Answers to Review Questions

Macro Chapters 14a-15a

Extra Stuff . . Chapter 14a . . Chapter 15a

 Answers to questions as they were in July, 2006

Fiscal Policy Today

Exploring Consumption

1. Though the life-cycle and permanent-income hypotheses were both developed in the 1950s, not until the presidency of Lyndon Johnson did most economists fully realize the importance of the idea that people could smooth out fluctuations in income. In 1967 the Johnson administration proposed a tax increase to curb rising inflation. The proposed tax was unusual because it was a temporary tax, designed to last only one year, and because it was a surcharge, a 10% tax on the taxes a person owed. The proposed tax was temporary because the Johnson administration saw the problem of inflation as temporary. Proposing the increase as a surcharge rather than a change in the tax rates was a way to speed passage without having Congress attach a variety of changes in the tax laws. The surcharge was enacted in June of 1968 and expired in mid 1969.

a) What did the traditional consumption function predict would happen to consumption as a result of the surcharge? To savings? To the ratio of savings to consumption?

Consumption drops a lot, savings a little, the savings-to-consumption ratio should not change.

b) What did the permanent-income hypothesis predict would happen to consumption as a result of the tax? To savings? To the ratio of savings to consumption?

Consumption and savings both drop, but savings drops a lot because people because people do not let a temporary change in income change standard of living. Hence, the savings-to-consumption ratio drops.

c) Below are data showing the ratio of personal savings to personal outlays. Quarterly data are given for years with a Roman numeral. Do the savings ratios tend to support the prediction of the traditional consumption function or of the permanent-income hypothesis?

The change in the savings-to-consumption ratio was not expected at the time--it gave the permanent-income hypothesis credibility.



1968 IV
1969 I
1969 II
1968 I
1969 III
1968 II
1969 IV
1968 III

Source: 1971 Business Statistics (Biennial Supplement to The Survey of Current Business), Dept. of Commerce, Bureau of Economic Analysis

2. In the Two-Income Trap: Why Middle Class Mothers and Fathers Are Going Broke (Basic Books, 2003) authors Elizabeth Warren and Amelia Warren Tyagi found that households in which both spouses work are more likely to file for bankruptcy than households in which one spouse stays at home. This finding may sound counter-intuitive, and it surprised the authors. However, consumption theory may help explain why it is so. (Editorial comment: The authors know a lot about law but do not seem to have much background in economics. Their book would have been much more persuasive if they had used more economics.)

a. Suppose that we have two identical families, the Smiths and the Jones. Both Mr and Mrs Smith work and they earn $70,000. Only Mr Jones works and he earns $40,000. Should we expect the Smiths to save a greater percentage of their income than the Jones? Who will have the higher standard of living?
b. If Mr Smith and Mr Jones both lose their jobs, one option is to cut spending and reduce standard of living. Should this be easy for either? Should it be easier for Jones or Smith? Why? If we stop here, does the conclusion of The Two-Income Trap seem reasonable?
c. When a person loses a job, the household suffers a disruption of income. Suppose all workers have a 10% chance of suffering a loss of job. Which household is more likely to suffer a disruption of income during any year? Does this support or contradict the finding of The Two-Income Trap?
d. When a household suffers a disruption of income, one possible response is to cut standard of living. However, the family with only the husband working has another option that the two-income family does not have. What is it? Does this option make the finding of the book more plausible?

The two-income family adjusts to a higher standard of living because it has more income. It does not save a greater percentage of its income according to the permanent-income hypothesis. The two-income family will have more disruptions, but since their total income drops by a smaller percentage, it is easier to cut back. However, the family with the spouse at home has the option of having the non-working spouse get a job, perhaps only as a temporary measure, to cushion the decline. So it is not all that surprising that the two-income family is at greater risk of bankruptcy.


Exploration Exercise: The Quest for Fiscal Policy

3. The president of the United States has the constitutional right to pardon people convicted of federal crimes. If we look at this power as an economist might, we probably would reason as follows. If someone deserves to be pardoned, that person should be pardoned as soon as the president is convinced that the pardon is deserved. If someone does not deserve to be pardoned, that pardon should never be granted. Hence, presidential pardons should occur randomly during the time a president is in office.

However, this timing is not what we observe. An unexpectedly large number of pardons are granted during the last few days that a president is in office. The economic view of the world must be missing something. What do you think it is?


4. Is fiscal policy really dead as the author claims? You can test this assertion on the internet. If you can find a variety of articles that describe and debate current or proposed fiscal policy of the United States government, you will call into question a basic premise of this group of readings.

