Economics 302 Fall 2009 Midterm

Economics 302 Fall 2009 Midterm Binary Choice (worth 2 points each or 20 points total) Please circle legibly the letter that corresponds to your answer. Suppose you are a macroeconomist interested in building a short-run model of the aggregate economy. Most likely your model will assume that prices are Sticky in the short-run. Flexible in the short-run. Which of the following variables is a flow variable? Wealth Consumer expenditure When calculating real GDP per year using the method outlined in lecture, Prices are allowed to vary while quantities are equal to the base year quantities. Prices are equal to the base year prices while quantities are allowed to vary. The CPI provides a measure of the general price level of All goods and services produced in an economy during a specific time period. Goods and services that consumers typically purchase. Currently the unemployment rate as calculated by the Bureau of Labor Statistics does not include discouraged workers in the unemployed group. What would happen to the unemployment rate if these discouraged workers were reclassified as part of the unemployed instead of being treated as not in the labor force?The unemployment rate would Decrease. Increase. Suppose you are given the aggregate production function for an economy. Furthermore, suppose the amount of available capital increases for this economy. Holding labor constant, this increase in capital will cause the MPK to Decrease Increase Suppose you are given the aggregate production function for an economy. Furthermore, suppose the amount of available technology increases for this economy. Holding labor and capital constant, this increase in technology causes labor productivity to Increase Decrease Holding everything else constant, when the government increases its spending while maintaining the same level of taxation this results in A leftward shift in the supply of loanable funds curve. A rightward shift in the supply of loanable funds curve. In the loanable funds framework with a closed economy, when the interest rate is greater than the equilibrium interest rate this implies that the supply of goods and services is Greater than the demand for goods and services. Less than the demand for goods and services. The Fisher Effect refers to the Relationship between the demand for money and the supply of money and how this relationship determines the price level in an economy. Relationship between the inflation rate and the nominal interest rate. Short Answer/Graphing Questions (worth 5 points each or 25 point total) Please provide your answer in the provided space. Remember to write legibly and take the time to organize your answer before you begin to write. For short essay responses please remember to use complete sentences: sentences should have a subject, a verb, proper capitalization and proper punctuation. We reserve the right to lower your graph for responses that are not written in standard English with these components. 1. (5 points total) Provide a formula for the National Income Accounts Identity using the expenditure approach in the space below. Suppose that American exports decrease from $1,662 billion to $1,500 billion and at the same time American imports decrease from $2,370 billion to $2,100 billion. All other expenditure components in the American economy during this period of time are unchanged. What is the change in American GDP due to these changes? Show your work in the space below. 2. (5 points) Fill in the blank for the following two statements: An approximation for the percentage change in () is ______________________ An approximation for the percentage change in (A/B) is _______________________ Percentage change in () ? Percentage change in A+ Percentage change in B Percentage change in () ? Percentage change in APercentage change in B Provide an equation giving the relationship between the real wage and the nominal wage. Identify clearly any variable abbreviations you use in this equation. Real wage = Nominal wage/price index Use your equation and the relevant approximation technique to provide an approximation of the inflation rate when during the relevant time period the real wage grows by 3 percent while the nominal wage grows by 2 percent. Show your work. Percentage change in real wage ? Percentage change in nominal wagePercentage change in price Percentage change in price ? Percentage change in nominal wagePercentage change in real wage Percentage change in price ? 