Econ 200H: David Reiley
Due Tuesday, 5 December 2006

Problem Set #6

As before, the following exercises come from the "problems" at the end of each chapter of Taylor's textbook.  Note - the extra credit problems cover material from Problem Set #5 as well as this problem set.

1. Taylor, problem 24.2.
2. Taylor, problem 24.4.
3. Taylor, problem 24.6.
4. Taylor, problem 24.8.
5. Taylor, problem 24.9.
6. Taylor, problem 25.2.
7. Taylor, problem 25.4.
8. Taylor, problem 25.5.
9. Taylor, problem 25.6. For part (b), note that there is an error in the text.  Please assume the current inflation rate is 3%, not 2%.
10. Taylor, problem 29.3. To clarify part (b), when it talks about the "world trading price ratio," I want to know: for what values of the price of an item of clothing (in terms of bushels of wheat) will each side be willing to trade? Then, for purposes of illustrating on your diagram, I'd like you to pick just one price: let's choose 1.5 bushels of wheat per item of clothing.
11. Taylor, problem 29.6.
12. Taylor, problem 29.7.
13. Taylor, problem 29.9.
14. Taylor, problem 29.10.
15. (10 points) Visit the Federal Reserve's Web page on open-market operations to change the federal funds rate, and use the information there to answer the following questions:
1. How many times did the Fed change the interest rate in 2000, and what was the total change in the interest rate over the course of the year?
2. How many times did the Fed change the interest rate in 2001, and what was the total change in the interest rate over the course of the year?
3. How many times did the Fed change the interest rate in 2005, and what was the total change in the interest rate over the course of the year?
4. How would you characterize monetary policy in 2000, 2001, and 2005? (Choose between "expansionary" and "contractionary," and describe how strong the tendency is.) Why do you think there are differences between these years?
16. (40 points, plus 10 extra-credit points) For this question, please read this December 2004 Wall Street Journal article about consumer spending in Europe.
1. (2 points) Over the preceding two years, where had the growth of real GDP been higher: in the United States, or in the Euro zone? Provide evidence from the article.
2. (3 points) Suppose, as in the “real business cycle” approach to macroeconomics, that this international difference in GDP growth is due only to international differences in the growth of potential GDP. Name the three main determinants of the growth of potential GDP.
3. (3 points) Now suppose that at least part of the international difference in growth rates over the preceding two years was due to gaps between actual and potential GDP. Which area was more likely to be experiencing a recessionary gap at the time of the article, the United States or the Euro zone? Explain your reasoning.
4. (2 points) Suppose real GDP in the Euro zone was 3% below potential GDP at the time of the article. Draw an aggregate-demand diagram illustrating this situation. Make sure to label your axes.
5. (3 points) Suppose part (d) gives an accurate description of the situation in Europe at the time of the article. Then how would you expect the inflation rate of the euro to change over the next couple of years? Would it increase, decrease, or stay the same? Use your diagram to explain your reasoning.
6. (2 points) Where do you think the propensity to consume was higher, in the United States or in the Euro zone? Provide evidence from the article.
7. (5 points) Suppose the marginal propensity to consume in Europe was 0.6, and that neither imports nor taxes varied with income. If the European Union increased government spending on agriculture by \$100 billion, what would have been the total increase in European GDP?
8. (5 points) “The article states that Americans currently save 0.8% of their disposable income, so the marginal propensity to consume must be 99.2%.” Use your knowledge of the difference between average and marginal quantities to argue why this statement is not correct.
9. (2 points) According to the article, what was happening to the exchange rate between the dollar and the euro? Was the dollar appreciating or depreciating? Provide evidence from the article.
10. (3 points) As the exchange rate changed in (i), would you expect the result to have a positive or negative effect on European GDP growth? Explain your reasoning.
11. (3 points) The article points to both differences in culture and differences in economic regulations that favored higher saving rates in Europe than in the United States. Identify three examples of European regulations that promote a high savings rate.
12. (2 points) According to the article, that July France’s parliament tried to boost consumer spending (and hence GDP) by enacting a 2-year tax credit on interest paid on consumer loans. Use the permanent-income model to argue why we should expect this policy’s multiplier effect on GDP to be relatively small.
13. (3 points) The article points out that retail store hours were restricted by law in the Euro zone relative to the United States. Argue why removing this regulation might reduce the average costs in European shops.
14. (2 points) Provide examples of someone who wins and someone who loses by having legal restrictions on store hours. They needn’t be actual people discussed in the article; you can make up hypothetical examples if you wish.
15. (5 extra-credit points) Do you think it is reasonable to assume that the factors in (b) can explain the differences in economic growth in Europe versus the United States? Explain why or why not.
16. (5 extra-credit points) Why do you think the exchange rate was changing this way? Think about possible international differences in the inflation rate, and about the trade deficit. Provide evidence from the article if possible.
17. (Optional - 10 extra-credit points). Provide two newspaper articles, one illustrating a fiscal-policy action, and the other illustrating a monetary-policy action. These newspaper articles may be either current or historical. Describe what the policy goal is, and whether you think the policy action is consistent with the goal. Explain your reasoning in one short paragraph for each article.
18. (Optional - 15 extra-credit ponts) In this problem, you will use a simple model to derive the demand for money, and see how this demand varies with the interest rate. (This model is based on research published by William Baumol in 1952, and by Nobel Laureate James Tobin in 1956.)

Suppose that at the beginning of each month, an individual receives a wage payment Y, and spends this amount evenly over the course of the month. She can earn interest at the rate r per month by holding money in Treasury bonds. There is a cost of c per transaction for moving between bonds and money, so if she makes n different cash conversions per month from her bond holdings, she incurs total transaction costs of nc per month.

The individual wishes to minimize her cost of money management during the month. Those costs consist of the transaction costs nc, plus the opportunity cost of interest that could be earned by her money if she had left it in bonds. If M is the average holdings of cash during the month, then the foregone interest payments (opportunity cost of holding money) are rM. Our goal is to derive a formula for M in terms of the monthly salary Y, the interest rate r, and the transaction cost c.
1. Suppose that each time the individual makes a transaction, she transfers X dollars from bonds into money. Suppose she makes n equal-sized withdrawals from bonds over the course of each month. Use this fact to write down a formula for X as a function of the variables Y and n.
2. Now we wish to relate the average cash balance M to the number of transactions n. Recall that we assume that expenditures Y get spent evenly over the course of the month, so a graph of cash holdings versus time would start out at the amount X, and decline in a straight line down to zero until the next withdrawal, at which point the cash balance would jump back up to X again. Draw a graph with n=3, and draw a horizontal line indicating the average level M of cash balances. Write down an equation relating M to X, and then use result (a) to relate M to Y and n.
3. Recall that the individual wishes to minimize her total money-management costs. Write down her costs, including both transaction costs and foregone interest costs, as a function of r, Y, c, and n.
4. Although n represents a discrete number of transactions, let's assume for simplicity that it varies continuously, so that we can use calculus to derive the optimal number n* of transactions. Take the derivative of total costs with respect to n in order to derive the optimal value n* as a function of r, Y, and c.
5. Now use your results (b) and (e) to derive the individual's demand for average money balance M. Describe in words how it varies with the interest rate, the monthly salary, and the transaction cost of converting bonds into money.
6. Remember that n is actually a discrete number of transactions. There is one transaction guaranteed at the beginning of each month. Suppose that the individual has Y=\$1,800, and r=0.5% per month. How large would the transaction cost c have to be to discourage the individual from making a second transaction (i.e., discourage her from holding any bonds at all)?