14.02 Principles of Macroeconomics
Problem Set 4: Spring 1998

This problem set is due on Friday, March 13, 1998,

1. Why do long term interest rates rise when the Federal Reserve Chairman Alan Greenspan testifies before Congress that future demand growth in the economy looks strong?

2. Republicans have long argued for a reduction in capital-gains taxes -i.e., the taxes that are paid on the increase in value of an asset between the time it is purchased and the time it is sold. Explain what macroeconomics effect you would expect a cut in capital-gains taxes to have, assuming no change in any other policy.

3. A new president--who promised during the campaign that she would decrease future income taxes--has just been elected. Assume that people trust that the new president will keep her promise. Using the IS-LM model with the only two periods (current and future) and zero expected current and future inflation, determine the impact on curent output, the current interest rate, and current private spending, under each of the following assumptions:

a) The Fed does nothing.
b) The Fed will act to prevent any change in current and future output.
c) The Fed will act to prevent any change in the current and future interest rate.

4. In the text, you have seen details of the Clinton deficit program during 1993. How would the impact of the deficit reduction program have been different if it had included the temporary fiscal stimulus, as originally proposed? [Hint: How would the Fed have reacted?]

5. True/False/Uncertain (Explain)
a) The demand for money depends on the expected future real interest rate.
b) Since there are many cases where investors behave in an irrational way, any economic models that assume rational expectation would not be valid, and thus useless in explaining real-world economic events.

6. One reason why higher interst rates discourage investment is that many firms must borrow funds to purchasse plant and equipment. But what about investment projects financed from a firm's own retained earning--income from profits that is kept within the firm? Since no borrowing occurs, will higher interst reats discourage investment in this case? Why or why not?