Homework 5
Economics 503
Foundations of Economic Analysis
Assigned: Saturday, October 8th, 2005
Due: Saturday, October 15th, 2005
1.
The long-term interest rate in 1966 in the USA was 4.61% (i.e. i = .0461).
Suppose that Howard Hughes had invested his US$650 million in a T = 38 year
bond that paid an interest rate of 4.61% per year. What was the value of his payoff
at the end of 38 years? What was the real value of that payoff in 1966 dollars?
What was the average real return earned on this investment? Use the GDP
deflator data in the notes to answer this question.
In 1966, Howard Hughes put $650 million into a 38 year bond with an interest of 4.61%.
After 36 years the investment was worth (1+i)T∙Principal = 3603.255318. Convert this
into 1966 dollars using the GDP deflator. Divide by the price level in the current year
(2004) and remultiply by the price level in 2004.
P
Payofft  ref  3603.255318  22.855
 762.8188767 . The real return is
Pt
107.958
 Payofft T

Pt+T
 Principal
t

Pt

2.





1
T

 762.8188767
650 
1
38
 1.004220678
In HK, we observe a sudden, unanticipated increase in investor confidence. Use
the business cycle model to analyze the effects of this event on output, price level,
employment, and interest rates.
a. Draw an AS-AD model and show the short-run effects of this event on the
goods market.
YLR
P
P**
SRAS
2
P*=PE
1
´
AD
AD
GDP
If business confidence increases, then firms will want to invest more in
physical capital. They will purchase more goods at any given price level
shifting the price level upwards. Given input prices fixed by long-term
contracts, the profit maximizing level of output increases as prices increase.
Output increases above potential output.
b. Draw graphs of the labor and loanable funds market and the short-run
effects of this event. Redraw your graph of the goods market and identify
the automatic adjustment impacts of outcomes in the labor and loanable
funds market.
The economy is in a boom. Therefore firms are increasing their scale of
production. The demand for labor shifts up. In equilibrium, real wages and
labor increase. This increases the cost of production. To produce any level of
output, the firms will charge a higher price. The short run aggregate supply
curves shifts up. Firms also need to borrow more to buy more capital
equipment. The demand for loanable funds increase. This increases the
interest rate which will have a negative impact on the AD curve.
Labor Supply
W/P
2
Labor Demand
1
´
Labor Demand
Labor
LS
i
2
LD
1
´
LD
Loanable Funds
YLR
P
SRAS
SRAS´
P**
3
2
P*=PE
´
AD
AD
AD´´
GDP
´
c. Draw one more graph of the goods market showing the long-term effects
of the rise in investor confidence showing the self-correction mechanism.
In the short run, the price level is higher than the expected price level
priced into long-term contracts. Input producing firms made a mistake.
When contracts expire, they will correct their mistake by charging higher
prices for their inputs. This will increase the cost of production for output
firms. They will increase the price that they would demand to produce at
any level of output. The SRAS curve will shift up as long as input firms feel
they should increase their prices. They will do so, until the prices actually
equal the prices they price into their contracts.
1
SRAS´
SRAS´´
´
5
SRAS´
P
4
P**
3
P*=PE
´
AD
AD
AD´´
GDP
3.
´
New Orleans, Louisiana, is an important part of the transportation system in the
USA and an important center for the petrochemical industry in that country.
Consider the impact of the recent hurricanes that devastated that city as a
temporary supply shock for the USA.
a. Discuss, in one paragraph or less, the outcomes that we are likely to see in
terms of goods markets and the loanable funds market in the USA as a
result of this negative business cycle shock.
A supply shock increases the cost of production at any scale of production.
The firms will charge a higher price and the SRAS curve will shift up. When
production levels are reduced. Firms will reduce their production levels and
reduce their demand for labor and capital, and thus loanable funds.
YLR
SRAS
P
2
SRAS´
1
AD
GDP
W/P
Labor Demand
Labor Supply
´
1
2
Labor Demand
Labor
i
LD
LS
´
1
2
LD
Loanable Funds
b. Analysts are also worried that the natural disaster may have a negative
impact on consumer confidence. Discuss briefly the differences in
outcomes that we would observe if this demand side effect were stronger
from the outcomes that we would observe if the supply side effects were
dominant.
If consumer confidence declined, then demand would decline. This would lead
to lower prices and output. Both the impact of the shock as a supply shock and
as a demand shock reduce the level of output. Both would reduce the demand
for labor and capital (and thus, for loanable funds). However, a stronger
demand shock would reduce price levels. A stronger supply shock would lead
to higher price levels.
YLR
P
SRAS
P*=PE
1
P**
2
AD
´
AD
GDP
c. Discuss the impact that these events would have on Hong Kong’s
economy. Consider both the impact on Hong Kong’s exports and the
effect on Hong Kong’s loanable funds market.
From either perspective, these events will lead to lower levels of output and
demand in the USA. Since the USA is a market for HK exports, this will
reduce the demand for HK’s exports. On the other hand, consider the effect on
HK’s loanable funds market. The USA interest rate will decline increasing the
amount of loanable funds direct toward HK. The lower interest rate would
stimulate demand for capital goods, housing and consumer durables in HK.
Thus, there would be counter-veiling effects of this shock on output in HK.
i
LD
´
LS
1
LD
2
Loanable Funds
Homework 5, Pt 2
Economics 503
Foundations of Economic Analysis
Assigned: Saturday, October 8th, 2005
Due: Saturday, October 15th, 2005You are studying unemployment trends
4.
in Hong Kong. An economic organization identifies the following years as
containing business cycle peaks and troughs.
Peak
1987
1996
1999
Trough
1984
1989
1997
2001
a. Calculate the average unemployment rate during peak years and trough
years. Which is higher? Use unemployment rates obtained from here?
The average unemployment rates during trough years is 3.1 years. The average
unemployment rates during the peak years. 3.57 is actually higher than trough years.
That doesn’t make sense, does it?
Peak
Peak
Unemployment Rate
1987 1.7
1996 2.8
1999
6.2
Trough
Unemployment Rate
1984 3.9
1989 1.1
1997
2001
2.2
5.1
b. Calculate the average unemployment rates in Hong Kong in 1997-2004
and compare those in the years 1989-1996. Explain how changes in
cyclical and frictional employment might explain these trends.
Hong Kong Census and Statistics Department
http://www.info.gov.hk/censtatd/eng/hkstat/fas/labour/ghs/labour1_index.html
Unemployment Rate
1989
1990
1991
1992
1993
1994
1995
1996
1.1
1.3
1.8
2.0
2.0
1.9
3.2
2.8
Average
2.0125
1997
1998
1999
2000
2001
2002
2003
2004
2.2
4.7
6.2
4.9
5.1
7.3
7.9
6.8
5.6375
In the years before 1996, the average unemployment rate was 2.0125. After 1996, the
unemployment rate averages 5.6375. This long run rise in the unemployment rate may
indicate an increase in the structural rate of unemployment.