Macro & Micro Economics

The questions as well as intructions are attached.

Microeconomics (Week 6)

1. Suppose seven people are trying to decide whether to get a pizza with pepperoni, a pizza with sausage and pepperoni, or a pizza with everything on it. Four people want everything, one wants pepperoni and sausage, and two want pepperoni only. Assume that each person prefers a pizza closer to his or her first choice to a pizza that is unlike the first choice. What is the preference of the median voter? Which pizza will be selected if the majority rules?

2. What dilemma faces regulators trying to regulate natural monopolies?

3. Distinguish among private goods, public goods, natural monopoly, and open-access goods.

4. Political corruption is epidemic in Russia today. What effect does this have on the Russian economy? Compare and contrast bureaus and business firms.

5. How does social regulation differ from economic regulation?

6. Additional Question: Answer in as many words as it takes to answer – Has airline deregulation been a success? Be sure to take into account the accessibility and flight amenities, as well as price. What, if any, effects do you think rising fuel costs will have on airline regulation/deregulation?

Microeconomics (Week 7)

1. Explain how welfare creates work disincentives.

2. Discuss the factors that cause the average income of nonwhites to be lower than the average income of whites.

3. Education is often used as an example of a positive externality. Are the external benefits greater for elementary, secondary, or college education? Explain.

4. Explain why the optimal level of pollution is not zero. According to an EPA study, the health hazards of Superfund sites have been greatly exaggerated and air pollution tends to be a bigger health hazard than toxic waste dumps. Why is more attention focused on toxic waste dumps than on air pollution?

5. Explain the changes in welfare caused by the “Personal Responsibility and Work Reconciliation Act” of 1996.

6. To what extent do you think U.S. income distribution is determined by economic factors? Use the material developed in this unit to inform your (positive) position. To what extent do you think the U.S. income distribution should be determined by economic factors? Use the material developed in this unit to inform your (normative) position.

Each question (1-5 for both) need to be answered in 75 words or greater. The additional question (6 for both) can be answered in as many words as it takes to answer the question. I need the book that is being used to be referenced in APA format. The book being used is ECON MICRO 3 by William McEachern. I need these back Tuesday (4/9) by 7:00pm so that I have time to read over and submit them. 7:00 EST.

Macroeconomics (Week 6)

1. Explain how banks are financial intermediaries. What are reserves? What are excess reserves? Explain how the Fed can affect the quantity of excess reserves in the banking system.

2. What are the three functions of money, and why are they important?

3. What are the differences between M1 and M2?

4. Discuss the factors that led to deregulation of U.S. financial markets in the 1980s.

5. How can the Fed affect the money supply by using the discount rate?

6. Additional Question: Answer in as many words as it takes to answer – The chapter traces out the evolution of money from commodity moneys to unbacked fiat moneys. How is money likely to change during this century?

Macroeconomics (Week 7)

1. Explain how the short-run Phillips curve, the long-run Phillips curve, the short-run aggregate supply curve, the long-run aggregate supply curve, and the natural rate hypothesis are all related. How do active and passive views of these concepts differ?

2. What is meant by the demand for money? Which way does the demand curve for money slope? Why?

3. Explain why the Fed can attempt to target either changes in the money supply or changes in interest rates, but not both.

4. Explain how an active policy differs from a passive policy.

5. How does monetary policy affect aggregate demand in the short run? How does monetary policy affect aggregate demand in the long run?

6. Additional Question: Answer in as many words as it takes to answer – What are the major similarities and major differences between the direct and indirect channels of monetary policy?

Each question (1-5 for both) need to be answered in 75 words or greater. The additional question (6 for both) can be answered in as many words as it takes to answer the question. I need the book that is being used to be referenced in APA format. The book being used is ECON MACRO 3 by William A. McEachern I need these back Tuesday (4/9) by 7:00pm so that I have time to read over and submit them. 7:00 EST.

Case StudiesCase Studies
MONEY AND THE FINANCIAL SYSTEM

Case Study 14.1: Mackerel Economics in Federal Prisons

The economist R.A Radford spent several years in prisoner-of-war camps in Italy and Germany during World War II,

and he wrote about his experience. Although economic activity was sharply limited, many features of a normal

economy were found in the prison life he observed. For example, in the absence of any offi cial currency behind

bars, cigarettes came to serve all three roles of money: medium of exchange, unit of account, and store of value.

