This Document Contains Chapters 16 to 17 CHAPTER 16 INFLATION Chapter Overview In this chapter we’ve explored one of the most complex issues in economics: inflation. We’ve seen how mismanagement of the money supply can lead to runaway inflation, how even relatively modest inflation can have far-reaching consequences for healthy economies, and why deflation is a problem. We’ve also seen that expectations of inflation help determine whether savings will hold their value and whether it’s a good time to borrow. We’ve seen too that when people expect inflation to continue, those beliefs can, in themselves, perpetuate inflation. Thus, inflation can be a self-fulfilling prophecy. Getting runaway inflation under control thus requires the right monetary policy plus convincing people that inflation will indeed fall. Learning Objectives LO 16.1 Define inflation, deflation, headline inflation, and core inflation. LO 16.2 Explain the neutrality of money. LO 16.3 Describe and illustrate the classical theory of inflation. LO 16.4 Explain the quantity theory of money and relate it to inflation and deflation. LO 16.5 Analyze the economic consequences of inflation. LO 16.6 Analyze the economic consequences of deflation. LO 16.7 Describe disinflation and hyperinflation and explain the role of monetary policy in creating both situations. LO 16.8 Understand why policy-makers favor a small amount of inflation over zero inflation. LO 16.9 Explain the relationship between inflation, the output gap, and monetary policy. LO 16.10 Explain how the relationship between inflation and unemployment is modeled by the Phillips curve and integrated into the non-accelerating inflation rate of unemployment. Chapter Outline A LAND OF OPPORTUNITY… AND INFLATION Changing Price Levels Measuring Inflation (LO 16.1) The Neutrality of Money (LO 16.2) The Classical Theory of Inflation (LO 16.3) The Quantity Theory of Money (LO 16.4) BOX FEATURE: REAL LIFE – WHERE’S GEORGE? Other Causes of Changing Price Levels Why Do We Care about Changing Price Levels? Inflation (LO 16.5) BOX FEATURE: REAL LIFE – INFLATING AWAY THE DEBT Deflation (LO 16.6) Controlling Inflation, or Not: Disinflation and Hyperinflation (LO 16.7) BOX FEATURE: REAL LIFE – A REAL PLAN—WITH FAKE CURRENCY Why a Little Inflation Is Good (LO 16.8) Inflation and Monetary Policy The Competing Goals of the Dual Mandate (LO 16.9) Inflation and Unemployment (LO 16.10) Beyond the Lecture Class Media: The Inflation Rate (LO 16.4) Have students view this brief clip from the movie Austin Powers: International Man of Mystery (show Chapter 6 on the DVD). In the movie, Dr. Evil proposes a $1 million ransom in the 1990s, which is worth far less in real terms than it was during the 1960s time period that Dr. Evil remembers. (You can do the media clip here if you didn’t already show it in Chapter 25). Class Discussion and Media: Inflation, Disinflation, and Hyperinflation (LO 16.4, LO 16.6) Have students read this brief article from The Economist, which describes the use of other currencies in Zimbabwe and the hyperinflation the country has been experiencing in recent years. Discuss the following: 1. What happened to Zimbabwe? What causes hyperinflation? 2. What is the impact of hyperinflation on a country? 3. How can hyperinflation be stopped? What can be done to stabilize money? 4. Watch this video story about Zimbabwe hyperinflation. Class Discussion: Deflation (LO 16.5) Have students read this brief article from Bloomberg, which discusses fear of deflation in the U.S. resulting from falling oil prices. 1. What causes deflation? In other words, how can consumer expectations of future prices create deflation and make it worse? 2. Why can deflation be problematic in theory? Shouldn’t we want lower prices? Class Discussion: The Competing Goals of the Dual Mandate (LO 16.7) Show students the historical federal funds target rate (both in graph format) and discuss the following: 1. How does the Fed influence the federal funds rate? 2. When does the Fed influence rates to rise? When does the Fed influence rates to decline? Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. 1. What is an implication of the neutrality of money? [LO 16.1] A. People don’t care how much money they earn B. Aggregate price levels don’t change real output in the long run C. Money can’t buy real goods D. At any point in time, consumers prefer viewing real prices instead of nominal prices Feedback: This is actually related to the vertical slope of the LRAS! 2. What is the cause of cost-push inflation? [LO 16.2] A. Increases in the money supply B. Increases in government spending C. Increases in the price of key inputs D. Increases in consumer confidence Feedback: Oil is an example of a key input. If it gets more expensive, it may affect a lot of prices. 3. Even if inflation is steady and predictable, firms may still face costs of changing prices. These costs are referred to as _____________. [LO 16.4] A. Menu costs B. Shoe-leather costs C. Tax distortions D. Costs of doing business Feedback: Think about a restaurant. If price levels increase, it will have to reprint all of their menus. There are costs involved in doing this. 4. Suppose that inflation suddenly and unexpected increased by a large amount. Which of the following could perhaps be better off as a result? [LO 16.4] A. Alice, who stores all her money in her mattress B. Billy, who has a large savings account in his bank C. Carl, who just borrowed a lot of money for a fixed-rate mortgage D. Dylan, a teenager who receives a fixed allowance each month from his parents Feedback: Carl paid for his house with the mortgage. However, the amount of money he borrowed and must repay just got a lot smaller in real terms. Borrowers can be made better off from inflation. 5. The Phillips curve show a _________ relationship between inflation and unemployment in ___________ [LO 16.8] A. direct; short run B. direct; long run C. inverse; short run D. inverse; long run Feedback: Strong economies (with many people working, earning, and spending), cause faster increases in price levels. The relationship doesn’t hold in the long run. However, even in the short run, we can’t often successfully “exploit” this relationship with policy. This is part of the Lucas Critique, which is most likely beyond the scope of this course. Solutions to End-of-Chapter Questions and Problems Review Questions 1. What is the difference between the Consumer Price Index and the inflation rate? [LO 16.1] Answer: The Consumer Price Index (CPI) is a number that measures the cost of a market basket of goods and services in a given year relative to the cost of the same market basket of goods and services in the base year. For example, if the basket of goods cost $80 in the base year and $120 in 2016, the CPI in 2016 would have a value of ($120/$80) × 100, or 150. This means prices are 50% higher in 2016 than in the base year. The inflation rate measures the percentage change in the CPI from year to year. If the CPI in 2016 was 150 and in 2017 it was 155, then the inflation rate is equal to (155 – 150)/150 × 100 or 3.33%. 2. What is the difference between core inflation and headline inflation? Why do economists calculate both types of inflation? [LO 16.1] Answer: Headline inflation is a measure of inflation that includes all of the goods and services that the average consumer buys. Economists calculate headline inflation to measure changes in the overall price level. Core inflation is a measure of inflation that excludes energy and food from the basket of goods and services purchased by the average consumer. The reason to calculate core inflation is to exclude the goods whose prices are highly volatile. Given food and energy are each about 17% of the market basket, a large change in one of these prices can cause a large change in the overall price level and make it look like there is higher inflation than there really is. In 2015, the price of gasoline dropped 27.3 percent, while core inflation rose by 1.7 percent. 3. Your uncle comes to you with an investment idea. He tells you that the nominal GDP of Paradisia quadrupled over the past year and suggests that you invest there. Unemployment is at 20 percent, and inflation over the last year was 500 percent. Do you think it’s a good idea to invest? Draw on the neutrality theory of money to explain why or why not. [LO 16.2] Answer: Although nominal GDP has quadrupled (risen by 400%), this does not mean the value of real GDP has increased. Nominal GDP is measured by multiplying current prices times current output, so the growth rate of nominal GDP is equal to the growth rate of prices + the growth rate of output. Therefore, the growth rate of real output is equal to the growth rate of nominal output minus the inflation rate, or -100%. Given the decline in real GDP and the high unemployment rate, Paradisia is not a good place to invest. The neutrality of money defines the idea that, in the long run, changes in the money supply affect nominal variables, such as prices and wages, but do not affect real outcomes in the economy. 4. Why might we want to measure GDP in dollar terms? In output terms? How does the neutrality of money relate to your answer? [LO 16.2] Answer: GDP is intended to measure production. Calculating GDP in dollar terms is a convenient way to add up the many different goods and services produced in the economy. However, nominal GDP will increase anytime there is inflation—even when the economy is not producing any more goods and services than before. By measuring GDP in real (output) terms, we can focus on growth and actual production. Neutrality of money describes the idea that nominal variables such as prices do not affect real variables such as output. 