Unit 17 Answers to exercises principles of economics PDF

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UNIT 17EXERCISE 17 FARMERS IN THE GREAT DEPRESSIONDuring the Great Depression, demand for agricultural output fell. Facedwith falling prices for agricultural output and with high levels of debt,farmers increased production. The response of farmers may have madesense from an individual point of view,...

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EXERCISE ANSWERS UNIT 1

UNIT 17 EXERCISE 17.1 FARMERS IN THE GREAT DEPRESSION During the Great Depression, demand for agricultural output fell. Faced with falling prices for agricultural output and with high levels of debt, farmers increased production. The response of farmers may have made sense from an individual point of view, but collectively it made the situation worse. Using wheat farmers as an example, and assuming that wheat farms are all identical, draw diagrams of an individual pricetaking farm’s cost curves and industry-wide supply and demand to illustrate this situation. Explain your reasoning.

Answer Suppose the situation before the Great Depression was at point A in Figure 1. After the Depression hit the economy, demand fell and the industry reached a new equilibrium at point B, with lower output and prices. Assume that each individual wheat farm was highly profitable in the short-run, hence the average cost (AC) curve was below the marginal revenue (MR1) curve (as shown in Figure 2 for a representative farm we call ‘Firm A’). During the Depression, the price of wheat fell to $200, hence the marginal revenue curve shifted down (MR2). At point A, each farm’s marginal cost exceeds their marginal revenue, so they make a loss on each unit. The response of the farmers was an increase in production, hence the aggregate supply shifted out and the price fell further to $80 (Figure 3). Hence, the MR shifted down further (MR2 to MR3). Notice that each farm is making losses at this point and is driven out of the market (Figure 4).

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Eileen Tipoe UNIVERSITY COLLEGE LONDON

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EXERCISE 17.2 ADVANTAGES AND DISADVANTAGES OF FIXED EXCHANGE RATES In an ‘Economist in action’ video ( http://tinyco.re/6433456), Barry Eichengreen, an economist and economic historian, discusses fixed exchange rate systems such as the gold standard in the Great Depression and the euro system in the aftermath of the financial crisis. 1. According to the video, what are some advantages and disadvantages of fixed exchange rate systems? 2. How can countries that are in these exchange rate systems effectively respond to economic shocks? What are some features of the euro system that make it difficult to respond effectively?

Answer 1. One advantage is exchange rate stability. Exchange rates that vary a lot can create problems for countries by disrupting trade flows, and currency depreciation can cause inflation. A major disadvantage is that fixed exchange rate systems are fragile and cannot cope as well with shocks, especially when one country is hit worse by shock than the others. A pegged exchange rate system limits the monetary policy options—the central bank cannot act as a lender of last resort, depreciate the exchange rate to boost export competitiveness, or cut interest rates, so countries can get stuck in a bad economic situation. Using a historical example, the Gold standard worsened the Great Depression (countries that left the gold standard earlier recovered earlier).

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2. Countries with a pegged exchange rate system need other policy mechanisms to substitute for missing monetary policy. For example, a tax and transfer system, and policies that promote a high level of labour mobility. Unlike other exchange rate systems in the past, the Euro system is a symmetrical system without a centre country. Since all countries in the system use the Euro, it is harder to abandon than earlier systems (under the gold standard, every country had its own currency). Also, there is a low level of labour mobility across EU countries, probably because of language barriers.

EXERCISE 17.3 WORKERS’ BARGAINING POWER In the light of the Great Depression, most advanced economies adopted policies after the Second World War that strengthened the bargaining power of employees and labour unions. By contrast, after the golden age, the policies chosen weakened workers’ bargaining power. 1. Explain the reasons for these contrasting approaches. 2. Discuss the possible role of weaker worker bargaining power in the run-up to the global financial crisis.