2%-3% = -1% (5 points) Suppose that a Japanese firm buys an existing U.S. firm (located in the U.S. and using American workers) and sends some of its Japanese managers to operate the firm and oversee the American workers. Assume that the firm’s output is unchanged, but that the former U.S. managers are now unemployed. Describe the effect of this transaction on U.S. GDP and U.S. GNP in the space below. Be specific in your answer and make sure you explain why the effect occurred. The effect on U.S. GDP: The U.S. GDP will remain unchanged. The production in the U.S. is unchanged; therefore the U.S. GDP doesn’t change. The effect on U.S. GNP: The U.S. GNP will decrease. The former U.S. managers lose their jobs and this reduction in their income will decrease U.S. GNP. The income the Japanese managers receive while managing the firm will not be counted in U.S. GNP since they are not U.S. citizens. (5 points) Wage rigidity is defined as the failure of wages to adjust to a level at which labor supply equals labor demand. Explain briefly why minimum-wage laws may cause wage rigidity. Wage rigidity: the failure of wages to adjust to a level at which labor supply equals labor demand. Minimum-wage laws set a legal minimum on the wages that firms pay their employees. For some workers, especially the unskilled and inexperienced, the minimum wage raises their wage above its equilibrium level and, therefore, reduces the quantity of their labor that firms demand. This causes an excess supply of labor. (5 points) Suppose that you are analyzing the U.S. economy using a classical long-run model. You see that the U.S. government increases its level of government spending while the level of aggregate output, consumption, net exports, and taxes are held constant. How will this increase in government spending affect the loanable funds market? Explain your answer verbally and illustrate your answer with a graph depicting the effect of this change in the loanable funds market. Be sure your graph is clearly labeled (horizontal and vertical axis, any curve used in the graph, and any equilibrium points) and that you identify the initial equilibrium as well as the equilibrium after the government increases its level of spending. In your answer identify the effect of this change on the real interest rate. An increase in government purchase will reduce the level of government saving and this will cause the supply of loanable funds to shift to the left at every interest rate. For a given loanable funds demand curve this implies that the interest rate will increase. On the graph the student should have the initial I1, r1 marked as well as the new I2, r2 marked on the graph. In addition, the supply and demand curves should be clearly marked (S1, S2, D1) and the two axis labeled. Essay/Problem (points noted for each question: total points in this section equal to 30 points) For the essay response please remember to use complete sentences: sentences should have a subject, a verb, proper capitalization and proper punctuation. We reserve the right to lower your graph for responses that are not written in standard English with these components. 1) (15 points total) Let ) AK)L) be an aggregate production function that maps total capital (K) and labor (L) into output (Y). Parameter ? is such that 0 ? ? ? 