5. Suppose a country’s currency is a gold coin. One day, speculators find a large gold mine, which doubles the supply of gold coins in the economy. What will happen to output in the short run? What about price levels? What will happen to output in the long run? What about price levels? [LO 16.3] Answer: Although the process by which the supply of money has increased is different from when the Fed increases the money supply, the effect is the same. The increase in the supply of gold coins (money) will result in lower interest rates, which encourages borrowing and pushes up the consumption and investment components of aggregate demand. Therefore, in the short run, both output and the price level will rise due to a rightward shift of the aggregate demand curve. In the long run, the increase in the demand for labor and other inputs will increase the costs of production. Firms will increase prices, shifting the short-run aggregate supply curve to the left. The price level ends up at a higher level, while output goes back to its long-run level. 6. Explain how some analysts might use the short-run and long-run effects on the aggregate demand–aggregate supply model to argue that monetary policy can’t affect employment in the long run. [LO 16.3] Answer: In the short run, expansionary monetary policy shifts the aggregate demand curve rightward, increasing the price level and output. Over time the increase in output will have increased the demand for labor and inputs, and this will increase the costs of production. In response to higher costs of production, firms will increase prices and this will shift short-run aggregate supply to the left. The economy will end up going back to its same level of output with a higher price level. This assumes the economy is at potential output to start with. If the economy is not initially at potential output, monetary policy may have long-term effects on output and employment. 7. Why might the velocity of money increase around the holidays? If the Federal Reserve wants to avoid inflation in those times, what should it do? [LO 16.4] Answer: During the holidays, people increase their spending, which may mean that each dollar of income is spent more times. This is an increase in velocity. To see how inflation could result, consider the quantity equation: MV = PY. If velocity increases while the money supply M and real output Y are constant, inflation will indeed occur. But if the Federal Reserve responds by lowering the money supply, the economy could avoid inflation. 8. Use the quantity theory of money to explain how expansionary monetary policy can be inflationary. [LO 16.4] Answer: The quantity theory of money (MV = PY) can written in growth rate terms: % Change in M + % Change in V = % Change in P + % Change in Y. If we assume that velocity and real output Y are unchanging (in other words, their percentage change is zero), then any change in the money supply M must be matched by an equal change in the price level P. 9. Imagine you own an ice cream store in New York City. Write a brief note to your senators explaining two ways in which unpredictable inflation hurts your business. [LO 16.5] Answer: When inflation is unpredictable, it is harder for the business to make plans. The business may set its plan under one set of assumptions about prices, and then have to change its plan if there are unpredictable changes in prices. When inflation is higher than expected, this will reduce the real value of savings. When inflation is lower than expected, the real interest rate will rise and firms will have to make higher real interest payments. Shoe leather costs and menu costs occur with predictable inflation. 10. Is inflation harmful only when it’s unexpected? If yes, why? If no, name two costs that occur with even predictable inflation. [LO 16.5] Answer: Inflation is harmful even when predictable. Costs involve menu costs (from changing prices on websites, supply sheets, or literal menus), shoe leather costs (related to switching assets from those that pay interest—since predictable inflation is captured in the nominal interest rate—to those that are liquid when we want to spend), and bracket creep, (when increases in nominal but not real income result in being taxed more when our incomes haven’t risen in terms of purchasing power at all). 11. Your senators now claim that lowering prices would be good for everyone—“Who doesn’t like lower prices, after all?” They tell you they plan to lobby for deflation. Explain why falling prices could lead to a bad situation. [LO 16.6] Answer: Deflation is a very bad idea for an economy. It makes debt harder to pay back because loans are made in nominal terms, yet borrowers will have to give up increasing shares of their real income when they pay them back. This will hurt households’ ability to consume. While deflation increases the value of savings in real terms, consumption will remain depressed because people will expect prices to keep on falling and therefore won’t want to spend until they come down even more. The economy would find itself in a deflationary trap in which low investment and consumption would lead to even more low investment and consumption. Deflation is definitely not the answer! 12. When does inflation become hyperinflation? What causes hyperinflation? [LO 16.6] Answer: Hyperinflation occurs when there is an extremely long-lasting and painful increase in the price level. When inflation spirals out of control, it often renders the currency completely useless because people have to hold larger and larger amounts of money to pay for goods and services. Hyperinflation is caused by the printing of too much money or sometimes by expectations that prices will continue to rise. If people expect prices to rise, they demand higher wages, and this then causes firms to increase prices. This can lead to a nasty cycle of rising wages followed by rising prices. When the government prints too much money, and there is no change in velocity or real output, the increase in the money supply is matched by an increase in the price level, as stated by the quantity theory of money. 13. What could have happened to prices and inflation in the wake of the years during and after2007–2009 recession if the government and Federal Reserve had not intervened in the economy? How would this have affected the economy? [LO 16.7] Answer: If the government and Federal Reserve had not intervened, the reductions in consumption and investment would have continued, pushing the aggregate demand curve so far left that we may have seen deflation in addition to below-potential output in the short run. Deflation can be hard to eliminate once it becomes established due to people being unwilling to borrow money and increase spending. 14. Are deflation and disinflation the same thing? Why or why not? [LO 16.7] Answer: No. Deflation is a decrease in overall prices and is very unhealthy for a nation. Disinflation is a decrease in the rate of inflation (a decrease in the rate of increase of overall prices) and can be quite healthy for a nation, especially when it’s the result of contractionary policy meant to cool down the economy. 15. Would you expect nominal interest rates to be higher in countries that have higher target inflation rates? Why or why not? [LO 16.8] Answer: The nominal interest rate will be higher in countries that have higher target inflation rates. Given the target inflation rate is higher, actual inflation rates are likely to be higher as well. Higher inflation rates lead to higher nominal interest rates in order to maintain a reasonable real interest rate. The real interest rate is equal to the nominal interest rate minus the inflation rate, so higher inflation rates will reduce the real interest rate, all else the same. As a result, nominal interest rates will rise. 16. Your friend claims that a target inflation rate of zero is a good policy because this will keep prices stable. You claim a positive target inflation rate is preferred because the country will be able to better avoid a liquidity trap. Who is right? [LO 16.8] Answer: A target inflation rate of 2–3% reduces the risk of deflation. If the inflation rate tends to hover around zero percent, and the central bank miscalculates by making monetary policy too contractionary, the result would be deflation, and this can have serious impacts on the economy. If the target inflation rate is 2–3%, then nominal interest rates will be above that level, meaning the Federal Reserve has some room to reduce interest rates before hitting the zero lower bound. A target inflation rate of 2–3% makes it easier for firms to adjust real wages. If prices are stable, reducing the real wage requires employers to reduce the nominal wage; workers may respond to a 1 percent reduction in their nominal pay by reducing their work effort. 17. In the 1960s, policy based on the simple short-run Phillips curve worked better than similar attempts in the 1970s. How might better information availability have contributed to this result? [LO 16.9] Answer: Inflation expectations play a key role in the long-run relationship between unemployment and inflation. We expect inflation to continue at its current level, so after a while output stops responding to inflation changes. The result is output going back to its previous level in the long run while inflation stays high. Essentially, policymakers were using the 1960s Phillips curve to make predictions, but by the 1970s the curve had shifted. 