Answer 1. Postwar golden age. The diagnosis of the causes of the Great Depression, based on the new economics of Keynes, identified the weakness of aggregate demand as the key. Postwar governments were committed to a policy environment that would prevent the occurrence of a collapse in aggregate demand. Rapid productivity growth during this period encouraged capital accumulation and job creation (the price-setting curve shifted up) and a broad agreement between employers and workers known as the postwar accord meant that until the mid 1960s, a balanced pattern of productivity and real wage growth took place (see Figure 17.12). The strength of unions, supported by legislation, helped workers participate in the productivity growth—reflected in an upward shift of the wage-setting curve. The upward shift in the wage-setting curve also reflected the gains accruing to workers from the development of the welfare state in the postwar years, where governments implemented policies to provide them with more protection from the insecurity of the business cycle. These policies were related to government objectives in terms of social welfare/reducing inequality as well as to ensuring adequate aggregate demand. Stagflation and its aftermath. The golden age was characterized by higher productivity growth and employment (increase in the size of the pie) and also less inequality (brought about by the worker protections embodied in the policies post-Great-Depression and the strength of trade unions). The cumulative effect of this over the years of the golden age made the economies vulnerable to a very different kind of crisis from the Great Depression. This encouraged workers to think that there was little chance of job loss. It strengthened their demands on both employers (compensation) and the government (greater redistribution in terms of e.g. unemployment benefits). The postwar accord collapsed—this can be represented in an upward shift of the wage-setting curve—and occurred following a slowdown in productivity growth (pushing the price-setting curve down). So conflict increased over a pie that was

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not expanding as fast as before (exacerbated by the oil shocks). The result was industrial unrest, large wage increases, and at the macro level, the collapse of the Phillips curve. The deterioration of macroeconomic performance in the years of stagflation explains why a different set of policies from those following the Great Depression was introduced. The new policies (see Section 17.4-6) of supply side reforms sought to push the wage-setting curve down—not by an accord between workers and employers (which only remained in the Nordic economies), but by weakening union bargaining power indirectly by allowing unemployment to remain high for a lengthy period and directly by changing legislation to reduce the power of unions. The cost of job loss was increased by reductions in unemployment benefit and of employment protection.

2. The conditions for the global financial crisis were in part the long-term consequences of the success in shifting the balance of power away from workers. Higher inequality and less employment protection made workers more susceptible to dependence on credit, and aggregate demand in the economy came to rest on consumption and housing booms fuelled by credit rather than by the expectation of growing post-tax wages.

EXERCISE 17.4 HOUSEHOLD WEALTH AS A BALANCE SHEET 1. Show the information in Figure 17.20 in the form of a balance sheet, for one household from the lowest and one from the highest net worth quintile (use the balance sheets in Figures 10.16 and 10.17 as a guide). Assume that the sum of assets and liabilities is $200,000 for the poorer household and $600,000 for the richer household, both households have some savings, and that assets do not depreciate. Think about the proportions of debt held by these households that might consist of mortgage debt. Now consider the relative effects on the households of a fall in house prices. 2. Define negative equity as a situation where the market value of a house is less than the debt secured on it. In your example balance sheet for the poorer family, calculate the fall in house prices that would push this household into negative equity. 3. If house prices fell by just enough to push the household into negative equity, would this household be insolvent? Explain. Answer Note: The balance sheet below further decomposes each category in Figure 17.20 into specific items to illustrate the difference between the wealth and debt composition of poorer and richer households, but it is not necessary to do so.

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Figure 17.20 Household wealth and debt in the US: Poorest and richest quintiles by net worth (2007).

Note: Answers to Q2 and Q3 depend on the figures in the student’s balance sheet. 2. For the poorer family, a fall in the market value of > $17,000 (>17%) would mean the house was worth less than the mortgage debt and the household would be in negative equity. 3. In the answer to Q2, we have seen that a fall in house price of > $17,000 will create negative equity. But this would leave the household with positive net worth of $15,000, consisting of the value of their savings (minus the credit card debt). Since insolvency requires negative net worth taking into account all assets, this household would not be insolvent. Insolvency would require a fall in the value of the house of > $32,000 (>32%).

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EXERCISE 17.5 DIFFERENCESS BETWEEN EQUILIBRIUM AND STABILITY Explain in your own words, giving examples, the difference between the terms equilibrium and stability.