1. Parameter A represents the level of available technology. Fix ? and A for the rest of the problem: leave them as constants in the Cobb-Douglas production function. A) (1 point) Characterize the returns to scale of ). Explain your answer. Constant returns to scale. B) (2 points) Compute the marginal product of capital (MPK; ,))) and the marginal product of labor (MPL; ,))) for ). Are they positive or negative? ,)) = The sign of ?Y/?K is ______________ ,)) = The sign of ?Y/?L is ______________ ,)) A?K))L) A?,)))) 0 ,)) AK))L) A),)))) 0 C) (2.5 points) Compute the second partial derivatives )Y,))) and )Y,))) (just differentiate ) twice with respect to the same variable in each case). If the second partial derivative is negative (positive) this indicates that the first derivative is decreasing (increasing). Given this hint, interpret the significance of the sign of the second derivatives that you have calculated. )Y,))) = The sign of )Y,))) is _____________________ )Y,))) = The sign of )Y,))) is _______________ )Y,))) A?)K))L) 0 )Y,))) AK))?L) 0 Interpret the significance of the second derivatives in the space below: Both factors of production are subject to diminishing marginal returns because both ? and (1-?) are less than one. In other words, the marginal product of capital is decreasing as capital increases, and the marginal product of labor is decreasing as labor increases, all else held constant. D) (2 points) Provide a qualitative graph of output (Y) versus the level of capital (K) holding technology ()) and labor ()) constant. Output should be on the (vertical) y-axis, and capital should be on the (horizontal) x-axis. Label your axes. 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3 3.1 3.2 3.3 3.4 3.5 3.600.3162277660170.44721359550.5477225575050.6324555320340.7071067811870.7745966692410.8366600265340.8944271910.94868329805111.048808848171.095445115011.14017542511.183215956621.224744871391.264911064071.303840481041.34164078651.378404875211.414213562371.449137674621.483239697421.516575088811.549193338481.581138830081.612451549661.643167672521.673320053071.702938636591.732050807571.760681686171.7888543821.816590212461.843908891461.870828693391.8973665961 Time (t) Technology (A) Capital (K) Labor (L) Land (N) Output (Y) Change in Output (?Y) Output Growth Rate (%?Y) Marginal Product of Capital (MPK) Marginal Product of Labor (MPL) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 DATE GDP UR %?GDP ?UR 01-01-48 260.30015625 3.73333333333 04-01-48 267.30015625 3.66666666667 07-01-48 273.80015625 3.76666666667 10-01-48 275.1 3.83333333333 01-01-49 269.9 4.66666666667 04-01-49 266.20015625 5.86666666667 07-01-49 267.6 6.70000488281 10-01-49 265.20015625 6.96666666667 01-01-50 275.20015625 6.4 04-01-50 284.5 5.56666666667 07-01-50 301.9 4.63333333333 10-01-50 313.30015625 4.23333333333 01-01-51 329 3.5 04-01-51 336.6003125 3.10000244141 07-01-51 343.5 3.16666666667 10-01-51 347.9003125 3.36666666667 01-01-52 351.2003125 3.06666666667 04-01-52 352.1003125 2.96666666667 07-01-52 358.5 3.23333333333 10-01-52 371.4003125 2.83333333333 01-01-53 378.4003125 2.7 04-01-53 382 2.56666666667 07-01-53 381.1003125 2.73333333333 10-01-53 375.9003125 3.7 01-01-54 375.2003125 5.26666666667 04-01-54 376 5.80000488281 07-01-54 380.8003125 5.96666666667 10-01-54 389.4003125 5.33333333333 01-01-55 402.6003125 4.73333333333 04-01-55 410.9003125 4.4 07-01-55 419.4003125 4.1 10-01-55 426 4.23333333333 01-01-56 428.3003125 4.03333333333 04-01-56 434.2003125 4.20000244141 07-01-56 439.2003125 4.13333333333 10-01-56 448.1003125 4.13333333333 01-01-57 457.2003125 3.93333333333 04-01-57 459.2003125 4.1 07-01-57 466.4003125 4.23333333333 10-01-57 461.5 4.93333333333 01-01-58 453.9003125 6.30000488281 04-01-58 458 7.36666666667 07-01-58 471.7003125 7.33333333333 10-01-58 485 6.36666666667 01-01-59 495.5 5.83333333333 04-01-59 508.5 5.1 07-01-59 509.3003125 5.26666666667 10-01-59 513.2 5.6 01-01-60 527 5.13333333333 04-01-60 526.2 5.23333333333 07-01-60 529 5.53333333333 10-01-60 523.7 6.26666666667 01-01-61 528 6.80000488281 04-01-61 539 7 07-01-61 549.5 6.76666666667 10-01-61 562.6003125 6.20000488281 01-01-62 576.1003125 5.63333333333 04-01-62 583.2 5.53333333333 07-01-62 590 5.56666666667 10-01-62 593.3 5.53333333333 01-01-63 602.5 5.76666666667 04-01-63 611.2 5.73333333333 07-01-63 623.9003125 5.5 10-01-63 633.5 5.56666666667 01-01-64 649.6003125 5.46666666667 04-01-64 658.900625 5.2 07-01-64 670.5 5 10-01-64 675.600625 4.96666666667 01-01-65 695.700625 4.9 04-01-65 708.100625 4.66666666667 07-01-65 725.200625 4.36666666667 10-01-65 747.5 4.1 01-01-66 770.800625 3.86666666667 04-01-66 779.900625 3.83333333333 07-01-66 793.100625 3.76666666667 