ch 21

Sometimes during times of heightened national security, government expenditures are larger than normal. What could the Fed do to reduce the effects this spending creates on interest rates? a.Decrease the money supply by selling bonds. b.Increase the money supply by buying bonds. c.Decrease the money supply by buying bonds. d.Increase the money supply by selling bonds.

Increase the money supply by buying bonds The crowding-out effect is the offset in aggregate demand that results when expansionary fiscal policy, such as an increase in government spending or a decrease in taxes, raises the interest rate and thereby reduces investment spending. In order to counter this rise in the interest rate, the Fed would want to increase the money supply since this puts downward pressure on the interest rate in the market for money. In order to do this, the Fed could buy bonds through open-market operations.

When the interest rate increases, the opportunity cost of holding money decreases, so the quantity of money demanded decreases. True False

false According to liquidity preference theory, the opportunity cost of holding money is the interest rate. That is, when you hold wealth as cash in your wallet, instead of as an interest-bearing bond, you lose the interest you could have earned on that money. Therefore, when the interest rate increases, the opportunity cost of holding money increases, so the quantity of money demanded decreases.

According to liquidity preference theory, the opportunity cost of holding money is the inflation rate. True False

false According to liquidity preference theory, the opportunity cost of holding money is the interest rate. That is, when you hold wealth as cash in your wallet, instead of as an interest-bearing bond, you lose the interest you could have earned on that money.

If the Fed decreases the money supply, the interest rate increases. True False

true A decrease in the money supply increases the equilibrium interest rate since the money-demand curve is downward sloping.

If the multiplier is 5, then the MPC is a.10 b.0.2 c.2 d.0.8

0.8 The multiplier for changes in government spending is calculated as 1/(1 - MPC). Rearranging this equation yields MPC = 1 - (1/Multiplier). Therefore, if the multiplier is 5, then the MPC is 1- (1/5) = 0.8.

If the interest rate is below the Fed's target, the Fed should sell bonds to decrease the money supply. True False

True If the interest rate is below the Fed's target, then the Fed should conduct open-market operations that would raise the interest rate. Because a decrease in the money supply would raise the equilibrium interest rate to rise, the Fed should sell bonds to lower the money supply.

Which of the following Fed actions would decrease the money supply? a.Lowering the reserve requirement b.Decreasing the discount rate c.Raising the reserve requirement d.Buying bonds

raising the reserve requirement When the Fed raises the reserve requirement, banks must keep more funds as reserves so the money supply decreases. When the Fed buys government bonds, the reserves of the banking system increase, so the money supply increases. Also, a decrease in the discount rate (the interest rate at which banks can borrow reserved from the Fed) encourages bank borrowing, which increases bank reserves and the money supply.

Which of the following does fiscal policy not primarily affect in the long run? a.aggregate demand b.saving c.growth d.investment

aggregate demand In the long-run, fiscal policy influences saving, investment, and growth. In the short run, it affects primarily aggregate demand.

In a certain economy, when income is $200, consumer spending is $160. The value of the multiplier for this economy is 4. It follows that, when income is $300, consumer spending is a.$560 b.$235 c.$260 d.$240

$235 The spending multiplier is calculated as 1/(1 - MPC). Rearranging this equation yields MPC = 1 - (1/Multiplier). Therefore, if the multiplier is 4, then the MPC is 1- (1/4) = 0.75. If income increases by $300 - $200 = $100, then consumer spending will rise by 0.75 x $100 = $75, to $160 + $75 = $235.

Refer to the Figure (Figure K in OneNote). Suppose the multiplier is 4 and the government increases its purchases by $10 billion. Also, suppose the AD curves would shift from AD1 to AD2 if there were no crowding out; the AD curve actually shifts from AD1 to AD3 with crowding out. Also, suppose the horizontal distance between the curves AD1 and AD3 is $35 billion. The extent of crowding out, for any particular level of the price level, is a.$75 billion b.$5 billion c.$40 billion d.$35 billion

$5 billion The multiplier effect is the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending. If the multiplier is 4 and the government increases its purchases by $10 billion, this means that the aggregate demand curve will shift to the right by 4 x $10 billion = $40 billion. The crowding-out effect is the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending. Because the distance between AD1 and AD3 is $35 billion, this means the extent of crowding out is $40 billion - $35 billion = $5 billion.

