Economics 104: Introduction to Macroeconomics STUDY GUIDE FOR FINAL EXAM Economic Growth-2 1. The late Professor Vernon Ruttan asks the question, “Is war necessary for economic growth?” His answer was Don't forget about the age old question of what type of mass movement occurs when rocks fall freely through the air
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“Yes.” What specifically did he mean by this? • War is not necessary for economic growth. What he means by this is industrial policy is necessary for economic growth. Industrial policy is enacted through the U.S. pentagon. Relevant advances of technology happened in the U.S. pentagon; they were not developed out of the free market. The fundamental technology to have the internet was created though the pentagon. 2. What is industrial policy? What are the main features of industrial policy that have contributed to the strong economic growth performance of some Asian countries such as, initially, Japan, then South Korea and China? • They produce things that people in other countries want to buy, they lend money at cheap rates to companies that can demonstrate the ability to sell things on export money. Actively engaging in the government and not relying on static comparative advantage. Electronic manufacturing, making cars; these are things that people in wealthier countries need and are willing to buy. Unemployment and Inflation 1. Evidence on inflation/unemployment trade-off: Is it accurate to say that there is always a trade-off between unemployment and inflation? Compare evidence on a decade-by decade basis. What do the patterns show? • No in the 50s and 60s there is a trade-off but in the 70s this reverses and there was no longer a tradeoff, the rose concurrently. The relationship is unstable, sometimes it is inverse, sometimes it is direct. 2. Consider the decade of the 1970s. What could explain the relationship between unemployment and inflation that we observe then, relative to the relationship we observe for the 1950s and 1960s? • 3. Consider the 1990s: Then Federal Reserve Chair Alan Greenspan hypothesized that the U.S. workers had become “traumatized.” If Greenspan’s observation is accurate, why might that influence the inflation/unemployment trade-off, both in the 1990s and more generally? • At low unemployment workers acquire more bargaining power. Global Economic Patterns and Global Trade 1. Be clear on where the U.S. stands in the global economy. How big is the U.S. economy as a share of the global economy? How important is the U.S. in terms of population? In terms of addressing climate change? • U.S. in terms of GDP is about 20% of the world’s economy, 5% of the population and, 15% of greenhouse gasses. 2. Rich, poor and middle-income countries: Be clear on some of the major differences between countries in terms of what the average person in each category of country can expect. • Large disparity between countries between average income and life expectancy. Some places might have much lower income per capita, but their average life expectancy might have them living longer. 3. What is the law of comparative advantage? Following the law of comparative advantage, why would any given country seek to specialize in producing one or two products and importing everything else they need, rather than diversifying? • Countries are better off specializing in economic activities in which they are best at and they should import other things from other countries. It leads to higher productivity. 4. If we consider the cases of South Korea and China, is it accurate to say that their successful growth experiences have been tied to the idea of comparative advantage? In this context, be able to distinguish between “static” and “dynamic” comparative advantage. • Static comparative advantage is the proposition that when you take a snapshot in a moment of time it is what a country is good at producing. Snapshot of China in the 1980s they weren’t producing anything. Dynamic approach you look at China, South Korea, and Japan, they are good at producing manufactured goods. China and the U.S. Economy 1. China’s successful growth experience since the early 1980s has been closely tied to its achievements as an exporter, with the United States being the largest single purchaser of Chinese-made products. What have been the main factors behind China’s success in exports? • They are making things that people are willing to buy. They were able to establish capacity in making products that they could sell in bulk for exports. They were able to establish a way to produce a lot, at a low cost. They were able to this because they kept labor costs low. China has also maintained the value of their currency keeping exports low in other countries including the United States. China actively intervenes in currency markets in order to keep their currency’s value low. 2. Be sure to understand the role of exchange rate issues with respect to China and the US, and more generally. How does having a “cheap” currency help a country export? How could China continue to help keep its currency value low? • Cheaper currency allows country to produce goods cheaply and can sell at a low price to other countries. Hey can keep their currency’s value low by selling yuan and using American money to drive down the value of the yuan and drive up the value of the dollar. They buy U.S. government bonds in dollars to drive down the value of the yuan 3. Has the rise of China as an export powerhouse been detrimental in any way to working people in the U.S.? If so, how; and if not, why not? • Yes, global trade in general, specifically with China, has effectively expanded the reserve army of labor meaning that workers bargaining have to deal with companies in the U.S. threatening to move operations to china or to buy from china. Immigration Jobs and Public Services in the U.S. 1. It is a widely held view among some politicians and authors (e.g. Camerota, NY Times) that immigrants in the U.S. labor market hurt job prospects for native U.S. workers. Why might this be the case? On balance, what does the evidence on this issue find? • Expanding reserve army of labor, have more people competing for the same number of jobs. This is true at low wage levels. Evidence does not seem to be the case. 2. It is also a widely held view that immigrants living in the U.S. are absorbing a significant share of the economy’s available public services, without paying a proportional share of taxes to support these services. On balance, what does the evidence on this issue find? • The immigrants are helping all people living on social security pensions. They are paying in their taxes but they are not getting benefits because they are not documented. Fiscal Policy and the U.S. Federal Government Budget 1. Be very clear on key categorical distinctions/definitions. Understanding them is not a matter of mere word games, but of understanding the issues at hand. The key definitions to know are: • Deficits vs. accumulated debto Deficits are flow of how much government borrowed over any time (usually the year); accumulated is added up from deficit and is how much you owe. • Cyclical vs. structural deficits o Cyclical is deficit that results from recession; structural deficits are deficits when the country is not in a recession and is is even growing while they still have deficits. 