10-01-66 806.900625 3.7 01-01-67 817.800625 3.83333333333 04-01-67 822.300625 3.83333333333 07-01-67 837 3.8 10-01-67 852.700625 3.90000244141 01-01-68 879.800625 3.73333333333 04-01-68 904.100625 3.56666666667 07-01-68 919.300625 3.53333333333 10-01-68 936.200625 3.40000244141 01-01-69 960.900625 3.40000244141 04-01-69 976.100625 3.43333333333 07-01-69 996.300625 3.56666666667 10-01-69 1004.5 3.56666666667 01-01-70 1017.100625 4.16666666667 04-01-70 1033.1 4.76666666667 07-01-70 1050.5 5.16666666667 10-01-70 1052.700625 5.83333333333 01-01-71 1098.1 5.93333333333 04-01-71 1118.800625 5.9 07-01-71 1139.1 6.03333333333 10-01-71 1151.4 5.93333333333 01-01-72 1190.1 5.76666666667 04-01-72 1225.6 5.70000488281 07-01-72 1249.300625 5.56666666667 10-01-72 1286.6 5.36666666667 01-01-73 1335.10125 4.93333333333 04-01-73 1371.5 4.93333333333 07-01-73 1390.70125 4.80000244141 10-01-73 1431.80125 4.76666666667 01-01-74 1446.5 5.13333333333 04-01-74 1484.80125 5.20000488281 07-01-74 1513.70125 5.63333333333 10-01-74 1552.80125 6.6 01-01-75 1569.40125 8.26666666667 04-01-75 1605 8.86666666667 07-01-75 1662.40125 8.46666666667 10-01-75 1713.90125 8.3 01-01-76 1771.90125 7.73333333333 04-01-76 1804.20125 7.56666666667 07-01-76 1837.70125 7.73333333333 10-01-76 1884.5 7.76666666667 01-01-77 1938.5 7.5 04-01-77 2005.20125 7.13333333333 07-01-77 2066 6.9 10-01-77 2110.8 6.66666666667 01-01-78 2149.10125 6.33333333333 04-01-78 2274.7 6 07-01-78 2335.2 6.03333333333 10-01-78 2416 5.9 01-01-79 2463.3 5.86666666667 04-01-79 2526.40125 5.7 07-01-79 2599.7 5.86666666667 10-01-79 2659.4025 5.96666666667 01-01-80 2724.1025 6.30000488281 04-01-80 2728 7.33333333333 07-01-80 2785.2025 7.66666666667 10-01-80 2915.3025 7.4 01-01-81 3051.4025 7.43333333333 04-01-81 3084.3025 7.4 07-01-81 3177 7.4 10-01-81 3194.7025 8.23333333333 01-01-82 3184.9025 8.83333333333 04-01-82 3240.9025 9.43333333333 07-01-82 3274.4025 9.90000488281 10-01-82 3312.5 10.6666666667 01-01-83 3381 10.3666666667 04-01-83 3482.2025 10.1333333333 07-01-83 3587.1025 9.36666666667 10-01-83 3688.1025 8.53333333333 01-01-84 3807.4025 7.86666666667 04-01-84 3906.3025 7.43333333333 07-01-84 3976 7.43333333333 10-01-84 4034 7.3 01-01-85 4117.2025 7.23333333333 04-01-85 4175.7025 7.30000488281 07-01-85 4258.3025 7.20000488281 10-01-85 4318.7025 7.03333333333 01-01-86 4382.4 7.03333333333 04-01-86 4423.2025 7.16666666667 07-01-86 4491.3025 6.96666666667 10-01-86 4543.3025 6.83333333333 01-01-87 4611.1 6.6 04-01-87 4686.7025 6.26666666667 07-01-87 4764.5 6 10-01-87 4883.1 5.83333333333 01-01-88 4948.6 5.70000488281 04-01-88 5059.3025 5.46666666667 07-01-88 5142.8025 5.46666666667 10-01-88 5251 5.33333333333 01-01-89 5360.305 5.20000488281 04-01-89 5453.605 5.23333333333 07-01-89 5532.905 5.23333333333 10-01-89 5581.705 5.36666666667 01-01-90 5708.105 5.30000488281 04-01-90 5797.405 5.33333333333 07-01-90 5850.605 5.70000488281 10-01-90 5846 6.13333333333 01-01-91 5880.205 6.6 04-01-91 5962 6.83333333333 07-01-91 6033.705 6.86666666667 10-01-91 6092.5 7.1 01-01-92 6190.705 7.36666666667 04-01-92 6295.205 7.6 07-01-92 6389.705 7.63333333333 10-01-92 6493.605 7.36666666667 01-01-93 6544.5 7.13333333333 04-01-93 6622.705 7.06666666667 07-01-93 6688.305 6.80000488281 10-01-93 6813.805 6.63333333333 01-01-94 6916.305 6.56666666667 04-01-94 7044.305 6.20000488281 07-01-94 7131.805 6 10-01-94 7248.205 5.63333333333 01-01-95 7307.705 5.46666666667 04-01-95 7355.805 5.66666666667 07-01-95 7452.5 5.66666666667 10-01-95 7542.5 5.56666666667 01-01-96 7638.205 5.53333333333 04-01-96 7800 5.5 07-01-96 7892.705 5.26666666667 10-01-96 8023 5.33333333333 01-01-97 8137 5.23333333333 04-01-97 8276.8 5 07-01-97 8409.905 4.86666666667 10-01-97 8505.7 4.66666666667 01-01-98 8600.605 4.63333333333 04-01-98 8698.605 4.4 07-01-98 8847.2 4.53333333333 10-01-98 9027.5 4.43333333333 01-01-99 9148.605 4.30000244141 04-01-99 9252.605 4.26666666667 07-01-99 9405.105 4.23333333333 10-01-99 9607.7 4.06666666667 01-01-00 9709.5 4.03333333333 04-01-00 9949.105 3.93333333333 07-01-00 10017.5 4 10-01-00 10129.8 3.90000244141 01-01-01 10165.105 4.23333333333 04-01-01 10301.3 4.4 07-01-01 10305.2 4.83333333333 