If the marginal propensity to consume is 0.80, and there is no investment accelerator or crowding out, a $10 billion increase in government expenditures would shift the aggregate demand curve to the right by $50 billion $10 billion $40 billion $8 billion

$50 billion The multiplier is calculated as 1/(1 - MPC). Because the MPC = 0.80, this means the multiplier is 1/(1 - 0.80) = 1/(0.20) = 5. Therefore, a $10 billion increase in government expenditures translates into a $10 billion x 5 = $50 billion increase in aggregate demand in the absence of the crowding-out effect.

scenario 34-1. Take the following information as given for small, imaginary economy: When income is $10,000, consumption spending is $6,500.When income is $11,000, consumption spending is $7,100. Refer to the scenario. For this economy, an initial increase of $200 in net exports translates into a _________ increase in aggregate demand in the absence of the crowding-out effect. a.$800 b.$500 c.$120 d.$1,000

$500 The spending multiplier is calculated as 1/(1 - MPC). The marginal propensity to consume is the fraction of extra income that a household consumes rather than saves. In this case, an extra $1,000 of income increases spending by $600, so the MPC = 0.60. This means the multiplier is 1/(1 - 0.60) = 1/(0.40) = 2.5. Therefore, a $200 increase in net exports translates into a $200 x 2.5 = $500 increase in aggregate demand in the absence of the crowding-out effect.

scenario 34-1. Take the following information as given for small, imaginary economy: When income is $10,000, consumption spending is $6,500.When income is $11,000, consumption spending is $7,100. Refer to the scenario. The marginal propensity to consume for this economy is a.0.80 b.0.60 c.0.50 d.0.75

0.60 The marginal propensity to consume is the fraction of extra income that a household consumes rather than saves. In this case, an extra $1,000 of income increases spending by $600. This increase represents a $600/$1,000=0.60 fraction of the increase in income.

The multiplier for changes in government spending is calculated as a.1/(1 + MPC). b.1/(1 - MPC). c.MPC/(1 - MPC). d.1 - MPC.

1/(1 - MPC) The impact on aggregate demand of a change in government purchases is the equivalent to the infinite sum 1 + MPC + MPC2 + MPC3 + ... Using the formula for an infinite geometric series, this means that the multiplier is equal to 1/(1 - MPC).

scenario 34-1. Take the following information as given for small, imaginary economy:When income is $10,000, consumption spending is $6,500.When income is $11,000, consumption spending is $7,100.Refer to the scenario. The marginal propensity to consume for this economy is a.5.00 b.0.60 c.1.50 d.2.50

2.50 The spending multiplier is calculated as 1/(1 - MPC). The marginal propensity to consume is the fraction of extra income that a household consumes rather than saves. In this case, an extra $1,000 of income increases spending by $600, so the MPC = 0.60. This means the multiplier is 1/(1 - 0.60) = 1/(0.40) = 2.5. Additional Resources

If the marginal propensity to consume is 2/3, then the government purchases multiplier is a.1.67 b.3 c.2 d.0.33

3 The multiplier for changes in government spending is calculated as 1/(1 - MPC). Since the MPC = 2/3 in this case, the multiplier is 1/(1 - 2/3) = 1/(1/3) = 3.

According to liquidity preference theory, which of the following is NOT true? a.A decrease in the interest rate is shown as a movement along the money-demand curve. b.A decrease in the interest rate does not affect the money-supply curve. c.A decrease in the price level shifts money demand to the right. d.A decrease in the interest rate increases the quantity of money demanded.

a decrease in the price level shifts money demand to the right . According to liquidity preference theory, a decrease in the interest rate increases the quantity of money demanded but does not change the quantity of money supplied since this is fixed by the Fed. This is shown as a movement along the money-demand curve. Also, an increase in the price level shifts money demand to the right because people will choose to hold a larger quantity of money as a result of higher prices.

