1.Explain each of the following: (a) the wealth effect, (b) interest rate effect, and (c) international trade effect.
The real balance effect states that the inverse relationship is established through changes in the value of monetary wealth. As the price level changes, the purchasing power of monetary wealth changes, causing the quantity demanded of Real GDP to change.
The interest rate effect states that the inverse relationship is established through changes in household and business spending that is sensitive to interest rate changes. As the price level changes, it takes a different quantity of money to purchase a fixed bundle of goods, and this leads to a change in savings (the supply of credit increases). Subsequently, the price of credit, which is the interest rate, changes, causing households and businesses to change their borrowing levels, and changing the quantity of Real GDP to change.
The international trade effect states that the inverse relationship is established through foreign sector spending. As the price level in the U.S. changes, U.S. goods become relatively cheaper or more expensive than foreign goods. As a result, Americans and foreigners change the amounts of U.S. goods they buy, changing the quantity of Real GDP to change.
2.Explain what happens to the aggregate demand in each of the following cases: (a) The interest rate rises; (b) Wealth falls; (c) The dollar depreciates relative to foreign currencies; (d) Households expect lower prices in the future; (e) Business taxes rise.
In examples (a), (b), (d), and (e), the aggregate demand curve would shift to the left, causing both Real GDP and the price level to decrease in the short run. In (c), the aggregate demand curve would shift to the right, causing both Real GDP and the price level to increase in the short run.
3.Explain what is likely to happen to U.S. export and import spending as a result of the dollar depreciating in value.
A depreciation of the U.S. dollar makes foreign goods more expensive for Americans and American goods cheaper for foreigners. Therefore, U.S. exports will likely rise (foreigners will buy more American goods since they are cheaper) and U.S. imports will likely fall (Americans will buy fewer foreign goods since they are more expensive).
4.How will a change in the money supply affect aggregate demand?
A change in the money supply will change interest rates, which will change consumption and investment, therefore changing aggregate demand.
5.Explain how each of the following can affect short-run aggregate supply: (a) An increase in wage rates; (b) A beneficial supply shock; (c) An increase in the productivity of labor; (d) A decrease in the price of a nonlabor resource (such as oil).
An increase in wages in (a) will shift the short-run aggregate supply curve to the left because the higher wage rates will cause Real GDP to be produced at a higher price level than existed before. The three remaining changes in (b), (c), and (d) would each shift the short-run aggregate supply curve to the right since, in these three cases, the same level of Real GDP could be produced at a lower price level.
6.A change in the price level affects which of the following? (a) The quantity demanded of Real GDP; (b) Aggregate demand; (c) Short-run aggregate supply; (d) The quantity supplied of Real GDP.
A change in the price level would affect the quantity demanded of Real GDP and the quantity supplied of Real GDP (both [a] and [d]), but it would not change either aggregate demand or short-run aggregate supply (either [b] or [c]).
7.In the short run, what is the impact on the price level and Real GDP of each of the following: (a) An increase in consumption brought about by a decrease in interest rates; (b) A decrease in exports brought about by an appreciation of the dollar; (c) A rise in wage rates; (d) A beneficial supply shock; (e) An adverse supply shock; (f) A decline in productivity.
(a)A decrease in interest rates increases autonomous consumption, which shifts the AD curve rightward. The price level and Real GDP rise, ceteris paribus. (b)An autonomous decrease in exports shifts the AD curve leftward. The price level and Real GDP fall, ceteris paribus. (c)A rise in wage rates shifts the SRAS curve leftward. The price level rises and Real GDP falls, ceteris paribus. (d)A beneficial supply shock shifts the SRAS curve rightward. The price level falls and Real GDP rises, ceteris paribus. (e)An adverse supply shock shifts the SRAS curve leftward. The price level rises and Real GDP falls, ceteris paribus. (f)A decline in productivity shifts the SRAS curve leftward. The price level rises and Real GDP falls, ceteris paribus.
8.What is the difference between short-run equilibrium and long-run equilibrium?
Short-run equilibrium occurs at the intersection of SRAS and AD, while long-run equilibrium occurs at the intersection of LRAS and AD. Because there are reasons why SRAS may be upward sloped, there is no reason to assume that short-run equilibrium will occur at the full employment level in the economy. LRAS does not suffer these issues and will be located at the Natural Real GDP level, or full employment equilibrium.
9.An economist is sitting in the Oval Office of the White House, across the desk from the president of the United States. The president asks, “How does the unemployment rate look for the next quarter?” The economist answers, “It’s not good. I don’t think Real GDP is going to be as high as we initially thought. The problem seems to be foreign income—it’s just not growing at the rate we thought it was going to grow.” How can foreign income affect U.S. unemployment?
Foreign income is linked to the unemployment rate in the United States through changes in Real GDP. If foreign income falls, foreigners may buy fewer exports from the U.S. And if U.S. export spending declines, so does aggregate demand for U.S.-produced goods and services. A decline in aggregate demand, in turn, leads to lower Real GDP in the short run. And a lower Real GDP is likely to come with a higher unemployment rate.