Use one of the search engines on the internet to see what you can find about current, discretionary, macroeconomic fiscal policy of the United States. In addition to the term "fiscal policy," you might try searching for "full employment budget," "high employment budget," "full employment surplus," "high employment surplus," "full employment deficit," and "high employment deficit."

You will get many hits, but most of them will not be the evidence you seek. Many will have discussions of the concept of fiscal policy. You will also find that some people use the term "fiscal policy" in a broader way than we are using it. Sometimes fiscal policy refers to any change in taxes or government expenditure for any purpose. We are only interested in discussions of changes when they are intended to affect the level of total spending. States do not have fiscal policy, so sites that tell you about the current fiscal policy of Alaska are irrelevant. (States do have fiscal policy in the broad meaning of the term, but not in the more narrow meaning we are using--as a way to change total spending.) Similarly, to find that there is a fiscal policy office in Thailand is not evidence that fiscal policy is alive and well. Finally, remember that one swallow does not spring make.

(At the time this question was written, there was virtually no discussion of fiscal policy. However, there will certainly be discussion of fiscal policy in the future--old ideas never really die in economics. If fiscal policy is in a revival when you answer this question, and there is debate about some proposal to cut taxes or raise spending, you might ask if these proposals are using a fiscal policy argument to sell something that is really desired for quite different purposes.)

Happy hunting.

Answers will vary depending on when the search is made.

5. In what ways is the Fed independent of the political process, and is that good? Summarize the point of view found at

<> and <>

Internet exploration.

Exploration Fiscal Policy

6. The economy is moving into recession, and Senators Miller and Busch propose to stimulate the economy by cutting the tax on alcoholic beverages. They make the case that since the poor spend a larger part of their income than the rich on alcoholic beverages, and since the poor have a high marginal propensity to consume, this tax cut would have an unusually high impact on total spending and hence would be sound fiscal policy. List as many objections to their proposal as you can. How many of your objections have nothing to do with fiscal policy? In what way does this example illustrate the main point of the reading?

One reason for the high tax rates is to discourage the use of alcohol. Lowering the tax will affect incentives. It will also affect the distribution of income--the tax on alcoholic beverages is regressive.

Exploring Lags

7. Describe the recognition, decision, implementation, and take-effect lags for the following:

a. alcoholism
b. drug addiction
c. getting lost in the woods
d. getting lost in a course
e. making a bad investment
f. taking an unsuitable job

Answers may vary.

Exploring Crowding Out

8. JavaScript


Extra Stuff . . Chapter 14a . . Chapter 15a

 Monetary History

Exploring International Payments

1. As a result of the development of North Sea oil fields, Britain switched from importing oil in the 1970s to exporting oil in the 1980s. During the entire period the British pound was floating.

a) What effect should the change in oil trade have had on the price of British pounds in the foreign exchange market?
b) As a result of this change in exchange rate, should British consumers decide to import more or less? Should it have become easier or harder for British businesses to export?
c) If wages are flexible, what would the effect of these changes in part b have been? If wages are not flexible, what are the likely effects on employment of these changes?

The value of the pound should have risen. This would make it cheaper for the British to buy foreign products and more difficult for them to sell their products abroad. There could be job losses in some industries which export a lot. If wages adjust, the wages in these industries would fall relative to other industries and might lessen job losses.

2. In 2002 most of Europe completed its transition from national currencies (German Mark, French Franc, Italian Lira) to a single currency, the Euro. Almost everyone agreed that the single currency would make transactions from country to country much easier, and thus encourage commerce. If unified currency was a good idea, why did it take so long for European countries to adopt it?

The countries that adopted the euro lost control of monetary policy. They in effect gave up some of their sovereignty.

3. Is there a secret message in the Wizard of OZ? Some economists have suggested that it is actually an allegory for the political discount of the populist era and that there are many references to the dispute about the gold standard. Others think that it is a harmless children's story and the symbolism that some find is accidental. You can find both sides on the internet. Try searching for "Wizard of OZ" "gold standard." Other searches are possible--happy searching. What do you conclude--intentional symbolism or accident?

This one is just a lot of fun. If you read the various interpretations, you will never be able to view the Wizard of Oz in the same way.

Exploring Bretton Woods

4. Though the system of fixed exchange rates that the Bretton Woods Conference imposed in the industrial world is long gone, two organizations that had their beginnings in that conference are still alive. They are the International Monetary Fund and the World Bank. Look for them on the internet and find out what they do. (Try and Both of these organizations are often the focus of political protests. Why are they controversial?

Internet exploration.

Monetary Recovery: Explorations

5. The reading mentions a number of episodes that the Fed reacted to: run on Continental Illinois in 1984, the stock market crash in October of 1987, the liquidity problems of Long Term Capital Management in September of 1998, and the threat of cash withdrawals from the banking system as the result of fears of the so-called millennium bug in January 2000.