If the stock market booms, then a.aggregate demand increases, which the Fed could offset by increasing the money supply. b.aggregate supply decreases, which the Fed could offset by buying government bonds. c.aggregate supply increases, which the Fed could offset by decreasing the money supply. d.aggregate demand increases, which the Fed could offset by selling government bonds.

aggregate demand increases, which the Fed could offset by selling government bonds

Which of the following events would cause the Fed to stabilize output through decreasing the money supply? a.an increase in interest rates b.an increase in net exports c.a decrease in government spending d.an increase in taxes

an increase in net exports A decrease in the money supply by the Fed would cause interest rates to rise. Because the interest rate is the cost of borrowing, the rise in the interest rate lowers the quantity of goods and services demanded, which would decrease the equilibrium level of output in an economy. This means that the event that would cause the Fed to stabilize in this way must cause output to rise. A decrease in government spending, an increase in taxes, and an increase in interest rates all cause aggregate demand to fall, whereas an increase in net exports causes aggregate demand to rise.

Which of the following events would cause the Fed to stabilize output through increasing the money supply? a.a decrease in interest rates b.an increase in net exports c.an increase in government spending d.an increase in taxes

an increase in taxes An increase in the money supply by the Fed would cause interest rates to decline. Because the interest rate is the cost of borrowing, the fall in the interest rate raises the quantity of goods and services demanded, which would increase the equilibrium level of output in an economy. This means that the event that would cause the Fed to stabilize in this way must cause output to fall. An increase in net exports, an increase in government spending, and a decrease in interest rates all cause aggregate demand to rise, whereas an increase in taxes causes aggregate demand to decline.

Which of the following is NOT an automatic stabilizer? a.the U.S. tax system b.unemployment benefits c.an increase in money supply d.the welfare system

an increase in the money supply Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. Some examples of automatic stabilizers include the unemployment compensation system, the federal income tax, and the welfare system.

Which of the following is NOT correct? a.When money demand shifts leftward, the interest rate falls. b.As the interest rate falls, the quantity of money demanded falls. c.A lower interest rate increases the quantity of goods and services demanded. d.A lower price level shifts money demand leftward.

as the interest rate falls, the quantity of money demanded falls A lower price level means that people will choose to hold a smaller quantity of money, causing the money-demand curve to shift to the left. Recall that the money-demand curve is downward sloping, so a lower interest rate means a higher quantity of money demanded. When money demand shifts leftward, the interest rate falls. Because the interest rate is the cost of borrowing, the lower interest rate increases the quantity of goods and services demanded.

Changes in taxes or government spending that increase aggregate demand without requiring policy makers to act when the economy goes into a recession are called a.stabilization policies. b.automatic stabilizers. c.time lags. d.the crowding-out effect.

automatic stabilizers Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. Stabilization policies are enacted by the government or Fed and may result in time lags.

If the Federal Reserve decided to lower interest rates, it could a.buy bonds to lower the money supply. b.sell bonds to lower the money supply. c.sell bonds to raise the money supply. d.buy bonds to raise the money supply.

buy bonds to raise the money supply If the Fed buys government bonds in open-market operations, it will increase the money supply. This reduces the equilibrium interest rate which raises the quantity of goods and services demanded at a given price level.

Which of the following policies would Keynes's followers support when a decrease in business optimism shifts the aggregate-demand curve away from long-run equilibrium? a.decrease the money supply b.decrease taxes c.decrease government expenditures d.sell bonds to the public

decrease taxes If business optimism dampens, this would cause the aggregate-demand curve to shift to the left. Followers of Keynes would argue that aggregate demand needs to be stimulated. A decrease in government expenditures, the selling of bonds to the public, and a decrease of the money supply, cause aggregate demand to shift further to the left. However, a decrease in taxes causes aggregate demand to increase, which would counteract the effect of a decline in business optimism.

