Comments on Assignment Questions John Maynard Keynes/Managing Aggregate Demand 1. Keynesian economics is often viewed as justifying increases in deficit spending … How does this proposal related to Keynes own writing? There is an important point to emphasize: Keynes didn’t necessarily believe that the only way to stimulate the economy was through more spending by government. He also argued that tax cuts and instilling confidence to get people spending again were also important. You could draw a picture of the game with two players who each face a save/spend decision that we discussed in class. Then the challenge for the government is to shift the economy from the low to the high welfare Nash equilibrium. This may depend as much on instilling confidence as the government spending more money/cutting taxes. Greater confidence may be reflected in a higher multiplier, c (where C = a + cY) so that people decide to go out and spend more of the money they are earning. This effect can even boost output with no extra government spending required. 2. What role do confidence and psychology play in Keynes understanding of the economy and role of government? You should emphasize the quote of Keynes that he believed that the Great Depression “comes from some failure of the material devices of the mind”. And quote the examples of speculative stock market booms and busts that concerned Keynes. The key issue is that lack of confidence and uncertainty about the future may lead business to stop investing and consumers to stop spending which may bring on a slump. So psychology plays an important role. 3. Why is Keynes so concerned with uncertainty? The main point here concerns how uncertainty can lead to sudden changes in business ‘bullishness’, or desire to invest (see also question 2). You could add that it was a special kind of uncertainty that Keynes focussed on, called ‘Knightian uncertainty’, where you just don’t even know enough to assign probabilities. This kind of uncertainty leads to ‘herding’ / animal spirits, whereby people tend to replicate average behaviour. More uncertainty can lead to less investment and consumption demand and consequently a recession - and the effect can be magnified by herd behaviour. This is why Keynes was so concerned with uncertainty. 2 4. Explain intuitively the mechanism by which an increase in government spending can lead to more output. This is discussed in the case: ‘Fiscal Policy, Managing Aggregate Demand’ and in our discussions of the multiplier. The key equations are Y = C + I + G which explains how higher G has a direct effect on creating more demand and leading to higher Y. The other key equation is C = a + cY which says that when Y goes up, there is an extra effect whereby consumption demand goes up which further raises Y and so on (i.e., the multiplier). 5. Is it reasonable to assume that firms will supply more output when consumers ...

1. Comments on Assignment Questions
John Maynard Keynes/Managing Aggregate Demand
1. Keynesian economics is often viewed as justifying increases
in deficit spending … How
does this proposal related to Keynes own writing?
There is an important point to emphasize: Keynes didn’t
necessarily believe that the only
way to stimulate the economy was through more spending by
government. He also
argued that tax cuts and instilling confidence to get people
spending again were also
important. You could draw a picture of the game with two
players who each face a
save/spend decision that we discussed in class. Then the
challenge for the government is
to shift the economy from the low to the high welfare Nash
equilibrium. This may depend
as much on instilling confidence as the government spending
more money/cutting taxes.
Greater confidence may be reflected in a higher multiplier, c
(where C = a + cY) so that
people decide to go out and spend more of the money they are
earning. This effect can
even boost output with no extra government spending required.

2. 2. What role do confidence and psychology play in Keynes
understanding of the economy
and role of government?
You should emphasize the quote of Keynes that he believed that
the Great Depression
“comes from some failure of the material devices of the mind”.
And quote the examples
of speculative stock market booms and busts that concerned
Keynes.
The key issue is that lack of confidence and uncertainty about
the future may lead
business to stop investing and consumers to stop spending
which may bring on a slump.
So psychology plays an important role.
3. Why is Keynes so concerned with uncertainty?
The main point here concerns how uncertainty can lead to
sudden changes in business
‘bullishness’, or desire to invest (see also question 2). You
could add that it was a special
kind of uncertainty that Keynes focussed on, called ‘Knightian
uncertainty’, where you
just don’t even know enough to assign probabilities. This kind
of uncertainty leads to
‘herding’ / animal spirits, whereby people tend to replicate
average behaviour.
More uncertainty can lead to less investment and consumption
demand and consequently
a recession - and the effect can be magnified by herd behaviour.
This is why Keynes was
so concerned with uncertainty.

