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CHAPTER 14
Quick Check
1
a.
b.
c.
d.
e.
f.
g
h.
i.
j
k.
2.
3.
True
True
False. Interest rates change frequently as market conditions change.
Uncertain. Bonds typically have a repayment of principal at maturity as well as a constant
income stream of interest payments.
True
True including an owner renting to herself
True
False - the assets vary in risk
False. Bubbles occur when prices are pushed above the expected present value of future
returns.
False. The stock market is very volatile and can change in price dramatically over one
year.
Uncertain or true. There may be a lag in the protection.
a.
A change in the expected value of the interest rate has direct consequences on the present
value of the bond, i.e., its price. There is an inverse relationship between bond prices and
interest rates, so an expected decline in interest rates should increase the bond price to
more than $100.
b.
Even if next year’s expected decline in interest rates is temporary and the interest rate in
the following year comes back to its current value, the bond price will be more than $100.
a.
The number of years over which interest is compounded is 390 (=2016  1626). The
value of Manhattan Island should be $260,301 billion.
b. Estimates put the real estate value of Manhattan at around $23 trillion in 2009, well
below the value computed in part a. One obvious reason for the divergence has to do with
the unrealistic assumption of a constant interest rate over such a long period of time.
4.
a.
The equation discounts the first dividend received so it must be received one period in the
future.
b.
The first component if the discounted value of the expected dividend. The second
component imagines the stock is sold in one period. It discounts the expected price of that
sale.
c.
The price of stock falls today.
d.
The price of the stock falls today.
e.
The price of the stock rises today.
f.
The coefficient on $De
t+3
is 0.85 and on $De
t+10
is 0.46. Thus an expected $1 increase in
a dividend two years hence adds 85 cents to the share price today. An expected one
dollar increase in a dividend 10 years hence adds only 46 cents to the share price today.
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5.
6.
g.
The new values are 0.78 and 0.29. Higher discount rates make future events less
important.
a.
Both bonds have a present value of $952.38.
b.
Arbitrage works because even though the interest rate on the one-year bond is different
from the expected one-year interest rate on the two-year bond, the face values are
different.
c.
With equal face value and unchanged interest rates, the present value of the two-year
bond would now be lower than the present value of the one-year bond. To equalize
present values again, the expected interest rate would have to decrease to 0%.
a.
Very little will happen to stock prices. Only the term in from of the first dividend gets
slightly (the first discount factor is slightly smaller)
b.
Now all the discount factors get slightly smaller and the terms in front of all expected
dividends are slightly larger. Stock prices rise more.
c.
Stock prices rise by more than in part (b) since the expected dividends now increase,
Dig Deeper
7.
8.
a.
The bond’s present value of $47.23 is higher than the stock’s value of $45.66. Therefore,
the investor should choose to invest in bonds.
b.
The lowering of the risk premium on stocks makes the stock more remunerative than
bonds since the present value of the stock goes up to $49.73.
c.
The present value of both the stock and the bond decline. However, the bond price drops
lower than the stock price, and the investor will prefer to invest in stocks. Even though
both securities undergo a similar decline in interest rates, the decline favors stocks since
stock prices incorporate earlier payments (dividends earned in year t + 1 and t + 2).
a.
Houses last a long time. Rents are likely to rise with inflation. Real interest rates would
be better.
b.
Let Re
t+n
be the expected real rent on the house. Let Q
Ht
be the price of a house. We can
let xH be the risk premium on a house. The equation would be
QHt =
e
R
t+1
(1+ r1t+xh)
+
e
Rt+2
e
(1+r1t+xH) (1+r1 t+2+ xH)
+ …….
c.
The future rents would be discounted less and the price would rise.
d.
xH would decline in value. The discount factors would be less and the price would rise.
e.
Answers will vary
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Explore Further
9.
10.
a.
This measure did predict the US crash – see the Box “The Increase in US Housing
Prices:
Fundamental or Bubble?”
Which country is currently most overvalued will vary
depending on date of access.
b.