2. The main justification for cyclical deficits comes from the “functional finance” approach. The overall approach here is not to think of government deficits as necessarily either good or bad, but to ask the question: What function are the deficits serving? Are the deficits being put to good use? • In a recession you want to counteract the recession instead of making people suffer. 3. Two perspectives other than “functional finance” on the governments running fiscal deficits are the doctrine of “sound finance” and the “Ricardian Equivalence” theory. Be clear on what these mean. In both cases, they would argue against the government running deficits. But what are their arguments? In what ways do they differ from the functional finance perspective? • Government should use it budgetary powers for the good by thinking about ways that would stabilize the economy, mainly during recession. When private spending is going down, government spending should go up. Sound finance is when government should balance its budgets except during major wars, you don’t want to build up debts. Is proposition that functional finance approach won’t work on its own terms, when government borrowing goes up, private spending goes down. 4. As a share of U.S. GDP, the federal government’s fiscal deficit reached its highest level since World War II between 2009-12. What is the explanation for deficits at this level? • 1950 through present 2.2 or 2.3 percent of GDP. The deficit got big to counteract the great recession, taxes go down and expenditures for government spending go up. 5. While the fiscal deficit reached an historic high over 2009-12, government interest payments as a share of overall government spending remained historically low. How could this be possible? Why has it happened? • The government interest payments are 1.3% of GDP while government debt to people is about 75%. Low because government borrowed a low amount of money during recession but they also bought at low interest payments. The government borrowed at such low interest rates because the Federal Reserve drove down the federal funds rate to zero. Government bonds rate move at the same rate as the federal funds. Government bonds are risk free. Federal Reserve and U.S. Monetary Policy 1. Be clear on what we are referring to when we talk about “The Fed.” Who are the main decision makers at the Fed? • Open market committee includes five people who are appointed by the president of the united states; they are presidents of the 12 regional banks. 2. The Fed’s mandate is to maximize employment in a manner consistent with price stability. The Fed’s main policy tools are to: 1) lower or raise the Federal Funds interest rate; and 2) lender of last resort policies. Be clear on what both of these policies are and how they differ. • Lowering the Federal Funds rate aims to lower all rates and stimulate business investment while raising the Federal Funds rate aims to raise all rates and slow down a boom that may be excessive. Lender of last resort is an institution, usually a country's central bank, that offers loans to banks or other eligible institutions that are experiencing financial difficulty or are considered highly risky or near collapse. 3. Using the tools available to them, how might it be more difficult for the Fed to maintain control over inflation and unemployment when financial markets are unregulated? • The Fed has control over the movement of the federal funds rate and the lender of last resort bailouts. Unregulated =unusable=more bailouts. Policies over inflation and employment got swamped by the financial crisis. 4. We have gone over how the current monetary policy stance at the Fed has been extraordinary in historical terms, because the Fed held the Federal Funds interest rate at close to zero for nearly 7 1/2 years. The Fed is currently slowing raising the Federal Funds rate, but only very modestly. What is the purpose of this policy? • Leaving the rates low Limits policy options for future, also you can’t push Federal Funds rate below zero, low interest rates hurts small savers, people counting on interest earned on bank deposits and, low interest rates encourages speculation by large-scale financial market participants. 5. What would be reasons for the Fed to be raising the Federal Funds rate now? Is there a relationship between their most recent actions, and their understanding of the concept of the “natural rate of unemployment?”• We are at the full employment now based on the “natural rate of employment” and any reduction in employment will result in a greater increase in inflation. They are raising the Federal Funds Rate to in order to keep employment at its current rate. Financial Collapse, Great Recession, Austerity, Recovery? 1. In 2007 – 09, the U.S. and global economy experienced the most severe financial bubble, collapse, and crisis in 70 years. Be clear on the basic dynamics driving a financial bubble. Why can financial bubbles be self-reinforcing? Why do they collapse? • People choose to buy at a low price and borrow money to do this. This drives up eventually it gets too big and it bursts. It bursts when the ability to service debt is not forthcoming. 2. Two factors have contributed to making this most recent financial bubble and crash bigger than previous ones: 1) rising inequality in the U.S. economy; and 2) Deregulation of U.S. financial markets. How have these factors contributed to the crisis? • Rising inequality contributes to economic instability because it moves more money toward the richer people and they have more money to move around in financial markets. Effective regulations historically help financial market and if they start to deregulate the economy becomes more unstable. 3. How did the government try to get out of the crisis using monetary policy, fiscal policy, lender-of-last-resort and financial regulatory policies? • Monetary policy: Drive down federal funds rate to zero at 5.2% in 2007 and 2009 it was zero. Aggressive expansionary fiscal policy, increase in government deficit from what it had been in 2007 1.7% and by 2009 it was about 10% counter cyclical approach. U.S. treasury bailing out big banks to the tune of $1 billion, the fed bailing out the rest at 30% GDP. Critics say that the policy was too modest. Financial regulatory policy (Dod-Frank): as the economy moves into another expansion we will limit the forces that brought down the economy in 2007/2008.