Cigarettes were of uniform quality, of limited supply (they came in rations from the International Red Cross),

reasonably durable, and individually could support small transactions or, in packs, larger ones. Prices measured in

cigarettes became fairly uniform and well known throughout a camp of up to 50,000 prisoners of many nationalities.

Now fast-forward half a century to the U.S. federal prison system. Prisoners are not allowed to hold cash. Whatever money sent by relatives

or earned from prison jobs (at 40 cents an hour) goes into commissary accounts that allow inmates to buy items such as snacks and toiletries.

In the absence of cash, to trade among themselves federal prisoners also came to settle on cigarettes as their commodity money (despite offi –

cial prohibitions against trade of any kind among inmates). Cigarettes served as the informal

money until 2004, when smoking was banned in all federal prisons.

Once the ban took effect, the urge to trade created incentives to come up with some

other commodity money. Prisoners tried other items sold at the commissary including

postage stamps, cans of tuna, and Power Bars, but none of that seemed to catch on.

Eventually prisoners settled on cans of mackerel, a bony, oily fi sh. So inmates informally use

“macks”—as the commodity money came to be called—to settle gambling debts, to buy

services from other inmates (such as ironing, shoe shining, and cell cleaning), and to buy

goods from other inmates (including special foods prepared with items from the commissary

and illicit items such as home-brewed “prison hooch”). At those federal prisons where the

commissary opens only one day a week, some prisoners fi ll the void by running mini-com-

missaries out of their lockers.

After wardens banned cans (because they could be refashioned into makeshift knives),

the commodity money quickly shifted from cans of mackerel to plastic-and-foil pouches of

mackerel. The mack is considered a good stand-in for the dollar because each pouch costs

about $1 at the commissary, yet most prisoners, aside from weight-lifters seeking extra

protein, would rather trade macks than eat them.

Wardens try to discourage the mackerel economy by limiting the amount of food prison-

ers can stockpile. Those caught using macks as money can lose commissary privileges, can

be reassigned to a less desirable cell, or can even spend time in the “hole.” Still, market

forces are so strong that the mackerel economy survives in many federal prisons.

SOURCES: R. A. Radford, “The Economic Organization of a P.O.W. Camp,” Economica, 12 (November 1945): 189–201: and Justin Scheck, “Mackerel Economics in Prisons Leads
to Appreciation of the Oily Fillets,” Wall Street Journal, 2 October 2008.

QUESTION
1. How well do pouches of mackerel satisfy the six properties of ideal money (durable, portable, divisible, uniform quality, low opportunity cost,

stable value)?

14

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Case Study 14.2: The Hassle of Small Change

About 8 billion U.S. pennies were minted in 2009, and about 150 billion pennies circulated. That’s about 500 pennies per U.S. resident. Most

pennies are resting in change jars, drawers, or other gathering places for the lowly coin. Pennies are abandoned in the tiny bins and donation

cans at store counters. Many people won’t bother to pick one up on the sidewalk (as evidenced by the number you fi nd there). The penny, like

all U.S. currency, has over time been robbed of its exchange value by infl ation. Today’s penny buys only one-seventh as much as it did in the

1950s. Pennies can’t be used in parking meters, vending machines, or pay telephones, and penny candy is long gone. To avoid the hassle of

small change, some restaurants, such as the Vanilla Bean Café in Pomfret, Connecticut, charge prices exactly divisible by 25 cents. That way,

pennies, nickels, and dimes aren’t needed for any transaction.

The exchange value of the penny has declined as the cost of minting it has risen. For more than a century, the penny was 95 percent

copper. In 1982, copper prices reached record levels, so the U.S. Mint began making pennies from zinc, with just a thin copper fi nish. Then the

price of zinc rose, boosting the metal cost of a penny in 2009 to 0.8 cents. Add to that the 0.8-cent minting cost per penny, and you get

1.6 cents per coin. So the government loses 0.6 cents on each penny minted, or $14.4 million on the pennies minted in 2009. Nickels, which

are mostly copper, are also money losers; in 2009 they cost 6 cents to make.