The ratio of the house price to income is a sort of measure of the ability to pay the rents
on houses - say those rents are a constant proportion of income. If this ratio were way
out of its historical norm, this would also predict a crash. This measure also suggested the
US housing price crash would occur.
a.
As of March 2016, the yield curve was clearly upward sloping, with lower yields for shortterm bonds (or bills) than for long-term bonds. This reflects a “normal” relationship
between bond maturities and yield, i.e., lower the maturity, lower the yield (because of
lower risk).
b.
As of March 2015, the yield curve for Japan was also upward sloping and was sharper
than it was a year later. In other words, the yield curve slightly flattened in Japan over
that period. This might have reflected worsening expectations on the part of economic
agents.
CHAPTER 15
Quick Check
1.
a.
b.
c.
d.
e.
f.
g.
h.
2.
False. Human wealth for a college student will be much higher since they have their
entire working life ahead of them.
False. Consumption does appear to depend somewhat on expected future income.
True
False. Buildings only depreciate about 2.5% per year while equipment depreciates at a
rate of 15% or more.
False. Higher Tobin’s qs correspond to higher investment.
False. Figure 15-3 shows that investment and current profit are strongly related.
True.
True. The percentage change in investment is larger, but the absolute size of consumption
is much bigger, so total changes in consumption and investment are of similar magnitude.
a.
Lucy’s human wealth and total wealth amount to $149,960; Adam’s human wealth and
total wealth are $96,403 and $146,403, respectively.
b.
Lucy’s permanent consumption level is $49,987; Adam’s is $48,801.
c.
An increase in taxation would decrease the two friends’ human wealth and therefore their
consumption levels. Lucy’s total wealth and permanent consumption would decline to
$139,248 and $46,416, respectively. Adam’s total wealth and permanent consumption
would decline to $139,517 and $46,506, respectively.
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3.
4.
a.
No; the present value of expected profits is $833,333 below the actual cost of the
equipment.
b.
The expected present value of future profits would rise to $1,000,000. The investment
would carry neither a net loss nor a net profit. The hospital may decide to invest in the
hope that future profits may be slightly higher than expected profits.
a.
$44,000(1-0.4)36-$40,000(1-0.4)38=$38,400
b.
$44,000(1-0.3)36-$40,000(1-0.3)38=$44,800
Dig Deeper
5.
6.
7.
a.
EPDV of future labor income = $30. Consumption=$10 in all three periods.
b.
youth: -5; middle age: 15; old age: -10
c.
Total saving =n(-5+15-10)=0
d.
0 – 5n + 10n = 5n
a.
youth: 5; middle age: 12.5; old age: 12.5
The consumer cannot borrow against future income when young.
b.
0 + 12.5n - 12.5n = 0
c.
0 + 0 + 12.5n = 12.5n
d.
By allowing people to borrow to consume when young, financial liberalization may lead
to less overall accumulation of capital.
a.
Expected value of earnings during middle age is 0.5($40,000+$100,000)=$70,000.
EPDV of lifetime earnings = $20,000 + $70,000=$90,000.
The consumption plan is $30,000 per year.
The consumer will save -$10,000 (i.e., the consumer will borrow $10,000) in the first
period of life.
b.
In the worst case, the EPDV of lifetime earnings = $60,000.
Consumption = $20,000 and saving=0 in the first period of life.
Consumption is lower than part (a), and saving is higher.
c.
Consumption in youth is $20,000; in middle age is $50,000; and in old age is $50,000.
Consumption will not be constant over the consumer’s lifetime.
d.
The uncertainty leads to higher saving by consumers in the first period of life.
Explore Further
8.
b.
Sales are more volatile, followed by investment.
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9.
a.
Even though the values of the consumer confidence index have been consistently
negative since 1985, one can identify periods of improvement and deterioration in
consumer confidence. In the last ten years, the worst deterioration of consumer
confidence at the EU level occurred in the wake of the global financial crisis of 2007–08.
b.
Constant increases in consumer confidence have been observed since 1985. An exception
(decline) was in 2009, corresponding to the recession following the global financial crisis
of 2007–08.
c.