Answer An equilibrium is a self-perpetuating situation in which the object of interest (for example, housing prices) does not change unless influenced by an outside force (for example, an exogenous demand shock). Stability refers to a type of equilibrium. An equilibrium is stable if there is a tendency to return to this equilibrium after it is disturbed by a shock. Using housing prices as an example, a stable equilibrium is one in which a rise in prices leads to a fall in demand for houses, which reduces the price. Here, the initial price changes are dampened rather than exaggerated as a result of negative feedback.

EXERCISE 17.6 THE CRISIS AND THE MULTIPLIER 1. Show the features of the 2008 crisis in the multiplier diagram, using Figure 14.6 for the Great Depression as a model. Use the concepts of the consumption function, a house price bubble, the financial accelerator, and positive feedback in your answer. 2. How can you represent the role played by the higher marginal propensity to consume of households in the bottom quintile in your analysis? Refer to Figure 17.20 and assume the economy is closed.

FIGURE 14.6 Aggregate demand in the Great Depression: Multiplier and positive feedback

Answer 1. Due to increasing house prices, increasing expectations of house prices and increasing expectations of higher demand for houses, house prices rocketed

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before mid-2006 and we saw a house price bubble. This is the situation shown by point A in the aggregate demand function below. In mid-2006, house prices started falling, which caused many mortgagers to be in negative equity and consequently become insolvent. Autonomous consumption (the c0 of the consumption function) fell and the AD curve shifted downward, reducing output from A to B. At the same time, this called into question the real value of financial instruments, which relied on subprime mortgages. Hence, investors started selling the financial derivatives backed by (pooled) subprime mortgages. This resulted in a panic on the markets, and many investors sold their derivatives. Banks were suddenly holding a lot of contaminated liabilities and the banking sector essentially froze. At this stage, banks were unwilling to lend to other firms. This further reduced consumption (through c0) but also reduced the level of investment (I), lowering aggregate demand and output still further. Hence, the financial crisis resulted in an economic crisis (positive feedback)— initially, investment fell (point B), but soon many firms had to cut costs and started laying off employees. The financial accelerator further exacerbated this situation—many loans and mortgages were available based on home equity, but once house prices started falling, consumers and firms were no longer able to borrow. Hence, consumption fell (point C). The government then adopted fiscal stimulus such as bank bailouts (increase of G in the consumption function), which is depicted in point D.

2. Recall the multiplier formula (assume a closed economy for the purposes of this question):

Hence, as the MPC gets larger, the multiplier becomes larger and the consumption function becomes steeper. The aggregate MPC underlying any AD function is a weighted-average of individual MPCs. It is normally assumed that people with lower incomes have higher MPCs. If this is the case, then the more income earned by the lowest income groups, the greater will be the aggregate MPC. In this instance, it appears that the bottom quintile was badly hit by events surrounding the sub-prime crisis. Its share of income fell, which will have lowered the overall MPC, making the AD curve flatter.

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EXERCISE 17.7 HOW CONVENTIONAL WISDOM ON FINANCIAL MARKETS CONTRIBUTED TO THE GLOBAL FINANCIAL CRISIS In the ‘Economist in action’ video of Joseph Stiglitz (http://tinyco.re/7394572) he explains that the financial crisis was a market failure. Watch it, and consider these questions: 1. What assumptions were made about financial markets before the crisis, and which assumption was particularly problematic? 2. How did incentives given to banks play a role in the recent financial crisis?

