bond Prices and Interest Rates Why is there an inverse relationship between the nominal interest rate on a bond and the price of the bond? That is, why does the interest rate fall when the price of the bond rises. Since bonds have a fixed coupon rate and the yield fluctuates, when new bonds come out with lower yields, the old bonds b. Explain why, if the interest rate on one type of bond falls, the interest rate on other types of bonds will fall as well. Does this explain why economists routinely speak of the interest rate? When interest rates fall in one type of bond falls (aka the price increases), demand for the other bonds increases, leading to an increase in P of the other bonds, and thereby decreasing the interest rates on those bonds. This
a.

substitute effect is modeled by (PbA increase => iA decrease) then: (PbB increase => ib decrease) 4. Fisher Equation
a.

What are the two versions of the Fisher Equation (one with re on the LHS and the other with i on the LHS)? re= i - e or i = re + e where i = nominal interest rate, re= expected real interest rate, and e= expected inflation rate AND the inflation premium built into the Fisher equation.

What is the expected real interest rate? Why is it an expected rate? The expected real interest rate c. Why does the nominal interest rate incorporate an inflation premium? The nominal interest rate incorporates an inflation premium in order to remain even with the change in purchasing power. d. If the rate of money growth is 20%, output growth is 4%, and the expected real interest rate is 5%, what is the nominal interest rate? 5= e. If actual inflation turns out to be higher than expected inflation, who benefits? Borrowers or lenders? How do you know? Benefits borrowers (aka banks) because they will have borrowed the bonds at a lower rate than actual. e e f. Suppose that i = 5%, r = 3%, and = 2%. Suppose that actual inflation turns out to be 4%. What is the actual real interest rate (ra) earned by lenders and paid by borrowers? Is this consistent with your answer to part e? At what point in the life of the bond can this actual real interest rate be calculated?
b.

5. Government Budget Constraint (G + TR = T + BS + MC)

a. b.

What is the GBC? Government Budget Constraint Why is a ceteris paribus increase in G impossible? Government expenditures must be financed. Why is a ceteris paribus tax cut impossible? The tax cut needs to be financed/offset by an increase in other areas. What are the four ways to finance an increase in G? decrease transfer payments (social security, food stamps), or increase T (tax revenue), BS (bond sale revenue), or MC (money creation). What are the four ways to finance a tax cut? Increase BS or MC, or decrease G (govt expenditures)/ TR (transfer payments). Pure fiscal policy involves change in which variables in the GBC? G, TR, BS, T Why is the effect of (pure) fiscal policy on aggregate demand so difficult to predict? The effect of fiscal policy is difficult to predict because you need to know the movements of each of the variables of fiscal policy. Monetary policy via open market operations involves changes in which two variables in the GBC? BS & MC

c.

d.

e.

f. g.

h.

i.

What is a budget deficit? In what two ways can a deficit be financed? A budget deficit is when G + TR > T. A budget deficit can be financed by bond sales or money creation (seniorage) What is a budget surplus? What two things can be done with the surplus revenues? A budget surplus is when G + TR < T. Surplus revenues can be used to repurchase debt (bonds) or uncreate money (remove money from circulation). Uncreating money is never done. Where do hyperinflations come from? Hyperinflations come from rapid increases in MC.

j.

k.

6. Conventional Business Cycle Theory

a.

In the conventional view, what is the cause of business cycles? Illustrate this using the AD-AS graph (i.e., the graph of the goods market). The cause of business cycles according to the conventional business cycle theory is sudden demand shocks.

b.

What is the role of the SRAS curve in the AD-AS graph? That is, what does the SRAS tell us? The SRAS shows the amount of real output at different prices

7. Natural Rate Hypothesis What is the Natural Rate Hypothesis? The Natural Rate Hypothesis states that theres an equilibrium rate of output to which the economy will automatically return following a demand shock. b. In the AD-AS graph, which curve shifts to return the economy to equilibrium at natural output following a demand shock? What causes this curve to shift? c. Does the NRH say anything about the speed of adjustment back to natural output? d. Can the natural rate of output change over time? Give an example of something that would do this.
a.