Yes, the EU data show that consumer confidence does correlate with final consumption.
CHAPTER 16
Quick Check
1.
a.
b.
c.
d.
e.
f.
g.
h.
2.
3.
False. Changes in the current real policy rate have limited impact on spending, c.p.
False. The IS curve gets steeper.
True
True/Uncertain. Consumers can rely on forecasts by others, but somebody has to do it.
False. Expected changes in tax rates or deficit reduction do appear to impact current
economic activity.
True.
False. The evidence is mixed on whether deficit reduction leads to output expansion.
False. The net effect of the fiscal consolidations was contractionary.
a.
Both quotes are clearly trying to influence the expected future policy interest rate. One
says that the rate will remain zero as long as unemployment is high. The other indicates
that even when unemployment falls to the 6.5% level, rates will not automatically rise.
b.
A reasonable conjecture is that the unemployment rate was getting close enough to 6.5%
that the chair was concerned that the expected future path of the policy rate would be at a
higher level. (As of June 2013, the unemployment rate was 7.5% and had rapidly fallen
from a peak of 10.0% in October 2009.)
c.
Here the Federal Reserve was trying to ensure that even at zero nominal rates, expected
inflation would be positive and expected real rates would be negative.
a.
The IS curve shifts right.
b.
The LM curve shifts up.
c.
There are three effects. First, an increase in expected future taxes tends to reduce
expected future after-tax income (for any given level of income), and therefore to reduce
consumption. This effect tends to shift the IS curve to the left.
Second, the increase in future taxes (a deficit reduction program) would require that the
central bank reduce the real policy rate so that output returns to potential. At the lower
real policy rate, there is more investment. More investment might, in the very long run,
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increase the level of potential and actual output. This could increase wealth (the expected
present discounted value of future output) and thus shift the IS back, even in the short
run.
The net effect on the IS curve is ambiguous. Note that the model of the text has lump sum
taxes. If taxes are not lump sum, the tax increase may increase distortions in the
economy. These effects tend to reduce output (or the growth rate). So the size of any
increase in potential output could be affected by the mix of taxes chosen.
d.
The IS curve shifts to the left.
4.
Rational expectations may be unrealistic, but it does not imply that every consumer has perfect
knowledge of the economy. It implies that consumers use the best available information—
models, data, and techniques—to assess the future and make decisions. Moreover, consumers do
not have to work out the implications of economic models for the future by themselves. They can
rely on the predictions of experts on television or in the newspapers. Essentially, rational
expectations rules out systematic mistakes on the part of consumers. Thus, although rational
expectations may not literally be true, it seems a reasonable benchmark for policy analysis.
5.
The answers below ignore any effect on capital accumulation and output in the long run.
Assume the tax cut policy in the future is temporary, so we need only worry about future shortrun effects.
6.
a.
The effect on current output is fairly clear. The tax cut in the future leads to higher
expected future income at the same interest rate. Wealth and consumption rises today.
The IS curve shifts right and the LM curve remains unchanged. Current output rises. Here
it is unclear whether the Fed is expected to increase future interest rates to return output
to its original level. If this is the case, then the rightward shift in IS will be smaller and
the increase in current output will be smaller.
b.
This means that the Fed will increase the interest rate in the future (shift the LM curve up)
so that actual output remains at the same level. The IS curve would still shift right but the
LM curve shifts up so the intersection is at the same level of income. The higher interest
rate reduces investment by the same amount that the decrease in expected future taxes
increases consumption.
c.
The contrast here is to part (a). If the Fed explicitly commits to no change in current and
future real interest rates, then the IS shifts right with the decrease in expected future
taxes. There is no leftward shift associated with a potential increase in real interest rates
to return output to its original level.
a
A deficit reduction in the medium to long run implies that, if output is to return to
potential, the real interest rate must drop. Thus a fiscal consolidation could lead to higher
investment and an increase in the growth rate of potential output.
b.
The discussion in the text states that the first consolidation focused on tax increases and
less on government spending cuts. The second did the opposite.
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c.