Answer 1. Before the crisis, markets were assumed to be efficient (perfect competition, perfect information, no externalities), so that prices of housing and financial assets were sending the ‘right signal’. However, markets were clearly not efficient pre-crisis, with capital allocated to inefficient uses e.g. due to the housing bubble, house prices sent the ‘wrong signal’, leading to houses being built in the middle of the desert. The assumption of no externalities was the most problematic: as explained in the video, banks that were ‘too big to fail’ took excessive risks with other people’s money. (Could also argue that perfect information was a particularly bad assumption, since people were not informed about what banks were doing with their money). 2. In the late 1990s, there was de-regulation in the banking sector, so banks could grow to be ‘too big to fail’ and also become increasingly leveraged. Banks that were ‘too big to fail’ had the incentive to take excessive risks, because managers would get large profits if they won, with no consequences if they lost (the government would bail them out). These banks could also grow bigger by borrowing at lower interest rates (since lenders knew the government was backing those banks). Banks also invested in risky assets e.g. mortgage-backed securities. When the US housing bubble burst, this risk-taking behaviour of big banks was responsible for their failure, and also helped spread the crisis globally (since many foreign investors/entities trusted the financial products of these banks).

EXERCISE 17.8 BEHAVIOUR IN THE FINANCIAL CRISIS ‘The Crisis of Credit Visualized’ (http://tinyco.re/3866047) is an animated explanation of the behaviour of households and banks in the financial crisis available on YouTube. 1. Use the models discussed in this unit to explain the story told in the video. 2. Are there parts of the video that you cannot explain using the models and concepts from this unit?

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Answer 1. Cheap credit resulting from low policy interest rates and surplus from other states resulted in banks being highly leveraged. Furthermore, investors were looking for opportunities to invest after the dot-com bubble, and banks offered them collateralized debt obligations (CDOs). Initially, CDOs were mostly backed by (pooled) prime mortgages, but eventually CDOs changed their structure to sub-prime mortgages. This was working well as long as house prices kept rising. Households were able to use their house as collateral to borrow and since its value kept rising, they could borrow more and more, increasing the demand for houses and pushing up prices still further. This can be explained using a simple demand-and-supply model. Initially, demand for houses increased due to the financial accelerator effect and availability of sub-prime mortgages. Hence, house prices increased as well. Since the supply of houses is fairly inelastic in the short run, the supply curve has a steep slope. The initial increase in demand has a significant effect on prices and then as prices rise, a house comes to be seen as a safe investment and households buy because they expect prices to rise. The demand curve shifts upward again and prices rise further. But once many households defaulted on their mortgages, more and more houses were put up for sale by banks, and hence supply increased. House prices fell and the CDOs became essentially worthless. The whole financial sector was so contaminated that most investment banks and big insurance companies were no longer able to pay their obligations, so the inter-bank sector froze. Lending also froze, with spillover effects to the real economy. The next stage can be explained using the labour market model. Since there was no lending, firms were no longer able to borrow (at low interest rates) or take up new projects. Furthermore, many firms had also invested in the (now worthless) CDOs. Al together, the wage curve shifted down, causing a rise in unemployment. Moreover, many firms had to cut their costs by decreasing wages, hence the real wage curve shifted down as well. 2. One aspect that is difficult to model is the role of information. The CDOs eventually became “ticking time bombs”, yet they were valued very highly for several years preceding the crisis. One reason for this is that the actors on the market knew the CDOs were ‘junk’, but saw the short-term returns and got involved in trading them. Alternatively, and perhaps more likely, market participants were not aware of what the CDOs consist of. This can be illustrated using the demand-and-supply model (once people realized the CDOs were worthless, demand decreased etc.), but the timing and the conditions why/when people realized it, is difficult to capture in a model.

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EXERCISE 17.9 BANKING REGULATIONS CAN HELP BRING ON FINANCIAL CRISES An ‘Economist in action’ video (http://tinyco.re/8573554) shows Anat Admati, an economist, explaining the problems with the regulation of the banking system. 1. Using housing prices as an example, explain the upsides and downsides of leverage. 2. According to the video, what is the key difference between banks and other corporations, and why is this dangerous for the banking system? 3. What are some factors that contribute to the fragility and riskiness of the banking system, and how can we prevent future financial crises from occurring?

Answer 1. Leverage is when investors contribute only a proportion of the total cost of an investment (equity) and finance the rest using borrowed money. In the context of housing, individuals will pay the down payment (which is only a small percentage of the house price; around 5–10%), and take out a mortgage for the remaining amount. The upside of this leverage is that if housing prices increase, the individual can make huge returns ...