Suppose Jason believes that the government should follow an active stabilization policy when the economy is experiencing severe unemployment. Which of the following policies would he recommend in this case? a.Repeal an investment tax credit. b.Decrease taxes. c.Decrease government expenditures. d.Sell bonds to the public.

decrease taxes If the economy is experiencing severe unemployment, then a proponent of an active stabilization policy would argue that aggregate demand needs to be stimulated. A decrease in government expenditures, a decrease of the money supply, and a repeal of an investment tax credit cause aggregate demand to shift further to the left. However, a decrease in taxes causes aggregate demand to increase, which would alleviate the existing unemployment.

Which among the following assets is the most liquid? a.real estate b.stocks and bonds c.deposits that can be withdrawn using ATMs d.fine art

deposits that can be withdrawn using ATMs . An asset's liquidity refers to the ease at with which that asset can be converted into the economy's medium of exchange. Because money is the economy's medium of exchange, it is by definition the most liquid asset available. Therefore, of the assets listed, deposits that can be withdrawn using ATMs are the most liquid.

Refer to the Figure (figure H in OneNote). You can explain a decrease in Y from Y1 to Y2 in the following way: A decrease in P in P2 to P1 causes the money-demand curve to shift from MD1 to MD2; this shift of MD causes r to increase from r1 to r2; and this increase in r causes Y to decrease from Y1 to Y2. True False

false An increase in P from P1 to P2, causes people to want to hold more money, which shifts the money-demand curve to the right from MD1 to MD2. This shift in money demand causes the interest rate to rise from r1 to r2. Because the interest rate is the cost of borrowing, the increase in the interest rate reduces the quantity of goods and services demanded from Y1 to Y2.

During periods of expansion, automatic stabilizers cause government expenditures to rise and taxes to fall. True False

false Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. Some examples of automatic stabilizers include the unemployment compensation system, the federal income tax, and the welfare system.

If the Fed conducts open-market purchases, the money supply decreases and aggregate demand shifts right. True False

false If the Fed buys government bonds in open-market operations, it will increase the money supply. This reduces the equilibrium interest rate which raises the quantity of goods and services demanded at a given price level. Therefore, the aggregate-demand curve also shifts to the right.

The Federal Funds Rate is the interest rate the Fed charges depository institutions for short-term loans. True False

false The Federal Funds rate is the interest rate banks charge each other for short-term loans. The discount rate is the interest rate on the loans that the Fed makes to banks.

The multiplier effect states that there are additional shifts in aggregate supply from fiscal policy because it increases income and thereby increases consumer spending. True False

false The multiplier effect is the additional shifts in aggregate demand that result when expansionary fiscal policy, such as increasing government purchases, increases income and thereby increases consumer spending. Additionally, the logic of the multiplier effect applies to any change in spending on any component of GDP.

The theory of liquidity preference only attempts to explain the nominal interest rate. True False

false The nominal interest rate is the interest rate as usually reported, and the real interest rate is the interest rate corrected for the effects of inflation. The theory of liquidity preference is trying to explain both interest rates by assuming that expected inflation is held constant.

A tax increase has a multiplier effect but not a crowding-out effect. True False

false The size of the shift in aggregate demand resulting from a tax change is also affected by the multiplier and crowding-out effects. When the government cuts taxes and stimulates consumer spending, earnings and profits rise which further stimulates consumer spending. At the same time, higher income leads to higher money demand, which tends to raise interest rates. This makes borrowing more costly, which reduces investment spending.

The interest-rate effect stems from the idea that a higher price level decreases the real value of households' money holdings. True False

false The wealth effect, not the interest-rate effect, stems from the idea that a higher price level decreases the real value of households' money holdings. Instead, the interest-rate effect depends on the idea that decreases in interest rates increase the quantity of goods and services demanded.