Has the penny outlived its usefulness? In the face of rising metal prices, the government has some options. First option: mint them from a

lower-cost alloy. This would buy some time, but infl ation would eventually drive the metallic cost above the exchange value of the coin. Second

option: abolish the penny. Take it out of circulation. Countries that have eliminated their smallest coins include Australia, Britain, Finland, Hong

Kong, and the Netherlands. New Zealand eliminated its 5-cent coin, as well as its 2-cent and 1-cent coins. The United States abolished the

half-cent coin in 1857, at a time when it was worth 8 cents in today’s purchasing power.

Third option: decree that the penny is worth fi ve cents, the same as

a nickel. At the same time, the government could withdraw nickels from

circulation. With pennies worth so much more, there would be no incentive

to hoard them for their metallic value (a current problem), and it would likely

be decades before the metallic value caught up with the exchange value.

Rebasing the penny to 5 cents would increase the money supply by about $6

billion, a drop in the bucket compared to a total money supply of $1.7 trillion,

so the move would have virtually no effect on infl ation.

If the penny gets so little respect, why did the Treasury mint 2.4 billion

in 2009? As noted, some people are hoarding pennies, waiting for the day

when the metallic value exceeds the exchange value. Another source of

demand is the sales tax, which adds pennies to transactions in 44 states.

Charities also collect millions from change cans located at check-out coun-

ters. And zinc producers lobby heavily to keep the penny around as a major

user of the metal. Thus, the penny still has its boosters. That’s why retailers

continue to order pennies from their banks, these banks order pennies from the Fed, the Fed orders them from the U.S. Mint, and the Mint

presses yet more pennies into idle service.

SOURCES: Austan Goolsbee, “Now that the Penny Isn’t Worth Much, It’s Time to Make It Worth 5 Cents,” New York Times, 1 February 2007; Elizabeth Williamson, “Will Nickel-Free
Nickels Make a Dime’s Worth of Difference,” Wall Street Journal, 10 May 2010; and Thomas Sargent and Francois Velde, The Big Problem of Small Change (Princeton, NJ: Princeton
University Press, 2002). View the rounded prices on Vanilla Bean Café’s menu at http://www.thevanillabeancafe.com/.

QUESTION
1. In countries where the monetary system has broken down, what are some alternatives to which people have resorted to carry out

exchange?

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Case StudiesCase Studies
INTERNATIONAL FINANCE

Case Study 19.1: The Big Mac Index

As you have already learned, the PPP theory predicts that in the long run the exchange rate between two cur-

rencies should move toward equalizing the cost in each country of an identical basket of internationally traded

goods. A light-hearted test of the theory has been developed by The Economist magazine, which compares prices

around the world for a “market basket” consisting simply of one McDonald’s Big Mac—a product that, though not

internationally traded, is essentially the same in more than 100 countries. The Economist begins with the price of a

Big Mac in the local currency and then converts that price into dollars based on the exchange rate prevailing at the

time. A comparison of the dollar price of Big Macs across countries offers a crude test of the PPP theory, which predicts that prices should be

roughly equal in the long run.

This chart lists the

dollar price of a Big Mac in

March 2010, in 22 surveyed

countries plus the euro zone

average. By comparing the

price of a Big Mac in the

United States (shown as

the green bar) with prices

in other countries, we can

derive a crude measure of

whether particular curren-

cies, relative to the dollar,

are overvalued (red bars) or

undervalued (blue bars). For

example, because the price

of a Big Mac in Norway,

at $6.87, was 92 percent

higher than the U.S. price of

$3.58 the Norwegian krone

was the most overvalued

relative to the dollar of the

countries listed. But Big

Macs were cheaper in most

of the countries surveyed.

The cheapest was in China, where $1.83 was 49 percent below the U.S. price. Hence, the Chinese yuan was the most undervalued relative to

the dollar.

