Instructors Resources

for

Economic Report of the President

Ron Cronovich
University of Nevada, Las Vegas

to accompany

N. Gregory Mankiw

macroeconomics
fifth edition

WORTH PUBLISHERS

Instructors Resources for Economic Report of the President by Ron Cronovich to accompany N. Gregory Mankiw: Macroeconomics, fifth edition

Copyright 2004 by Worth Publishers

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, or otherwise, without the prior written permission of the publisher.

Printed in the United States of America ISBN: 0-7167-8713-X

First printing Text Design: S. B. Alexander

Worth Publishers 41 Madison Avenue New York, NY 10010 www.worthpublishers.com

CONTENTS

To the Instructor Activities for Chapter 1: The Science of Macroeconomics Excel Exercises for Chapter 2: The Data of Macroeconomics Excel Exercises for Chapter 4: Money and Inflation Excel Exercises for Chapter 5: The Open Economy Activities for Chapter 6: Unemployment Activities for Chapters 7 and 8: Economic Growth Excel Exercises for Chapter 9: Introduction to Economic Fluctuations Activities for Chapters 1012: Aggregate Demand and Economic Fluctuations Excel Exercises for Chapter 13: Aggregate Supply Excel Exercises for Chapter 15: Government Debt Activities for Chapter 16: Consumption

v 1 4 5 6 7 10 14 16 19 22 23

iii

TO THE INSTRUCTOR
The Economic Report of the President (ERP) is a rich source of real-world examples and data for the intermediate macroeconomics course. This Instructors Resources provides suggestions for using the ERP, which is bundled with Macroeconomics, fifth edition, by N. Gregory Mankiw. For selected chapters from Macroeconomics, we identify a corresponding reading assignment in ERP, followed by reading comprehension questions and discussion questions. We also include exercises requiring students to look up and perform calculations on relevant data from the statistical tables in the ERPs appendix. Answers to the reading comprehension questions and data exercises and suggested discussion points for each discussion question are provided. Most intermediate macro students have basic Microsoft Excel skills, and so instructors are now requiring (or would consider requiring) their students to use Excel to work with real-world macroeconomic data. The ERP includes a great many statistical tables (also available online in Excel format), so we include several exercises involving the use of Excel to prepare graphs of the ERP data (see instructions on p. vi). Students are also asked to discuss the connection between the behavior of the data they have graphed and the implications of the models they are learning from the text. This Instructors Resources is also available in Microsoft Word and PDF format, so you can easily create handouts or answer keys for your students or copy any of the included graphs into PowerPoint presentations for use in your teaching. It can be downloaded from http://bcs.worthpublishers.com/mankiw5/. If you are registered, simply enter your username and password to access the instructors side of the Web site. If you are not registered, please click Instructor on the left-hand column to do so and gain access. If you encounter any problems, please contact Worth Publishers technical support department at techsupport@bfwpub.com or 800-936-6899. We hope you find the ERP and this manual to be a positive addition to your intermediate macroeconomics course.

Ron Cronovich November 2003

Instructions for Exercises Requiring the Use of Microsoft Excel

For Chapters 2, 4, 5, 9, 13, and 15 of Mankiws Macroeconomics, we provide exercises that require the use or Excel or other spreadsheet software to work with data provided in the ERPs Appendix B. The ERP tables are available in Excel files at http://w3.access.gpo.gov/usbudget/fy2004/erp.html Some points that may be helpful when using Excel to work with these files: These files contain the year as a text string rather than a number. If you wish to create a time series graph with the year measured on the horizontal axis, you may have to convert the year data to numerical values. When graphing two variables with different units of measurement (e.g., GDP measured in trillions and the inflation rate measured in percent per year), measure one of the variables on the secondary Y axis. To do this, double-click on one of the data series, choose Format Data Series . . . , then click the Axis tab, then click Plot series on Secondary axis.

vi

TO THE INSTRUCTOR

ACTIVITIES for Economic Report of the President

CHAPTER 1 THE SCIENCE OF MACROECONOMICS

READING ASSIGNMENT: the ERPs Overview, pp. 1525

READING COMPREHENSION 1. Describe the behavior of output during the contraction of 2001, and in 2002. ANSWER: Output fell by 0.6 percent during the contraction and then grow at an annual rate of 3.4 percent during the first three quarters of 2002 (p. 16). 2. How does the ERP define corporate governance? What are the three core principles of corporate governance? ANSWER: Corporate governance is the system of checks and balances that serves to align the decisions of corporate managers with the desire of shareholders to maximize the value of their investments (p. 17). The three core principles are: accuracy and accessibility of information, accountability of management, and independence of external auditors (p. 18). 3. How did the number of people employed change from the beginning to the end of 2002? ANSWER: Employment fell by 181,000 from December 2001 to December 2002 (p.19) 4. What is meant by the double taxation of corporate income? What is the effect of this double taxation? ANSWER: Corporations pay taxes on income they earn. This income is taxed a second time when shareholders receive it in the form of dividends. This double taxation distorts corporate finance decisions, reduces the after-tax return to investment, and therefore reduces capital accumulation. This slows the growth of worker productivity and real wages (p. 22).