18. When we have a negative output gap, what is the proper monetary policy response in the short run? What are its intended effects on interest rates and employment? [LO 16.9] Answer: When we have a negative output gap, we are producing below our potential output, so expansionary monetary policy would be the best response to bring actual GDP closer to potential levels. The intent would be to lower interest rates to boost borrowing and spending and increase production and therefore employment. 19. Explain the effect contractionary monetary policy will have on the output gap, inflation, and unemployment if unemployment is currently at the non-accelerating inflation rate of unemployment. [LO 16.10] Answer: Contractionary policy will reduce the output gap by decreasing spending and lowering employment. This will result in an increase in the unemployment rate, and inflation will decrease. 20. Compare and contrast the effect of increased unemployment on inflation in the short and long run. [LO 16.10] Answer: In the short run, increased unemployment is associated with decreases in inflation, as captured in the original form of the Phillips curve, but over the long run this relationship tends to disappear as inflation expectations adjust. Problems and Applications 1. The price index values used to calculate headline and core inflation for 2012 through 2016 are found in Table 16P-1. [LO 16.1] a. Calculate the annual inflation rate for each series. b. Which series represents core inflation and which represents headline inflation? c. How do you know? Is there inflation or deflation in each year? Answer: a. The annual inflation rate is calculated as (current series value – previous year's series value)/previous year's series value, multiplied by 100 to convert from decimal to percentage form. For example, in 2013 for series 1: (136.22 – 132)/132 = 0.0319 × 100 = 3.196%, or 3.2% rounded to the nearest tenth. Year Series 1 Annual Inflation Rate Series 2 Annual Inflation Rate 2012 132 n/a 122 n/a 2013 136.22 3.2% 124.56 2.1% 2014 138.26 1.5% 126.68 1.7% 2015 143.24 3.6% 129.72 2.4% 2016 144.81 1.1% 131.79 1.6% b and c. Core inflation removes food and energy prices because these prices are very volatile. Core inflation provides better information about "true" inflation because it removes the impact of short-run shocks to food and energy prices. Series 2 is likely to represent core inflation because the change in the inflation rate is smaller from year to year. 2. Determine whether each of the following events is likely to cause deflation, disinflation, no change in the price level, or inflation. [LO 16.1] a. A bubble in the biomedical industry just burst. b. A new technology is introduced into the economy, sparking an economic boom. c. The Federal Reserve conducts contractionary monetary policy. d. The Federal Reserve is successful at meeting its dual mandate of full employment and price stability. Answer: a. A bubble that bursts in the biomedical industry will lead to a reduction in investment spending. This is most likely to lead to disinflation (a falling inflation rate) and not deflation (a negative inflation rate). Prices in the industry were likely to have been rising at a relatively high rate given the bubble, so the bursting of the bubble will slow the rate of price increase. b. An economic boom will increase spending and output and lead to inflation. c. Contractionary monetary policy will slow growth in the economy and lead to disinflation (a falling inflation rate). d. When the economy is fully employed and prices are stable, there is no change in the inflation rate. 3. Which of the following can be affected by the money supply in the long run? [LO 16.2] a. Nominal GDP. b. Real GDP. c. Inflation. d. Unemployment. Answer: a and c. In the long run, the money supply can affect only nominal, not real, variables. The money supply affects nominal GDP in the short run, nominal GDP in the long run, real GDP in the short run, inflation in the short run, inflation in the long run, and unemployment in the short run. 4. The average individual in a country earns an annual salary of $60,000, of which $24,000 is spent on housing, $10,800 on food, $10,800 on transportation, and $14,400 on other goods and services. Suppose the government in this country mandates that all salaries and the prices of all goods and services be reduced by 40 percent. [LO 16.2] a. How much does the average individual now earn? b. How much does the average individual now spend on housing, food, transportation, and other goods and services? c. What happened to the average individual's real salary? Answer: a. The individual's salary is now only 60% of its previous value, or $36,000. b. All prices and expenditures are now only 60% of their previous level: $14,400 is spent on housing, $6,480 is spent on food, $6,480 is spent on transportation, and $8,640 is spent on other goods and services. c. The real salary has not changed. If the nominal salary and all prices change by the same percentage, then the real salary does not change. In reality it is not possible for the government to mandate a 40% decrease in all prices and salaries, but hypothetically if they did then in real terms there would be no impact. 5. To increase the self-esteem of dieters everywhere, powerful fashion designers lobby Congress to redefine “five pounds” as “one pound.” Under this system, what would have previously been five pounds of bananas will now be one pound of bananas and a 500-pound gorilla would now weigh only 100 pounds. [LO 16.3] a. How much would someone who originally weighed 180 pounds now weigh as a result of this redefinition? b. Has there been a nominal change in the person’s weight? A real change? c. How is this story similar to contractionary monetary policy via a decrease in the money supply in the long run? (Hint: Congress essentially shrunk the “pounds supply” by redefining the word.) Answer: a. Someone who originally weighed 180 pounds would now weigh 180/5 = 36 pounds. b. There has been a nominal change (in the number of pounds), but not a real change in the person’s weight. c. This is similar to a decrease in the money supply done through contractionary monetary policy because the “supply” of pounds has decreased. Really, it’s not so different from what countries with overheating inflation do when they redefine prices downward. Through prices (or here, pounds) change, the amount of output doesn’t, which means in the long run we end up with lower prices but no change in output or employment, just as the weight watchers in our example now weigh less in numbers but have no change in body shape or health level that would be experienced if they had really lost weight. 6. “Monetary policy is incredible,” your friend says. “Just a little manipulation of the money supply and interest rates, and we end up at just the right price level and amount of output.” Is your friend overstating the Fed’s control over price levels and output? Why or why not [LO 16.3] Answer: Your friend is overstating the effectiveness of monetary policy for several reasons. In the short run, the Fed can shift the aggregate demand curve via monetary policy. For example, with expansionary monetary policy, the Fed can shift the AD curve rightward by lowering interest rates and thereby pushing up consumption and investment, causing an increase in the price level and real output. When the economy is in recession, this can be an effective policy in terms of putting people back to work. During an expansion, the Fed can use contractionary monetary policy to reduce aggregate demand and prevent an increase in the price level. However, in either case, the effectiveness of monetary policy depends upon how responsive households and firms are to the lower/higher interest rates. Additionally, it is difficult for the Fed to know exactly how much it needs to change interest rates to return the economy to potential output. Finally, sometimes the economy ends up in a liquidity trap where interest rates cannot go any lower but the economy is still in a recession. 7. Your dormitory Griffingate has appointed you central banker of its economy, which deals in the currency of wizcoins. Assume that the velocity of wizcoins in Griffingate is constant at 10,000 transactions per year. Right now real GDP is 1,000 wizcoins, and there are 2,000 wizcoins in existence. [LO 16.4] a. What will be the value of each of the variables that make up the quantity equation—M, V, and P? b. Now indicate how the other variables will respond to each of the following scenarios, taking each case separately and assuming that velocity remains constant. (i) Real GDP: You increase the money supply to 4,000, and prices increase twofold. (ii) Price level: Start with the initial values. Real GDP drops to 500 wizcoins, and the money supply remains constant. (iii) Real GDP: Start with the initial values. Prices increase threefold because of a sudden scarcity of soda, and you decide to keep the supply of wizcoins constant. (iv) Real GDP: Start with the initial values. You increase the money supply to 5,000 wizcoins, and prices rise by 350 percent. Answer: a. The money supply (M) is 2,000; velocity (V) is constant at 10,000. We can solve for price level (P) using the other variables: MV = PY, so 2,000 × 10,000 = P × 1,000. After solving for P, we find it is 20,000. b. (i) Real GDP: 1,000 wizcoins. You increase the money supply to 4,000 wizcoins and prices increase twofold. M is now 4,000 wizcoins instead of 2,000 wizcoins (it’s doubled), and prices have doubled as well, from 20,000 to 40,000. Velocity is constant, so we want to solve for our new level of real output Y: MV = PY, so 4,000 × 10,000 = 40,000 × Y. So Y is unchanged at 1,000 wizcoins. Could we have solved this another way? One way would be to use the quantity equation in its percentage-change form: Percentage change in M + Percentage change in V = Percentage change in P + Percentage change in Y. Plug in our changes in percentage form: 100 percent increase in M + No change in V = 100 percent increase in P + Percentage change in Y. We can see that there is no change in real GDP using this formula as well. (ii) Price level: 40,000 wizcoins. Start with the initial values. Real GDP drops to 500 wizcoins and the money supply remains constant. Y is now 500 wizcoins instead of 1,000 wizcoins, and the money supply and velocity are constant. Let’s find out what must happen to the price level P. We’ll use our old values for M and V and the new value for Y, then solve for P using the quantity equation. MV = PY, so 2,000 × 10,000 = P × 500. Inflation has occurred, as P = 40,000, double its initial value of 20,000. (iii) Real GDP: 333 wizcoins. Start with the initial values. Prices increase threefold because of a sudden scarcity of soda, and you decide to keep the supply of wizcoins constant. We are now solving for the effect on Y using the quantity equation: MV = PY. Plug in our known values (2,000 money supply, 10,000 velocity) and our new value (prices are now 300 percent of 20,000 = 60,000): 2,000 × 10,000 = 60,000 × Y. Y equals about 333 wizcoins. We can see that this huge increase in prices, everything else held constant, caused a major decrease in real output, from 1,000 wizcoins to 333 wizcoins. It’s a third of its original size! (iv) Real GDP: 714 wizcoins. Start with the initial values. You increase the money supply to 5,000 wizcoins and prices rise by 350 percent. First, let’s calculate the change in prices using wizcoin terms: 350 percent of 20,000 = 70,000 wizcoins. So the money supply (M) has risen to 5,000 and prices are now at 70,000. Still assuming velocity is constant at 10,000, we can solve for the new real GDP: MV = PY, so 5,000 × 10,000 = 70,000 × Y. Y now equals about 714 wizcoins, a reduction from its original value of 1,000 wizcoins. Therefore, we can say that this increase in the money supply combined with high inflation caused a reduction in real output. 8. Express the following relationships using the equation for the quantity theory of money. [LO 16.4] a. The money supply is given by nominal GDP divided by the velocity of money. b. The relationship of the money supply to the price level is the same as the relationship between real GDP and velocity. (Hint: Start by dividing the money supply by the price level.) c. Real GDP is given by the flow of money divided by the price level. d. The price level of an economy can be found by dividing the product of the money supply and its velocity by real GDP. Answer: a. M = PY/V. b. M/P = Y/V. c. Y = MV/P. d. P = MV/Y. 9. Identify whether the following individuals will be affected by bracket creep next year given the rates of taxation and levels of inflation found in Table 16P-2. [LO 16.5] a. Gabriela makes $9,500, and inflation is at 5 percent. b. Cooper makes $160,000, and inflation is at a record high of 20 percent. c. Shawna makes $140,000, and inflation is at 8 percent. d. Samuel makes $45,000, and inflation is at 6 percent. e. Marguerite makes $96,000, and inflation is at 6 percent. Answer: a. If Gabriela’s $9,500 income grows by 5 percent due to inflation, she will make 1.05 x $9,500 = $9,975. She will stay in her current tax bracket. However, more inflation than that could mean trouble. b. Cooper is already at the highest marginal tax rate. He won’t change brackets as a result of inflation. c. If Shawna’s $140,000 income grows by the inflation rate of 8 percent, she’ll end up with 1.08 x $140,000 = $151,200. Bracket creep has occurred, as this change in her nominal income has caused him to enter a higher tax bracket. d. Samuel is not likely to be a victim of bracket creep; if his current income of $45,000 grows by the inflation rate of 6 percent, he’ll have 1.06 x $45,000 = $47,700, not the $50,001 required to pay a marginal tax rate of 20%. e. Marguerite is likely to fall victim to bracket creep. If her income increases by the inflation rate of 6 percent, she’ll have income of 1.06 x $96,000 = $101,760. Her marginal tax rate will rise from 20 to 23 percent. 10. Cookie Monster has decided to channel his love of cookies into a new business, “Me Want Cookies Inc.,” a new partnership he has formed with Miss Piggy. They are considering different countries in which to start their venture and would like to rank the countries based on the inflationary environment. They decide to give a country 10 “menu-cost” points for each percent of actual inflation in the last year, since inflation will cause their menu costs to increase. They also dislike unstable inflation, so they will give a country 20 “uncertainty” points for each percent difference in the actual inflation rate when compared to the projected inflation rate. Countries with the least total points will receive the highest rankings. Complete Table 16P-3 for Cookie Monster. [LO 16.5] Answer: Country Projected inflation (%) Actual inflation (%) Uncertainty points Menu-cost points Total points Rank KermiKopia 2 4 (4 – 2) x 20 = 40 4 x 10 = 40 40 + 40 = 80 2 Gonzoland 4 5 (5 – 4) x 20 = 20 5 x 10 = 50 20 + 50 = 70 1 Elmostan 7 8 (8 – 7) x 20 = 20 8 x 10 = 80 20 + 80 = 100 3 Country Projected inflation (%) Actual inflation (%) Uncertainty points Menu-cost points Total points Rank Oscaria 10 13 (13 –10) x 20 = 60 13 x 10 = 130 60 + 130 = 190 5 Bertico 14 14 (14 –14) x 20 = 0 14 x 10 = 140 0 + 140 = 140 4 11. Jack recently took out a loan from Diane at an interest rate of 5 percent. Diane expected this year’s inflation rate to be 2 percent and the real interest rate to be 3 percent. The loan is due at the end of this year. Complete Table 16P-4, showing the real interest rate for each possible inflation rate. For each situation, determine whether the unexpected inflation level benefits Jack or Diane. [LO 16.5] Answer: The expected real interest rate on the loan is 5 percent– 2 percent= 3 percent. If the actual real interest rate is above 3 percent, Diane benefits. Otherwise, Jack benefits. This year’s actual inflation rate (%) Actual real interest rate (%) Who benefits? 1 5 – 1 = 4 Diane 4 5 – 4 = 1 Jack 0 5 – 0 = 5 Diane –2 5 – (–2) = 7 Diane 12. Assume the prices shown in Table 16P-5 are the prices of Big Macs in 2030, 2031, and 2033, and that changes in the price of Big Macs tend to closely keep up with inflation. For each of the four instances, determine the following. [LO 16.6, 16.7] a. The percentage changes in price levels between each consecutive year. b. Whether the economy was experiencing inflation, deflation, disinflation, or hyperinflation over each period. (Assume that inflation above 100 percent constitutes hyperinflation.) Answer: From 2030 to 2031, the price level changed by (1.02 – 1.00)/(1.00) = 2 percent; in other words, it had inflation of 2 percent. From 2031 to 2032, the inflation rate was (1.03 – 1.02)/1.02 = 0.98%. From 2030 to 2031, prices fell from 1.00 to 0.99. Therefore, there was deflation at a rate of (0.99 – 1.00)/1.00 = 1%. From 2031 to 2032, there was further deflation at a rate of (0.97 – 0.99)/0.99 = 2.02%. From 2030 to 2031, there was hyperinflation, as price levels increased by a whopping (0.05 – 0.01)/0.01 = 400%. Hyperinflation continued as we moved from 2031 to 2032, at a rate of (1.00 – 0.05)/0.05 = 1900%. From 2030 to 2031, there was inflation at a rate of (1.10 – 1.00)/1.00 = 10 percent.; Disinflation occurred between 2031 and 2032 as the inflation rate fell to (1.15 – 1.10)/1.10 = 4.54%. 13. Assuming that inflation above 100 percent is hyperinflation, categorize each of the inflation rates in Table 16P-6 as deflation, disinflation, inflation, or hyperinflation as we move from one year to the next. [LO 16.7] Answer: Year Inflation rate (%) Description 1900 90 Inflation 1901 80 Disinflation 1902 120 Hyperinflation 1903 40 Disinflation 1904 -2 Deflation 14. Suppose you live in Frigidia, a country near the North Pole that is experiencing hyperinflation. You work for a U.S. company that pays you a monthly income of $100 U.S. Today, you can exchange those dollars for frigids, the currency of Frigidia, at a rate of 1,000 frigids/dollar. You pay a monthly heating bill that costs $10 U.S. Instead of paying the heating bill, you could simply burn Frigidia notes (which you can obtain in one-frigid denominations) at a rate of 1 million per month to supply heating. What would the exchange rate between frigids and U.S. dollars have to be for you to decide to burn bills instead of paying for heating? What level of inflation does this represent, assuming the real exchange rate remains the same? [LO 16.7] Answer: The current exchange rate is 1,000 frigids = $1. That means that our heating bill costs $10 × 1,000 frigids = 10,000 frigids. And, of course, the other option—burning the frigids—would cost 1,000,000 frigids. What exchange rate between dollars and frigids would make us indifferent to paying the bill or burning the currency? It would be the exchange rate that would make $10 equivalent to 1,000,000 frigids. If dollars traded at a rate of 1,000,000/10 = 100,000 frigids to one dollar, we would be indifferent between burning the currency or paying the bill. And if that exchange rate went up any more, we’d be better off burning the currency. This would represent a level of hyperinflation of (1,000,000 – 10,000)/10,000 = 9,900 percent! 