ECO 368M - Exam 2

two steps in Fisher’s debt-deflation cycle, beginning with attempts to repay debt

1. heavily indebted borrowers sell assets to repay loans, making prices fall further

2. falling general price level raises the real burden of nominal debt, distress sales and defaults deepen the downturn

two ways debt and weak bank balance sheets contributed to Japan’s prolonged stagnation

1. after property and equity bubbles burst, indebted firms and households reduced spending to pay loans

2. bad loans and weak balance sheets restricted lending, making it harder for businesses/households to spend/invest

two ways expected continued deflation could prolong Japan’s slump

1. households expecting lower prices may postpone purchases, reducing demand

2. firms expecting weak demand may delay investment

expected deflation becomes self-fulfilling

1) define reflation and 2) explain how fisher expects it to reduce the real burden of debt

1. raising the general price level after deflation

2. Fisher proposed expanding the money supply to restore prices and a higher price level would reduce the real value of debts and make them easier to repay

two responses to Japan’s deflation

1. QE: central bank purchases digital assets to inject money and ease financial conditions

2. cutting interest rates towards 0: lower interest rates aimed to encourage borrowing, spending, and investment during 1990s slump

two policy lessons from Japan’s experience with deflation/stagnation

1. avoid sustained deflation: falling prices raise the real burden of nominal debts and can depress spending

2. consider more than QE alone: monetary easing may not be enough to change expectations or restore demand, use both monetary and fiscal measures

two reasons why QE alone struggled to end deflation in Japan

1. entrenched expectations: expectations of falling prices encouraged households and firms to hold back on spending, making deflation self-fulfilling

2. structural and financial obstacles: aging population and the need for structural changes hindered recovery

two reasons Keynes supported gov. borrowing during downturns

1. spending can replace deficient private demand and move output and employment towards their potential

2. when the economy is below potential, borrowing to spend isn’t inflationary because there is room to increase output

two policies Keynes recommended to boost demand

1. public works to create jobs and deficit spending to raise demand

2. tax cuts to increase disposable income and encourage consumption

define a gov. budget deficit and a gov. debt and explain how they differ

deficit: gov. spending exceeds revenue in a given year

debt: reflects accumulated deficits over time

differ: deficit is in a year and debt is accumulation over many years

1) define automatic stabilizer and 2) use unemployment benefits to explain how one works

1. changes gov. spending as economic conditions change without a new policy decision

2. during a downturn, people become eligible for unemployment benefits, increasing gov. spending and helping support incomes/demand

two objections to gov. borrowing/fiscal stimulus

1. critics feared persistent deficits and rising debt would cause investors to demand higher returns, increasing gov. borrowing costs

2. crowding out of private investment: gov. borrowing may raise interest rates, making borrowing more expensive for private firms

two reasons why Keynes thought low interest rates alone might fail to restore investment during weak recovery

1. weak expected sales: firms have little incentive to expand when household and gov. spending remain weak

2. uncertainty about recovery: long recession makes firms hesitant to commit money to long-term projects

1) define paradox of thrift and 2) explain its effect on savings in two linked steps

1. when people try to save more, consumption falls, reducing demand and output

2. lower output/demand reduces incomes and the funds available to save, so aggregate saving can fall despite people trying to increase it

two responses to weak consumption/investment and how each could support demand

1. public investment: gov. borrowing for investment raises output and incomes, supporting consumption when private investment is insufficient

2. automatic stabilizers: payments rise during downturns without new policy decisions, helping support household incomes/spending

1) define austerity and 2) one reason European governments adopted it after the GFC

1. fiscal restraint aimed at reducing budget deficits and containing gov. debt

2. European govs. argued that fiscal discipline was needed to restore investor confidence and preserve access to borrowing

when should governments borrow to spend and when should they repay debt?

borrow: to spend during downturns when deficient demand leaves output and employment below their potential

repay: debt during good times or a boom, when the economy is stronger

define crowding out and crowding in

crowding out: gov. borrowing can raise interest rates and make private investment more expensive

crowding in: public investment, like better telecommunications, can increase the returns to private investment

define creative destruction

process through which innovations replace older products, technologies, firms, or ways of organizing production

how does creative destruction promote economic growth?

by raising productivity which raises the economy’s growth potential and improves living standards

example of creative destruction

smartphones: iphone and android displaced nokia’s and blackberry’s market leadership through software development

why did nokia and blackberry fall?

nokia: fell b/c they were slow to response to software devlopments like touchscreen and app stores, gradual loss may have delayed response and sense of urgency

blackberry: focused on business users and failed to response when the market shifted to consumer uses and cell-phone innovation

two strengths of Chinese companies in developing innovative products and services

1. large home market allows to test products/services before introducing it to foreign markets

2. rising investment in R&D and research activity of firms provide resources for technological development

obstacles China faced transitioning from imitation to innovation (4 s’s)

1. state-sector dominance: state-owned firms dominated key sectors and made it difficult for private companies

2. spending: high spending in R&D didn’t guarantee innovation

3. sheltered: home market lets a firm get huge without proving it can beat global competitors

4. suspicion: overseas worries about government links and industrial espionage limited access to foreign markets

Huawei as an entrepreneurial innovator

went from an importer of telecommunications to a major global telecommunications business which showed how an entrepreneur can reshape a business and challenge established competitors

two competitive pressures faced by apple/samsung according to yueh

1. market saturation: slower smartphone sales growth in developed markets limit opportunities for expansion

2. new competitors in China are competing for international market shares

apple and samsung possible response to competitive pressures

apple: offer complimentary software like music streaming services along with hardware

samsung: invest in wearable technology, although uptake is slow as shown by apple

schumpeter doesn’t imply apple/samsung will be ___, he implies:

replaced; creative destruction pushes for continued innovation but doesn’t identify the next winning firm or innovation

“made in China” vs “designed in China”

mic: manufacturing in China doesn’t establish that Chinese firms created the tech

dic: Chinese firms develop useful innovations and globally competitive products and brands, moving beyond assembly

mic vs dic: why it’s important for China’s growth (two reasons)

1. entrepreneurial innovations raise productivity and drives economic growth

2. product and brands recognized internationally for quality demonstrates Chinese firms can compete through innovation

credit-fueled boom and bust (think CSB)

1. cheap credit: low interest rates encourage investment in areas where demand is only temporarily boosted and not sustainable

2. stuck capital: specialized capital, like machinery, can’t be easily transferred to other sectors or stages of production

3. bust: when demand fades, the capital becomes underused/abandoned, resulting in a recession and reveals inefficiently invested savings

“Road to Serfdom” central warning and what prompted it

central warning: continued gov. control through central planning could sacrifice individual freedom and lead to a totalitarian society
what prompted it: British considered its post-war direction after being used to a centrally planned economy during the war

two dangers associated with central planning

1. loss of individual choice: planners impose decisions of a small group of people on the total population

2. risk of totalitarianism: continued control of economic decisions can product an oppressive society

Hayek connecting Fed Reserve policy to the buildup of the GFC (think IRS)

1. interest-rate cuts: Fed reduced interest rates from 6.5% to 1% between 2000-2004 to support investment and consumption

2. riskier housing borrowing: cheap credit encouraged excessive borrowing and greater risk-taking in the housing market

3. suprime-mortgage problems: those borrowing decisions contributed to problems in subprime mortgages a few years later

Hayek’s likely position vs. Yueh’s uncertainty on systemic risk

Hayek: suggests that institutions who lent badly should be allowed to fail

Yueh: questions where he would’ve supported their rescue to prevent those failures from triggering the collapse of otherwise sound businesses

his response to systemic risk is uncertain