The evidence presented was that in the deficit reduction program that focused on
spending cuts, household savings rate fell (which means the consumption function shifted
up). Hence although the IS shifted left with the cut in G, it shifted right as consumer
spending increased at the same level of disposable income. One interpretation is that
consumer expected higher future disposable incomes and were willing to consume more
today.
d.
It is worrisome that the latter years of the consolidation continue to show very high
unemployment rates, in fact, much higher than earlier in the decade. This cautions against
thinking all was well in Ireland during the second fiscal consolidation.
Dig Deeper
7.
a.
A “surprise” announcement with widespread expectations that the expansionary move
will be a one-off event, will have only a modest impact on economic agents’ behavior, as
it will not change expectations about the future levels of output and the rate of interest.
There is a slight downward movement of the LM curve.
b.
If market participants, upon receiving the news that the central bank has expanded the
money base yet once again, build their expectations about the future policy of the central
bank on its past behavior, then the expansionary effects of the increase in money supply
will be compounded by a change in expectations. The LM curve and the IS curve shift to
the right. The yield curve becomes steeper.
c.
The reactions of market participants, and therefore the significance of the shift of the LM
and IS curves, will depend on the credibility of the central bank to effectively abandon its
expansionary approach to monetary policy.
Explore Further
8.
a.
A drop in government spending as percentage of GDP, and an increase in GDP growth.
b.
There has been a steady decline in the Canadian central bank’s main rates between 1990
and 2008.
c.
Given the currently very low level of interest rates, a restrictive fiscal policy would not
likely generate (favorable) changes in expectations, since Canadian economic actors
cannot expect further drops in the Bank’s rate.
CHAPTER 17
Quick Check
1.
a.
b.
c.
d.
e.
True.
False. GDP = C + I + G + (exports – imports) so imports exceeding GDP is possible, but
not likely.
False. Not necessarily. It could simply be due to product preferences.
False. It implies that FX will adjust to make returns equivalent.
False. It is the price of the domestic currency in terms of the foreign currency.
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f.
g.
h.
i.
j.
2.
False. Differences in inflation rates can cause movements in opposite directions.
True
False. The domestic rate must equal the foreign rate minus the expected appreciation of
the domestic currency.
False The statement should read: “Given the definition of the exchange rate adopted in
this chapter, if the dollar is the domestic currency and the euro the foreign currency, a
nominal exchange rate of 0.75 means that one dollar is worth 0.75 euros.”
False. Domestic goods become relatively more expensive.
Domestic Country Balance of Payments ($)
Current Account
Exports
Imports
Trade Balance
Investment Income Received
Investment Income Paid
Net Investment Income
Net Transfers Received
Current Account Balance
Capital Account
Increase in Foreign Holdings of Domestic Assets
Increase in Domestic Holdings of Foreign Assets
Net Increase in Foreign Holdings
Statistical Discrepancy
Foreign Country Balance of Payments ($)
Current Account
Exports
Imports
Trade Balance
Investment Income Received
Investment Income Paid
Net Investment Income
Net Transfers Received
Current Account Balance
Capital Account
Increase in Foreign Holdings of Domestic Assets
Increase in Domestic Holdings of Foreign Assets
Net Increase in Foreign Holdings
Statistical Discrepancy
3.
25
100
-75 (=25-100)
0
15
-15 (=0-15)
-25
-115 (=-75-15-25)
80 (=65+15)
-50
130 (=80-(-50))
-15 (=115-130)
100
25
75 (=100-25)
15
0
15 (=15-0)
25
115 (=75+15+25)
-50
80 (=65+15)
-130 (=-50-80)
15 (=130-115)
a.
The nominal return on the Brazilian bond is 10,000/(9,630) – 1 = 3.84%.
The nominal return on the Turkish bond is 5.82%.
b.
Uncovered interest parity implies that the expected exchange rate is given by
E(1 + i*)/(1 + i) = 0.79(1.0582)/(1.0384) = 0.805 TRY/BRL.
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c.