15. “The problem wasn’t having the wrong idea about interest rates,” a sheepish central bank official says at a conference, “but rather not having the right idea about inflation rates.” What does the official mean? How does the inflation rate affect the central bank’s interest rate target, and how can a wrong prediction about inflation make monetary policy go awry? [LO 16.7] Answer: A central bank like the Federal Reserve generally targets a level of inflation that is positive but small—instead of going for zero growth in prices, they allow some to happen. The reasons for this are mostly policy-related; by keeping a small positive target there is room for rates to fall, and if inflation is slightly different from expectations interest rates are less likely to hit zero. Real interest rates are what affect the economy through loanable funds, as discussed in previous chapters. But the Fed is targeting nominal interest rates, which include two components: real interest, and expected inflation. If their guess about inflation isn’t correct, they won’t achieve the real interest rate they hoped to get to by pushing the economy toward its nominal target rate. 16. In which scenario is monetary policy likely to be more effective? Explain. [LO 16.8] Scenario A—The inflation rate in the country has hovered close to zero for the last three years. Scenario B—The inflation rate in the country has averaged 3 percent for the last three years. Answer: Monetary policy is more effective if the inflation rate in the country has averaged 3 percent for the last three years because nominal interest rates will be higher so the Federal Reserve will not have to worry about hitting the zero lower bound. Keeping the inflation rate at a modest positive level gives the central bank some leeway to make mistakes, without running the risk of tipping the country into a deflationary spiral. If the inflation rate is close to zero, then nominal interest rates will be very low so the central bank will not have much room to lower the interest rate in order to stimulate spending (expansionary policy is not likely to be effective). If the inflation rate is close to zero, the real interest rate is not necessarily lower—this will depend on where the nominal rate is relative to the inflation rate. When the inflation rate is higher, the nominal interest rate tends to be higher so that lenders will still earn a positive real rate of return. 17. Consider a country that has experienced a decline in labor demand that results in a 2 percent reduction in the equilibrium real wage. [LO 16.8] a. If the inflation rate in the country has been at zero percent, what has to happen to the nominal wage to restore labor market equilibrium? b. If the inflation rate in the country has been at 4 percent, what has to happen to the nominal wage to restore labor market equilibrium? c. Do you think workers and employers would prefer to have a zero percent inflation rate or a 4 percent inflation rate in this case? Explain. Answer: The real wage is equal to the nominal wage divided by the price level, so percentage change in real wage = percentage change in nominal wage – inflation rate. a. -2% = percentage change in nominal wage – zero percent, so nominal wages will fall by 2%. b. -2% = percentage change in nominal wage – 4%, so nominal wages will rise by 2%. c. All else the same, workers prefer higher nominal wages. Psychologically they are likely to be happier with a 2% increase in nominal wages and 4% inflation as opposed to a 2% reduction in nominal wages and 0% inflation. In both cases the change in the real wage is the same, but workers are likely to feel happier with rising nominal wages because some of them will fail to distinguish between the nominal wage and the real wage. Employers also prefer higher nominal wages because employee effort is likely to be greater, given some of them have failed to distinguish between real and nominal wages. Employers are paying higher nominal wages, but if the inflation rate is 4%, then prices are rising faster than nominal wages, so employers are happy. 18. Determine whether the Federal Reserve would pursue contractionary monetary policy, expansionary monetary policy, or no change in policy in each of the following situations. [LO 16.9] a. Inflation is 10 percent, above its average of 3 percent in the last several years. b. The output gap is positive. c. Unemployment is at a record high. d. The economy is experiencing full employment. e. The economy is on the brink of deflation. f. A new technology causes output to surge. Answer: a. Contractionary monetary policy. b. Contractionary monetary policy. c. Expansionary monetary policy. d. No change in policy. e. Expansionary monetary policy. f. No change, or prepare for contractionary policy to bring down inflation. 19. Answer each of the following questions assuming the economy is experiencing a positive output gap. [LO 16.9] a. Is inflation decreasing, increasing, or stable? b. Is actual output greater than or less than potential output? c. Is unemployment rising or falling? d. Is the Federal Reserve more likely to pursue expansionary or contractionary monetary policy? e. Is the economy likely experiencing an expansion or contraction? Answer: When the economy is experiencing a positive output gap, actual output is greater than potential output, and the economy is experiencing expansion. With nearly everyone employed (and working overtime), hiring new workers can be very expensive. Workers can eventually command higher salaries to switch jobs, since employers have to compete for them. Likewise, companies are competing to buy up machines, factories, or other inputs to meet soaring demand for their products, leading to a rise in those prices as well (i.e. increasing inflation). To curb inflation, the Federal Reserve will pursue contractionary monetary policy to slow the expanding economy. 20. Answer each of the following questions assuming the economy is experiencing a negative output gap. [LO 16.9] a. Is inflation decreasing, increasing, or stable? b. Is actual output greater than or less than potential output? c. Is unemployment rising or falling? d. Is the Federal Reserve more likely to pursue expansionary or contractionary monetary policy? e. Is the economy likely experiencing an expansion or contraction? Answer: When the economy is experiencing a negative output gap, actual output is greater than potential output, and the economy is experiencing contraction. There are a lot of resources—either factories or workers—not being fully used. Workers are unemployed, and factories are sitting idle, waiting for work. In other words, the economy is experiencing recessionary conditions. During recessionary periods, low rates of inflation occur in part because there is so little demand for money. The Federal Reserve can fix this problem in the short-run by engaging in expansionary monetary policy. 21. Assume the Phillips curve is given by the simple equation U = –I + 20. The non-accelerating rate of unemployment is 10 percent. If inflation changes to 15 percent, what will be the unemployment rate in the short run? What will it be in the long run? [LO 16.10] Answer: a. We want to calculate the short-run unemployment rate when the inflation rate (I) is 15 percent. We can do so using the formula given: U = -I + 20. We plug in 15 for I and get U = –15 + 20 = 5 percent; that will be the short-run unemployment rate. b. In the long run, though, unemployment will return to the NAIRU rate of 10 percent. 22. Using what you know about the Phillips curve, determine whether the following quantities will increase, decrease, or remain the same. [LO 16.10] a. Unemployment in the short run after an increase in inflation. b. Unemployment in the long run after an increase in inflation. c. Inflation in the short run after a decrease in unemployment. d. Inflation in the long run after a decrease in unemployment. Answer: a. Decrease—this is an upward movement along the short-run Phillips curve. b. Remain the same—unemployment in the long run always returns to the natural rate. c. Increase—this is an upward movement along the short-run Phillips curve. d. Remain the same—in the long run, the inflation rate and the unemployment rate are independent. A structural change that reduces the natural rate of unemployment will not impact the inflation rate in the long run. CHAPTER 17 FINANCIAL CRISIS Chapter Overview This chapter began with a simple question: Why do financial crises occur? Usually, financial crises arise from a combination of irrational expectations and leverage, which create bubbles that burst with dire consequences for the real economy. Crises have been around since the very first financial markets, as the example of the South Seas Company in the 1700s shows. These forces surfaced once again when innovations in the subprime lending market led to a dramatic increase in home ownership and housing prices. When the real estate bubble burst in 2007, a financial crisis struck again, challenging economists’ belief that economic crises had become a thing of the past. Recent events show that we still have much to learn about the macroeconomy. Can we permanently moderate the business cycle? How will increasing global interdependency affect future crises? What can governments do to make financial markets work better? There are no quick and easy answers to these questions, but we are starting to better understand the complexity of the challenges. The unfortunate reality is that economies can collapse almost overnight, but they often take a lot longer to recover. Learning Objectives LO 17.1 Describe the role of irrational expectations and leverage in the creation of financial crises. LO 17.2 Discuss the causes of two famous historical financial crises. LO 17.3 Trace the role of mortgage-backed securities and tranching in the rise of subprime lending. LO 17.4 Analyze the factors that led to the housing bubble and rising levels of household debt. LO 17.5 Explain how the collapse of the