CHAPTER 1

THE SCIENCE OF MACROECONOMICS

DISCUSSION QUESTIONS 1. What do macroeconomists study? List as many examples from the ERPs Overview as you can. DISCUSSION POINTS: This question is meant to tie content from the ERP with text section 1-1 (What Macroeconomists Study). The potential list of examples could be quite long. For instance, students might include any of the following: the economys total output; the components of demand (consumption, investment, government purchases, net exports); the capital stock (the value of the countrys stock of productive assets); the growth rate of productivity (output per worker); employment, unemployment, and job creation; the Federal Reserves monetary/ interest rate policies; tax cuts and how they support economic activity; the current account (i.e., trade) deficit; inflows of foreign capital; corporate governance; government policies to promote employment; regulation; tax policy; the relation of domestic and foreign economic growth. 2. The first statistic mentioned in the ERPs Overview is the recent behavior of the U.S. economys total output of goods and services. The first data graph in text Chapter 1 shows data on output per person. Why do you think the behavior of output is of such central importance? In what ways might the behavior of aggregate output affect you, your parents, businessmen and woman and workers in your community, or other ordinary individuals? DISCUSSION POINTS: Macroeconomics is the study of aggregates, perhaps most important, aggregate output/income. The objective of this question is to get students to see the connection between the behavior of aggregate output and the well-being of ordinary individuals. The behavior of total output affects the ability of new college graduates to get good jobs, the success or failure of small businesses in the community, and the incomes of people in the economy (since total output = sum of everyones income). 3. The ERP is written by economists. What key concepts or principles seem to guide or pervade their thinking and writing about the economy? DISCUSSION POINTS: This question is meant to tie content from the ERP with text section 1-2 (How Economists Think). The following words appear repeatedly in the ERP Overview: dynamism, efficiency, flexibility, incentives, and markets. (The first sentence under Developing Regulation for a Dynamic Economy on p. 20 summarizes it all very nicely.) These words are key concepts in economics. If time permits, you might ask students what each term means and why it is important in economics.

CHAPTER 1

THE SCIENCE OF MACROECONOMICS

DATA EXERCISES 1. To put the recent behavior of output in context, compute the average annual growth rate of output (Real Gross Domestic Product, in Table B-4) from 1959 to 2001. ANSWER: The average annual growth rate of output between 1959 and 2001 was 3.45 percent. 2. In how many years from 1959 to 2000 was the growth rate lower than in 2001? Please specify which years. ANSWER: Six years: 1970, 1974, 1975, 1980, 1982, 1991.

CHAPTER 1

THE SCIENCE OF MACROECONOMICS

EXCEL EXERCISES for Economic Report of the President

CHAPTER 2 THE DATA OF MACROECONOMICS

1. Use the data in Table B-2 and B-42 to create a replica of Figure 2-5 on p.36 of the text. (You may omit the year-labels that appear next to some of the data points in Figure 2-5.)

Three measures of Velocity, 1960-2001

10.0 9.0 8.0

Velocity (PY/M)

7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 1960 1965 1970 1975 1980 1985 1990 1995 2000

V (PY/M1)

V (PY/M2)

V (PY/M3)

CHAPTER 2

THE DATA OF MACROECONOMICS

EXCEL EXERCISES for Economic Report of the President

CHAPTER 4 MONEY AND INFLATION

1. What does the Quantity Theory of Money assume about the behavior of velocity? Solve the quantity equation for velocity (the income version of velocity, not the transactions version). Use your result, and the data in Tables B-1 and B-69 to create a time series chart of three measures of velocity: one using M1, one using M2, and one using M3. Which of these three monetary aggregates would be most appropriate to use with the Quantity Theory of Money? Explain. ANSWER: The quantity theory of money assumes that velocity is constant. In the graph below, its easy to see that M1 velocity is not constant, so it would not be appropriate to use M1 with the Quantity Theory. M3 velocity has a slight downward trend, but is much more stable than M1 velocity. M2 velocity appears to be the most stable of the three measures, so M2 is probably the most appropriate choice of the three monetary aggregates for use with the quantity theory of money.

Three Measures of Velocity, 19602001

10.0 9.0 8.0

Velocity (PY/M)

7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 1960 1965 1970 1975 1980 1985 1990 1995 2000

V (PY/M1)

V (PY/M2)

V (PY/M3)

CHAPTER 4

MONEY AND INFLATION

EXCEL EXERCISES for Economic Report of the President

CHAPTER 5 THE OPEN ECONOMY

1. Prepare a scatter chart measuring net exports as a percentage of GDP on the horizontal axis, and the trade-weighted real exchange rate (Broad index) on the vertical axis. The latter series can be found in Table B-110 for years 1982 through 2002. Adjust the scale of the vertical axis so it just encompasses the range of values of the exchange rate series. Finally, right-click on any data point on the chart and choose Add Trendline to add a linear trendline. Which graph or curve from Chapter 5 is represented by your trendline? How do you explain points off the line? ANSWER: See graph below. The trendline is most similar to the NX curve from Figure 5-7 on p. 130. Each point is for a different year. If the true NX curve was shifting around over time, then most points would be off the trendline. Hence, the trendline represents the average position of the NX curve during the 20 year period covered by the data.

