ECON 301 George Washington University Macroeconomics Worksheet

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ECON 301: Homework 9
April 19, 2022
Instructions
• How to submit
– You may hand-write or type your answers.
– However, you must submit your PDF file online on Canvas using the
online submission tool.
– You can convert hand-written pages to PDF using apps like
CamScanner, Office Lens etc. Alternately, there is a scanner available at
the Library.
• General guidelines
– Answers must be clear, concise and legible (if hand-written). They
must demonstrate how you arrived at the solution, and make it clear
that you understand the underlying concepts.
– Your submitted work must be original and submitted individually,
although you may work in groups to arrive at solutions. Academic
integrity is taken very seriously
1
Financial Frictions
Financial frictions are often described in terms of an -rate spread” between the
policy rate and private debt (like consumer loans, corporate bonds or mortgages).
1. How can financial frictions worsen a recession?
2. Explain this with an IS-MP diagram that incorporates financial frictions
3. Show that financial frictions can be interpreted as an additional demand
shock to an economy.
2
Deflation and Liquidity Traps
1. Inflation is usually understood to mean positive inflation – i.e., an increase in
the general price level over time. Given this, what do you think deflation”
means? What’s the difference between deflation and disinflation?
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2. Using the Fisher equation and the IS-MP model, describe why deflation can
be dangerous. Use the IS-MP model to explain how a potential ”deflationary
spiral” would work in the context of a recession
3. If you were the Fed Chairman, how would you respond to deflation?
3
Government Debt
1. How does the evolution of the debt-to-GDP ratio depend on g (the growth
rate) and i (the interest rate)? Explain how inflation could help to reduce
the debt-to-GDP ratio .
2. Consider the steady-state debt-to-GDP ratio
(a) Derive this relationship mathematically. What does this relationship
describe?
(b) Assume an economy with a government that targets a long-run debttoGDP ratio of 75%. If the economy is growing at 3.0% per year, and the
government pays an interest rate of 1.5% per year on its debt, how high
a primary deficit can the government run (as a percent of GDP) without
increasing its debt-to-GDP ratio?
3. Use the ”FRED” database from St. Louis Fed (available at https://fred.
stlouisfed.org/). Download the Government Debt-to-GDP data for the US and
Spain. What was the debt-to-GDP ratio in the US and Spain before the Great
Recession (let’s say 2007)? Did they evolve differently during the recession?
Explain why (hint: you can use other data to support your answer)
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4
Developing countries and Government Debt
Figure 1: General Government Debt % GDP
1. In Figure 1, we see that, on average, developed countries tend to have a much
larger government debt-to-gdp ratio than developing countries (data refers
to 2020 or the latest available). However, economists and analysts deem that
developed countries government debt is not as riskier as developing
countries one. How do you explain this paradox? (Hint: This data is collected
from https://data.oecd.org/. You may go to this site and try to collect other
data that is related to government debt)
2. Do you believe that an increase in government debt by developed countries
has an impact on developing countries’ capacity to increase their own
borrowing? If so, how?
5
Government Expenditures and Debt
1. The political cartoon below appeared in a popular magazine in 2011, when
many advanced economies were struggling with the effects of the Great
Recession. The cartoon ironically refers to the public discourse of many
capitalists, which is usually different in recessions than in normal times.
(a) Explain why an increase in government expenditures during a
recession might favor capitalists’ profits.
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(b) Why does the impact of government expenditures on investment might
differ between recessions and normal times?
(c) Explain how the rationale for fiscal expansion during a demanddriven
recession (leaving aside the use of monetary policy) relates to the
concept of “crowding-in”.
2. The Nobel laureate Trygve Haavelmo wrote the paper “Multiplier Effects of
a Balanced Budget” in 1945 that shows that the government may increase
output by increasing expenditures without increasing the primary deficit.
How is this possible? (Hint: use the definition of primary deficit and the IS
curve. You do not need to read the paper to answer the question, but
reflecting about the title or reading the introduction may help you.)
3. The US has a government debt ceiling by law (i.e. the maximum level of
government debt is legally determined). If this ceiling is reached and the
government wants to expand its debt, the government has not alternative
but to negotiate with the Congress an increase of the debt ceiling. During the
debt-ceiling crisis of 2011, to circumvent the political deadlock in the
Congress, some economists (such as Paul Krugman, another Nobel laureate)
proposed the creation of a trillion-dollar coin that would be issue by the
Treasury and used to pay off (part of) the national debt, but it would be held
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in the Federal Reserve Bank vault forever. Leaving the legal issues aside, i)
explain the economic rationale and mechanism of this proposal (hint: use
the Government Budget Constraint), and ii) critically assess the proposal.
5

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liquidity traps

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