If you expect the Brazilian real to depreciate, purchase the Turkish bond since it pays a
higher interest rate and you expect a capital gain on the currency.
d.
The Brazilian real depreciates by 5.06%, so the total return on the Turkish bond (in BRL)
is 5.82% + 5.06% = 10.88%. Investing in the Brazilian bond would have reaped a 3.84%
return.
e.
The uncovered interest parity condition is about equality of expected returns, not equality
of actual returns.
Dig Deeper
4.
5.
a.
GDP is 15 currency units in each economy. Consumers will spend 5 currency units on
each good.
b.
Each country has a zero trade balance. Country A exports food to Country B, Country B
exports clothes to Country C, and Country C exports cars to Country A.
c.
For a country to have a negative trade balance with another country, it needs to export
goods and services whose value is equivalent to the value of its imports from this nation.
Since each county exports to a country different from the one from which it imports, no
country has a negative trade balance with any other country.
d.
There is no reason to expect that the €28 will have a balanced trade with any particular
country, even if it eliminates its overall trade deficit. A particularly large trade deficit
with one country may reflect the pattern of specialization, competitive prices, or
comparative advantage rather than trade barriers.
a.
The relative price of domestic goods falls. Relative demand for domestic goods rises.
The domestic unemployment rate falls in the short run.
b.
The price of foreign goods in terms of domestic currency is P*/E. A nominal depreciation
(a fall in E) increases the price of foreign goods in terms of domestic currency.
Therefore, a nominal depreciation tends to increase the CPI.
c.
The real wage falls.
d.
Essentially, a nominal depreciation stimulates output by reducing the domestic real wage,
which leads to an increase in domestic employment.
Explore Further
6.
a.
The euro is considered the domestic currency.
b.
Considering the evidence through 1999 till the end of March 2016, the South African
rand generally depreciated against the euro throughout this period. However, there were
short periods of appreciation following each episode of sharp depreciation. The most
rapid depreciation was during the global financial crisis in 2008. But the rand reached its
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weakest value against the euro in 2016 when China devalued its currency to boost its
exports. Being highly reliant on mineral and primary exports to China, South Africa was
most exposed to this devaluation.
7.
8.
c.
Depreciation of the South African rand.
d.
The South African rand has sharply depreciated since the global financial crisis,
especially in 2015–16. The weak rand weakens the country’s growth prospects as it
carries the risk of inflation of imported goods, especially since droughts have pushed the
farming industry into recession and increased food prices.
a.
The sum of world current account balances should be zero. In 2014, the sum was
positive, which implies literally that the world as a whole was borrowing. Obviously,
this cannot have been true.
b.
In 2014, the United States was the world's biggest borrower by far. The rest of the
advanced economies as a whole were lenders. The Euro area was a lender in 2014. The
economies of the Middle East and developing economies in Asia were other large
lenders; the economies of central and eastern Europe were large borrowers.
c.
In 2014, the total saving of the advanced economies including the United States was
$189.5B. The US was dissaving by $389.5 B. Thus the advanced economies in total
were saving and lending to the rest of the world.
d.
The projections in the October 2015 World Economic Outlook suggested one substantial
change. The Middle East countries are projected to move from lenders in 2014 to
borrowers in 2015 and 2016.
a.
World saving essentially equals world investment, as must be true logically.
b.
In 2014, the United Kingdom’s saving was 11.9% of GDP, but its investment was 17.8%
of GDP. The United Kingdom financed the difference by borrowing from abroad.
c.
For most countries, GNP and GDP differ insignificantly. Whether GNP is higher or lower
than GDP depends on the ratio of domestic to foreign manufacturers in a country. China's
GDP is slightly higher than its GNP due to the large number of foreign companies
manufacturing in the country. Germany’s GNP is higher than its GDP because of its
massive investments in foreign nations.
CHAPTER 18
Quick Check
1.
a.
b.
False. When savings declines consumption increases, both on domestic and imported
goods.
False. An increase in the budget deficit will lead to an increase in the trade deficit, but we
can't conclude that from the national income accounting identity. We have to use our
model to make that prediction.
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