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MGEB05H3 Study Guide - Midterm Guide: Government Budget Balance, Factors Of Production, Opportunity Cost

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kka
24 Oct 2020
School
UTSC
Department
Economics for Management Studies
Course
MGEB05H3
Professor
iris au

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Document Summary

Investment (i) assumption: the return on investment is predetermined. It comes from firms and households (when purchasing new houses). I = i(r), where r = real interest rate. I = i0 d r, where i0 = autonomous investment d = sensitivity of investment to changes in r. Investment is inversely related to the real interest rate. (cid:15482) real interest rate, r, represents the opportunity cost of undertaking investment. Although there are differences in measuring inflation rate by using the. Gdp deflator and the cpi, these two measures of inflation generally move together. It classifies the adult population (age 15 or above) into 3 groups: employed: those who get a paid job. 2) unemployed: those who currently do not have a job but are looking for one or are waiting to start a new one. 3) not in the labour force: those who do not have a job and are not looking for one.

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Related Questions

Finance and Monetary Policy: Use our standard Keynesian macroeconomic model:

Y = E = C + I + NX + G: GDP equals the sum of consumption, investment, net exports, and government purchases.

C = c0 + cy x Y: consumption equals the consumer-confidence term plus the mpc times GDP or income

I = I0 - Ir x r: Business investment spending equals the business animal-spirits term minus the interest sensitivity of investment times the long-run real risky interest rate.


μ = 1/(1 - cy): The multiplier is the inverse of one minus the mic.


Y = μ(c0 + I0 + NX) - (μ Ir) x r + μG: Our summing-up equation, telling us how the level of annual GDP depends on the multiplier μ, on the private spending flows c0 + I0 + NX, on the interest-sensitivity parameter Ir, on the interest rate r, and on government purchases G

 

a) Suppose that the short-term safe nominal interest rate on government securities the Federal Reserve controls, i = 5%, the expected inflation rate = 2.5%, the term premium = -1%, and the risk premium = 3%. What is the real risky interest rate r at which banks lend to companies the rate that matters for investment spending?

b) Suppose that the expected inflation rate stays the same, but a financial crisis causes the risk premium to spike from 3% to 8%. What happens to the long-term risky real interest rate r if the term premium and the short-term safe interest rate on government securities 'i' remain constant?

c) Suppose that for each one-percentage-point the Federal Reserve reduces the interest rate it controls 'i', the term premium moves by 1/2 percentage point in the opposite direction. What happens to the long-term risky real interest rate r if the risk premium spikes from 3% to 8% and the Federal Reserve responds by lowering the short-term safe nominal interest rate 'i' it controls by as much as possible?

d) Suppose that the interest sensitivity of investment 'Ir' is $0.2T that a 1% point change in r moves annual investment spending I by $0.2T in the opposite direction. By how much downward pressure would the shift from the situation in (a) to the situation in (c) have put on investment spending?

e) With a multiplier μ of 3, and holding other things constant, how much downward pressure on annual GDP Y would have been generated by the downward pressure on investment spending in (d)?

f) Suppose that the Federal Reserve had kept the 'i' it controls the same. How much downward pressure would the financial crisis and its interest rate spike have put on annual GDP Y?

g) Suppose the Federal Reserve took active, aggressive, and successful policy steps to convince people that it would keep the interest rate 'i' it controlled at zero for a long time into the future, and so had nailed the term premium to the value of 0. What would your answer to (f) have
been?

Monetary Policy and Inflation: Use our standard Keynesian macroeconomic model:

• Y = E = C + I + NX + G — GDP equals the sum of consumption, investment, net exports, and government purchases
• C = c0 + cy x Y — consumption equals the consumer-confidence term plus the mpc times GDP or income
• I = I0 - Ir x r — business investment spending equals the business animal-spirits term minus the interest sensitivity of investment times the long-run real risky interest rate
• μ = 1/(1 - cy) — the multiplier is the inverse of one minus the mic
• Y = μ(c0 + I0 + NX) - (μ Ir) x r + μG — our summing-up equation, telling us how the level of annual GDP depends on the multiplier μ, on the private spending flows c0 + I0 + NX, on the
interest-sensitivity parameter Ir, on the interest rate r, and on government purchases G


For this problem, assume a value of the Keynesian multiplier of μ = 2, and with Ir, the sensitivity of investment spending I to the interest rate r, such that Ir = $0.15T. And let’s use the Greek letter Δ—capital delta—as a shorthand symbol for changes from the previous equilibrium situation.


The Federal Reserve controls the short-term safe interest rate on government securities—it can nail that value to whatever it wants by buying and selling bonds for cash. We call this interest rate i. But the interest rate that matters for determining investment spending is the long-term real risky interest rate at which banks lend to companies. We call this interest rate r.


a) Suppose that the interest rate r that matters for investment spending falls by 1.5%-pts:
Δr = -1.5
By how much would you expect investment spending to fall given the parameter values of our model? How large is ΔI?

b) Continue your analysis from (a): given the parameter values of our model and the boosting of investment spending you calculated in (a), by how much would you expect GDP Y to grow?


c) Annual real GDP in the mid-2000s was about $15T. How large is this boost to GDP ΔY you calculated in (b) as a percentage of the then-level of real GDP?


d) On average, a 1% extra boost to GDP is associated with a 1.5% extra decrease in the unemployment rate. By how much extra would you expect the unemployment rate to fall as a
result of the boost to GDP you calculated in (b) and (c)?


e) Suppose that with the interest rate decline the unemployment rate falls from 6% to 4.5%. What would the unemployment rate have been without this interest-rate decline?

f) Suppose that real GDP had been lower for each of three years by the amount you calculated in (b). How much poorer would Americans have been in terms of reduced income over those three years had the interest rate r not fallen?


g) In an America with about 135 million workers, how much is this lost income per worker?

2. Assume that households’ consumption function is given by C(Y − T) = 50 + 0.75(Y − T), that firms’ investment function is I(r) = 150 − 10r, government spending is G = 150, and the tax bill T = 200.

(a) What is the Marginal Propensity to Consume (“MPC”)?

(b) What is the equilibrium level of real GDP, in the goods market, if the real interest rate is 5%? (Plug in r = 5 for 5%, rather than 0.05 This is an assumption about the way we scale the coefficients in the investment function.)

(c) Solve for the equation of the IS Curve (“Investment-Savings”). How will this equation change if government spending increases to 200? The money supply is MS = 3000 and the price level is P = 4. Money/liquidity demand is given by Md/P = L(r, Y ) = Y − 50r.

(d) Solve for the equation of the LM Curve (“Liquidity-Money”).

(e) Based on your answers to the previous two questions, what are the equilibrium levels of the real interest rate and real GDP? (G is back to 150.)

(f) Assume now that P is unknown. Solve for the equation of the Aggregate Demand curve (“AD”)