10.Diagrammatically represent the effect on the price level and Real GDP in the short-run of each of the following: (a) an increase in wealth, (b) an increase in wage rates, and (c) an increase in labor productivity.
11.Directions: For each question, draw an economy in equilibrium, labeling the initial equilibrium price level and equilibrium quantity of Real GDP. Then shift the appropriate curve and label the new equilibrium price and equilibrium quantity. Next, fill in the blanks to describe what happened.
There is a decrease in wealth.
The price level will fall and Real GDP will fall .
There is a decrease in wage rates.
The price level will fall and Real GDP will rise .
Consumers start to expect lower future incomes.
The price level will fall and Real GDP will fall .
There is a decrease in productivity.
The price level will rise and Real GDP will fall .
Consumers start to expect higher future prices.
The price level will rise and Real GDP will rise .
There is a decrease in personal income taxes.
The price level will rise and Real GDP will rise .
There is an adverse supply shock.
The price level will rise and Real GDP will fall .
There is an increase in foreign real national income.
The price level will rise and Real GDP will rise .
What will happen if there is a decrease in interest rates at the same time that there is an increase in wage rates, and AD shifts by more than SRAS shifts?
The price level will rise and Real GDP will rise .
What will happen if there is a decrease in the value of the U.S. dollar at the same time that there is a decrease in prices of nonlabor inputs, and AD and SRAS shift by the same amounts?
The price level will stay the same and Real GDP will rise .
12.What is the classical economics position with respect to (a) wages, (b) prices, and (c) interest rates?
All three are considered by classical economics to be flexible both up and down, and to be determined by the interaction of supply and demand in their respective markets, leading to a position of equilibrium.
13.What is the explanation for why investment falls as the interest rate
rises?
The interest rate is the cost of borrowing funds. The higher the cost of borrowing funds is, the fewer funds firms will borrow and invest.
14.According to classical economists, does an increase in saving shift the AD curve to the left? Explain your answer.
No, because the increase in savings (and resulting decrease in consumption) will be exactly offset by an increase in investment created when the additional savings forces interest rates down
15.According to economists who believe in a self-regulating economy, what happens—step-by-step—when the economy is in a recessionary gap? What happens when the economy is in an inflationary gap?
According to economists who believe in a self-regulating economy, the economy is self-regulating. If the economy is in a recessionary gap, it will move back to its long-run equilibrium without any intervention by the government. In a recessionary gap, excess unemployment exists. This will cause wages to fall, and the SRAS curve will shift to the right, moving along the AD curve until the economy returns to its long-run equilibrium. In an inflationary gap, unemployment is below its natural rate, creating wage inflation. This shifts the SRAS curve to the left, moving along the AD curve until the economy returns to its long-run equilibrium.
16.Jim says, “I think it’s a little like when you have a cold or the flu. You don’t need to see a doctor. In time your body heals itself. That’s sort of the way the economy works too. We don’t really need government coming to our rescue every time the economy gets a cold.” According to Jim, how does the economy work?
Jim believes the economy is self-regulating and will heal itself. The economy will move itself out of either an inflationary gap or a recessionary gap and will settle down (eventually) in long-run equilibrium at the natural unemployment rate and Natural Real GDP.
17.How is Keynes’s position different from the classical position with respect to wages, prices, and Say’s law?
According to Keynes, wages and prices might not be as flexible as classical economists had assumed, so that Say’s law might not hold. It could take years for the economy to adjust to a new equilibrium, leaving the economy in a recessionary gap for years before the self-regulating economy moved back to its long-run equilibrium.
18.Give two reasons why wage rates may not fall.
Keynes believed that employees and labor unions may resist wage cuts. New Keynesians believe that long-term contracts and efficiency reasons for firms paying higher-than-market wages might explain wage rate inflexibility.
19.How was Keynes’s position different from the classical position with respect to saving and investment?
Keynes believed that an increase in savings might not be matched by an equal increase in investment, since both saving and investment depend on a number of factors that may be far more influential than the interest rate. The classical position was that interest rate changes would equate saving with investment.
20.What is the difference between discretionary fiscal policy and automatic fiscal policy?
When changes in government expenditures and taxes are brought about deliberately through government actions, fiscal policy is said to be discretionary. In contrast, a change in either government expenditures or taxes that occurs automatically in response to economic events is referred to as automatic fiscal policy.
21.Why is crowding out an important issue in the debate over the use of fiscal policy?
Those who advocate the use of fiscal policy believe it is capable of affecting the aggregate demand curve and therefore Real GDP. Crowding out calls the effectiveness of fiscal policy into question. For example, if an increase in government purchases causes private expenditures to fall by the same amount, then there is complete crowding out and the aggregate demand curve does not shift. Thus, there is no change in Real GDP.
22.Tax cuts will likely affect aggregate demand and aggregate supply. Does it matter which is affected more? Explain in terms of the AD-AS framework.
Yes. If AD and SRAS both increase, real output will increase. However, the effect on the price level depends upon the relative magnitudes of the changes in AD and SRAS. If AD increases by more than SRAS, then the price level will rise. If SRAS increases by more than AD, then the price level will fall. And, if AD and SRAS increase proportionally, then the price level should remain constant.