Thus, Big Mac prices in March 2010 ranged from 92 percent above to 49 percent below the U.S. price. The euro was 29 percent overval-

ued. The price range lends little support to the PPP theory, but that theory relates only to traded goods. The Big Mac is not traded internation-

ally. Part of the price of a Big Mac must cover rent, which can vary substantially across countries. Taxes and trade barriers, such as tariffs and

quotas on beef, may also distort local prices. And wages differ across countries, with a McDonald’s worker averaging about $8 an hour in the

United States versus more like $1 an hour in China. So there are understandable reasons why Big Mac prices differ across countries.

SOURCES: “The Big Mac Index: Exchanging Blows,” The Economist, 17 March 2010; David Parsley and Shang-Jin Wei, “In Search of a Euro Effect: Big Lessons from a Big Mac
Meal?” Journal of International Money and Finance, 27 (March 2008): 260–276; Ali Kutan et al., “Toward Solving the PPP Puzzle: Evidence from 113 Countries,” Applied Economics,
41 (Issue 24, 2009): 3057–3066; and the McDonald’s Corporation international Web site at http://www.mcdonalds.com.

QUESTION
1. The Big Mac Index computed by The Economist magazine has consistently found the U.S. dollar to be undervalued against some curren-

cies and overvalued against others. This fi nding seems to call for a rejection of the purchasing power parity theory. Explain why this index

may not be a valid test of the theory.

19
Cost of a Big Mac by Country

$0.00 $1.00 $2.00 $3.00 $4.00 $5.00 $6.00

Norway
Switzerland

Euro zone
Canada

Australia
Hungary

Turkey
United States

Japan
Britain

South Korea
United Arabs Emirates

Poland
Saudi Arabia

Mexico
South Africa

Russia
Egypt

Taiwan
Indonesia

Thailand
Malaysia

China

6.16
4.62

4.06
3.98

3.75
3.71

3.58
3.54

3.48
3.00
2.99

2.86
2.67

2.56
2.44
2.39
2.37

2.28
2.36

2.12
2.16

1.83

Big Mac prices converted to U.S. dollars

$7.00

6.87

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Case Study 19.2: What About China?

The U.S. trade defi cit with China of $227 billion in 2009 exceeded America’s combined defi cits with the European Union, OPEC countries, and

Latin America. The defi cit with China grew about 15 percent annually between 2007 and 2010. Americans spend four times more on Chinese

products than the Chinese spend on American products. Between 2007 and 2010, China’s holdings of U.S. Treasury securities more than

doubled from $400 billion to $900 billion.

Many economists, politicians, and union offi cials argue that China manipulates its currency, the yuan, to keep Chinese products cheaper

abroad and foreign products more expensive at home. This stimulates Chinese exports and discourages imports, thereby boosting Chinese

production and jobs. At the same time, the average Chinese consumer is poorer because the yuan buys fewer foreign products.

As we have seen, any country that establishes a fi xed exchange rate that undervalues or overvalues the currency must intervene continu-

ously to maintain that rate. Thus, if the offi cial exchange rate chronically undervalues the Chinese yuan relative to the dollar, as appears to be

the case, then Chinese authorities must continuously exchange yuan for dollars in foreign exchange markets. The increased supply of yuan

keeps the yuan down, and the increased demand for dollars keeps the dollar up.

But the charge that China manipulates its currency goes beyond simply depressing the yuan and boosting the dollar. China’s trading part-

ners increasingly feel they are being squeezed out by Chinese producers without gaining access to Chinese markets. China seeks every trade

advantage, especially for the 125 state-owned enterprises run directly by the central government. For example, China offers some domestic

producers tax rebates and subsidies to promote exports, while imposing quotas and tariffs to discourage imports, such as a 25 percent tariff on

auto-parts imports.

China has tried to soothe concerns about the trade defi cit. Most importantly, Chinese authorities in 2005 began allowing the yuan to rise

modestly against the dollar. As a result, the yuan rose a total of 20 percent against the dollar between July 2005 and July 2010. China also

announced plans to cut tax rebates paid to its exporters and to lower some import duties. But these measures seemed to have had little effect

on America’s monster defi cit with China.