3. 2
4. Explain intuitively the mechanism by which an increase in
government spending can
lead to more output.
This is discussed in the case: ‘Fiscal Policy, Managing
Aggregate Demand’ and in our
discussions of the multiplier. The key equations are Y = C + I +
G which explains how
higher G has a direct effect on creating more demand and
leading to higher Y. The other
key equation is C = a + cY which says that when Y goes up,
there is an extra effect
whereby consumption demand goes up which further raises Y
and so on (i.e., the
multiplier).
5. Is it reasonable to assume that firms will supply more output
when consumers and the
government demand to purchase it?
You must emphasize the concept of the ‘Output Gap’ here. If
actual output is greater than
potential output then firms will be depleting stocks so that more
demand is eventually
going to push up prices/cause inflation (and not lead to more
output). Only if actual
output is less than potential output will firms have spare
productive capacity to supply
more when there is more demand from the government or

4. consumers.
The Central Bank and Inflation
1. What revealed objectives do the actions of the Fed suggest
that it is following with
respect to its conduct of monetary policy?
I think the best answer would include a reference to the Taylor
Rule that we discussed in
class (see also Mankiw’s discussion of it in his essay on US
monetary policy in the
1990s). The idea is that the Taylor rule does a good job of
explaining how interest rates
were changed: they were lowered when unemployment went up
to help stabilize the
economy and raised whenever inflation started going up to help
avoid more inflation (by
more than one for one).
So the revealed objectives appear to be that it is trying to
achieve low and stable inflation
and also avoid recessions when unemployment starts to rise.
2. Do you believe that the US Federal Reserve is independent?
Has it been influenced by
politicians?
The question is about whether the US Fed has set interest rates
to help satisfy political
objectives (e.g., to win elections) or whether they have solely
been aimed at fighting
inflation / stabilizing the economy.

5. 3
Mankiw has a section with answers to this in his essay on US
monetary policy in the
1990s. For example, he discusses how (Democratic) Clinton
renewed (Republican)
Greenspan’s appointment.
3. Are the costs of falling prices the same as the costs of rising
prices? Why may they
differ?
There is discussion on this question in Mankiw’s essay on “US
Monetary Policy in the
1990s”. Falling prices may cause firms to default on their loans
and go bankrupt (if they
are denominated in nominal amounts). This is because as prices
fall then in real terms the
value owed goes up. It is this sort of problem that can make the
costs of deflation
different from the costs of inflation.
4. Should so much power be given to unelected central bankers
like Greenspan?
One of the main points here is that giving lots of power to
unelected central bankers may
be good since then they have independence from politicians and
the need to win
elections. That can result in monetary policy aimed more at
keeping inflation low than

6. trying to boost the economy even when actual output equals
potential output. However
the downside is that you need a person who the markets have
confidence in - that is,
someone who conducts policy in a transparent and credible way.
5. Has Greenspan been a success at the Fed? What prepared him
for the role of
Chairman?
Most commentators seem to have judged that Greenspan has
been a success using a range
of indicators. You should use objective evidence to back up this
view. For example, using
measures of inflation, real GDP growth, unemployment, stock
price rises and
productivity growth, all of these do better under Greenspan than
in the 14 years prior to
his tenure.
6. Should Greenspan speak more clearly to Congress, the public
and financial markets?
Why or why not?
This is not a question with a right or wrong answer. You could
discuss examples that we
did in class about how the yield curve barely changed at all
across the ‘anticipated’
interest rate cut of 2 October, 2001 (shortly after September
11). This suggests that
Greenspan had been communicating so well with the markets
that they fully expected
what was about to happen and the change was both transparent
and credible. However

7. remember there was also an earlier interest rate cut on 4
January, 2001 which did change
the yield curve and ‘surprised’ the markets, suggesting that
communication had not been
4
so perfect. This is the kind of discussion that is expected here,
including the idea that
Greenspan may deliberately be eloquent or obfuscating, as the
situation required.
7. Should economists be celebrities?
An important point to make here is the idea that celebrities
leave no legacy (i.e., how do
you copy one?) whereas rules can be implemented by any
person, regardless of their
celebrity status. This is an opportunity to discuss the question
of discretion versus rules
(like the Taylor Rule) in the setting of monetary policy.
The German Hyperinflation
1. Who is to blame for the German Hyperinflation?
We covered this in class. In addition to blaming the government
and central bank
governor, there is also an argument that the German extremists
were to blame. There
were extremists on the far right (Hitler) and far left
(communists) and the government

