1) What is the principle of comparative advantage and why is it important to international trade policy?
The principle of comparative advantage is the idea that some economies can produce certain goods & services at a lower opportunity cost than other countries which can produce the same goods & services. The principle of comparative advantage is important for international trade policy because it is the basis for free trade. The reason nations benefit from free trade is because they both export goods they have a comparative advantage at producing, while importing foreign goods at a lower cost.
2) Should governments be made by law to balance their budgets or should they be permitted to run deficits sometimes? How would Keynes answer this question? Explain.
Whether or not governments should be made by law to balance their budgets depends on the size of the nation’s debt as a percent of GDP, how it generally spends borrowed revenue, and how much revenue it can generate annually. If a nation is running persistent budget deficits and it seems likely that in the future they may be unable to reduce the national debt, it simply makes sense to restrain budgets by law. Nations can simply default on their debts to avoid paying them, but this would have disastrous political consequences, discourage the possibility of future borrowing, and discourage (if not entirely eliminate) foreign investment from abroad. However, in many cases, such as America during World War II, deficit spending can be used to increase economic growth in such a way that revenues may be higher later, leading to no overall increase in public debt. Keynes would support this view, based upon his belief that government can increase economic growth through boosting aggregate demand, and that spending increases in and of themselves lead to an increase in national income because of the spending multiplier.
3) Real GDP/capita is greater in the U.S. than in Sweden. What does this mean? Should everyone prefer to live in the U.S.? Explain.
The fact that real GDP per capita is greater than America than in Sweden means that the size of the economy divided by the population is greater in America than in Sweden. This is a very rough measure of standard of living, suggesting life in America is better than Sweden. However, not everyone should prefer to live in the U.S. necessarily, because many other factors (both economic and non-economic) affect quality-of-life, including: the level of equality & poverty (the amount of public services like healthcare and education), the level of technological development, the culture, the rate of crime, and the level of freedom.
4) Why do some economists argue that fiscal policy is ineffective and should not be employed?
Some argue that fiscal policy is ineffective because the amount of time it takes for governments to act means that governments can never react quickly enough to market forces. Another objection is that governments may overreact when they do establish fiscal policy, thus causing economic instability rather than addressing it. A third objection is that governments may not react to market forces at all, as political parties tend to favor specific policy measures such as tax cuts, no matter what the conditions are.
5) Does the outsourcing of U.S. jobs to workers in other countries hurt the U.S. economy? Why or why not?
Outsourcing is good for the American economy, as it is simply international trade in the labor market. Keeping in mind the principles of comparative advantage, nations which can use certain forms of labor (such as skilled or unskilled labor, or labor within a certain industry) at a lower opportunity cost than others, should use that form of labor and export all other forms of labor. This exporting of labor is exactly what outsourcing is. Just as with the market for goods, free trade with labor benefits both nations by providing each with certain specific types of labor at a lower opportunity cost.
6) How and to what degree is the president of the U.S. responsible for current U.S. economic conditions? Why or why not?
It depends on what the President does. Generally, the President simply makes recommendations to Congress, signs or vetoes the U.S. budget and other spending-related bills, and nominates the chairman of the Federal Reserve. This is a very minor role, because he can’t directly control taxation, spending, or monetary policy. However, if the President steps outside of his traditional constitutionally-limited role, such as by using government funds without congressional approval or convincing congress into starting wars based upon false evidence, he can have a substantial effect on the economy.
7) What is the impact of expansionary monetary policy on short term interest rates? On 30-year mortgage rates? Explain.
Expansionary monetary policy decreases the short-term interest rate, but not interest rates in the long-run. As the Fed buys securities from its member banks, it increases the amount of money in each bank. Having greater reserves, banks are capable of short-run lending at a lower rate. 30-year mortgage rates are unaffected by expansionary monetary policy, because it is a long-term decision; the interest rate is fixed. A decision by the Fed to expand the money supply is a short-run decision. In the long-run, any decision by the Fed to expand the money supply should be counterbalanced by a decision in the future to contract the money supply, neither of which would affect a person’s ability to pay back the loan in the long-term.
8) How does the Fed impact prices, employment, and output by buying bonds? Explain.
In reaction to a recession (and sometimes also high unemployment), the Federal Reserve expands the money supply by buying government bonds from its member banks. The increased reserves in each bank allow banks to loan funds at a lower rate. This equally allows businesses to borrow at a lower rate in order to expand their businesses, hiring more workers, producing more goods & services, and offering goods at lower prices. Aside from increasing aggregate demand causing inflation, when the money supply increases, inflation is caused by the value of each dollar decreasing in value.
In reaction to increasing inflation, the Federal Reserve contracts the money supply by selling government bonds to its member banks. This has the opposite effect of expanding the money supply: lower prices, higher unemployment, and lower output.
9) If you ran a country, what policies would you employ to grow your country’s economy in the long run? Would these policies entail short run sacrifices?
If I ran a country, in order to encourage long run economic growth, I would first establish a stable government with a police force, well-defined and enforced property rights, an independent central bank, and financial institutions so that there can be a market for capital. I would focus my economy on expanding the production of exports in which my nation has a comparative advantage. I would then borrow money from the World Bank in order to finance public research and useful public works projects (such as the development of infrastructure). Both contribute to the development of capital goods. Finally, I would establish intellectual property regulation, although it would be strictly limited. The only short-run sacrifice would be foreign debt.
10) Is there a short run policy trade off between inflation and unemployment? How come inflation and unemployment sometimes move in the same direction?
Yes. Expansionary policy increases inflation and decreases unemployment. Contractionary policy decreases inflation and increases unemployment. Inflation and unemployment sometimes move in the same direction in reaction to supply shocks. Inflation caused by changes in aggregate demand is demand-pull inflation. Inflation caused by a drop in supply (such as a rise in the price of oil) is cost-push inflation. Cost-push inflation causes unemployment because of the price-wage spiral. When there is a supply shock, business owners attempt to protect profit margins from rising costs by raising prices, that is, cost-push inflation. Workers attempt to push their wages up to account for the inflation, to avoid a loss in real wages. As a result of the supply shock, wages chase prices and prices chase wages, causing both inflation and unemployment.
11) Suppose a news report says that the CPI rose 3% last year. What does this mean? Who might be impacted by this announcement?
The consumer price index is an ecomomic statistic measuring the average price of consumer goods and services purchased by households, as determined by calculating the average price level for a specific basket of goods consumers tend to purchase. It essentially means inflation for consumers. Consumers are directly affected, but because a rise in the CPI usually means a rise in the general level of inflation, it affects us all.
12) How would an income tax cut affect aggregate demand? Could this policy affect aggregate supply? Explain.
Tax cuts (assuming government spending is constant) increases aggregate demand, because public spending is paid for through deficits rather than taxation. This increases national income in the short-run. This policy cannot affect aggregate supply, because no actual physical capital is created or destroyed.