housing bubble created a credit crisis and subsequent contraction in output. LO 17.6 Describe the monetary and fiscal policy responses to the financial crisis of 2008. LO 17.7 Describe the different tools that can be used to stimulate the economy when interest rates are at the zero lower bound. Chapter Outline A FINANCIAL STORM The Origins of Financial Crises Irrational Expectations (LO 17.1) BOX FEATURE: FROM ANOTHER ANGLE – DO INVESTORS RATIONALLY INFLATE BUBBLES? Leverage Two Famous Historical Financial Crises (LO 17.2) The Great Recession: A Financial-Crisis Case Study Subprime Lending (LO 17.3) The Creation of the Housing Bubble (LO 17.4) Effects of the Housing Bubble Collapse (LO 17.5) The Immediate Response to the Crisis (LO 17.6) BOX FEATURE: REAL LIFE – TOO BIG TO FAIL? Stimulus at the Zero Lower Bound (LO 17.7) BOX FEATURE: REAL LIFE – JAPAN’S LOST DECADE Beyond the Lecture Reading Assignment: Irrational Expectations (LO 17.1) Have students read “Bubbles in Asset Prices” by Burton Malkiel. You may have to copy and paste the link into your browser: http://www.princeton.edu/ceps/workingpapers/200malkiel.pdf. In this paper, Malkiel provides an excellent summary of a number of asset bubbles in modern history. This can be used to start a discussion on the role of irrational expectations. Additionally, this paper can be used as the basis for a writing assignment regarding irrational expectations and the possibility of addressing asset bubbles with monetary policy. Class Discussion: Subprime Lending (LO 17.2) Have students read this brief article from Bloomberg, which discusses the mortgage-backed security problem and a potential angle for reform. 1. Why is there so much discussion regarding mortgage reform? 2. Do you think that the potential mortgage reforms being discussed could prevent future housing market troubles? Class Media: The Housing Crash and Unemployment during the Recession (LO 17.2) This video “The Crisis of Credit” presents an intuitive an animated view of the housing bubble (and burst) which was a main cause of the Great Recession. The video is well-worth the class time used to show it. In addition, this animation can be shown as a startling reminder of the unemployment effects of the recession. Reading Assignment: The Immediate Response to the Crisis (LO 17.5) Quantitative easing and paying interest on reserves are two of the biggest monetary policy developments from the financial crisis of 2008. Have students read this report (by the Federal Reserve Bank of New York, an interesting piece that helps explain one of the reasons inflation remains low despite expansionary monetary policy. Also, have students review this chart from the Wall Street Journal, which explains how quantitative easing works. Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. 1. What role did leverage play in the recent Great Recession? [LO 17.1] A. It magnified losses since many investments were made with borrowed funds B. It caused people to believe that housing values would always rise C. It caused government to wrongly regulate securities D. It made investors too cautious and reduced risk-taking 2. In the year 1932 during the Great Depression, ________ of the stock market’s value had been erased. [LO 17.1] A. 50% B. 66% C. 75% D. 90% Feedback: It’s amazing to think about that fact. In addition, it took 25 years for the stock market to recover to pre-Depression levels. 3. Which of the following is viewed as a key cause of the recent Great Recession? [LO 17.2, 17.3] A. High health care costs B. Subprime mortgages C. Banks refusing to lend and take any risks with their reserves D. A decrease in the money supply Feedback: People bought bigger homes they couldn’t afford, and many of those buyers soon defaulted. This caused the housing bubble to be created, and then come crashing down. 4. Many banks were bailed out by the U.S. Treasury in the immediate aftermath of the housing market crash and recession under the rationale that the banks were__________ [LO 17.5] A. deserving of federal assistance B. too big to fail C. employing a lot of workers D. politically powerful Feedback: The banks and financial system are so intertwined with the rest of the economy that letting them fail could have perhaps led to a deeper and longer recession. The government and Federal Reserve needed to unfreeze the credit markets and get the economy moving again. 5. Quantitative easing policies aimed to _______________. [LO 17.6] A. increase the money supply B. forgive debts of businesses and individuals C. increase the number of banks D. making interest rates negative Feedback: This isn’t done by printing or minting new money. It’s mostly done by electronic creation of new money. This can quickly allow billions (or even trillions) of new dollars to be “created”. Solutions to End-of-Chapter Questions and Problems Review Questions 1. Your best friend comes to you for financial investment advice. She is wondering whether she should invest in (a) a sector of the economy that has been performing extremely well in the last five years relative to historical levels or (b) one that has been performing extremely poorly in the last five years relative to historical levels. What would you advise? How might irrational expectations affect your recommendations? [LO 17.1] Answer: You might advise your friend to invest in the sector that’s been performing poorly on the assumption that what goes down must eventually go back up, or you might advise her to invest in the sector that’s been performing well on the assumption that what’s done well will continue to do well. Either way, irrational expectations can affect your answer via the recency effect, in which investors pay too much attention to recent events and not enough attention to the big picture. 2. What is leverage, and how can it make an asset pricing bubble worse? [LO 17.1] Answer: Leverage refers to using borrowed money to engage in economic investment. In an asset price bubble, irrational exuberance can keep pushing prices higher. These higher prices make it easier for a firm to borrow and therefore to invest via borrowing. However, if the increases in prices are truly caused by a bubble, leverage can worsen the situation by encouraging too much investment, which can go badly if firms cannot repay the loans they’ve made. 3. What causes a stock market bubble to form? [LO 17.2] Answer: A stock market bubble forms when stock prices become inflated beyond the point where anyone can explain precisely why the stocks should be so valuable. This tends to happen because the people who buy the stocks develop irrational expectations regarding what will happen to the stock prices in the future. Usually investors are irrationally optimistic in these cases and assume the asset's price will continue to rise. 4. History suggests that all stock market bubbles will eventually pop and cause severe financial loss for many of those who purchased stock. Given this history, do you think that stock market bubbles will continue to occur? Why or why not? [LO 17.2] Answer: Stock market bubbles are likely to continue to occur despite the fact that the bubble always bursts, causing stock prices to fall back to normal levels. Bubbles occur because people have irrational expectations and assume prices will continue to increase. Investors may know the bubble will eventually burst, but they may irrationally assume they can purchase the stock at a low price and then sell before the bubble bursts. 5. Explain why it’s possible for tranching to make investing in a mortgage-backed security more risky than investing in a single subprime loan. [LO 17.3] Answer: Tranching is dividing a large loan into several smaller parts with different characteristics in terms of risk and return; it allows loans to be made that would not have been made otherwise due to borrower uncreditworthiness, but it may result in overextension of credit (loans may be made to borrowers who are simply uncreditworthy). When this occurs, a mortgage-backed security can actually be riskier than a single subprime loan, despite the fact that tranching was created to reduce risk. 6. Explain how a mortgage-backed security can increase loan availability to those with little credit or bad credit. [LO 17.3] Answer: When a bank makes a traditional loan, it takes on the risk of that loan; if the borrower defaults, the bank will suffer significantly. Mortgage-backed securities bundle many mortgages together, with the idea that while one or a few home borrowers may default on their mortgages, the chance of all of them doing so is much less. Spreading out risk in this fashion can make banks more willing to provide credit to those it would not otherwise lend to, increasing loan availability to those with little or bad credit—though, as seen throughout the chapter, sometimes this can go too far. 7. Explain the role that leverage played in the recent housing bubble. [LO 17.4] Answer: Leverage came into the recent housing bubble in the form of “flipping” houses. With the easy availability of credit, many people bought houses and made minor cosmetic adjustments, counting on prices in the housing market to continue rising so these houses could be quickly resold for a higher price. The resulting increase in demand for houses pushed up housing prices even more, causing more strain on the bubble that would eventually pop. 8. How did government policies and asymmetric information problems make the recent housing bubble worse? [LO 17.4] Answer: The government played a role in the recent housing bubble by promoting loans to low-income individuals, some of which were probably not creditworthy. On the monetary side, the Federal Reserve kept interest rates quite low, encouraging more borrowing to buy houses and for business growth. Investment banks bought loans assuming that commercial banks did their due diligence in researching borrowers and learning as much about them and their likelihood of repayment as possible, but many of those banks were more focused on the fees they could get from making loans than on the kind of information that would imply whether the loan would be repaid in full. 9. Many subprime borrowers entered into “adjustable-rate mortgages” with low teaser rates. These mortgages allowed borrowers to pay a low interest rate for the first two years on their mortgage, before the rate jumped to market levels. But the loan documents sometimes made it difficult for borrowers to understand that the rate would increase. Explain why this practice could lead to a bubble in housing prices. [LO 17.5] Answer: Anytime borrowers don’t understand what they’re agreeing to, they run the risk of taking on loans they won’t be able to pay back, and this was definitely the case during the recent housing bubble. If borrowers don’t understand when interest rates on their loans will rise, or how this will affect their required payments, they may take on too much debt and not be able to make payments when the rate change occurs. 