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You win $100 in a basketball pool. You have a choice

Principles of Microeconomics | 7th Edition | ISBN: 9781285165905 | Authors: N Gregory Mankiw ISBN: 9781285165905 94

Solution for problem 4 Chapter 1

Principles of Microeconomics | 7th Edition

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Principles of Microeconomics | 7th Edition | ISBN: 9781285165905 | Authors: N Gregory Mankiw

Principles of Microeconomics | 7th Edition

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Problem 4

You win $100 in a basketball pool. You have a choice between spending the money now and putting it away for a year in a bank account that pays 5 percent interest. What is the opportunity cost of spending the $100 now?

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The Roaring Twenties (Chapter 22) I. Introduction A. A Brief Overview  1920s decade is generally considered to have been a period of growth & prosperity: o Real GNP Growth Rate (1920­29) = 4.2 % per year (on average) o Real GNP Per Capita Growth Rate (1920­29) = 2.7 % per year (on average)  However, the decade started and ended with significant recessions: o Short, but intense recession of 1920­21 o Crash of 1929 & The Great Depression B. While economists disagree on causes of Great Depression, the 1920s may hold clues to understanding the 1930s. As you study the 1920s, look for signs of underlying “structural weaknesses” that may help explain the Great Depression. C. Recall (from Econ 2105):  Aggregate Demand (at a given price level) = Aggregate Expenditures AE = C + I + G + (EX ­ IM) Net Exports Newly constructed homes are categorized in Investment, and not Consumption  3 “traditional” monetary policy tools of the Federal Reserve (Consider how each policy tool affects the monetary base and bank reserves.) 1 The Discount Rate: interest rate the Fed charges commercial banks for short­term (“overnight”) loans  If Fed ↓ DR: Lower discount rate incentivizes borrowing Banks feel less conservative about their reserve holding Banks increase outstanding loans When there are more loans, interest rates decrease Money supply increases  increases consumption and investment (aggregate expenditures/demand rise) EXPANSIONARY MONETARY POLICY – used during a recession  If Fed ↑ DR: Banks feel more conservative about their reserves Banks decrease outstanding loans Less loans will drive up interest rates “reverse multiplier effect” money supply decreases  consumption and investment will drop (houses and firms will borrow less) aggregate expenditures/demand will go down CONTRACTIONARY MONETARY POLICY – economy is overheated, concerned about inflation 2 Reserve Requirement: % of liabilities (deposits) that commercial banks are required to hold as reserves  If Fed ↓ RR: Banks have excess reserves  increases loanable funds Banks loan out more money  interest rates decrease Money supply goes up Consumption and investment rise – aggregate expenditures/demand go up EXPANSIONARY MONETARY POLICY – expands money supply (as part of the process) but the FED’s ultimate plan was to expand consumption and investment  If Fed ↑ RR: Banks have shortages of reserves and have to come up with money to make the difference Decrease loans – pushes up interest rates Reverse multiplier effect Decrease money supply  consumption and investment go down – aggregate expenditures/demand go down CONTRACTIONARY MONETARY POLICY – overheated economy, avoid inflation Note: The Fed rarely uses the RR as a policy tool. Why 3 Open Market Operations (OMO): The Fed purchases or sells Treasury bonds MOST COMMON TOOL USED TODAY – not really discovered until the late 1920’s Treasury bond – form of debt issued by the government, purchaser of a bond gives government cash repaid with interest over the life of the bond  If Fed buys bonds: Increase monetary base Increase banks reserves (excess reserves) Increases loanable funds  decreases interest rates M up, C and I rises Aggregate expenditure/demand go up EXPANSIONARY MONETARY POLICY  If Fed sells bonds: decrease monetary base banks reserves go down banks reduce loans  rising interest rates reverse multiplier effect M down, C and I down Aggregate expenditures/demand down CONTRACTIONARY MONTARY POLICY (reduces money supply, but FED’s main goal is to decrease consumption and investment)  Fed Funds Rate: the interest rate that commercial banks charge each other for short­term (“overnight”) loans. The FFR is used by the Fed as a target when conducting OMO. Banks keep their reserves at their district bank FFR – market determined price, but FED can affect the rate (through OMO) Discount rate – FED determined price Current FFR target: 0.25­0.50% FFR target in June 2006: 5.25% II. 1921­22 Depression A. 1919: WWI ends. US economy doing well because:  Continued deficit spending by the federal government Government spending > tax revenues  High European demand for US exports Exports continued to be high for a short time after the war is over – Europe