Prior to an international fi nance meeting in June 2010, a key European Central Bank offi cial said “the rigidity of the Chinese monetary

regime had slowed down the recovery in the developed world.” Facing political pressure to do something, China announced that it would allow

the exchange rate to become more fl exible. We’ll see.

SOURCES: Lee Branstetter and Nicholas Lardy, “China’s Embrace of Globalization,” NBER Working Paper 12373 (July 2006); Jason Dean and Shen Hong, “China Central Bank
Tames Yuan Appreciation Hopes,” Wall Street Journal, 22 June 2010; Yujan Zhang, “China Steel Group Accuses U.S. Lawmakers of Protectionism,” Wall Street Journal, 5 July 2010;
and Michael Casey, “Showdown Looms Over China’s Currency at G-20,” Wall Street Journal, 11 June 2010.

QUESTION
1. Why would China want its own currency to be undervalued relative to the U.S. dollar? How does China maintain an undervalued currency?

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Case StudiesCase Studies
PUBLIC GOODS AND PUBLIC CHOICE

Case Study 16.1: Farm Subsidies

[Note: This is a more detailed look at farm subsidies than the similar material in Chapter 16 of the text]

The Agricultural Marketing Agreement Act became law in 1937 to prevent what was viewed as “ruinous competi-

tion” among farmers. At the time, one in four Americans lived on a farm. In the years since, the government intro-

duced a variety of policies that set fl oor prices for a wide range of farm products. Now, only one in fi fty Americans

lives on a farm, but this program is still with us. Subsidies in the 2008 Farm Act cost U.S. taxpayers $15.4 billion

in 2009. Worse still, the U.S. government often sells surplus crops overseas for lower prices. That sounds altruistic,

but U.S. exports put some poor farmers around the world out of business. U.S. farm subsidies continue to be a sticking point in negotiating

freer international trade agreements.

Let’s see how price supports work in the dairy industry, using a simplifi ed example. The exhibit below presents the market for milk. Without

government intervention, suppose the market price of milk would average $1.50 per gallon for a market quantity of 100 million gallons per

month. In long-run equilibrium, dairy farmers would earn a normal profi t in this competitive industry. Consumer surplus is shown by the blue-

shaded area. Recall that consumer surplus is the difference between the most that

consumers would be willing to pay for that quantity and the amount they actually pay.

Now suppose the dairy lobby persuades Congress that milk should not sell for

less than $2.50 per gallon. The higher price encourages farmers to increase their

quantity supplied to 150 million gallons per month. Consumers, however, reduce their

quantity demanded to 75 million gallons. To make the fl oor price of $2.50 stick, the

government every month must buy the 75 million gallons of surplus milk generated

by the fl oor price or somehow get dairy farmers to cut output to only 75 million gal-

lons. For example, to reduce supply, the government spent about $1 billion on milk

products in 2009 under one federal program.

Consumers end up paying dearly to subsidize farmers. First, the price consumers

pay increases, in this example by $1 per gallon. Second, as taxpayers, consumers

must also pay for the surplus milk or otherwise pay farmers not to produce that milk.

And third, if the government buys the surplus, taxpayers must then pay for storage.

So consumers pay $2.50 for each gallon they buy on the market, pay another $2.50 in higher taxes for each surplus gallon the government

must buy. Instead of paying a freemarket price of just $1.50 for each gallon consumed, the typical consumer-taxpayer in effect pays $5.00 for

each gallon actually consumed.

How do farmers make out? Each receives an extra $1 per gallon in revenue compared to the free-market price. As farmers increase their

quantity supplied in response to the higher price, however, their marginal cost of production increases. At the margin, the higher price just offsets

the higher marginal cost of production. The government subsidy also bids up the price of specialized resources, such as cows and especially

pasture land. Anyone who owned these resources when the subsidy was introduced would benefi t. Farmers who purchased them after that (and,

hence, after resource prices increased) earn only a normal rate of return on their investment. Because farm subsidies were originally introduced

more than half a century ago, most farmers today earn just a normal return on their investment, despite the billions spent annually on subsidies.