U.S. Net Exports and the Real Exchange Rate, 19822001

125 120 115 110 105 100 95 90 85 -4.0% Trade-weighted real exchange rate

-3.0%

-2.0% NX (as a % of GDP)

-1.0%

0.0%

CHAPTER 5

THE OPEN ECONOMY

ACTIVITIES for Economic Report of the President

CHAPTER 6 UNEMPLOYMENT

READING ASSIGNMENT: Chapter 3 of the ERP, pp.109134

READING COMPREHENSION 1. According to data cited in the ERP, how long are people typically unemployed? What does this data imply about the job finding rate (denoted f in text Chapter 6)? ANSWER: On page 121, the ERP notes that the median duration of unemployment is 8.2 weeks in the year after a recession and 6.6 weeks otherwise. These numbers imply that the normal (nonrecession) job finding rate is about 0.15 (in the typical week, about 15% of unemployed workers will find jobs); in recessions, the rate falls to about 0.12. 2. What data does the ERP cite regarding the relationship between education and wages? What about the relationship between education and unemployment? ANSWER: The return on each additional year of education is 6 to 10 percent higher wages. The median earnings of adults with bachelors degrees in 2002 was $944 per week, compared to $545 for adults with only a high school diploma. The unemployment rate for the former group was 3.0 percent; for the latter group, it was 5.1 percent (ERP p. 133). 3. What evidence does the ERP cite regarding the effects of unemployment insurance (UI) on unemployment? ANSWER: In one study, 40 percent of unemployed workers not receiving UI became employed again within 4 weeks of job loss; only 35 percent of unemployed workers receiving UI were employed after 4 weeks. In another study, the duration of unemployment increases one day for each additional week of UI eligibility. In Europe, UI is more generous, and unemployment periods last longer than in the United States. In addition, research shows that the probability of unemployed workers receiving UI returning to employment increases when benefits are about to expire, but the probability of finding a job does not increase at the same point among unemployed workers not receiving UI benefits (ERP p. 122). UNEMPLOYMENT 7

CHAPTER 6

DISCUSSION QUESTIONS 1. The ERP discusses unemployment insurance (UI), the Earned Income Tax Credit (EITC), and President Bushs proposed Personal Reemployment Accounts. Compare the merits of these three policies. DISCUSSION POINTS: The ERP stresses the employment disincentives of unemployment insurance, as does the Mankiw text. However, while the text conjectures that UI might result in better matches between jobs and workers, the ERP cites evidence (pp. 123, 126) that the extra search time afforded by UI has not lead to better jobs for the workers that enjoyed this extra time. The EITC subsidizes the wages of low-income workers, which increases their incentive to work and likely reduces unemployment among this group of workers. (That the EITC imposes a high marginal tax rate in the income range in which it is phased out would affect only the marginal work effort of the employed; it would not affect unemployment.) The Personal Reemployment Accounts (PRA) program is designed specifically to reduce the disincentive to work caused by UI. 2. Is most unemployment short-term or long-term? Why is this an important question? DISCUSSION POINTS: According to data cited in the ERP and the text, most periods of unemployment are fairly short in duration, but most unemployment is accounted for by a small number of long-term unemployed persons. This question is important because its answer will help determine which policies are likely to be most effective in reducing unemployment. 3. The ERP states labor markets work best when they are fluid and flexible (p. 113). What does this mean? Can you think of examples of policies or institutions that inhibit the fluidity or flexibility of labor markets? DISCUSSION POINTS: The ERP describes fluid and flexible labor markets as those in which workers and employers can change their mutually agreed-upon working arrangements as they see fit, to meet changing needs. Workers can change jobs easily when better opportunities become available at other firms, and firms can hire or let go of (lay off or fire) workers easily as economic conditions change. Wage rigidities such as the minimum wage inhibit labor markets from functioning efficiently, as do policies such as unemployment insurance, which prolong the job search for the unemployed.