relying heavily on U.S. for products because of war destruction in European countries  Expansion of M by the Federal Reserve Decrease the discount rate  consumption and investment rise Supporting war efforts and enticing spending by firms Did not want war to stifle growth  High post­war domestic demand for consumer goods Consumption increase Emotional exuberance after war is over causes people to spend more because they are in happier times  Thus, AD (and aggregate expenditures) was increased. C+I+G+(Ex­Im) all go up B. By 1920, the scene had changed:  European recovery led to decreased demand for US exports o 1919: $8.6 billion (US exports to Europe) o 1921: $4.6 billion U.S. exports to Europe not needed anymore  Federal government ceased deficit spending o By 1920, $291 million budget surplus Spending less than before Government spending < tax revenues  The Federal Reserve sharply reduced M Jan 1920: ↑DR from 4.75% to Decreased consumption and 6% investment June 1920: ↑DR from 6% to 7%  Thus, AD was decreased. AE = C+IG+(Ex­Im) all go down C. Resulting recession was short, but intense: “V­shaped recession”  Real net national product fell by 4%.  Unemployment rate increased to nearly 10%.  Deflation: wholesale P­level fell by 1/3; CPI fell by over 15% Decrease in AD after 1920, decreases PL and GDP Agregate Supply Aggregate Demand 1919 Aggregate Demand after 1920 NOTE the damaging impact of fiscal and monetary policy on macroeconomy in 1920.  Coordination is important.  Should the Fed have acted differently III. By 1923, US economy had fully recovered: "The Roaring 20s" Characterized by: A. Urban migration: reflects the continuing growth of manufacturing  especially among African­Americans  increase demand for manufacturing labor especially after immigration restrictions of mid­1920’s  By 1920, over 50% of Americans (≈ 54 million) are living in urban areas B. Growth of the “Consumer Culture”  Increased purchases & ownership of consumer durables (goods that last  appliances) (Table 22.1) o 1922­1929: Growth in consumer durables purchases ≈ 8.3% per year electricity allows for more in­home durables (ovens, radios, lighting) o Linked to growing network of dependable electrical power supply o Warning! Consumer durables market is highly correlated with the business cycle. Consumers more inclined to buy new durable goods when economy is strong When economy is doing poorly, consumers will put it off because what they have at the moment is “durable” so it can last a little longer until they feel comfortable buying a new durable o Widespread ownership of automobiles  Ford Model T (video clip): over 15 million produced 1908­1927  1913: Ford introduced mechanized, conveyor­belt assembly line Ford was not the first to use the assembly line, but he was the first to use power­driven line to move parts along as workers are stationary Further specialization and division of labor  Reductions in per­unit cost Taking advantage of economies of scale  Reductions in price 1908: about $850 by mid­1920’s: less than $300  ↑ Government support for (paved) road­building (p. 400)  Automobile ownership linked to suburban growth and increased leisure demand. Increased demand for service stations, hotels, restaurants, etc. o ↑ consumer credit & installment plans: “Buy now, pay later.” Durable Consumer % purchased on Good credit in1925 The good itself provides Radios 75% collateral for the credit Household Appliances 80% Furniture 70% Automobiles 75% o ↑ advertising (radio & print). Ads provided info on:  new products  prices  installment plans advertising stimulated demand for products and further encouraged the growth of consumption C. Construction Boom  Single­family & multi­family homes: Year New Housing Starts Contributed to (includes rental & owner­occupied) 1920 247,000 the growth of 1925 937,000 investment, 1929 509,000 especially in 1920­1925 Homes are not considered  Also growth in construction of commercial buildings & infrastructure  In aggregate, real housing prices rose until about 1925, then began to fall. Most economists believe that the market was saturated by 1925, less demand for the same supply  Home mortgage debt outstanding increased steadily throughout the 1920s (even after 1925). o Typical mortgage:  5­year term with balloon payment at end  Refinancing at end of term was common.  Home buyers accumulated equity very slowly. A lot of payments were only for interest and not the principle, so it took a long time for home owners to pay off the principal o ↑ mortgage debt (& refinancing) was not a big problem as long as incomes & property values were also ↑. If property values start falling  defaults increase AND banks are less willing to refinance A bank may repo property, but they will be obtaining a property that is worth less than it was when they gave out the loan for that property  Some evidence of speculative buying & lax mortgage lending practices.  