10. How did the recent housing crisis affect the aggregate demand curve? [LO 17.5] Answer: The aggregate demand curve shifted leftward mostly because of decreases in investment and consumption spending. Investment spending fell as credit became less available, and the types of consumption that require borrowing were similarly affected. Moreover, households felt less wealthy than before as the value of their homes decreased, further depressing spending. Their need to make payments on loans pushed consumption down even further by reducing the amount of money households could spend on goods and services. 11. Imagine what would have happened if the Federal Reserve was not in place to act as a lender of last resort during the financial crisis. Absent government involvement, what would be the likely effect on aggregate supply? Why? What would be the likely effect on aggregate demand? Why? [LO 17.6] Answer: The Fed’s “lender of last resort” function means that it stands ready to provide loans to banks that need liquidity. If the Fed didn’t fulfill this function, it would not buy up bad assets or provide reserves to banks that needed them, further decreasing the availability of credit. So aggregate demand would likely decrease even further as borrowing to invest becomes less possible. Eventually, lack of investment would also reduce aggregate supply, as businesses wouldn’t be able to invest in new technology and productive assets, which would hurt their ability to produce goods and services. Therefore, both AD and AS would shift leftward by a larger amount during a financial crisis if the Fed did not act as a lender of last resort. 12. As the Federal Reserve responded to the recent housing crisis, how did this affect its balance sheet? Can you think of what caused the balance sheet’s size to change so much? [LO 17.6] Answer: As a result of monetary policy actions taken to fight the effects of the housing crash, the Fed’s balance sheet more than doubled in size in just a few months. During this time, the Fed was not only buying U.S. Treasury securities (as it normally does to conduct open market operations), but it was also buying up large quantities of mortgage-backed securities and other financial assets in order to provide liquidity to the financial market. 13. What is the “zero lower bound” that must be considered in monetary policy, and how can it cause problems in enacting such policy? [LO 17.7] Answer: The “zero lower bound” refers to interest rates hitting zero—after all, if interest rates are already at zero, how can the Federal Reserve enact expansionary monetary policy by lowering them? Hitting the lower bound can cripple monetary policy, as was the case in Japan over the 1990s. 14. What is quantitative easing, and when might it be used? [LO 17.7] Answer: Quantitative easing occurs when a nation’s central bank targets monetary policy directly at the money supply instead of attempting to affect it indirectly via interest rates (the usual method). This can be effective when the government is at or near the zero lower bound on interest rates and cannot take them further downward; it was used with some success after the recent housing market bubble burst. Quantitative easing involves the purchase of long-term government bonds or other financial assets by the Federal Reserve, as opposed to its more typical policy of purchasing short-term government securities. Problems and Applications 1. Determine whether or not each of the following is an example of irrational expectations. [LO 17.1] a. The price of Amazon’s stock rises after tech blogs reveal that the company plans to release a new tablet, rumored to be competitive with Apple’s iPad. b. The CEO of a new start-up producing applications for tablets is quoted as proclaiming a new era of media, in which thirst for content will rise indefinitely as information becomes more and more convenient for people to digest. An economics blog continues the discussion a year later, discussing returns to investment that have never before been contemplated. Stock prices for media companies are consistently outperforming historical levels by 50 percent and seem to be on a permanent rise. c. After an unusually cool summer, investors in Papa’s Cool Pops decide to sell, believing demand for frozen treats will never reach historic levels again because of the weather. d. The Justice Department reveals allegations against the CEO of a food and beverage company, alleging misconduct within the company. A trial could cost the company millions of dollars. The stock price falls by 5 percent by the day’s end. Answer: Irrational expectations lead people to make decisions that are not optimal because they fail to adequately use all available information. There is a basic human tendency to overvalue recent experience when trying to predict the future, and this leads people to make irrational decisions. Irrational expectations are often based on overly optimistic projections for the future, leading to stock market or housing market bubbles. a. This would not be an example of irrational expectations unless investors are reacting too much to the recent event in buying Amazon stock. b. This is an example of the recency effect, in which investors react too much to recent events. Also, it’s irrational to assume that media companies will continue to outperform historical levels by such a large amount. c. This is irrational due to relying too much on recent data rather than looking at the bigger picture. It will get warm, and people will want popsicles again! d. This is probably not an example of irrational expectations, as the market is reacting in a logical fashion to factors that will decrease the desirability of the firm’s securities. 2. Ike, an investor, is considering opening a margin account and investing $1,000 in Mike’s mutual fund. The terms of the account require that he pay back the amount he borrowed on the margin by the end of the year with 10 percent interest. Ike is trying to decide what level of margin he wants. For example, if he chooses an account at the level of 50 percent, the bank will let him borrow and invest an additional $500, or 50 percent of his original $1,000. Complete Table 17P-1 by filling in Ike’s account value at the end of the year, given varying levels of the margin account and mutual fund performance. Assume that Mike’s mutual fund will return 40 percent per year in a stellar market and 5 percent per year in a fair market, and that in a terrible market, it will lose 30 percent. [LO 17.1] Answer: Margin account level Account value in a stellar market Account value in a fair market Account value in a terrible market No margin $1,000 x 1.40 = $1,400 $1,000 x 1.05 = $1,050 $1,000 x (1-0.30) = $700 60% ($1,000 + (0.60 x $1,000)) x 1.40 = $2,240 ($1,000 + (0.60 x $1000)) x 1.05 = $1,680 ($1,000 + (0.60 x $1,000)) x (1-0.30) = $1,120 100% ($1,000 + (1 x $1,000)) x 1.40 = $2,800 ($1,000 + (1 x $1,000)) x 1.05 = $2,100 ($1,000 + (1 x $1,000)) x (1-0.30) = $1,400 150% ($1,000 + (1.50 x $1,000)) x 1.40 = $3,500 ($1,000 + (1.50 x $1,000)) x 1.05 = $2,625 ($1,000 + (1.50 x $1,000)) x (1-0.30) = $1,750 200% ($1,000 + (2 x $1,000)) x 1.40 =$4,200 ($1,000 + (2 x $1,000)) x 1.05 =$3,150 ($1,000 + (2 x $1,000)) x (1-0.30) =$2,100 3. Consider a stock whose value increases across an 8-year period as shown in Table 17P-2. [LO 17.2] a. Calculate the percentage change in the value of the stock from year to year. b. Calculate the percentage change in the value of the stock across the entire 8-year period. c. Do you think this qualifies as a bubble? Why or why not? Answer: a. Percentage change is calculated as (new value – old value)/old value, all times 100 Year Stock Value Percentage Change 1 $50.00 n/a 2 $60.00 (60 – 50)/50 × 100 = 20% 3 $75.00 (75 – 60)/60 × 100 = 25% 4 $86.25 (86.25 – 75)/75 × 100 = 15% 5 $103.50 (103.50 – 86.25)/86.25 × 100 = 20% 6 $155.25 (155.25 – 103.50)/103.50 × 100 = 50% 7 $248.40 (248.40 – 155.25)/155.25 × 100 = 60% 8 $372.60 (372.60 – 248.40)/248.40 × 100 = 50% b. (372.60 – 50)/50 × 100 = 645.2%. c. A bubble involves trade in an asset whose price has risen unsustainably far above historically justified levels. From year 1 to year 5, the percentage change in the price was (103.50 – 50)/50 × 100 = 107%. From year 5 to year 8, the percentage change in the price was (372.60 – 103.50)/103.50 × 100 = 260%. The increase in the stock value is likely to be classified as a bubble because the annual growth rate in the last few years (years 6–8) is much greater than the annual growth rate in the first few years (years 1–5). There would have to be some special circumstance that caused the large increase in the growth rate to be justified as opposed to irrational. 