ENG 110 HW6 ANSWERS Spring 2013 Mel B.

Taciroglu

Due: June 8, 2013, 11:59pm

1. Please read the following article and answer the following questions using the information given in the article: http://economix.blogs.nytimes.com/2013/03/08/the-sequester-and-fiscal-policy/ a) According to the IMF (International Monetary Fund) data, Nominal US GDP in 2012 was $15.685 billion. If the US Marginal Propensity to Consume is 0.7, how much extra government expenditure is necessary to achieve the full employment GDP? Multiplier is 1/(1-0.7) = 3.33. The gap between actual and potential GDP is 8%. Then the gap is 15.685 x 0.08 = $1.2548 billion. The extra government expenditure necessary = 1.2548/3.33 = $0.3764 billion. b) Why does the central bank of US (Federal Reserve) have been purchasing government bonds for the past few years? What does it want to achieve with this move? The so-called OMO (Open Market Operations) is the major tool by which the central bank can control the money supply hence may have an effect on the interest rates in the economy. Since US economy has been in a recession for a while, central bank would like to create economic activity by buying the bonds that the banks are holding hence increasing their cash accounts. c) How does this move effect private businesses? Central Bank hopes that banks are going to loan this cash hence provide funds to private investors. Also, increased money supply may reduce the pressure on interest rates, allowing private businesses to get funds at lower costs! (Aside: The logic behind the link between money supply and interest rates: The basic way to think about this link may go as followsany commodity that is in abundance is going to get cheaper. Likewise, any commodity that is in shortage will get more and more expensive. Just think money as another commodity and interest rates as its price!) d) Why are the deficit reduction policies seen as counterproductive? Deficit reduction calls for either less government spending or increased taxes, or both. When there is a recession these policies will work towards slowing down the economy further (by putting less cash in peoples pockets) hence may be counterproductive. e) According to the article Mr. Bernanke admonished Congress in his recent statement that monetary policy cannot carry the entire burden of ensuring a

speedier return to economic health. . As it is also discussed during lecture, there are limits to monetary policy. What is an indication that the monetary policy has reached its limits? Interest rates are close to zero percent which makes it hard for the central bank to create further economic stimulus. (There is no more room for creating cheap funds to businessesthey are at their cheapest level already). As we discussed during lectures, this usually is the time to call in the fiscal policy, which is exactly what Ben Bernanke is doing. 2. Assume that Taiwan and South Africa each has 600 units of resources and each divides the resources equally between Diamond and Computer Chip production. Currently they are not engaged in any trade. The following table describes the production technology in each country. Units of resources needed to produce 1 unit: Diamonds Computer Chips South Africa 1 5 Taiwan 15 3 a) Given the above information, would there be any gains from trade? Why or why not? In South Africa, the opportunity cost of 1 Computer Chip is 5 Diamonds. That is, South Africa needs to release the resources from the production of 5 diamonds to be able to produce 1 unit of computer chip. In Taiwan, the opposite is true, that is 1 diamond is worth 5 computer chips. Then, South Africa has a comparative advantage in Diamond production and Taiwan has a comparative advantage in Computer Chip production. Hence there would be gains from trade if each country specializes in the commodity for which it has a comparative advantage. b) What should be the terms of trade? (hint: terms of trade refers to the price of a commodity in terms of another other commodity) 1/5 Diamonds < 1 Computer Chip < 5 Diamonds (logic: Taiwan specializes in the production of computer chips. They are able to get 1/5 diamonds for 1 computer chip domestically hence if they are going to trade with South Korea, they would want better terms than this, that is more than 1/5 diamonds. South Korea has Diamonds after specialization and no computer chips. If they release resources, they could get 1 Computer Chip for 5 Diamonds domestically, hence they do not want to pay more than 5 diamonds for 1 computer chip internationally. Alternatively, 1/5 Computer Chip < 1 Diamond < 5 Computer Chips. !