Homework ch 26 ECO 201: Principles of Macroeconomics Due 9/29/05 From Frank and Bernanke: Chapter 25 Questions 3, 4, 5, and 7 3. Generally, producers of durable goods are affected most by recessions while producers of services and nondurables (like food) are affected least. This suggests that the automobile producer would see its profits reduced the most, the janitorial service the least. Boots and shoes are “semi-durable”, since a pair of shoes may last for several years (and people can put off purchases of these for a while if necessary). Thus the boot manufacturer’s losses are likely to fall in between those of the other two firms. 4. The natural unemployment rate is the sum of structural and frictional unemployment and excludes cyclical unemployment. Thus the natural unemployment rate by definition should not be affected by a recession. Also by definition, the cyclical unemployment rate rises in recession. Inflation tends to decline in the period following a recession. 5. Potential output, or potential GDP, is the amount of output the economy can produce when it is using its inputs, such as capital and labor, at normal rates. Because inputs can be used at greater than normal rates for a time (for example, workers can work overtime and machines can be used at night or on weekends), it is possible for the economy to produce an amount exceeding potential output. 7. False. When output equals potential output, the unemployment rate equals the natural unemployment rate. Cyclical unemployment is zero when output equals potential output, but frictional and structural unemployment still exist. Exercises 3 and 5 Notice that in exercise 3 you are asked for the output gap as a percentage of potential GDP, among other things. 3. Year Gap (Y*-Y) Gap as % potential Growth rate of GDP **YYY− 1988 -56 -1.0% (expansionary) --- 1989 -113 -1.9% (expansionary) 3.6% 1990 -70 -1.1% (expansionary) 1.9% 1991 190 3.0% (recessionary) -1.6% 1992 218 3.4% (recessionary) 2.3% 1993 244 3.7% (recessionary) 2.3%You can see that GDP growth slowed in 1990 as the recession began. In 1991 GDP growth was negative and a significant recessionary gap opened up. Growth at close to normal rates resumed in 1992, which is why the trough is assigned to 1991, but the recessionary gap took a while to be eliminated. 5. Y Y* (Y*-Y)/Y* unatural u unatural-u 7840 8000 2.0% 5.0 6 1.0% 8100 8100 0.0% 5 5 0.0% 8282 8200 -1.0% 4.5 4 -0.5% 8415 8250 -2.0% 5 4.0 -1.0% Okun’s Law says that if the unemployment rate is above the natural rate by one percentage point, equilibrium output must be below potential output by two percentage points of potential output. ()*2**uuYYY−=− Conversely, if equilibrium output is above potential output by one percentage point of Y*, unemployment must be below natural unemployment by half a percentage point. ⎟⎠⎞⎜⎝⎛−=−**5.0*YYYuu The difference between natural unemployment and actual unemployment is cyclical unemployment. a. In 2001 real GDP is 2% below potential GDP, so cyclical unemployment is 1%. Since the actual unemployment rate is 6%, the natural rate must be 5%. b. The natural rate equals the actual rate, so cyclical unemployment equals zero and there is no output gap. Thus potential output equals 8100, the same as actual real GDP. c. Cyclical unemployment equals 4% - 4.5% = -0.5%, so by Okun’s Law the output is gap is –1%. If real GDP exceeds potential GDP by 1%, we find that real GDP must equal 8282. d. Real GDP is 2% above potential GDP (the output gap is –2%), so cyclical unemployment is –1%. As the natural unemployment rate is 5%, actual unemployment is 4%. Questions on the History of Economic Thought 1. Name three Classical economists. The three Classical economists I mentioned in the slides are Adam Smith, David Ricardo, and John Stuart Mill. Others are Thomas Malthus and Jean-Baptiste Say. I’m forgetting a large number of important people, but you can learn all about them in History of Economic Thought, usually taught by Dr. Montes.2. When did John Maynard Keynes write his famous book? What important macroeconomic event took place between 1929 and 1939? The famous book is the “General Theory of Employment, Interest, and Money”, written in 1936, although “A Treatise on Money” (1927) is very important as well. “The Economic Consequences of the Peace” was written, I believe, in 1919. But the General Theory is by far the most important book he ever wrote, probably the most important book on macroeconomics ever written. The “event” is the Great Depression. 3. What did Classical Economists believe about a. The relative importance of the short run and the long run? For them, the long run is the only thing that really matters. The short-run sorts itself out. b. Whether the economy is self-correcting or not? The economy was considered to be self-correcting because economic incentives ensured that demand met supply. c. The need for government intervention in the macroeconomy? For them, the government was completely unnecessary beyond basic rule-of-law and security. (This is quite a caricature, though. There’s a debate on whether Smith really believed that the government was unnecessary – he probably wouldn’t have said that. But many of his followers, particularly his modern-day followers, would say so). 4. What did Keynes believe about a. The relative importance of the short run and the long run? Keynes thought the short run was tremendously important, probably the only thing that matters, because “in the long run we are all dead.” b. Whether the economy is self-correcting or not? He thought that the economy was not self-correcting, that there were very few reasons for why economic problems should sort themselves out, and that there were a few forces that were downright destabilizing. c. The need for government intervention in the macroeconomy? His beliefs about the instability of the economy led him to advocate very active government intervention, either in overall planning and control or in counterbalancing the economy’s problems, or both. 5. What is the correct pronunciation of the word “Keynes”? “Canes”. Chapter 26 Questions: 1, 2, 3, 4, 5, and 61.