ECON 214 Problem Set 7 solutions complete answers

ECON 214 Problem Set 7 solutions complete answers 

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Question 1

 

Please read the article below, and use the information in the article to answer the following questions.

 

We're Still Not Sure What Causes Big Recessions by Noah Smith

 

Part 1

 

Suppose the economy is initially at point A on the graph below. This point occurs where the aggregate demand curve AD1 intersects the aggregate supply curve SRAS1. From this starting point, assume that there is a problem in the financial system that causes a disruption in the banking system. According to the “formal economic models of financial shocks” (the article’s term), the        will shift.   

 

Part 2

 

This curve will shift to the

 

Part 3

 

In the short run, the economy will end up at

 

Part 4

 

At this point,

 

Question 2

 

Imagine an economic debate among five presidential candidates. At the time of the debate, the government announces that the economy has entered a recession. Assuming each candidate makes one statement about the economy, can you tell whether he or she is a classical or a Keynesian economist?

 

Question 3

 

Part 1

 

Some economists who analyze financial disasters belong to the wealth-effect school. These economists believe that when       , people will suddenly feel poorer.  

 

Part 2

 

Because people feel poorer, they will reduce their

 

Part 3

 

Cutting back on spending causes        to drop in the short run, leaving the economy in a recession.     

 

Question 4

 

Part 1

 

According to economists of the debt-overhang school, people can experience a sudden decrease in their willingness to 

 

Part 2

 

According to economists of the debt-overhang school, consumers        their spending when they become worried about their debt levels. 

 

Part 3

 

When consumers decrease their spending, the result will be a drop in       , which will put the economy in a recession.

 

Question 5

 

Part 1

 

There is disagreement among economists over whether the “wealth effect” or a “debt overhang” is the primary reason that financial disasters lead to recessions. Each explanation suggests that a different government policy should be followed. If the wealth effect causes financial crises to lead to recessions, then policy makers should concentrate on 

 

Part 2

 

On the other hand, if debt overhang is the primary reason that financial disasters lead to recessions, then government policy makers should concentrate on 

 

Question 6

 

Identify whether each of the following statements is more likely to come from a classical economist or a Keynesian economist.

 

a. “Because employee wages aren't changing quickly, the economy is in for trouble.”  

 

b. “There are some things government should do to facilitate economic activity, but the list is very short..”

 

c. “Any policy needs to focus on the supply side of the economy.”

 

d. “In the long run, we are all dead.”  

 

e. “There is no reason to believe that most prices will take more than several months to adjust in either direction.”  

 

Question 7

 

In December 2007, the U.S. economy entered the Great Recession, which turned out to be longest recession since World War II. To examine the factors that contributed to the Great Recession, it helps to look at an aggregate demand–aggregate supply model. The figure below shows the aggregate demand and long-run aggregate supply curves in 2007, at the start of the recession.

 

You may want to refer to the figure when you answer the questions below.

 

Part 1

 

As the figure illustrates, the Great Recession was caused by shocks to both aggregate demand and long-run aggregate supply. Which of the following are demand shocks? Which are supply shocks?

 

Part 2

 

All of the following statements are true EXCEPT:

 

Question 8

 

Part 1

 

According to the article, the Great Recession and similar episodes are        shocks.

 

Part 2

 

To analyze the shock mentioned in Part 1, first assume that before the shock, the economy is at Point A on the graph below. At this point, the aggregate demand curve AD1 and the aggregate supply curve SR-AS1 intersect. Next, when the shock occurs, the        curve will shift to the left.

 

Part 3

 

After the curve mentioned in Part 2 shifts, the economy is at

 

Part 4

 

At the point that you picked in Part 3,

 

Question 9

 

In this chapter you learned about one of the major debates in macroeconomics between classical and Keynesian economists—whether or not the macroeconomy has a natural adjustment mechanism that brings the economy back to long-run equilibrium. Which of the following would classical economists believe, and which of the following would Keynesian economists believe?