If the extra $1 per gallon that farmers receive for milk were pure profi t, farm profi t would increase by $150 million per month under the

government program. But total outlays by consumer-taxpayer jumped from $150 million per month for 100 million gallons to $375 million per

month for 75 million gallons. Thus, cost to consumer-taxpayers increases by $225 million, though they drink 25 million fewer gallons. Like

other special-interest legislation, farm subsidies have a negative impact on the economy, as the losses outweigh the gains. The real winners

are those who owned specialized resources when the subsidy was fi rst introduced. Young farmers must pay more to get into a position to reap

the subsidies. Ironically, subsidies aimed at preserving the family farm raise the costs of farming.

SOURCES: Barratt Kirwan, “The Incidence of U.S. Agricultural Subsidies on Farmland Rental Rates,” Journal of Political Economies, 117 (February 2009): 138–164; Ani Katchova,
“A Comparison of Economic Well-Being of Farm and Nonfarm Households,” American Journal of Agricultural Economics, 90 (August 2008): 733–747; Bill Egbert, “Councilman
Eric Gioia Having a Cow Over Milk Prices: $6 A Gallon Is Too High, He Says,” New York Daily News, 5 July 2009; Calitza Jimenez, “USDA Pulls Plug on Some Farm Subsidy Data,”
Center for Public Integrity, 21 May 2010, at http://www.publicintegrity.org/data_mine/entry/2100/; and Joseph Glauber, “Statement Before the Senate Judiciary Committee,” 19
September 2009, at http://www.usda.gov/oce/newsroom/archives/testimony/2009/VermontDairy .

QUESTION

S

1. “Subsidizing the price of milk or other agricultural products is not very expensive considering how many consumers there are in the

United States. Therefore, there is little harmful effect from such subsidies.” Evaluate this statement.

2. Subsidy programs are likely to have a number of secondary effects in addition to the direct effect on dairy prices. What impact do you sup-

pose farm subsidies are likely to have on the following?

a. Housing prices

b. Technological change in the dairy industry

c. The price of dairy product substitutes

16

S

Millions of
gallons per month

$2.50

1.50

0 75 100 150

Excess quantity supplied

D

o

ll
a
rs

p
e
r

g
a
ll
o

n

D

Effects of Milk Price Supports

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Case Study 16.2: Campaign Finance Reform

Critics have long argued that American politics is awash in special-interest money. Most Americans seem to agree. Two-thirds of those

surveyed support public fi nancing of campaigns if it eliminates funding from large private donations and organized interest groups. Since the

1970s, presidential campaigns, but not congressional races, have been in part publicly funded. Candidates who accept public funds must abide

by campaign spending limits. But by rejecting public funds, candidates can ignore spending limits.

Senators John McCain and Russ Feingold proposed a ban on so-called soft-money contributions to national parties. Soft money allows

political parties to raise unlimited amounts from individuals, corporations, and labor unions and to spend it freely on party-building activities,

such as get-out-the-vote efforts, but not on direct support for candidates. Hard money is the cash parties raise under rules that limit individual

contributions and require public disclosure of donors. The McCain-Feingold measure was approved as the Bipartisan Campaign Reform Act

of 2002. The act bans the solicitation of soft money by federal candidates and prohibits political advertising by special interest groups in the

weeks just before an election. The contribution limit is $2,300 for the primary and $2,300 for the general election, or a combined $4,600 for

both.

Limits on special-interest contributions may reduce their infl uence in the political process, but such caps also increase the advantage of

incumbents. Although there was anti-incumbent sentiment in the 2010 congressional election, historically about 95 percent of congressional

incumbents usually get reelected. Incumbents benefi t from a taxpayer-funded staff and free mailing privileges; these mailings often amount to

campaign literature masquerading as offi cial communications. Limits on campaign spending also magnify the advantages of incumbency by re-

ducing a challenger’s ability to appeal directly to voters. Some liberal and conservative thinkers agree that the supply of political money should

be increased, not decreased. As Curtis Gans, director of the Committee for the Study of the American Electorate argued, “The overwhelming

body of scholarly research . . . indicates that low spending limits will undermine political competition by enhancing the existing advantages of

incumbency.” Money matters more to challengers because the public knows less about them. Challengers must be able to spend enough to get

their message out. One study found a positive relationship between spending by challengers and their election success but found no relation-

ship between spending by incumbents and their reelection success. So campaign spending limits favor incumbents.