8. Stabilization Policy
a. b. c.

Stabilization policy is intended to offset shocks to what curve? AD curve Why would stabilization policy ever be needed if the NRH is true? The stabilization policy is needed to speed up the adjustment process back to natural adjustment. Illustrate a successful stabilization policy following a negative demand shock using the AD-AS graph.

d.

e.

Give an example of a (pure) fiscal policy that shifts the AD curve to the right. Use whatever assumptions (e.g., the value of the marginal propensity to consume out of disposable income) needed to make your example work. Which would be appropriate to counter a negative demand shock, open market purchases or open market sales?

9. Open Market Operations

a. b. c. d.

e.

What is an open market purchase? Show what happens using the GBC. What effect will an open market purchase have on the money supply? Explain What effect will an open market purchase have on the interest rate? Explain. If the central bank were to print up dollar bills and give them away, the change in wealth would affect aggregate demand. Explain why an open market purchase doesnt have a similar effect. So why does an open market purchase affect aggregate demand? The U.S. Treasury and the Fed might be selling essentially identical (U.S. government) bonds at the same time. When the Fed sells these bonds the money supply falls. When the Treasury sells these bonds the money supply remains constant. Why is this?

10. Transmission Mechanism of Monetary Policy What is the transmission mechanism of monetary policy? That is, why will an open market purchase raise aggregate demand? How do we know this is a shift in the AD curve and not a movement along the AD curve? b. What two components of aggregate demand are affected by monetary policy? c. Explain the empirical finding that a change in the interest rate has no effect on consumption spending by households.
a.

11. Inflation What is the Equation of Exchange? What does V represent? How can a relatively small money supply purchase a much larger dollar value of goods and services? b. Write out the percentage change version of the Equation of Exchange and solve it for the inflation rate? c. What assumption do we make that effectively converts the Equation of Exchange into a (testable) theory of inflation? Lets call the resulting equation the Monetary Theory of Inflation. d. Give an intuitive explanation of the Monetary Theory of Inflation. e. If the rate of money growth is 20%/year and the rate of growth of Y is 4% then what will be the (approximate) inflation rate? Does it seem more likely that this gap could be closed by reducing money growth or by raising output growth? f. If the rate of money growth is lower than the rate of output growth, the Monetary Theory of Inflation predicts that the price level will fall. Why does this have to happen? g. Once again, where do hyperinflations come from?
a.

12. The Permanent Income Hypothesis (PIH) Consider a household with a three period lifetime: DYt = $3000, DYt+1 = $2000, and DYt+2 = $1000. The interest rate (i) is .06.
a. b.

Calculate household wealth. [$5776.73] Give a quick estimate of permanent income. [$2000]

c. d. e. f. g. h.

i. j.

k. l. m. n.

Calculate permanent income precisely. [$2038.82] If there is no bequest motive and the household smooths consumption perfectly, what are Ct, Ct+1, and Ct+2? [$2038.82] How much does this individual lend in period t in order to execute his/her optimal consumption plan? [$961.18] How much of the proceeds of this loan are used to finance consumption in period t+1? [$38.82] How much of the proceeds of this loan are used to finance consumption in period t+2? [$1038.82] Suppose that this individual gets a permanent tax cut of $100 in each period. Recalculate W, PY, Ct, Ct+2, and Ct+2. Determine the MPC(DYt). [W = $6060.13, PY = $2138.82, Ct = Ct+1 = Ct+2 = $2138.82, MPC(DYt) = Ct/DYt = $100/$100 = 1] What is MPC(PY)? [1] Now suppose that this individual gets a temporary (i.e., first period only) tax cut of $100. Give a quick estimate of what MPC(DY) will be. [1/3] Calculate MPC(DYt) precisely. [.3529] What is MPC(PY)? [1] What two assumptions did we make that ensured MPC(PY) = 1 in every case? What well-known fact about the consumption behavior of households is the PIH capable of explaining? Explain, to a non-economist, why people will increase their consumption by small amount in response to an increase in current disposable income that they consider to be temporary but by a much larger amount if they expect that same increase in current disposable income to be permanent. [Notice that Im trying not to use the term MPC to a non-economist.]