8. may have been trying to print money in an attempt to pacify
them. Also you could argue
that the Allies were to blame - the French, who were
intransigent on reparations and
occupied the Ruhr, and the US for not forgiving War loans.
There is also a view that
some German industrialists were to blame (e.g., Stinnes) who
got access to cheap loans.
2. What were the consequences of the German Hyperinflation?
There are two categories of consequences: economic and
political (e.g., undermining the
regime). On economic, you could include the extreme volatility
of relative prices, random
redistribution of wealth and also that the savvy were able to
take advantage of the
situation whereas the not-so-savvy got their life savings wiped
out (like the Fuhrer’s story
of the old lady selling her postcards).
3. What advice would you have given the German government
about how best to reduce
the country’s inflation in November 1923?
Examples include stopping increasing the money supply and
cutting the budget deficit
(reducing spending / increasing taxes) although you should also
emphasize the possibility
of reducing the reparation payments and renegotiating with the
Allies.

9. 5
The Blair Wealth Project
1. What were the causes of Britain's "stop-go" economy? Did
Mrs. Thatcher address
them successfully?
Two points to emphasize here are that stop-go had its origins in
the Keynesian Demand
Management policies of the government (both fiscal and
monetary). And that Thatcher
blamed the Unions for destabilizing the economy in the first
place. To the extent that she
crushed the unions, her actions backed up her rhetoric that
unions were to blame.
2. What is the difference – if any – between "stop-go" in the
1950s and '60s and what
Gordon Brown, New Labour's Chancellor of the Exchequer (i.e.,
Finance Minister) has
called "twenty years of Tory boom and bust" under Mrs.
Thatcher and her Conservative
successors?
This question is comparing the origin of “stop-go” cycles with
the (“boom-bust”) cycles
that occurred under Thatcher. One difference is that “boom-

10. bust” appears to have part of
their origin in the deregulation of the economy and were a
consequence of markets (like
the credit boom / bust that occurred after financial
deregulation). That is, boom-bust
seems to have been caused by herd behavior and “irrational
exuberance” - whereas “stop-
go” was more a result of the unions and government
intervention.
This is an important theme of the case study – that maybe we’ve
just replaced one source
of instability with another in the UK.
3. Do you believe that the policies implemented by Blair's New
Labour government will
finally abolish macroeconomic instability in the U.K.? What
role – if any – would
adoption of the Euro play in containing such instability?
There are several issues to discuss here regarding New Labour.
One is that they have
made the Bank of England more independent, which should
improve macro-stability.
We discussed in class how adopting the Euro would mean that
the Bank of England loses
its ability (via controlling the supply of pounds and UK interest
rates) to conduct its own
demand management of the economy (e.g., by cutting UK
interest rates during a
recession). The Euro-skeptics argue that joining the Euro could
thereby make the UK
economy less stable, rather than more.

11. 6
Inequality and the American Model
1a. Which is of greater concern: poverty or inequality?
‘Poverty’ refers usually to an absolute – you cannot afford to
buy the basic necessities of
life – whereas ‘inequality’ is always a relative concept. The
question is asking about
which is more important. So you need to be able to discuss
issues like whether the large
inequality in the US (between Michael Dell, Bill Gates and the
poorest Americans) is
really a problem since a relatively poor American may still be
richer than a relatively
well-off Somalian.
1b. Should we be concerned with rising inequality in the US?
You should emphasize that high inequality may not be a
problem at all, to the extent that
it simply reflects capitalism at work, rewarding those who put
in lots of effort (the
American Dream) and punishing those who don’t. On the side of
the argument that it is a
problem, you should mention the morality/fairness question.

12. 2. How should business respond to rising inequality?
You should discuss corporate responsibility and the stake-
holder model here. And
mention that companies could maybe try to limit ‘excessive’
CEO pay, especially to the
extent that this is viewed as ‘unfair’ or unjustified by workers.
Involving more
‘stakeholders’ in business decisions is how the Europeans
appear to have reacted to keep
inequality low and maintain ‘fairness’.
3. What are the causes of higher inequality in the US?
We covered this in class and the answers are in one of the slides
on Web CT: the answers
include globalisation, higher returns to skilled labour,
government (tax/spend) policies
and corporate avarice.
4. What policy responses are appropriate? Can the US learn
from others?
It’s important to emphasize how which approach is adopted is
affected the belief system
of the country. For example, the US (with belief in free markets
and the ‘American
Dream) is more likely to support programs requiring effort from
beneficiaries (so are
more likely to dress up redistribution as a ‘credit’, like the
earned income tax credit). By
comparison Europe (with its assumption of stagnant classes) is