CHAPTER 6

UNEMPLOYMENT

DATA EXERCISES 1. The ERP also says A vibrant economy created over 40 million new jobs between 1980 and 2002. In the Appendix tables, find the data that support that assertion. Then, break down that job creation by U.S. president: That is, find the number of jobs created under Ronald Reagan, George H. W. Bush , Bill Clinton, and George W. Bush. Finally, compare job creation under Reagan with that under Clinton. If youre a Democrat, how do you use these numbers? What if youre a Republican? ANSWER: Table B-36 on p.320 shows that civilian employment increased by 35 million. If the ERPs statement is correct, then noncivilian employment must have increased by 5 million. In any case, the rest of this exercise uses the following data, from Table B-36: Year 1980 1988 1992 2000 2002 Employment (in 1000s) 99,303 114,968 118,492 135,208 134,269 President Reagan G. H. W. Bush Clinton G. W. Bush Total Job Job Creation per Creation (1000s) Year (1000s) 15,665 3,524 16,716 939 1958 881 2090 470

If youre a Democrat, you note that the economy created more jobs per year on average under Clinton than under Reagan. If youre a Republican, you compare not the absolute number of jobs created but the number relative to total employment. Job creation relative to total employment was slightly higher under Reagan (0.0197 = 1,958/99,303) than under Clinton (0.0176 = 2,090/118,492). 2. Sectoral shifts over the short run contribute to the natural rate of unemployment. Identifying sectoral shifts, though, is easier over the long run and across broadly defined industries, such as those in Table B-46 of the ERP. Use these data to compute the share of total non-agricultural employment accounted for by durables manufacturing and by the services sub-category of service-producing industries for the years 1960, 1970, 1980, 1990, and 2000. What shift do these data show? ANSWER: Year 1960 1970 1980 1990 2000 Employment Share of Durables Manufacturing 13.6% 11.6 9.0 7.3 5.6 Employment Share of Services 13.6% 16.3 19.8 25.5 30.7

The data show a pronounced shift from the manufacturing sector to the service sector.
CHAPTER 6

UNEMPLOYMENT

ACTIVITIES for Economic Report of the President

CHAPTERS 7 AND 8 ECONOMIC GROWTH

READING ASSIGNMENT: Chapter 6 of the ERP, pp.213255 READING COMPREHENSION 1. Name a region of the world that has enjoyed faster-than-average growth between 1980 and 2000. Name a region that has experienced slower-than-average growth during this period. ANSWER: The East Asia and Pacific regions have grown faster than average, whereas Latin America and sub-Saharan Africa have grown slower than average. (p.216) 2. What percentage of the worlds population lives below the $1/day poverty line, according to the World Bank? ANSWER: 20% (p. 222) 3. How does geography affect growth? ANSWER: Landlocked countries have lower growth rates because of the higher cost of transporting goods to and from overseas markets. Tropical countries have health issues, such as malaria, that significantly affect productivity and incomes. Geography also affects a countrys resource endowments and the frequency of natural disasters such as hurricanes (p. 224). 4. Does the Bush administration prefer loans or outright gifts of aid to developing countries? Why? ANSWER: The administration aims to help poor countries make productive investments without saddling them with ever-larger debt burdens (p. 254). The ERP briefly notes the difficulties that arise when countries default on their debts; grants eliminate the possibility of default because they are given without expectation of repayment.

10

CHAPTERS 7 AND 8

ECONOMIC GROWTH

DISCUSSION QUESTIONS 1. What does the ERP mean by the rule of law? Why is it important for growth? What variable or parameter in the Solow model do you think would be affected by the strength of a countrys rule of law? DISCUSSION POINTS: The rule of law is a state in which property rights are protected, dispute mechanisms exist, and people generally have faith that contracts will be enforced. Weak rule of law discourages investment (both by domestic and foreign residents), because it increases risk/uncertainty and therefore reduces the parameter s (the rate of saving and investment) in the Solow model (see p. 236 of the ERP for a more detailed discussion). 2. How might education affect growth? How might growth affect education? Under what circumstances might education fail to significantly increase growth? DISCUSSION POINTS: Education affects growth, because a worker with more education is more productive, earns a higher income, and generates a greater marginal product for his or her employer. In the Solow model (with technological progress), an increase in the average workers level of education could be represented by an increase in the efficiency of labor (the variable E). Also, a better-educated population is more likely to elect competent leaders and hold them accountable. Growth affects education, because growing incomes make education more affordable and less of a luxury. Also, expected future growth increases the expected return to education and therefore encourages people to acquire more education. Education might not promote growth if educated workers are not getting jobs that allow them to use their skills to achieve to greater productivity. This is most likely to occur in countries with corruption, excessive regulation, a large share of state-owned enterprises, and other such inefficiencies (see ERP p. 240 for a more detailed discussion). 3. Chapter 8 of the text states: As a matter of accounting, international differences in income per person can be attributed to either (1) differences in the factors of production or (2) differences in the efficiency with which economies use their factors of production (p. 221). According to the ERP, the three factors important for growth are openness, the protection of property rights, and macroeconomic stability. For each factor, discuss whether it affects growth through factor accumulation or production efficiency. DISCUSSION POINTS: openness: factor accumulation (inflows of foreign capital finance investment) and production efficiency (specialization according to comparative advantage).