Note the analogy to more recent problems in housing market, but: o The magnitude of the problem was smaller in 1920s. o the policy response to the recent housing crisis was much more aggressive. D. Continued Growth of Manufacturing & “Big Business”  1919­1929: US industrial production increased by nearly 2/3  1919­1929: Automobile output tripled o Supported growth of steel & other input industries o Also, Ford’s mechanized assembly line was adapted to other types of manufacturing.  High investment in technology and capital o Electricity: By 1920, ≈ 1/3 of US manufacturing power from electricity  more efficient  lower per­unit cost o Older plants replaced/rebuilt  ↑ use of more & better capital ⇒ ↑ labor productivity  Little government regulation of business, especially at federal level: o President Calvin Coolidge (1923­1929; Republican): “After all, the chief business of the American people is business. They are profoundly concerned with buying, selling, investing and prospering in the world.” (January, 1925) Coolidge purposely appointed people to the FTC that would not do much and would turn the other way in many situations o Little enforcement of antitrust laws (p. 402)  Weak, inactive FTC  Continued consolidation and mergers in many industries, including banking, iron/steel, electronics, automobiles, etc. Very pro­business stance by executive and regulatory branches of the federal government o Courts tended to be anti­union and pro­business  Allowed use of injunctions to break up strikes, pickets and boycotts  Upheld firm’s use of “yellow dog contracts” Firms would force employees to sign a contract that says they will not join a union, and if they do, they will be fired E. Good times for (non­farm) labor:  High demand for labor, especially in consumer durables industry The demand for labor is a derived demand. Thus, high demand for products can provide greater bargaining power for workers. Demand for workers stems from demand for products  Low unemployment 1923­1929: o Unemployment rate generally remained at or below 5% o Little or no cyclical unemployment In other words, unemployment was largely limited to frictional and structural components Cyclical employment comes from recession, which the U.S. was not experiencing at this time  Average hours/week fell in some sectors o By 1929: 48­hr week in most jobs, but 44­hr week increasingly common o Note Henry Ford’s introduction of the 40­hour week in 1914 and his use of efficiency wages. (paying more to entice the best workers and have low turnover) Railroads, mining, and other industries  Increases in human capital (training, skills) o ↑HC ⇒ ↑productivity ⇒ ↑wages o The “High School Movement” (Table 22.4)  Enrollment increased  Graduation rate increased  See summary of Goldin & Katz (2008) on p. 408. More people graduating high school, U.S. as a world leader in high school education (publically funded high schools with extracurricular, sports, diverse curriculum, etc.) 1) Rate of return from going to high school was beneficial (income is higher for those that graduate) 2) Communities willing to build and staff high schools to better future generations a. Communities with most social cohesion (strong sense of community) were not in big cities, but rather in rural farming areas (i.e. Nebraska, Iowa, Kansas) b. Chose to tax themselves locally to fund the school  Real per capita earnings increasing o Rose by 23% between 1919 & 1929 o Note that increased earnings were encouraged by:  increased human capital (& increased productivity)  high demand for labor workers outside of farming were doing well  Decreases in Immigration (Table 22.3) o 1921 and 1924 legislation: restricted # of immigrants admitted annually and established quotas by country o These restrictions were generally supported by domestic workers. Why Racism Prejudice against immigrants who were not northern European Concerns that the end of WWI would lead to an influx of immigrants that would adversely impact wages and employment of domestic workers  Union Membership (Table 22.2): Despite the strong U.S. economy, union membership declined. Why Usually union membership grows in a strong economy because unions are able to deliver the desires of workers during a growing economy because there is higher leveraging power and firms need laborers (1) jobs (2) better pay o Anti­union courts Ability to obtain injunctions Yellow dog contracts Made it difficult for unions to organize workers o Strong employer resistance Firms created “Company Unions” to prevent outside unions from organizing workers (internal union that would “represent” workers by a worker who sides more with management – just a façade of a union) o Poor union leadership Failed to aggressively organize mass production labor Unions began as skill unions, so they are not used to factory work o Worker contentment F. The Great Bull Market (p. 415­420): Will be covered in conjunction with Chap 23. IV. Macroeconomic Policy in the 1920s “post war readjustment” period (particularly early 1920’s) A. Faith in markets, limited government intervention & the “self­regulating” economy B. Fiscal Policy: Return to non­wartime environment  Limited G, especially at federal level (Table 22.5) o National defense o Veterans’ benefits This is what government spending o Postal service consisted of at the time o Payments on WWI debt  Reductions in federal taxes (1924, 1926 & 1928), including: o excise taxes (taxes on goods) o estate taxes o corporate income taxes o personal income taxes:  In 1920s, top marginal tax rate was gradually reduced from 77% (for income > $1 million) to 24%.  