10-01-01 10373.105 5.5 01-01-02 10498.7 5.70000488281 04-01-02 10601.9 5.83333333333 07-01-02 10701.7 5.73333333333 10-01-02 10766.9 5.86666666667 01-01-03 10888.41 5.86666666667 04-01-03 11008.1 6.13333333333 07-01-03 11255.7 6.13333333333 10-01-03 11416.5 5.83333333333 01-01-04 11597.21 5.70000488281 04-01-04 11778.41 5.6 07-01-04 11950.5 5.43333333333 10-01-04 12144.9 5.43333333333 01-01-05 12379.5 5.26666666667 04-01-05 12516.81 5.13333333333 07-01-05 12741.61 4.96666666667 10-01-05 12915.61 4.93333333333 01-01-06 13183.5 4.73333333333 04-01-06 13347.81 4.66666666667 07-01-06 13452.9 4.63333333333 10-01-06 13611.5 4.43333333333 01-01-07 13795.61 4.5 04-01-07 13997.21 4.53333333333 07-01-07 14179.9 4.70000244141 10-01-07 14337.9 4.80000244141 01-01-08 14373.9 4.93333333333 04-01-08 14497.81 5.36666666667 07-01-08 14546.7 6.06666666667 10-01-08 14347.3 6.86666666667 01-01-09 14178 8.06666666667 04-01-09 14143.3 9.26666666667 0 0 0.1 0.316227766017 0.2 0.4472135955 0.3 0.547722557505 0.4 0.632455532034 0.5 0.707106781187 0.6 0.774596669241 0.7 0.836660026534 0.8 0.894427191 0.9 0.948683298051 1 1 1.1 1.04880884817 1.2 1.09544511501 1.3 1.1401754251 1.4 1.18321595662 1.5 1.22474487139 1.6 1.26491106407 1.7 1.30384048104 1.8 1.3416407865 1.9 1.37840487521 2 1.41421356237 2.1 1.44913767462 2.2 1.48323969742 2.3 1.51657508881 2.4 1.54919333848 2.5 1.58113883008 2.6 1.61245154966 2.7 1.64316767252 2.8 1.67332005307 2.9 1.70293863659 3 1.73205080757 3.1 1.76068168617 3.2 1.788854382 3.3 1.81659021246 3.4 1.84390889146 3.5 1.87082869339 3.6 1.8973665961 Does the slope of this graph correspond with your result for the sign of )Y,))) in part (C)? The slope of the graph is decreasing as the level of capital increases, which corresponds with )Y,))) <0, our result from part (C). E) (2 points) Assume that factor markets are perfectly competitive, so the factors of production are paid their marginal products. Let’s say that it is now the long-run, so all factors of production are fixed, including the level of technology: ), ), and ). What is the long-run equilibrium wage )? Show your work. ) MPL ,)) ))),))))) )),))) F) (3 points) How much is paid to labor (labor income) in long-run equilibrium? What is labor’s share of total income? Labor Income = __________________________________________ Labor’s Share of Total Income = _____________________________ )) )),))) )),)))),))) ) G) (1 points) If you want to predict the long-run distribution of income across factors according to this production theory, what do you need to estimate in terms of parameters? In other words, what variables are needed to compute both capital’s share of income and labor’s share of income? You only need an estimate for ?. H) (1.5 points) The following graph was provided by the Federal Reserve Bank of St. Louis. This graph depicts two lines: 1) the total compensation of labor (labor’s share of total income) over time and 2) the share of labor compensation over time from wages and salaries. Assume that we are in the long-run, with ? still fixed. Is this graph consistent with your result from part (F) on labor’s share of total income? Think about what should happen over time, not the value. If ? is fixed, our long-run prediction from part (F) is that labor’s share of national income should remain roughly constant over time. The graph is consistent with this, although it seems like wages and salaries are becoming less important in terms of how labor is compensated. I’d assume that fringe benefits and health insurance are growing over time, accounting for this change (higher health insurance costs). 2) (15 points) This question takes your knowledge of the article “How Did Economists Get It So Wrong?” by Paul Krugman in The New York Times Magazine as given. John Cochrane is a professor at the University of Chicago, a “freshwater” school according to Krugman. On 9/16, he published a response to Krugman’s article on his website. Here is a short passage from Cochrane’s response to Krugman. “The sad fact is that few in Washington pay the slightest attention to modern macroeconomic research, in particular anything with a serious intertemporal [over time] dimension.  