A reduction in personal income taxes increases aggregate demand through an increase in private savings. True False

false When the government cuts personal income taxes, it increases households' take-home pay. Households will save some of this additional income, but they will also spend some of it on consumer goods. Because a tax cut increases consumer spending, it shifts the aggregate-demand curve to the right.

Mark is having a policy debate with his cousin Gina. Gina points out that the political process is mostly responsible for the lag in implementing a.neither fiscal policy nor monetary policy. b.fiscal policy c.monetary policy d.both fiscal policy and monetary policy.

fiscal policy The primary argument against active monetary and fiscal policy is that these policies affect the economy with a long lag. Monetary policy works by changing interest rates, which in turn influence investment spending, but many firms make investment plans far in advance. Therefore, most economists believe it takes at least six months for changes in monetary policy to have much effect on output and employment. In the case of fiscal policy, the lag is largely attributable to the political process. By the time the change in policy is passed and ready to implement, the condition of the economy may well have changed.

Which of the following is NOT true according to classical macroeconomics theory? a.For any given level of output, the interest rate adjusts to balance the supply of, and demand for, loanable funds. b.For any given level of output, the interest rate adjusts to balance the supply of, and demand for, money. c.Given output and the interest rate, the price level adjusts to balance the supply of, and demand for, money. d.Output is determined by the supplies of capital and labor and the available production technology.

for any given level of output, the interest rate adjusts to balance the supply of, and demand for, money According to classical macroeconomics theory, output is determined by the supplies of capital and labor and the available production technology. Moreover, for any given level of output, the interest rate adjusts to balance the supply of, and demand for, loanable funds. Then, given output and the interest rate, the price level adjusts to balance the supply of, and demand for, money.

Refer to the Figure (figure J in OneNote). Which of the following is true? a.If the current interest rate is 4 percent, there is an excess demand for money. b.The equilibrium interest rate is 2 percent. c.If the current interest rate is 2 percent, there is an excess supply of money. d.If the current interest rate is 2 percent, people will sell more bonds, which drives interest rates up.

if the current interest rate is 2 percent, people will sell more bonds, which drives interest rates up if the current interest rate is 2 percent, there is an excess demand for money. Therefore, people will sell more bonds, which drives interest rates up to the equilibrium rate of 3 percent

Refer to the Figure (Figure M in OneNote). Which of the following is correct? a.Unemployment falls as the economy moves from point a to point b. b.If the economy is at point b, a policy to restore full employment would be an increase in the money supply. c.Only fiscal policy could have caused the shift from AD1 to AD2. d.A wave of optimism could move the economy from point a to point b.

if the economy is at point b, a policy to restore full employment would be an increase in the money supply Since the root cause of the shift in aggregate demand is unknown, it is possible that either fiscal or monetary policy might have caused the shift from AD1 to AD2. A wave of optimism would cause an increase in aggregate demand and not a decrease as is shown in this figure. As a result of the decrease in aggregate demand, unemployment rises as the economy moves from point a to point b. To restore the economy to full employment, the Fed could increase the money supply which would cause aggregate demand to increase.

Refer to the Figure (Figure O in OneNote). Suppose the economy is at point A. Which of the following statements is true? a.If the economy is left alone, then as it corrects itself and moves to the natural level of output, the price level will remain at P1. b.If policymakers want to restore output to its natural level YN, they should decrease both government purchases and taxes. c.If policymakers want to restore output to its natural level YN, they should increase both government purchases and taxes. d.If the economy is left alone, then as it corrects itself and moves to the natural level of output, the price level will rise above P1.

if the economy is left alone, then as it corrects itself and moves to the natural level of output, the price level will rise about P1 Because the short-run equilibrium level of output is larger than the natural level, this means that the economy is not experiencing full employment and the unemployment rate is lower than its natural level. If the economy is left alone, then as the economy moves from point A to long-run equilibrium, the price level will rise further. However, if the government wants to restore output to its long-run level, it should reduce government purchases to cause a leftward shift of the AD or increase taxes cause a leftward shift of the SRAS.