Recall the difference between the marginal tax rate and the average tax rate in a progressive income tax structure. For most tax payers: o MTR ≠ ATR, and o MTR > ATR MTR=tax rate that applies to the last $ of an individual’s outcome  Andrew Mellon’s (Secretary of Treasury) rationale for tax cuts was similar to “supply­ side” arguments of Reagan administration: ↓ MTR → ↑ tax revenue Reduction in MTR’s provide incentives for people to: 1) Work more  earning from labor are higher 2) Save more  earning from savings are higher  Limited G, especially at federal level (Table 22.5) o National defense o Veterans’ benefits o Postal service o Payments on WWI debt C. Monetary Policy  1922­1929: The Fed oversaw a period of growth & price stability (Table 22.6) Moderate growth in M supported growth in Y without creating inflation. Price level pretty stable (MV=PY) while output grew  However, amidst the growth, hundreds of banks failed each year, reaching a peak of 975 failures in 1926 alone. o The Fed’s position on these bank failures: Generally, the FED did NOT act as lender of last resort. Instead, FED leaders felt the system as a whole would be stronger without these banks (they thought the banks were run poorly, mismanaged, and giving out too risky of loans) o The role of prohibitions on interstate (and often intrastate) branch banking (White, 1984): The vast majority of rural bank loans were to farmers (inherently risky loans) U.S. would not allow interstate branch banking at the time Banks could not diversity their lending portfolio because of restrictions on interstate branch banking, thus, the existing legal institutions prevented efficient banking operations V. The Struggling Agricultural Sector 1920s – farmers comprised about 27% A. 1896­1919: "Golden Era" for US farmers of U.S. labor force, and farm output was about 90% of U.S. GDP  High demand → ↑Prices for agricultural products (including exports)  New & improved machinery Increase in productivity  Biological & chemical innovations  Farmers’ income ↑  Property values ↑ (Farmers’ wealth ↑) land is the biggest asset to farmers  US farmers were encouraged to expand output during WWI o Government price supports for basic crops to prevent prices from falling when supply increased (supply increased to help the war efforts) o Purchases of land & machinery  1915­1922: Farm credit doubled to finance machinery and land to produce more the war efforts 1910: about $3 billion Farmers’ debt 1923: $11 billion B. Following WWI, prices began to fall, especially 1920­21 (recession & deflation)  European demand for US agricultural exports declined → prices fell  Adverse terms of trade (again): prices of agricultural products fell more rapidly that overall price level. Impact on debtors Debtors are repaying loans in dollars of greater purchasing power than dollars borrowed C. By 1925, prices for agricultural products had recovered and stabilized (adverse terms of trade resolved), and farmers’ income grew for remainder of 1920s. However, farmers were distressed. WHY  # of farm foreclosures remained high (data from H.T. Johnson, 1973) Year Farm Foreclosures (per 1000 mortgaged farms) 1918 2.8 1921 6.4 1922 11.2 1923­29 14­17, annually  US farmers had taken on increased debt, especially during WWI. o Land purchased during a period of high prices o Deflation in early 1920s o Plus, farmers faced their traditional problems: Linked to rural bank failures in the 1920’s Falling prices  lessened income for farmers  Income inelastic demand for farm products  Price inelastic demand for farm products D. Agitation for Agricultural Assistance: Please cover p. 495­410 on your own. As you read, consider two questions: 1 What did famers want 2 What did farmers actually get Review carefully:  McNary­Haugen bills & parity pricing (discussed, but never enacted)  Federal Farm Loan Act (1916) & Federal Intermediate Credit Act (1923)  Agricultural Marketing Act (1929)  Smoot­Hawley Tariff (1930) Bottom Line: Government programs to aid farmers are often ineffective because the supply of farm products is very price elastic. Price elasticity of supply = percent change in quantity supplied / percent change in price For farm products: PES >1 When prices go up, quantity supplied goes up even more

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Textbook: Principles of Microeconomics
Edition: 7
Author: N Gregory Mankiw
ISBN: 9781285165905

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You win $100 in a basketball pool. You have a choice