 

Question 10

 

The following figure depicts the aggregate demand (AD), short-run aggregate supply (SRAS), and long-run aggregate supply (LRAS) curves for the United States. The economy is initially at long-run equilibrium, at point A.

 

Many economists feel that the troubles of the Great Recession began in housing markets as a direct result of government policy regarding the money supply. The view is that there was too much monetary expansion at the beginning of the twenty-first century. This monetary expansion is believed to have fueled the rapid rise in housing prices leading up to the collapse of the housing market in 2008.  

 

When real-estate values fell, many of the largest financial institutions in the United States, such as Lehman Brothers, Bank of America, and Goldman Sachs, were directly affected because they held large quantities of mortgage-backed securities. This led to a systemic problem in U.S. financial markets. A financial crisis signals a breakdown in the loanable funds market.

 

The impact of breakdown in the loanable funds market, in isolation, can be viewed as having had only short-term effects.

 

However, leading up to the recession, there was a misallocation of resources due to the overconstruction of housing, which was not needed. In addition, new financial regulation, the Dodd-Frank Act, was enacted after the recession. This regulation established several new oversight bodies and regulations on financial institutions with the stated aim of reducing risk in financial markets. These regulations represent a permanent change in how financial institutions function.

 

In the figure below, shift the appropriate curve to depict the outcome of the misallocation of resources and the new financial regulation. 

 

Question 11

 

The following figure depicts the aggregate demand (AD) curve, the short-run aggregate supply (SRAS) curve, and the long-run aggregate supply (LRAS) curve for the United States. The economy is initially at long-run equilibrium, at point A.

 

The Great Recession was also characterized by a substantial fall in wealth: people’s homes are often the largest piece of their overall wealth, so when real estate values fell, people’s wealth dropped. In addition, U.S. stocks lost one-third of their value during 2008. For millions of people, this meant that their retirement savings dropped by a full one-third. Both of these situations contributed to large declines in wealth.

 

In the figure below, shift the appropriate curve to depict the outcome of the fall in wealth.

 

Question 12

 

Beginning in 2007, in addition to consumers experiencing a fall in wealth, consumers realized the economy was undergoing a downturn. The figure here shows the related Consumer Sentiment Index, which is a measure of consumers’ confidence about their own financial situation and the future direction of the economy. The Consumer Sentiment Index began falling ahead of the recession and then fell significantly during 2008.

 

The following the figure depicts the aggregate demand curve (AD), the short-run aggregate supply curve (SRAS), and the long-run aggregate supply curve (LRAS) for the United States. The economy is initially in long-run equilibrium, at point A. In the figure below, shift the appropriate curve to depict the outcome of the fall in expected future income.

 

Question 13

 

The figure below depicts the aggregate demand curve (AD), the short-run aggregate supply curve (SRAS), and the long-run aggregate supply curve (LRAS) for the United States. The economy is initially at long-run equilibrium, at point A.

 

The Great Depression was unusual because it was so deep and lasted so long. In fact, it was actually two separate recessions (August 1929 to March 1933, and May 1937 to June 1938). The Great Depression was also characterized by another striking condition: Prices across the economy declined throughout the course of the decade. In fact, at the end of the 1930s, the general price level, as measured by the GDP deflator, was 20% lower than it had been in 1929.

 

Due to the decline in the price level, it is evident that the primary cause of the Great Depression was a decline in

 

In the figure below, shift the appropriate curve to reflect your answer choice, which would create the outcome of declining prices during the Great Depression.

 

Question 14

 

The following figure depicts the aggregate demand curve (AD), the short-run aggregate supply curve (SRAS), and the long-run aggregate supply curve (LRAS) for the United States. The economy is initially at long-run equilibrium, at point A.