13. more likely to tolerate
direct transfer programs.
7
Exchange rates
What effect may large volumes of short-term portfolio flows
have on exchange rate
volatility?
You should include discussion of how short-term capital flows
coming from changes in
investment portfolios can play a big role in precipitating large
capital outflows from
countries when foreign investors get the jitters, leading to
devaluations and problems for
the government (if it is trying to support the value of the
currency).
That is, short-term capital flows coming from changes in
investment portfolios can be a
cause of greater exchange rate volatility. Remember we
discussed in class how exchange
rates are determined by supply and demand for a country’s
currency – which comes from
trade (imports and exports) and also capital flows. But capital
flows have become more
short term in recent times as international investors (like hedge
funds) shuffle their
portfolios as they chase high returns.

14. What are the advantages and disadvantages to a country of
having a fixed versus floating
exchange rate regime?
These are listed in the case on exchange rates under the
headings “trade”, “risk of a
destabilizing speculative attack” and also “institutional
credibility versus monetary
autonomy” (see page 5).
The “trade” argument is about how fixed exchange rates can
give exporters more
certainty and promote trade (this was a big argument in favour
of the Euro – to deepen
European trade links by fixing their exchange rates).
The “institutional credibility versus monetary autonomy”
argument is about how
countries like Germany after World War I may have been able
to gain credibility for its
Central Bank by promising to fix its exchange rate to, say, the
US dollar. This kind of
promise would prevent them from doing a hyperinflation since
that would result in the
currency devaluing – which they have made a promise will not
happen.
Mexico and the “Tequila Crisis”
1. How could extensive and well-executed fiscal, supply side
and trade reforms end up in
such a dismal situation?

15. You could emphasize the heavy reliance on foreigners and the
self-fulfilling cycle of
more foreign inflows and higher expectations of growth (as per
the diagram in the lecture
slide). This can cut both ways – when there is a shock like a
political assassination, there
8
can be outflows of foreign capital and lower expectations of
growth that can also generate
a self-fulfilling cycle that leads to a big slump.
2. What best explains the collapse of the Mexican currency:
psychological factors or
fundamentals?
This question is focussing on whether psychological factors and
crises of confidence that
are unrelated to fundamentals may have caused the collapse (see
Paul Krugman’s quote
in the case study that blames herd behaviour) versus the Martin
Feldstein view quoted in
the case study that it was “fundamental problems” (like an
overvalued exchange rate, lack
of competitiveness and the financial fragility of the banking
system) that caused all the
problems.
That is, some people argue there were “fundamental” problems
in the Mexican economy
and society that led to the crisis whereas others argue that, in an
age of globalization,
short term portfolio investment flows may cause crises purely

16. due to problems with
confidence (that are primarily psychological and are not related
to the fundamentals).
3. Should Mexico be bailed out? How does your answer to this
relate to your position of
the earlier questions?
One approach to answering this question is as follows: if it is
bad fundamentals in
Mexico (e.g., political, social instability, bad banking system)
maybe they shouldn’t be
bailed out (i.e., it’s their own fault!).
However if it’s psychological factors on behalf of fund
managers in New York who have
suddenly lost confidence in a country that in fact is in pretty
good shape, then maybe they
should be bailed out (i.e., it’s not the Mexicans that are to
blame!). In this scenario it’s
the fault of the wild and unstable global capital markets.
4. Is Paul Krugman’s analogy between the Mexican crisis and
the ‘irrational
exuberance’ usually associated with tulipmania a good one?
This question again relates to the issue of whether the crisis is a
psychological ‘bubble’
bursting or is due to fundamental factors.

17. Business Economics - Assignment Questions
The Importance of Institutions and Causes of Long Run
Performance
Question 1: How can governments influence the long run rate at
which the economy grows?
Question 2: ... or do governments have little power to affect
long run performance?
Fiscal policy: Managing Aggregate Demand
Question 1: Keynesian economics is often viewed as justifying
increases in deficit spending by the
government to stimulate real economic activity. How does this
proposal relate to Keynes own writing
reproduced in the case?
Question 2: What role do confidence and psychology play in
Keynes understanding of the economy
and the role of government?