If expected inflation is constant and the nominal interest increases by 3 percentage points, then the real interest rate a.increases but by less than 3 percentage points. b.decreases but by less than 3 percentage points. c.decreases by 3 percentage points. d.increases by 3 percentage points.

increases by 3 percentage points The nominal interest rate is the real interest rate plus the expected rate of inflation. If expected inflation is constant and the nominal interest rate increases by 3 percentage points, then the real interest rate must also increase by 3 percentage points.

Which of the following is true about liquidity preference theory? a.It supposes that the price level adjusts to bring money supply and money demand into balance. b.It is most helpful in understanding the wealth effect. c.It does not refer directly to Keynes' theory concerning the effects of changes in money demand and supply on interest rates. d.it is most relevant to the short run of interest rates.

it is most relevant to the short run of interest rates Liquidity preference refers directly to Keynes' theory concerning the effect of changes in money demand and supply on interest rates. Therefore, it is most relevant to the short run and supposes that the interest rate adjusts to bring money supply and money demand into balance. This theory is most helpful in understanding the interest-rate effect.

Which of the following is true about the interest-rate effect? a.It depends on the idea that increases in interest rates increase the quantity of goods and services demanded. b.It states that the interest rate is unrelated to the quantity of goods and services demanded. c.It does not explain the slope of the aggregate-demand curve. d.It is the most important reason, in the case of the United States, for the downward slope of the aggregate-demand curve.

it is the most important reason, in the case of the United States, for the downward slope of the aggregate-demand curve The interest-rate effect depends on the idea that decreases in interest rate increase the quantity of goods and services demanded. Of the three reasons why the aggregate-demand curve slopes downward (the wealth effect, the interest-rate effect, and the exchange-rate effect), the interest-rate effect is the most important reason, in the case of the United States, for the downward slope of the aggregate-demand curve.

Which of the following is NOT true about the Employment Act of 1946? a.It states that the government should not promote full employment and production. b.It implies that the government should avoid being a cause of economic fluctuations. c.It implies that the government should respond to changes in the private economy to stabilize aggregate demand. d.It reflected the ideas promoted in Keynes's influential book, The General Theory of Employment, Interest, and Money.

it states that the government should not promote full employment and production The Employment Act of 1946 states that "it is the continuing policy and the responsibility of the federal government to . . . promote full employment and production." This act has two implications. The first is that the government should avoid being a cause of economic fluctuations. The second is that the government should respond to changes in the private economy to stabilize aggregate demand. The act passed not long after the publication of Keynes' The General Theory of Employment, Interest, and Money, so the act does reflect some of the ideas noted in this book.

In the short run, which of the following statements is true about the effects of an increase in the money supply? a.It will cause aggregate demand to shift left. b.It will lower the cost of borrowing. c.It will decrease investment. d.It will cause interest rates to increase.

it will lower the cost of borrowing An increase in the money supply reduces the equilibrium interest rate. Because the interest rate is the cost of borrowing, the fall in the interest rate raises the quantity of goods and services demanded at a given price level. This causes the aggregate-demand curve to shift to the right.

Steve is having a policy debate with his brother Brian. He points the fact that business firms make investment plans far in advance. This is a lag problem associated with a.neither monetary policy nor fiscal policy. b.monetary policy. c.fiscal policy. d.both monetary policy and fiscal policy.

monetary policy The primary argument against active monetary and fiscal policy is that these policies affect the economy with a long lag. Monetary policy works by changing interest rates, which in turn influence investment spending, but many firms make investment plans far in advance. Therefore, most economists believe it takes at least six months for changes in monetary policy to have much effect on output and employment. In the case of fiscal policy, the lag is largely attributable to the political process. By the time the change in policy is passed and ready to implement, the condition of the economy may well have changed.