The U.S. Supreme Court in 2010 ruled that the federal government may not ban certain types of political spending by corporations and

labor unions, ruling that: “When governments seek to use its full power, including the criminal law, to command where a person may get his or

her information, . . . it uses censorship to control thought.”

Barack Obama and John McCain together spent a little more than $1 billion in the 2008 presidential race (with most of that spent by

Obama). More than a billion dollars sounds like a lot of money, but Coke spends at least twice that on advertising each year. The point is that

even well-meaning legislation often has unintended consequences. Efforts to limit campaign spending may or may not reduce the infl uence of

specialinterest groups, but by reducing a challenger’s ability to reach the voters, spending limits increase the advantage of incumbency, thus

reducing political competition.

SOURCES: Michael Ensley, “Individual Campaign Contributions and Candidate Ideology,” Public Choice, 138 (January 2009): 229–238; Jess Bravin, “Supreme Court Reverses
Limits on Campaign Spending,” Wall Street Journal, 21 January 2010; Jonathan Salant, “Spending Doubled as Obama Led Billion-Dollar Campaign,” Bloomberg News, 27
December 2008, at http://www.bloomberg.com/apps/news?pid=20601087&sid=apxzrZEHqU1o&refer=home#; the Federal Election Commission at http://www.fec.gov/; and
Common Cause at http://www.commoncause.org.

QUESTION
1. The motivation behind campaign fi nance reform was to limit the infl uence of special interests. In what sense could that legislation have the

opposite effect?

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Case StudiesCase Studies
INTERNATIONAL FINANCE

Case Study 20.1: The Big Mac Index

As you have already learned, the PPP theory predicts that in the long run the exchange rate between two cur-

rencies should move toward equalizing the cost in each country of an identical basket of internationally traded

goods. A light-hearted test of the theory has been developed by The Economist magazine, which compares prices

around the world for a “market basket” consisting simply of one McDonald’s Big Mac—a product that, though not

internationally traded, is essentially the same in more than 100 countries. The Economist begins with the price of a

Big Mac in the local currency and then converts that price into dollars based on the exchange rate prevailing at the

time. A comparison of the dollar price of Big Macs across countries offers a crude test of the PPP theory, which predicts that prices should be

roughly equal in the long run.

This chart lists the dollar

price of a Big Mac in March

2010, in 22 surveyed

countries plus the euro zone

average. By comparing the

price of a Big Mac in the

United States (shown as

the green bar) with prices

in other countries, we can

derive a crude measure of

whether particular curren-

cies, relative to the dollar,

are overvalued (red bars) or

undervalued (blue bars). For

example, because the price

of a Big Mac in Norway,

at $6.87, was 92 percent

higher than the U.S. price of

$3.58, the Norwegian krone

was the most overvalued

relative to the dollar of the

countries listed. But Big

Macs were cheaper in most

of the countries surveyed.

The cheapest was in China, where $1.83 was 49 percent below the U.S. price. Hence, the Chinese yuan was the most undervalued relative to

the dollar.

Thus, Big Mac prices in March 2010 ranged from 92 percent above to 49 percent below the U.S. price. The euro was 29 percent overval-

ued. The price range lends little support to the PPP theory, but that theory relates only to traded goods. The Big Mac is not traded internation-

ally. Part of the price of a Big Mac must cover rent, which can vary substantially across countries. Taxes and trade barriers, such as tariffs and

quotas on beef, may also distort local prices. And wages differ across countries, with a McDonald’s worker averaging about $8 an hour in the

United States versus more like $1 an hour in China. So there are understandable reasons why Big Mac prices differ across countries.

SOURCES: “The Big Mac Index: Exchanging Blows,” The Economist, 17 March 2010; David Parsley and Shang-Jin Wei, “In Search of a Euro Effect: Big Lessons from a Big Mac
Meal?” Journal of International Money and Finance, 27 (March 2008): 260–276; Ali Kutan et al., “Toward Solving the PPP Puzzle: Evidence from 113 Countries,” Applied Economics,
41 (Issue 24, 2009): 3057–3066; and the McDonald’s Corporation international Web site at http://www.mcdonalds.com.