18. Question 3: Why is Keynes so concerned with uncertainty?
Question 4: Explain intuitively the mechanism by which an
increase in government spending can lead
to more output.
Question 5: Is it reasonable to assume that firms will supply
more output when consumers and the
government demand to purchase it?
Question 6: Read the following from the Washington Post, 1
August 2003:
The economy continued to lose jobs during the 2nd quarter, as
the jobless rate
rose to a nine-year high of 6.4 percent in June. But the Labor
Department
reported yesterday that the number of people filing initial
claims for
unemployment benefits declined again last week, a possible
signal that the
lackluster U.S. labor market is beginning to improve, analysts
said. The

19. government's July employment figures will be released today.
Democrats have increasingly complained that President Bush's
economic policies,
which have centered on income tax cuts for individuals and
businesses, have
done little to help the more than 9 million unemployed workers.
The Bush administration welcomed the economic reports
yesterday.
"Today's announcement . . . indicates that our economy is
clearly moving in the
right direction," Commerce Secretary Donald L. Evans said in a
statement. "The
president's tax cut is beginning to work its way into the
economy, and the stock
market continues to reflect the confidence that investors have in
the short-term
economic outlook. Today's report also shows increased business
investment
during this past spring and provides some welcome news to
Americans looking for
work this summer and fall."

20. Is the above article consistent with the predictions of the
Keynesian theory?
The Central Bank and Inflation
Question: Read the following from the Washington Post, June
27, 2003:
"Some Federal Reserve officials believed in early May that they
might need to cut interest
rates again to spur stronger U.S. economic growth but decided
to wait because the recently
ended war in Iraq had clouded the economic picture. At the
same time, some officials made
clear at their May 6 policymaking meeting that they would not
wait indefinitely for the
clouds to clear before lowering rates again in response to falling
inflation rates and sluggish
economic growth, according to minutes of the meeting released
yesterday."

21. What does the above article suggest that the Federal is trying to
achieve?
The Blair Wealth Project: Antecedents and Prospects
Question 1: What were the causes of Britain's "stop-go"
economy? Did Mrs. Thatcher address them
successfully?
Question 2: What is the difference – if any – between "stop-go"
in the 1950s and '60s and what
Gordon Brown, New Labour's Chancellor of the Exchequer (i.e.,
Finance Minister) has called "twenty
years of Tory boom and bust" under Mrs. Thatcher and her
Conservative successors?
Question 3: Do you believe that the policies implemented by
Blair's New Labour government will finally
abolish macroeconomic instability in the U.K.? What role – if
any – would adoption of the Euro play in
containing such instability?

22. Inequality and the 'American Model'
Question 1: Which is of greater concern: poverty of inequality?
Should we be concerned with rising
inequality in the United States?
Question 2: How should business respond to inequality? Does it
create business opportunities?
Question 3: What are the causes of inequality in the United
States?
Question 4: What policy responses are appropriate? Can the
United States learn from the experience
of other countries discussed in this course? If so, what lessons
should it draw?
Economic Reform in New Zealand 1984-95: The Pursuit of
Efficiency
Question: How would you compare the NZ reforms of the 1980s
to the Thatcher reforms in the UK that
occurred around the same time?

23. Mexico: The Tequila Crisis 1994-1995
Question 1: What is your answer to the question posed by the
Banco de Mexico officials on page 1 of
the case: ‘How could extensive and well-executed fiscal,
supply-side and trade reforms end up in such a
dismal situation’?
Question 2: What best explains the collapse of the Mexican
currency: psychological factors
(expectations and confidence) or fundamental factors (economic
phenomena such as current account
and fiscal deficits)?
Question 3: Should Mexico be “bailed out” by the international
community? How does your answer to
this question relate to your position on questions 1 and 2 above?

24. Question 4: Is Paul Krugman’s analogy between the Mexican
crisis and the “irrational exuberance”
usually associated with tulipmania a good one?
Sub-prime Meltdown: American Housing and Global Financial
Turmoil
Question 1: Who was to blame for the Sub-Prime Crisis in the
US and the Global Financial
Turmoil experienced in 2008?
Question 2: What can Policy Makers do to prevent another
meltdown like the one suffered in
2008?