The government builds a new recycling plant. The manager of the company hires workers and pays them an annual salary. These workers then increase their spending. The firms that sell the goods these workers buy also increase their output. This type of effect on spending illustrates the a.wealth effect. b.multiplier effect. c.interest-rate effect. d.crowding-out effect.

multiplier effect The multiplier effect is the additional shifts in aggregate demand that result when expansionary fiscal policy, such as increasing government purchases, increases income and thereby increases consumer spending. Therefore, this scenario is an example of the multiplier effect.

Temporary tax cuts shift the aggregate-demand curve a.farther to the left than do permanent tax cuts. b.not as far to the right as do permanent tax cuts. c.not as far to the left as do permanent tax cuts. d.farther to the right than do permanent tax cuts.

not as far to the right as do permanent tax cuts If consumers believe a tax cut to be permanent, they will view the increased take-home pay as adding substantially to their financial resources and increase their spending by a large amount. By contrast, if households expect the tax change to be temporary, they will view it as adding only slightly to their financial resources and will increase their spending by only a small amount.

Refer to the Figure (Figure M in OneNote). Which of the following is NOT correct? a.A wave of optimism could not move the economy from point a to point b. b.Unemployment rises as the economy moves from point a to point b. c.Only monetary policy could be used to move the economy from point b to point a. d.If the economy is left alone, then as the economy moves from point b to long-run equilibrium, the price level will fall farther.

only monetary policy could be used to move the economy from point b to point a Since the root cause of the shift in aggregate demand is unknown, it is possible that either fiscal or monetary policy might have caused the shift from AD1 to AD2. A wave of optimism would cause an increase in aggregate demand and not a decrease as is shown in this figure. As a result of the decrease in aggregate demand, unemployment rises as the economy moves from point a to point b. If the economy is left alone, then as the economy moves from point b to long-run equilibrium, the price level will fall farther.

Assume the MPC is 0.6. Assume there is a multiplier effect and that the crowding-out effect is $10 billion. An increase in government purchases of $20 billion will shift aggregate demand to the a.left by $10 billion b.right by $40 billion c.left by $30 billion d.right by $50 billion

right by $40 billion The spending multiplier is calculated as 1/(1 - MPC). Because the MPC = 0.6, this means the multiplier is 1/(1 - 0.6) = 1/(0.4) = 2.5. This means that in the absence of crowding out, a $20 billion increase in government purchases will shift the aggregate demand curve to the right by 2.5 x $20 billion = $50 billion. The crowding-out effect is the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending. Therefore, accounting for the crowding-out effect, the aggregate demand curve will only shift to the right by $50 billion - $10 billion = $40 billion.

An increase in U.S. net exports would shift U.S. aggregate demand a.leftward. In an attempt to stabilize the economy, the government could increase expenditures. b.rightward. In an attempt to stabilize the economy, the government could decrease expenditures. c.rightward. In an attempt to stabilize the economy, the government could increase expenditures. d.leftward. In an attempt to stabilize the economy, the government could decrease expenditures.

rightward. In an attempt to stabilize the economy, the government could decrease expenditures An increase in U.S. net exports shifts U.S. aggregate demand to the right. This would cause the level of output in the economy to rise. If the government wants to stabilize output, it could decrease expenditures which would shift aggregate demand leftward and return output to its previous level.

If money demand shifted to the left and the Federal Reserve desired to return the interest rate to its original value, it could a.sell bonds to increase the money supply. b.buy bonds to decrease the money supply. c.buy bonds to increase the money supply. d.sell bonds to decrease the money supply.

sell bonds to decrease the money supply If the money-demand curve shifted to the left, this lowers the interest rate. In order to return the interest rate to its original value, the Fed would need to conduct an open-market operation that decreases the money supply since that will put upward pressure on the equilibrium interest rate. This occurs when the Fed sells bonds to the public.