CHAPTERS 7 AND 8

ECONOMIC GROWTH

11

protection of property rights: factor accumulation (by affecting the incentive to invest) and possibly production efficiency. macroeconomic stability: probably both factor accumulation and production efficiency. High inflation creates uncertainty and discourages investment, which affects growth through the factor accumulation channel. Also, recall from Chapter 4 of the textbook that high inflation creates relative price variability (because firms dont all raise prices at the same time), which distorts the allocation of resources.

4. Describe the Bush administrations proposed Millennium Challenge Account (MCA) program. What is its objective? How does it aim to achieve this objective? Do you think it would work? DISCUSSION POINTS: The MCA proposal is designed to promote growth among poor countries by providing grants to countries that demonstrate measurable progress in creating the circumstances in which growth can flourish on its own. The policymakers that designed the MCA clearly had in mind the principle that people respond to incentives. The prospect of MCA grants creates an incentive for poor countries to design and implement meaningful reforms. One pitfall, though, is that some poor countries have corrupt leaders, who may find it more personally profitable to continue expropriating their citizens property than to enforce property rights, especially if the funds from an MCA grant would not enhance their own personal wealth. Thus, it might be more effective in such cases to offer corrupt leaders an amount greater than what they can get from abusing their power in exchange for implementing the kinds of reforms that create an environment in which growth can flourish. But just how far are we willing to go with this line of reasoning? Its an interesting topic for student discussion. DATA EXERCISES 1. Compute the average annual U.S. saving rate (gross saving as a percentage of gross national product, Table B-32) in each decade from the 1960s through the 1990s. Is there a trend? Does this trend appear to be continuing into the current decade? ANSWER: The average annual U.S. saving rate by decade: 1960s: 20.9% 1970s: 19.6% 1980s: 18.3% 1990s: 17.1% The trend is clearly downward, by about 1.3 percent per decade. The trend appears to be continuing: The most recent data in Table B-32for the first three quarters of 2002shows a saving rate of 15 to 15.5 percent.

12

CHAPTERS 7 AND 8

ECONOMIC GROWTH

2. By what percentage did U.S. real GDP per capita grow over the periods 19601970, 19701980, 19801990, and 1990-2000? How does the trend compare with the trend in the saving rate you found in question 1? Is this comparison consistent with the predictions of the Solow model? ANSWER: 1960-70: 1970-80: 1980-90: 1990-2000: 32.7% 23.4% 24.7% 21.4%

The trend in growth mirrors that in the saving rate. According to the Solow model, a decrease in the saving rate should cause a decrease in the steady-state level of income but should not affect its growth rate. A possible explanation for the discrepancy between theory and data is that we are not actually measuring the steady state growth rate in this exercise. Another possibility is that the saving rate really does affect the growth rate, as in some endogenous growth models, such as the AK model described in Chapter 8 of the text.

CHAPTERS 7 AND 8

ECONOMIC GROWTH

13

EXCEL EXERCISES for Economic Report of the President

CHAPTER 9 INTRODUCTION TO ECONOMIC FLUCTUATIONS

1. Using the data in Table B-2, create the growth rate of real GDP, consumption, and investment. Create a time series graph of these three growth rates. What do you learn from this graph? ANSWER: See graph below. Investment is more volatile than GDP or consumption. Consumption appears to be approximately as volatile or slightly less volatile than GDP.

Growth Rates of GDP, Consumption, and Investment, 19602001 30% 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% 1960 1965 1970 1975
Y

1980
C

1985
I

1990

1995

2000

14

CHAPTER 9

INTRODUCTION TO ECONOMIC FLUCTUATIONS

2. One of the variables that fluctuates over the business cycle is the unemployment rate. Another is the capacity utilization rate, the percentage of the capital stock that is actually being used in production. What relationship would you expect between the unemployment rate and capacity utilization rate? Prepare a time series chart showing both of these variables. Data on the unemployment rate is in Table B-42 while the capacity utilization rate is from Table B-54 (use the one for manufacturing). ANSWER: One would expect a negative relationship between the unemployment rate and the capacity utilization rate. This relationship is very apparent in the graph below.

Unemployment and Capacity Utilization Rates, 19592001

12

10 8 6 4 2
1959 1964 1969 1974 1979 1984 1989 1994 1999 unemployment rate capacity utilization rate (mfg)

80 70 60 50 40 30

CHAPTER 9

INTRODUCTION TO ECONOMIC FLUCTUATIONS

Capacity utilization (% of capital stock)

Unemployment (% of labor force)

