Category: Economics

23-4 The Dangers of High Debt
Suppose that, for good or bad reasons, large deficits have led to a high debt ratio. What should the government do then? Simply trying to stablize the debt at this high level is unwise: The lesson from history is that high debt can lead to viclous cycles and makes the conduct of fiscal policy extremely difficult. Let’s look at this more closely.
High Debt, Default Risk, and Vicious Cycles
Return to equation (23.5):
BiYi-Bi-1Yi-1=(r-g)Bi-1Yi-1 (Gi-Ti)Yi
Take a country with a high debt ratio, say, 100%. Suppose the real interest rate is 3% and the growth rate is 2%. The first term on the right is (3%-2%) times 100%=1% of GDP. Suppose further that the government is running a primary surplus of 1%, thus just enough to keep the debt ratio constant (the right side of the equation equals (3%-2%) times 100% (-1%)=0%.
(Now suppose financial investors start to worry, that the government my not be able to fully repay the debit They ask tor a higher interest rate, to compensute for what they perceive as ahigher risk of defaily on the debt. But this in turn makes it more difficult for the government to stabilize the debt, Suppose, for example, that the interest nate increases from 3% to say, 8%. Then, fust to stablize the debt, the government now needs to run a primary surplus of 6% (the right side of the equation is then equal to

Use the real business cycle model to explain the business cycles.
This model assumes that persistent total factor productivity increases, can produce expansions.
Question 1:
Use the graphs of the labor, output, and money markets to show how a persistent TFP shock increase produces an expansion for exogenous monetary policy behavior. Denote the initial points with the letter A and the final points with the letter B. Graph the movement of each of the curves and explain, step-by-step, why those movements occur.
Question 2:
How consumption, employment, investment, price level, and total output change, i.e., how do C
B
, N
B
, I
B
, P
B
, Y
B
compare to C
A
, N
A
, I
A
, P
A
, Y
A
? To answer this question, just indicate the direction of change using the right symbol ( <, >, or = ), e.g., X
A
= X
B
.
Question 3:
What does the model predict for the following variables, after a persistent change in total factor productivity? Are they procyclical, countercyclical, or acyclical?
Consumption:
Employment:
Investment:
Price Level:
Question 4:
What do the data tell us for the following variables, are they procyclical, countercyclical, or acyclical?
Consumption:
Employment:
Investment:
Price Level:
Question 5:
Are total factor productivity shocks likely to be generating the business cycle? Circle: Yes / No (Tip: compare your answers in question 2 & 3).

2. The market for EpiPensConsider the pharmaceutical company Mylan that produces epinephrine injection devices called EpiPens. In the presence of other firms producing substitutes for this good, the price of EpiPens is $150.
Now suppose that competitors to Mylan no longer produce epinephrine injection devices, so Mylan now has pricing power in this market. As the economist on staff at Mylan, you are charged with the task of figuring out what your company’s new pricing strategy should be.
The following graph shows the marginal cost (MC), which is assumed to be constant, and the average total cost (ATC) of Mylan. The graph also shows the demand curve (D) for EpiPens and the marginal revenue curve (MR) once the firm has market power.
On the graph, use the grey point (star symbol) to indicate the quantity of EpiPens demanded if Mylan continues to charge $150. Dashed drop lines will automatically extend to both axes.
QDat $150Profit MaxATC at Profit MaxProfit01234567891010009008007006005004003002001000PRICE (Dollars per EpiPen)QUANTITY (Thousands of EpiPens)MRDMCATC
If Mylan continues to charge $150 per EpiPen, Mylan will earn economic profit.
True or False: Given the demand curve for EpiPens, you should tell Mylan’s CEO that total revenue will decrease if she raises the price of EpiPens because the demand curve in this region is relatively inelastic.
TrueFalse

The U.S. Army Corps of Engineers has contracted with a medium-size excavation firm to construct a small series of three earthen dams as part of a flood control project in North Carolina.
For economic reasons, dams #1 and #2 have to be constructed at the same time and dam #3 can be built only after #1 and #2 are completed. There is also a very important scheduled completion date that has to be met (relating to next year’s flood season). The project is being handled by Bryan Johnson, who has been with the company for about a year.
This is a new job for Bryan in that he had never before headed more than one project at a time. About 3 months into the building of dams #1 and #2, he began to notice an information problem. He had supervisors from dams #1 and #2 reporting to him, but he never knew how far along they were in relation to each other. Since dam #3 cannot be built until both dams are fully complete, he cannot tell if it will be started on time and therefore completed on time. Realizing that the situation was becoming serious, he began to wonder about how he could coordinate the projects. How could he tell where the projects were in relation to each other? How far were they jointly behind? Bryan’s major problem was his inability to monitor and record the dual projects effectively.
QuestionWhat would you recommend to Bryan?

➤ What does a 0.20 reserve requirement mean for bank lending and the money multiplier?
A 0.20 reserve requirement forces banks to keep 20% of deposits as reserves, allowing them to lend 80% if they hold no excess reserves. The money multiplier is 1/0.20 = 5, so an initial reserve injection can expand total deposits up to five times before reserve constraints halt further lending.