 

In addition to the crash of the stock market and a subsequent fall in expected future income, the Great Depression was also partially caused by a change in legislation regarding trade. In 1930, Congress passed the Smoot-Hawley Tariff Act. This legislation imposed tariffs (taxes) on thousands of imported goods and set off a global trade war as other nations reacted by imposing tariffs on U.S. exports. These tariffs on imports into the United States made imports more expensive.

 

In the figure below, shift the appropriate curve to depict the effect of the United States imposing tariffs on imports as a possible cause of the Great Depression.

 

Question 15

 

Which of the following would a Keynesian economist have recommended in year 1 of the Great Depression and Great Recession?

 

Question 16

 

The figure below depicts the aggregate demand curve (AD) and the long-run aggregate supply curve (LRAS) for the United States. The economy is initially at long-run equilibrium, at point A.

 

One of the most contentious issues among economists involves the economy’s adjustment to long-run equilibrium. Some economists believe that adjustment can and should occur naturally. This group, the classical economists, stresses the importance of aggregate supply. Others see the return to long-run equilibrium as an adjustment that occurs unpredictably and often with much delay. This group, the Keynesian economists, stresses the importance of aggregate demand and calls for the government to speed the process back to full employment.

 

One tenet of classical economics is the assumption that prices are flexible throughout the economy. If prices are completely flexible, then the economy is essentially self-correcting: no matter what factors change in the economy, no matter what curves shift, the economy automatically comes back to full-employment GDP.

 

Suppose the economy now faces a recession caused by a collapse of the stock market that is also matched by a fall in expected future income. This situation would be represented by a shift of the AD curve to the left, due to a significant drop in consumption expenditure. AD2 is the new AD curve that depicts the fall in consumption expenditure.

 

According to classical economics, the economy will self-correct and recover from the recession on its own without government intervention. Use the figure below to depict the self-correction of the economy following the leftward shift of the AD curve. Note that this question is specifically asking you to evaluate this scenario as a classical economist. Therefore, you must determine whether you need to drag the curves or whether you need to use the point tool to mark the new equilibrium without shifting any curves.

 

Question 17

 

Which of the following could have caused a change in real GDP and unemployment like the one experienced in the first two years of the Great Recession?

 

Question 18

 

The figure below depicts the aggregate demand curve (AD), the short-run aggregate supply curve (SRAS), and the long-run aggregate supply curve (LRAS) for the United States. The economy is initially at long-run equilibrium, at point A.

 

One of the most contentious issues among economists involves the economy’s adjustment to long-run equilibrium. Some economists believe that adjustment can and should occur naturally. This group, the classical economists, stress the importance of aggregate supply. Others see the return to long-run equilibrium as an adjustment that occurs unpredictably and often with much delay; this group, the Keynesian economists, stress the importance of aggregate demand and call for the government to speed the process back to full-employment GDP.

 

Although the classical economists dominated economics during the first part of the twentieth century, the Great Depression challenged the predominant view. In fact, the Great Depression set the stage for a new approach to macroeconomics.

 

Keynesian economists emphasize that wages do not adjust downward quickly enough during recessions—in other words, wages are “sticky downward”—perhaps because of the presence of long-term contracts and money illusion. As a result, high real wages prevent the labor market from reaching equilibrium and restoring full employment. This outcome leads to prolonged recessions.

 

Suppose that the economy now faces a recession caused by a collapse of the stock market that is matched by a fall in expected future income. This situation would be represented by a shift of the AD curve to the left, due to a significant drop in consumption expenditure. This shift is depicted in the figure below by a movement of the economy from point A to point B.

 

According to Keynesian economics, the economy will not self-correct and must be aided by the government in its recovery from the recession. In the figure below, shift the appropriate curve, or use the point tool to mark the correct point, to depict the Keynesian approach to dealing with the recession.

 

Question 19

 

Identify which of these graphs will be drawn by classical and Keynesian economists, respectively, for an economy experiencing a decrease in wealth. E1 and E2 are the initial and final equilibrium points before and after the wealth decrease.