90

15

ACTIVITIES for Economic Report of the President

CHAPTERS 1012 AGGREGATE DEMAND and ECONOMIC FLUCTUATIONS

READING ASSIGNMENT: Chapter 1 of the ERP, pp. 2771 READING COMPREHENSION 1. Which of the four components of aggregate demand played the biggest role in the U.S. economys recovery in 2002? ANSWER: Consumption. Consumption continued to be the prime locomotive for the recovery in 2002, rising at an annual rate of 3.0 percent over the first three quarters of the year (p. 29). 2. How does the ERP explain the growth in the U.S. trade deficit during 2002? ANSWER: U.S. GDP growth, while not spectacular, was higher in 2002 than was GDP growth in most of the countries that buy U.S. exports. As a result, U.S. demand for imports grew faster than foreign demand for U.S. exports (pp. 4546). 3. How would you characterize U.S. fiscal policy in 2002? ANSWER: Expansionary. Page 46 of the ERP notes that real federal government spending rose at an annual rate of 6.4 percent during the first three quarters of 2002, nearly twice as fast as GDP, which rose 3.4 percent (p. 27). In March 2002, the Job Creation and Worker Assistance Act provided tax cuts intended to boost consumption and investment, and expanded eligibility for unemployment insurance benefits. As a result of tax cuts and spending increases, the government budget turned from surplus to deficit.

16

CHAPTERS 1012

AGGREGATE DEMAND and ECONOMIC FLUCTUATIONS

4. According to the ERP, what are the four channels through which a decrease in interest rates stimulates aggregate demand? ANSWER: First, lower interest rates encourage consumption, particularly of bigticket consumer durables such as cars, which are often bought on credit. Second, a fall in interest rates stimulates business fixed investment by lowering the cost of capital. Third, lower interest rates increase the demand for housing, causing an expansion of residential investment. Fourth, a fall in interest rates causes depreciation of the exchange rate: The fall in rates causes financial capital to flow out of the country in search of higher foreign returns, which translates to an increase in the supply of dollars in the foreign exchange market, thus causing the exchange-rate value of the dollar to fall. The depreciation makes U.S. exports cheaper to people in other countries, while making imports more expensive to people in the United States, causing net exports to rise. DISCUSSION QUESTIONS 1. What grade would you give U.S. fiscal policy in 20012002? What about monetary policy? Justify your grades carefully, based on economics, not politics. DISCUSSION POINTS: This, of course, is a highly subjective question. One approach is to base the grade on the economys actual performance. During 2002, GDP grew modestly, inflation and interest rates were low, and productivity growth was healthy, but unemployment remained high and the budget deficit increased sharply. Students grading policy on the basis of economic performance might, therefore, give policymakers a B or C. However, this approach effectively gives to policy all the credit or blame for economic performance, and we know from text Chapters 9 through 13 that other factors (demand and supply shocks) affect inflation, economic growth, and unemployment. So, a second and perhaps fairer approach might be to grade policy on the basis of the extent to which the appropriate policies were implemented. In 2001, monetary policy was aggressive, with the Federal Reserve cutting the Fed Funds rate eleven times. The Fed knows that rate cuts do not affect the economy immediately, so the Fed held monetary policy fairly steady during 2002, allowing the rate cuts of 2001 to continue to stimulate the economy. The timing of fiscal policy measures is more difficult to gauge, due to the long lags associated with the legislative process. However, government spending increases and tax cuts in 2001 and 2002 acted to shift the IS curve to the right, that is, to stimulate the economy in the short run, and reductions in marginal tax rates were aimed at shifting the vertical long-run aggregate supply curve to the right. In this light, fiscal and monetary policymakers probably deserve a fairly high grade.

CHAPTERS 1012

AGGREGATE DEMAND and ECONOMIC FLUCTUATIONS

17

Keep in mind, though, the source of the ERP. Although the ERP appears to be fairly balanced and very well-grounded in mainstream economic theory, it is written by economists appointed by the White House. Thus, one cannot be absolutely certain that the ERPs discussion of fiscal policy is perfectly balanced. 2. Does the stock market affect the macroeconomy, or vice versa? Explain. DISCUSSION POINTS: Both occur. See if your students can think of specific channels through which the stock market affects the macroeconomy, or vice versa. Here are some examples, discussed in more detail in the ERP. If the macroeconomy is doing poorly, firms suffer reduced profits, which causes stock prices to fall. Also, saving usually falls sharply in a recession, which reduces demand for stocks and hence depresses stock prices. If the stock market is doing poorly, consumers feel worse off and generally cut back on expenditures, causing the macroeconomy to suffer. A booming stock market expands household wealth and empowers consumers to spend more. Also, if stock prices are high, then firms can more easily raise funds to finance investment projects. Also, rising stock prices often coincide with falling interest rates, which, again, facilitates increases in investment spending.

18

CHAPTERS 1012

AGGREGATE DEMAND and ECONOMIC FLUCTUATIONS

EXCEL EXERCISES for Economic Report of the President

CHAPTER 13 AGGREGATE SUPPLY

1. Make a scatter-type graph with the U.S. unemployment rate on the horizontal axis and the inflation rate on the vertical axis. You can find the unemployment data in Table B-42, and the inflation rate in B-63. Does your graph show evidence of a tradeoff between unemployment and inflation? ANSWER: See the graph below. The graph shows no evidence of a negative relationship or any systematic relationship.

