price of oil (a temporary adverse supply shock) on current output, employment, the real wage, national saving, investment, and the real interest rate. Because the supply shock is temporary, you should assume that the expected future MPK and households’ expected future incomes are unchanged. Assume throughout that output and employment remain at full-employment levels (which may change).
b. Analyze the effects of a permanent increase in the price of oil (a permanent adverse supply shock) on current output, employment, the real wage, national saving, investment, and the real inter- est rate. Show that in this case, unlike the case of a temporary supply shock, the real interest rate need not change. (Hint: A permanent adverse sup- ply shock lowers the current productivity of capi- tal and labor, just as a temporary supply shock does. In addition, a permanent supply shock low- ers both the expected future MPK and house- holds’ expected future incomes.)
4. Economists often argue that a temporary increase in government purchases—say, for military purposes— will crowd out private investment. Use the saving– investment diagram to illustrate this point, explaining why the curve(s) shift. Does it matter whether the tem- porary increase in military spending is funded by taxes or by borrowing?
Alternatively, suppose that the temporary increase in government purchases is for infrastructure (roads, sewers, bridges) rather than for military purposes. The government spending on infrastructure makes private investment more productive, increasing the expected future MPK at each level of the capital stock. Use the saving–investment diagram to analyze the effects of government infrastructure spending on current con- sumption, national saving, investment, and the real
interest rate. Does investment by private firms get crowded out by this kind of government investment? If not, what kind of spending, if any, does get crowded out? Assume that there is no change in current produc- tivity or current output and assume (for simplicity) that households do not expect a change in their future incomes.
5. “A permanent increase in government purchases has a larger effect than a temporary increase of the same amount.” Use the saving–investment diagram to evalu- ate this statement, focusing on effects on consumption, investment, and the real interest rate for a fixed level of output. (Hint: The permanent increase in government purchases implies larger increases in current and future taxes.)
6. (Appendix 4.A) Draw a budget line and indifference curves for a consumer who initially is a borrower. Be sure to indicate the no-borrowing, no-lending point and the optimal consumption point. Then show the effect on the budget line and the consumer’s optimal consump- tion of an increase in the real interest rate. Using an in- termediate budget line, show the income effect and the substitution effect. Do they work in the same direction or in opposite directions? Explain your answer.
7. (Appendix 4.A) Consumers typically pay a higher real interest rate to borrow than they receive when they lend (by making bank deposits, for example). Draw a consumer’s budget line under the assumption that the real interest rate earned on funds lent, rl, is lower than the real interest rate paid to borrow, rb. Show how the budget line is affected by an increase in rl, an increase in rb, or an increase in the consumer’s initial wealth.
Show that changes in rl and rb may leave current and future consumption unchanged. (Hint: Draw the consumer’s indifference curves so that the consumer initially chooses the no-borrowing, no-lending point.)
For data to use in these exercises, go to the Federal Reserve Bank of St. Louis FRED database at research.stlouisfed.org/fred2.
1. Graph the index of consumer sentiment, using data since 1965. Can you pick out the recessions of 1969–1970, 1973–1975, 1980, 1981–1982, 1990–1991, 2001, and 2007–2009?
Construct scatter plots relating the consumer senti- ment index to the growth rates of real consumption
expenditures and real consumption expenditures on durables, using quarterly data since 1965. Generally speaking, does consumption grow more quickly when consumers are more optimistic? Compare the growth rates of real consumption and of real consumption expenditures on durables during recessions.
2. The S&P 500 stock market index measures the total dollar value of a large set of stocks traded on the stock
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sures the real value of the wealth represented by that set of stocks, is obtained by dividing the index by a measure of the price level, such as the CPI. (To obtain monthly data on the S&P 500, use SP500 in the FRED database.)
Using monthly data for the period since 1961, graph the real value of the S&P 500 stock market index. What striking difference do you see in comparing the values in the 1970s with the values in the rest of the period? According to the theory, what effect should the behav- ior of stock market wealth during the 1970s have had on the national saving rate during that period, relative to the 1960s and 1980s? Look at a graph of the national saving rate for 1961 to the present from NIPA Table 5.1 at www.bea.gov. Would you say that the prediction is borne out? Discuss.
3. This problem asks you to calculate the actual (as opposed to the expected) after-tax real interest rate using annual data from 1961 to the present. The formula for the actual after-tax real interest rate is (1 - t)i - p, where i is the nominal interest rate, t is the tax rate, and p is the inflation rate.
Use the average for each year of the three-month Treasury bill interest rate for the nominal interest rate
i and measure annual inflation p by the CPI inflation rate from December to December. Take the tax rate t to be the ratio of total (Federal plus state and local) gov- ernment receipts to nominal GDP in the fourth quarter of each year. In what periods did financial conditions favor savers? Borrowers?
4. Using quarterly data from 1947 to the present, graph residential fixed investment relative to GDP.
a. Compare the graph of residential investment rela- tive to GDP to a graph of the civilian unemploy- ment rate. What happens to residential investment during recessions? In this respect, is residential investment similar to or different from other types of investment?
b. During the two decades after World War II, there was an upsurge in population growth and house- hold formation known as the “baby boom.” The baby boom was followed by a “baby bust” during which population growth slowed. How are these demographic trends connected to the behavior of residential investment relative to GDP shown in your graph?
5. The chapter claims that interest rates tend to move together. Using monthly data since 1975, graph the interest rate on three-month Treasury bills, the yield on high-grade corporate bonds, the 30-year conventional mortgage rate, the prime rate charged by banks, and the yield on ten-year Treasury bonds. Which interest rates tend to be highest? Lowest? Explain. Which interest rates tend to move together? Explain.
6. Graph real equipment and software investment and real structures investment since 1948. How has the rela- tive emphasis on the two types of investment changed in the past three decades or so? Can you think of an explanation? (Hint: What is the most important new technology to be introduced in the past three decades?)
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