QUESTION
1. The Big Mac Index computed by The Economist magazine has consistently found the U.S. dollar to be undervalued against some curren-

cies and overvalued against others. This fi nding seems to call for a rejection of the purchasing power parity theory. Explain why this index

may not be a valid test of the theory.

Cost of a Big Mac by Country

$0.00 $1.00 $2.00 $3.00 $4.00 $5.00 $6.00

Norway
Switzerland

Euro zone
Canada

Australia
Hungary

Turkey
United States

Japan
Britain

South Korea
United Arabs Emirates

Poland
Saudi Arabia

Mexico
South Africa

Russia
Egypt

Taiwan
Indonesia

Thailand
Malaysia

China

6.16
4.62

4.06
3.98

3.75
3.71

3.58
3.54

3.48
3.00
2.99

2.86
2.67

2.56
2.44
2.39
2.37

2.28
2.36

2.12
2.16

1.83

Big Mac prices converted to U.S. dollars

$7.00

6.87

20

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Case Study 20.2: What About China?

The U.S. trade defi cit with China of $227 billion in 2009 exceeded America’s combined defi cits with the European Union, OPEC countries, and

Latin America. The defi cit with China grew about 15 percent annually between 2007 and 2010. Americans spend four times more on Chinese

products than the Chinese spend on American products. Between 2007 and 2010, China’s holdings of U.S. Treasury securities more than

doubled from $400 billion to $900 billion.

Many economists, politicians, and union offi cials argue that China manipulates its currency, the yuan, to keep Chinese products cheaper

abroad and foreign products more expensive at home. This stimulates Chinese exports and discourages imports, thereby boosting Chinese

production and jobs. At the same time, the average Chinese consumer is poorer because the yuan buys fewer foreign products.

As we have seen, any country that establishes a fi xed exchange rate that undervalues or overvalues the currency must intervene continu-

ously to maintain that rate. Thus, if the offi cial exchange rate chronically undervalues the Chinese yuan relative to the dollar, as appears to be

the case, then Chinese authorities must continuously exchange yuan for dollars in foreign exchange markets. The increased supply of yuan

keeps the yuan down, and the increased demand for dollars keeps the dollar up.

But the charge that China manipulates its currency goes beyond simply depressing the yuan and boosting the dollar. China’s trading part-

ners increasingly feel they are being squeezed out by Chinese producers without gaining access to Chinese markets. China seeks every trade

advantage, especially for the 125 state-owned enterprises run directly by the central government. For example, China offers some domestic

producers tax rebates and subsidies to promote exports, while imposing quotas and tariffs to discourage imports, such as a 25 percent tariff on

auto-parts imports.

China has tried to soothe concerns about the trade defi cit. Most importantly, Chinese authorities in 2005 began allowing the yuan to rise

modestly against the dollar. As a result, the yuan rose a total of 20 percent against the dollar between July 2005 and July 2010. China also

announced plans to cut tax rebates paid to its exporters and to lower some import duties. But these measures seemed to have had little effect

on America’s monster defi cit with China.

Prior to an international fi nance meeting in June 2010, a key European Central Bank offi cial said “the rigidity of the Chinese monetary

regime had slowed down the recovery in the developed world.” Facing political pressure to do something, China announced that it would allow

the exchange rate to become more fl exible. We’ll see.

SOURCES: Lee Branstetter and Nicholas Lardy, “China’s Embrace of Globalization,” NBER Working Paper 12373 (July 2006); Jason Dean and Shen Hong, “China Central Bank
Tames Yuan Appreciation Hopes,” Wall Street Journal, 22 June 2010; Yujan Zhang, “China Steel Group Accuses U.S. Lawmakers of Protectionism,” Wall Street Journal, 5 July 2010;
and Michael Casey, “Showdown Looms Over China’s Currency at G-20,” Wall Street Journal, 11 June 2010.

QUESTION
1. Why would China want its own currency to be undervalued relative to the U.S. dollar? How does China maintain an undervalued currency?

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