U.S. Unemployment vs. Inflation, 1960-2002

14 inflation rate (percentage increase in CPI) 12 10 8 6 4 2 0 0 2 4 6 8 10 12 unemployment rate (percent of labor force)

CHAPTER 13

AGGREGATE SUPPLY

19

2. Make a scatter-type graph with cyclical unemployment on the horizontal axis and unanticipated inflation on the vertical axis. Cyclical unemployment in any year equals the actual unemployment rate minus the natural rate of unemployment. The natural rate cannot be specified; a simple way to estimate it is to use the average value of the actual unemployment rate. Unanticipated inflation in any year equals actual inflation that year minus expected inflation. There are no data on expected inflation. However, in the model of adaptive expectations discussed in Chapter 13, the expected inflation rate in any year equals the previous years actual inflation rate. ANSWER: See the graph below.

U.S. Cyclical Unemployment vs. Unanticipated Inflation, 1961-2002

6.0

Unanticipated inflation rate

4.0

2.0

0.0 -3.0 -2.0 -1.0 -2.0 0.0 1.0 2.0 3.0 4.0 5.0

-4.0

-6.0

Cyclical unemployment rate

3. Which of the two graphs you constructed provides the most supportive evidence for the Phillips Curve (PC)? Which of the two graphs is a fairer test of the Phillips Curve model? ANSWER: The second graph provides evidence for the PC, because it shows a negative relationship; the first graph does not. The second graph is also a fairer test of the PC. If the PC equation in Chapter 13 is true, the first graph would show a

20

CHAPTER 13

AGGREGATE SUPPLY

negative relationship only if expected inflation and the natural rate of unemployment remained constant over time. The second graph allows expected inflation and the natural rate to vary. 4. Open your second graph in Excel. Right-click on any of the data points. A little menu will pop up. Select Add Trendline . . . and add a linear trendline. Assuming that the Phillips Curve model is correct, give two reasons that the points are not all on the trendline. ANSWER: First, we used crude estimates of expected inflation and the natural rate of unemployment, which surely introduced some error. Second, the Phillips Curve equation also includes a term for supply shocks, which we have not accounted for here.

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EXCEL EXERCISES for Economic Report of the President

CHAPTER 15 GOVERNMENT DEBT

1. Prepare a time-series graph showing the federal budget surplus/deficit, both in nominal terms and with the inflation correction described on p. 410 of the text. For the inflation rate, use the percentage change in the GDP deflator, provided in ERP Table B-7. The other data are available in ERP Table B-78 (omit the transitional quarter data). ANSWER: The graph below shows that the inflation correction adds significantly to the budget surplus (or reduces the deficit) in all years since the early 1970s.

U.S. Federal Budget Surplus/Deficit, with and without inflation correction

400 300 200

$ billions

100 0 -100 -200 -300 -400 1960 1965 1970 1975 1980 1985 1990 1995 2000

surplus w/o correction

surplus w/ inflation correction

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ACTIVITIES for Economic Report of the President

CHAPTER 16 CONSUMPTION

READING ASSIGNMENT: Chapter 5 of the ERP

READING COMPREHENSION 1. According to the ERP, whats wrong with the current income tax system? ANSWER: It distorts incentives and alters the economys allocation of resources. It involves staggering costs of compliance. It reduces saving and therefore impedes capital accumulation and long-run growth in living standards. And its unfair: Different people with the same income have different tax liabilities. 2. Text Chapter 16 discusses the life-cycle hypothesis and the permanent income hypothesis. Can you find any allusion to these theories in Chapter 5 of the ERP? ANSWER: The first two paragraphs of page 181 of the ERP discuss both theories without mentioning them by name. DISCUSSION QUESTIONS 1. What does tax policy have to do with consumption? DISCUSSION POINTS: Tax policy affects current disposable income, an important variable in most of the consumption functions discussed in Chapter 16. Tax policy also affects the after-tax real interest rate, which is the relative price of current consumption in terms of future consumption.