23.The economy is in a recessionary gap and both Smith and Jones advocate expansionary fiscal policy. Does it follow that both Smith and Jones favor so-called big government?
Not necessarily. Expansionary fiscal policy only results in permanently larger government if the expenditure increases taken to shift the aggregate demand curve are left in place after the need for the policy has passed. Also, Smith may prefer more government spending (bigger government) while Jones prefers tax cuts (smaller government) when it comes to expansionary fiscal policy.
24.Graphically illustrate the following:
(a)Fiscal policy destabilizes the economy
(b)Fiscal policy eliminates an inflationary gap
(c)Fiscal policy only partly eliminates a recessionary gap.
The economy is at QN when the government increases AD from AD1 to AD2. The government shifts AD from AD1 to AD2, which moves the economy to QN. The government shifts AD from AD1 to AD2, which fails to move the economy completely to QN.
25.Money is a means of lowering the transaction costs of making exchanges. Do you agree or disagree? Explain your answer.
Agree. Without money, we operate in a barter economy and that requires the double coincidence of wants. We must find someone who has what we want and who wants what we have. The search process is likely to be long and ineffective. In a money economy it is unnecessary because I exchange what I have for money and then exchange the money for what I want.
26.The smaller the required reserve ratio the larger the simple deposit multiplier. Do you agree or disagree with this statement. Explain your answer.
Agree. The simple deposit multiplier = 1/the required reserve ratio. As the required reserve ratio gets smaller, the simple deposit multiplier gets larger.
27.Suppose r = 10 percent and the Fed creates $20,000 in new money that is deposited in someone’s checking account in a bank. What is the maximum change in the money supply as a result?
As always, we rely on our formula for determining the change in the money supply. The formula is
Maximum change in checkable deposits (brought about by the banking system) = 1/r × ΔER
In this case, ΔER = –$20,000 and r = 10%. So, ΔM = (1 / 0.10) x $20,000 = $200,000.
28.The Fed creates $100,000 in new money that is deposited in someone’s checking account in a bank. What is the maximum change in the money supply if the required reserve ratio is 5 percent? 10 percent? 20 percent?
5 percent: 1 / 0.05 × $100,000 = $2,000,000
10 percent: 1 / 0.1 × $100,000 = $1,000,000
20 percent: 1 / 0.2 × $100,000 = $500,000
29.Explain how an open market purchase increases the money supply.
Suppose the Fed buys government securities from a commercial bank. At the end of the transaction, the Fed has more government securities than before, and the commercial bank has fewer. What the commercial bank does have, however, is a higher balance in its account at the Fed. Since deposits at the Fed are part of reserves (reserves = deposits at the Fed + vault cash), then reserves in the banking system have risen. Since the United States has a fractional reserve banking system, only a fraction of the increased amount of reserves has to be placed in required reserves. The remainder, or the positive excess reserves, can be used to extend more loans, create more demand deposits, and increase the money supply.
30.Explain how an open market sale decreases the money supply.
Suppose that the Fed sells one million dollars worth of its government securities to a bank. That bank pays by giving the Fed one million dollars from its reserve account at the Fed so that the bank can meet its reserve requirement. With a reduction in its Fed reserves, the bank must reduce its total outstanding loans, which then reduces checkable deposits and money in the economy.
31.Explain how a decrease in the required reserve ratio increases the money supply.
If the required reserve ratio decreases, then banks will have more reserves than they are required to have, meaning that some formerly required reserves are now excess reserves.
These excess reserves can then be used to make new loans that cause an increase in checkable deposits and hence an increase in the money supply.
32.Suppose you read in the newspaper that all last week the Fed conducted open market purchases and that on Tuesday of last week it lowered the discount rate. What would you say the Fed was trying to do?
By conducting a policy in which it persistently bought securities and lowered the discount rate, the Fed appears to be trying to boost the money supply. A more discerning eye will also notice that, while taking expansionary measures with both the discount rate and open market operations, the Fed did not reduce the reserve requirement. This would suggest that the Fed is comfortable with the size of the simple deposit multiplier and does not want the banking system to be any more or less able to “multiply” the effects of the other policy changes.
33.The Fed has announced a new lower target for the federal funds rate. In other words, it wants the federal funds rate to be lower than it currently is. What does setting a lower target for the federal funds rate have to do with open market operations?
Setting a lower target for the federal funds rate means that the Fed will have to buy securities in an open market operation. This increases the supply of reserves in the banking system, causing the federal funds rate to fall (towards the lower target rate).
34.If reserves increase by $2 million and the required reserve ratio is 8 percent, then what is the maximum change in checkable deposits?
Maximum change in checkable deposits = (1/.08) x $2 million
= 12.5 x $2 million
= $25 million
35.Complete the following table:
Federal Reserve ActionEffect on the Money Supply (up or down?) Lower the discount rate(A) up
Conduct open market purchase(B) up
Lower required reserve ratio(C) up
Raise the discount rate(D) down
Conduct open market sale(E) down
Raise the required reserve ratio(F) down