4. Assume that a subprime mortgage involves a loan of $1,000 and is to be paid back in full with 30 percent interest after one year. [LO 17.3] a. Sometimes borrowers will not be able to pay off the entire mortgage or may default entirely. Calculate the final amount of money an investor earns under the payback rates shown in Table 17P-3. (Note that a rate of 130 percent means that the whole loan is paid off, plus the additional 30 percent of interest.) b. Assume investors are unwilling to invest in these loans unless the expected rate of return is 10 percent. Calculate the expected rate of return for this loan by adding up all of the products of the final value and the probability that that value will occur. Will investors want to invest in this loan? Answer: a. Amount Paid (%) Final Value ($) Probability Expected Value ($) 130 1,300 0.6 780 110 1,100 0.1 110 100 1,000 0.1 100 50 500 0.1 50 0 0 0.1 0 Total expected value 1,040 b. This represents a 4% return (since we gained $40, and $40/$1,000 = 4 percent), which falls far short of the 10% required by investors. They will not be interested in buying these loans. 5. A single bank is considering two options: First, it can make a $200,000 mortgage loan for a customer with a 10 percent probability of default, or, second, it can buy a $200,000 security representing a bundle of 100 mortgage loans, which break down as shown in Table 17P-4. You can calculate the weighted risk for each firm category by multiplying the percentage of loans represented (for example, the first tier includes 40 loans, which is 40/100 = 40% of the total) times the probability of default on loans of that category. Do so for each type of loan, then add together the weighted risks to come up with an overall expected default risk for this financial investment. If the bank is willing to take on only projects for which the default risk is 6 percent or less, which option(s) should it choose? [LO 17.3] Answer: Add together the weighted risks to calculate a measure of expected default risk for the security: 1.2% + 2.75% + 0.225% + 1% = 5.175%. If the bank is only willing to take only loans with a 6% chance or less of default, it will clearly prefer the bundle of mortgages in the security. Number of loans Probability of default (%) Weighted risk 40 3.0 40% x 3% = 1.2% 25 11.0 25% x 11% = 2.75% 15 1.5 15% x 1.5% = 0.225% 20 5.0 20% x 5% = 1% 6. Table 17P-5 shows hypothetical levels of average household debt and debt service payments in two years, 2010 and 2013. At what annual interest rate would consumers have had to borrow for the debt-service payments in 2013 to equal the debt-service payments in 2010, despite the increase in household debt? Assume households are paying only interest on their debt and not part of the principal. [LO 17.4] Answer: Here, in 2010 annual debt service payments were $800/$20,000 = 4 percent of total debt. If we want to keep our payments at $800 with our 2013 debt of $80,000, we’ll need to borrow at an interest rate of $800/$80,000 = 1 percent. 7. Table 17P-6 gives information on income and debt for a small nation for the years 2011 through 2014. The nation had average household debt of $34,000 at the end of 2010. Use this information to fill in the blanks. [LO 17.4] Answer: Year Household income ($) Financial obligations ($) Financial obligations as % of income Household debt ($) Debt as % of income 2011 35,000 4,000 $4,000/$35,000 = 11.43% $34,000 + $4,000 = $38,000 $38,000/$35,000 = 108.57% 2012 38,500 4,200 $4,200/$38,500 = 10.91% $38,000 + $4,200 = $42,200 $42,200/$38,500 = 109.61% 2013 42,000 5,000 $5,000/$42,000 = 11.90% $42,200 + $5,000 = $47,200 $47,200/$42,000 = 112.38% 2014 45,250 6,200 $6,200/$45,250 = 13.70% $47,200 + $6,200 = $53,400 $53,400/$45,250 = 118.01% 8. Imagine that your personal finances are summarized by the account balances shown in Table 17P-7. Assume also that your decision to save is a function of your income and net worth. More specifically, assume that your savings each year will be equal to: 0.2I – NW, where “I” is your income and “NW” is your net worth. [LO 17.4] a. If your income is $60,000, how much will you save this year? b. Assume the value of your house decreases by 20 percent. What is your net worth now? How much will you save? Answer: a. When your income is $60,000, you will need to first calculate your net worth, which is the difference between assets and liabilities. Your net worth is currently $125,000 in assets – $120,000 in liabilities = $5,000. From here, you can calculate the amount you’ll save as follows: 0.2($60,000) – $5,000 = $7,000. b. If the value of your house goes down by 20 percent, it will decrease to $100,000 (its original value) times (1 – 0.20 = 0.80) = $80,000. This is a reduction in assets of $20,000. Your assets will now total $125,000 – $20,000 = $105,000 and your liabilities will still be $120,000, for a net worth of $105,000 – $120,000 = –$15,000. Plug this amount into your savings equation, being careful about the negative net worth: 0.2($60,000) – (–$15,000) = $27,000. 9. If the rate currently payable on 10-year Treasury bonds is 4.8 percent and the risk spread is 2 percent, what is the average rate on other forms of commercial lending? [LO 17.5] Answer: The risk spread is equal to the difference between the rate paid on commercial lending and that paid on long-term Treasuries; in other words: Risk spread = Rate on commercial lending - Rate on 10-year Treasury bonds Since we know the risk spread is 2 percent and the rate on 10-year Treasuries is 4.8 percent, we can plug these into the equation and solve for the rate on commercial lending: 2% = X% – 4.8%. The average rate on commercial lending must be 6.8 percent. 10. Which of the following policies were used in response to the latest financial crisis? Of those used, which are examples of monetary policy? Of fiscal policy? [LO 17.6] a. Aggressive controlling of inflation by raising interest rates. b. Providing short-term financing directly to small businesses to jump-start investment. c. Bailing out banks that have large amounts of risky mortgage-backed securities. d. Purchasing long-term bonds to increase the money supply. e. Raising the Social Security eligibility age by five years to encourage people to work. Answer: a. Not used: Interest rates were instead lowered to control unemployment. b. Not used: Financing was provided to banks but not to small businesses. c. Used: The TARP program is an example of fiscal policy. d. Used: This describes expansionary monetary policy via open market operations. e. Not used. 11. Table 17P-8 shows the balance sheet of a bank in millions of dollars. [LO 17.6] a. What is the bank’s net worth? b. Assume housing prices increase and defaults on subprime mortgages rise, causing the bank’s assets in subprime mortgages to decrease from $500 million to $350 million. What are total assets now? What is the bank’s new net worth? c. How far would the value of subprime mort-gages have to fall to cause the bank to be insolvent (that is, for liabilities to be greater than assets)? Answer: a. Net worth = Total assets – Total liabilities, so it’s equal to $4,700 million – $4,500 million = $200 million. b. This $150 million decrease in subprime mortgages would cause a $150 million decrease in total assets, to $4,700 million – $150 million = $4,550 million. Net worth would now be $4,550 million – $4,500 million = $50 million. c. We can calculate this by figuring out the amount of subprime loans where total assets and total liabilities would be equal—any greater decrease in subprime loans would cause insolvency. Total liabilities are currently $4,500 million, so we would have to have total assets less than $4,500 million to be insolvent. Starting with our original values, that would require anything more than a $200 million decrease in total assets (since $4,700 million - $4,500 million = $200 million). Therefore, if our subprime loans fell by anything more than $200 million from their original levels, the bank would be insolvent. 12. Japan’s economic situation throughout its Lost Decade and beyond can be explained in terms of problems with monetary policy via interest rates. Explain what happened. Identify what Japan’s central bank should have done. [LO 17.7] Answer: The problems in Japan occurred because its monetary policy hit the zero lower bound of interest rates, making it impossible to further lower them to stimulate the economy. Suggestions might include letting some of its biggest banks fail and shifting focus to the money supply. Quantitative easing could target increases in the money supply directly, rather than through interest rates, and might represent a way out of the persistent monetary policy interest rate problems in Japan. 13. Consider an economy with $10 billion in base money and a multiplier of 4. The money supply is currently $10 billion × 4 = $40 billion. Now let’s say that the amount of base money rises by 50 percent, to $15 billion. How must the multiplier change for the money supply to remain unaffected by this change in base money? [LO 17.7] Answer: In this problem base money x multiplier = money supply, so now $15 billion × new multiplier = $40 billion. Therefore the new multiplier = $40 billion/$15 billion, or 2.67. Solution Manual for Macroeconomics Dean Karlan, Jonathan Morduch 9781259813436
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