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2. The ERP discusses the differences between current income and lifetime or permanent income. Should income taxes be based on current income (as they are now) or on permanent income (assuming it could be measured, or, at least, proxied by consumption or other observables)? Discuss the pros and cons of each. What is your position? DISCUSSION POINTS: The ERP asserts that the income tax system should relate a taxpayers tax liability to his or her ability to pay and to his or her well-being (p. 179) and argues that permanent income rather than current income is a better indicator of well-being. This may be true, but for consumers facing liquidity constraints, current income is a better indicator of ability to pay. College students and other young adults are likely to be more sensitive to this issue, as their permanent income is surely far higher than their current income. And what about persons temporarily unemployed during a recession? The taxation of current income is an automatic stabilizer that helps cushion the blow of negative transitory income shocks. If the government taxed permanent rather than current income, a temporary loss of current income would have little to no effect on a persons current tax liability, which could be a huge problem for individuals who cannot borrow freely out of their future income. 3. One of the tax reform ideas discussed in the ERP involves replacing the current system of taxing income with a consumption tax. In which of the various consumption theories from Chapter 16 would it make the most sense to model the switch to a consumption tax? How would you model it? What effects would it have in other models youve learned in this course? DISCUSSION POINTS: The objective of replacing the income tax with a consumption tax is to increase the incentive to save. The consumption theories best suited for modeling this are the forward-looking theories in which rational consumers choose the optimal amount to save for future consumption, namely the theories of Irving Fisher, Franco Modigliani, Milton Freidman, and Robert Hall. In Fishers theory of intertemporal choice, the switch to a consumption tax would make the budget line steeper, as it would raise the after-tax real interest rate. As long as the substitution effect is greater than the income effect for the average consumer, current saving would rise and current consumption would fall. The theories of Modigliani, Freidman, and Hall are just variations on Fishers model and would generate similar results. For example, in Modiglianis life-cycle model, the higher after-tax interest rate would reduce the height of the consumption path, increasing the gap between consumption and income, and causing wealth to accumulate more quickly until retirement (see Figure 16-12 on text p. 450).

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David Laibsons model is probably not an appropriate framework for analyzing the shift from an income tax to a consumption tax for two reasons. First, it is not really a formal model of consumption. Second, in his view, the consumer is less than perfectly rational. You might think it would be easy to use the simple Keynesian consumption function to model tax reform. If the tax reform really does reduce consumption and increase saving, then one might model this as a downward shift of the Keynesian consumption function, resulting in higher saving at each value of income. However, the Keynesian consumption function does not allow consumers to be forward-looking or to alter their consumption in response to changes in the (after-tax) interest rate. If your students are proficient in algebra, you might consider having them compare the slope and intercept of a linear Keynesian consumption function under a simple linear income tax to the slope and intercept of the same consumption function under a simple linear consumption tax. For reasonable parameter values, the consumption function has a lower intercept but a higher slope under the consumption tax than under the income tax! Moreover, at incomes higher than the point at which the two consumption functions cross, saving is lower under the consumption tax than under the income tax. This is not a case of the income effect exceeding the substitution effect. It is a case of asking a model to do more than it was intended to do. The question about the effects of the tax reform in the various macroeconomy models is equivalent to asking students to compare the effects of an exogenous increase in saving in the different models. In the IS-LM model (Chapter 10), the tax reform would represent a negative IS shock, so the Central Bank should consider easing monetary policy to prevent a (temporary) fall in output and employment. In the loanable funds model (Chapter 3), the saving or loanable funds supply curve would shift to the right, reducing interest rates and increasing investment. In the Solow model (Chapter 7), the saving rate would rise, leading to faster growth until the economy reached a new steady state with a higher standard of living. In the long-run open economy model (Chapter 5), the increase in saving would cause an increase in net capital outflows, a decrease in the exchange rate, and an increase in net exports (or, equivalently, a decrease in the trade deficit). 4. Do you think the tax system should be used to achieve social objectives? What are the costs and benefits of doing so? DISCUSSION POINTS: This is getting a bit off the topic of Chapter 16, but its a good topic for economics majors to think about, and it will certainly give rise to lively discussion. First, some examples of using tax policy for social objectives: The tobacco tax is intended in part to reduce teen smoking (as teen demand for tobacco is more price elastic than adult demand); the gas tax might be raised to encourage people to buy smaller cars, live closer to work, reduce congestion, conserve gas, and produce fewer greenhouse gases; the tax deduction for mortgage interest encourages home ownership.
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The benefits of using tax policy to achieve social objectives: People respond to incentives, and the tax system can increase the incentive for people to behave in socially desirable ways (e.g., buy a gas-electric hybrid car in exchange for tax credits) and can reduce the incentive for socially undesirable behavior (e.g., smoke and drink less or not at all to avoid taxes on tobacco and alcohol). If your students have had a microeconomics course recently, they might express this idea in terms of taxing activities that have negative externalities, and subsidizing those with positive externalities. The costs of using tax policy to achieve social objectives: It makes the tax system more complicated and less fair, because it results in differences in the tax liability of individuals in the same income group. It can also distort the allocation of resources and cause people to expend effort and money to devise strategies to reduce their tax liability. If you distrust politicians, you might worry that politicians would create politically-motivated tax breaks for certain groups of individuals or businesses. Completely disallowing the use of tax policy for social objectives would significantly reduce the power of special interest groups to affect policy and the allocation of resources. Finally, the existence of deductions for various activities reduces the tax base, requiring a higher tax rate to raise a given level of revenue. DATA EXERCISE 1. Using data from Table B-1, compute the average propensity to consume in the years 1960, 1970, 1980, and 1990. Does the APC appear roughly constant over time, or does there seem to be a trend? ANSWER: The APC equals 0.63 in 1960, 0.624 in 1970, 0.631 in 1980, 0.66 in 1990, and 0.68 in 2000. The APC remained roughly constant until about 1980, when it began an upward trend.

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