What happened in each of these cases? What did the Fed do? (You may have to go to the library or the internet to dig out the details.)

Internet exploration.

6. In using interest rates as targets for monetary policy, economists often talk about the neutral rate. Here is a problem on the neutral rate.

Exploring Policy Rules

7. We have only scratched the surface of policy rules. You can learn much more by searching the internet.

a. A policy rule that economists talk a great deal about is the "Taylor Rule." Search the internet for this term and explain what the Taylor Rule is.
b. A somewhat different policy rule that often appears in discussions of monetary policy is called "inflation targeting." What is it? What central banks use it and why? Why do many countries not use it?
c. The reading mentioned the gold standard as a policy rule. Barry Eichengreen is an economist who has argued that adherence to the gold standard and gold-standard thinking was the primary cause of the Great Depression. Search the internet for "gold standard" Eichengreen and see what you can learn about his position.
d. A number of economists have argued that Federal Reserve policy during the Great Depression was guided by the "real-bills doctrine" which is sometimes called the "commercial-loan theory of banking." Search for these terms. What was this theory or doctrine? How could it have led to bad monetary policy?

Internet exploration.

On d, if money is allowed to change as trade changes, the country will have amplifying feedback in its monetary policy and will make business fluctuations larger rather than smaller.

Exploring Policy Rules and Credibility

8. Some parents discourage belief in Santa Claus, the Easter Bunny, the Tooth Fairy, etc. because they think that when their children finally learn the truth, they will be disillusioned and will distrust their parents for lying. What do you think? Are beliefs in Santa Claus and the Easter Bunny harmless, or is there a credibility price to pay for even this level of untruth? Justify your answer.

Answers will vary.

9. A few years ago I was in a dentist's waiting room with a woman and her two children. They were doing little things that they should not have been doing--messing up the magazines, running, fighting, etc.--and their mother kept telling them to stop. They did not stop, and she did nothing to stop them, except to keep telling them to stop. Eventually the receptionist could take it no longer and told the mother to take her children out to her car and wait there. Analyze this situation in terms of policy rules and credibility.

Rules that are not enforced are not believed.

10. Governments keep secrets. It is easy to understand why they wish to withhold information from hostile governments, but sometimes they also withhold information from their own citizens. Many people believe that the U.S. government withholds information about aliens. Suppose that the U.S. government recovered a crashed space craft from another planet. What would be the rationale for keeping this information secret? What would be the rationale for making this information public? Does either rationale fit macroeconomic policy?

Answers will vary.

11. A library has a policy of fining patrons 25¢ per day for overdue books. After ten years it has thousands of dollars of unpaid fines for books which have been borrowed and never returned. It offers a "fine amnesty," whereby it allows people to return overdue books without any fine. What are the benefits and the costs of this amnesty? What happens to these costs and benefits as amnesties get more frequent? What topic that we have discussed in the past two weeks does a fine amnesty illustrate?

This is the time inconsistency problem. The library gets a lot of books back, but it encourages people to keep books because they may think there will be another amnesty somewhere in the future.

12. When the economy is in recession, the president can face a no-win situation. If he avoids saying that the economy is in recession, his critics will say that because he will not level with the American people, he lacks credibility. If he states that the economy is in recession, his critics will say that his admission will cause people to be frightened and pessimistic and thereby make the recession worse. What would you advise the president to do in this situation and why?

Answers will vary.

13. Search the internet for the term "time inconsistency." What examples can you find that are not mentioned in the reading.

Answers will vary.

Monetary Policy: Exploration and Discussion

14. Is the Fed still using the federal funds rate as its policy target? If so, what is the current target rate? Has the Fed been increasing or decreasing that rate over the past six months? What has been happening to the growth in monetary aggregates?

Answers will vary.

15. The readings argue that the Fed has learned from both its mistakes and its successes. If it has learned, then monetary policy should be better today than it was in its early years. Can you provide any evidence that it has or has not become better? (Suggestion: have the swings in economic activity gotten smaller or larger with time? Have they become more or less frequent? This is a question that requires some real-world data to answer.)

The fluctuations in real GDP have been smaller in the years since 1950.

16. The Federal Reserve publishes its goals. Does what it says agree or disagree with the position taken in the reading? (Here is one place you can find a statement of goals: <>. There may be others. Most students will probably say that the view on this site is very different from the view in the reading. If you are inclined to answer in this way, pretend you are on a debate team and your task is to make the case that these two views are in fact quite close. What would you say? Now that you have figured out that case, do you believe it?)

Answers will vary.

Extra Stuff . .Chapter 14a . . Chapter 15a