Externalities and the Environment

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Meyer describes the “Tragedy of the Commons.” The IMF article explains how this type of problem is an example of an “externality.” What is an externality? What might be a good government policy to solve the problem of the environmental externality that leads to high greenhouse gas emissions?
Moral Hazard and Adverse Selection

“Moral hazard” is a term often used in the context of peoples’ behavior once they have insurance. Szuchman and Anderson explore the idea of moral hazard in personal relationships. How would you define moral hazard? Provide an example of a moral hazard that you have observed in your own community or workplace.

How does moral hazard differ from adverse selection? Provide an example to illustrate this concept.

Monetary policy is the action taken by the Federal Reserve to expand or contract the money supply and influence interest rates.

What are the current unemployment and inflation rates? How has the Fed redefined its targets for inflation and unemployment, and how do current conditions compare to those targets?

As the top advisor to the chair of the Federal Reserve, define contractionary and expansionary monetary policies and explain which you advise the Fed to pursue today—given the inflation and unemployment targets versus the current rates.
Inflation – Winners and Losers

We often hear of inflation characterized as a bad thing, but Meyer describes both winners and losers from inflation. Give an example of one way in which you would win from unexpected inflation and an example of one way in which you would lose from unexpected inflation.
Before answering these questions, review this Summary of New Fed Monetary Policies. You may consult other sources as well and include them in your bibliography.

 

Classical v. Keynesian Approaches to Smoothing Business Cycles

Fiscal policies are the actions of Congress on spending and taxing. (Note this is different from monetary policy, which is the action taken by the Federal Reserve to change the money supply and interest rates.)

Explain and compare the Keynesian and classical points of view on whether or not to intervene during the business cycle (an expansion = positive real GDP growth; and a recession = negative real GDP growth).

Sample Solution

Externality refers to the unintended consequences of an economic activity that affects third parties who are not involved in the activity. In the context of the “Tragedy of the Commons,” the overexploitation of a shared resource leads to negative externalities for the entire community.

A government policy to address the environmental externality of high greenhouse gas emissions could be a carbon tax. This involves imposing a tax on the emission of carbon dioxide and other greenhouse gases, incentivizing individuals and businesses to reduce their emissions. The revenue generated from the carbon tax could be used to fund clean energy research and development, or to redistribute to households to offset the costs of the tax.

Moral Hazard and Adverse Selection

Moral hazard occurs when individuals change their behavior after obtaining insurance, leading to increased risk. For example, a person with car insurance may drive more recklessly, knowing that their insurance will cover any damages.

Adverse selection occurs when individuals with a higher risk of experiencing a loss are more likely to purchase insurance. This can lead to higher premiums for everyone, as the insurer is covering a riskier pool of individuals.

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Example of Moral Hazard: In a workplace context, a moral hazard could occur if an employee shirks their responsibilities knowing that their performance will not be closely monitored or evaluated.

Example of Adverse Selection: In the insurance market, individuals with pre-existing health conditions may be more likely to purchase health insurance, leading to higher premiums for everyone.

Monetary Policy and Current Economic Conditions

Current unemployment and inflation rates: As of early 2024, the unemployment rate in the United States was relatively low, while inflation was running higher than the Federal Reserve’s target.

Fed’s redefined targets: The Fed has traditionally aimed for an unemployment rate of around 4-4.5% and an inflation rate of around 2%. However, in recent years, the Fed has indicated a willingness to tolerate slightly higher inflation rates in order to achieve a lower unemployment rate.

Contractionary vs. Expansionary Monetary Policy:

  • Contractionary monetary policy involves actions taken by the Fed to reduce the money supply and raise interest rates. This is typically used to combat inflation.
  • Expansionary monetary policy involves actions taken by the Fed to increase the money supply and lower interest rates. This is typically used to stimulate economic growth and reduce unemployment.

Given the current economic conditions with relatively low unemployment and higher inflation, the Fed might consider pursuing a contractionary monetary policy. This could involve raising interest rates to slow down economic activity and reduce demand-pull inflation.

Inflation Winners and Losers

  • Winning from unexpected inflation: Individuals who hold assets that appreciate in value during inflation, such as real estate or stocks, can benefit from unexpected inflation.
  • Losing from unexpected inflation: Individuals with fixed incomes, such as retirees on pensions, can lose purchasing power due to unexpected inflation as the value of their income decreases relative to rising prices.

Classical vs. Keynesian Approaches to Smoothing Business Cycles

Classical economists generally believe that the economy is self-correcting and that government intervention is not necessary to stabilize business cycles. They argue that market forces will eventually bring the economy back to equilibrium.

Keynesian economists, on the other hand, believe that government intervention can be effective in smoothing business cycles. They argue that during recessions, government spending can help stimulate demand and create jobs, while tax cuts can put more money into the hands of consumers. During expansions, government spending can be reduced and taxes can be increased to slow down the economy and prevent overheating.

 

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