Paul’s simple Keynesianism has dominated policy analysis for decades and continues to do so … everyone just adds up consumer, investment and government “demand” to forecast output and uses simple Phillips curves to think about inflation.  If a failure of ideas caused bad policy, it’s a simpleminded Keynesianism that failed.” Please write a few paragraphs discussing Krugman’s assertions in his article and Cochrane’s response to those claims. You should briefly address the following questions: (4 points) What was Krugman’s problem with economic policy before the recession? (4 points) What type of economic policy did Krugman argue for? Why use this policy? (3 points) According to Cochrane (see the above quote), what type of economic policy is really used? Why is it flawed? (4 points) For each author, what was the cause of the recession? Contrast their views. Part I. [4; poor financial system regulation, Federal Reserve monetary policy, laissez-faire attitude (need two out of the three for full credit)] Krugman argues that economic policy did not actively address the root causes of the financial crisis. For example, the financial system was loosely regulated, which led to fraud, abuse, and an overextension of credit to households and firms. The Federal Reserve engaged in expansionary monetary policy with low real interest rates, so borrowing money was low-cost and the economy overheated. Due to the ideology of the “freshwater” school of macroeconomics, government officials thought that the markets would regulate themselves and find the optimal outcome in terms of growth. This turned out to not be the case with the financial and housing markets. Part II. [4; Keynesian economic policy, especially fiscal policy/stimulus, to stimulate aggregate demand] Paul Krugman makes the case for traditional Keynesian economic policy. He argues for a very large fiscal stimulus on the part of the US federal government. The purpose of this increase in government expenditure is to shore up aggregate demand, or just demand in general, for goods and services across the economy. The idea here is that such an economic stimulus will shorten the duration of the recession and more rapidly restore the economy to the full employment level of output (long-run growth path). Krugman also supports expansionary monetary policy, the lowering of real interest rates by the Federal Reserve. However, due to the severity of the financial crisis, monetary policy hit the zero interest rate lower bound, i.e. the Fed couldn’t push the nominal interest rate any lower (below zero). Therefore, monetary policy was ineffective and large fiscal policy measures were necessary. Part III. [3; Keynesian, the analysis is too simple and outdated] Cochrane says that traditional Keynesian economic policy is currently the modus operandi for the government officials. Those in charge of public policy do not use the most modern and up-to-date dynamic macroeconomic models, which are implicitly better than the old Keynesian models (AD/AS, IS/LM, etc.). Therefore, Krugman’s claims about the effects of “freshwater” economic thinking on policy are incorrect. Keynesian economic policy is flawed because its ideas are outdated and overly simplistic. Such policy was proven wrong in the past, and has proven itself to be wrong again in the last few years. Part IV. [4; Krugman: caused by “freshwater” influence on policy, Cochrane: caused by Keynesianism] Krugman: recession caused by irresponsible traders on Wall Street, lax regulation, and expansionary monetary policy. Due to the influence of the “freshwater” school, laissez-faire was popular again. Regulators were encouraged to not to intervene in the “free” market system. Bubble in housing prices; credit was abundant and too easy to get. Cochrane: recession caused by bad macroeconomic policy. Keynesian-type analysis is too simple and misses important features of the macroeconomy. Using Keynesian ideas, those in charge of policy couldn’t respond to a recession brought about due to a financial crisis because their economic tools were obsolete. Too much influence from the “saltwater” school of thought, which includes Krugman. 1