To stabilize interest rates, the Federal Reserve will respond to a decrease in money demand by a.selling government bonds, which increases the supply of money. b.buying government bonds, which increases the supply of money. c.buying government bonds, which decreases the supply of money. d.selling government bonds, which decreases the supply of money.

selling government bonds, which decreases the supply of money A decrease in money demand causes the interest rate to fall. If the Federal Reserve wants to stabilize the interest rate, it needs to decrease the supply of money to put upward pressure on interest rates. When the Fed sells government bonds, this open-market operation causes money supply to fall.

Refer to the Figure (figure L in OneNote). A decrease in government purchases will a.have no effect on aggregate demand. b.shift aggregate demand from AD1 to AD3. c.cause movement from points B to point A along AD1. d.shift aggregate demand from AD1 to AD2.

shift aggregate demand from AD1 to AD3 Fiscal policy refers to the government's choices regarding the overall level of government purchases and taxes. When the government decreases government purchases, this directly lowers aggregate demand, causing the aggregate-demand curve to shift from AD1 to AD3.

Which of the following statements about the multiplier effect is NOT true? a.Tax reductions are said to have a multiplier effect on aggregate supply. b.Government purchases are said to have a multiplier effect on aggregate demand. c.The multiplier effect states that there are additional shifts in aggregate demand from fiscal policy because it increases income and thereby increase consumer spending. d.The logic of the multiplier effect applies to any change in spending on any component of GDP.

tax reductions are said to have a multiplier effect on aggregate supply The multiplier effect is the additional shifts in aggregate demand that result when expansionary fiscal policy, such as increasing government purchases, increases income and thereby increases consumer spending. Additionally, the logic of the multiplier effect applies to any change in spending on any component of GDP.

Refer to the Figure (figure N in OneNote). Suppose the economy is currently at point A. Which of the following policies would policymakers NOT recommend to restore full employment? a.The government increases taxes. b.The Fed sells government bonds. c.The government reduces government purchases. d.The Fed increases the money supply.

the Fed increases the money supply If the economy is currently at point A, then a policy that decreases aggregate demand would restore the economy to full employment. When the Fed sells government bonds, it reduces the money supply, which causes aggregate demand to fall. Similarly, when the government engages in fiscal policy either by reducing government purchases or increasing taxes, this has a negative effect on aggregate demand.

Jason is a critic of stabilization policy. Which of the following statements would he NOT agree with? a.The Fed should try to fine-tune the economy during times of economic fluctuations. b.There is a lag between the time a policy is passed and the time a policy has an impact on the economy. c.There is a lag between the time a policy is needed and the time it takes to be implemented. d.Stabilization policy can be a source of, instead of a cure for, economic fluctuations.

the Fed should try to fine-tune the economy during times of economic fluctuation The primary argument against active monetary and fiscal policy is that these policies affect the economy with a long lag. Most economists believe it takes at least six months for changes in monetary policy to have much effect on output and employment. In the case of fiscal policy, the lag is largely attributable to the political process. By the time the change in policy is passed and ready to implement, the condition of the economy may well have changed.

Which of the following statements is true about the Kennedy administration in the early 1960s? a.The Kennedy tax cut of 1964 was designed to shift the aggregate supply curve to the left. b.The Kennedy administration made considerable use of fiscal policy to stimulate the economy. c.The Kennedy administration made considerable use of monetary policy to stimulate the economy. d.The Kennedy tax cut of 1964 was not successful in stimulating the economy.

the Kennedy administration made considerable use of fiscal policy to stimulate the economy In the early 1960s, the Kennedy administration made considerable use of fiscal policy to stimulate the economy. In particular, the Kennedy tax cut of 1964 was designed to shift the aggregate-demand curve and aggregate-supply curve to the right, and it was successful in stimulating the economy.

On the graph (Figure I in OneNote) that depicts the theory of liquidity preference, which of the following is NOT true? a.The supply-of-money curve is vertical. b.The quantity of money is measured along the horizontal axis. c.The interest rate is measured along the vertical axis. d.The demand-for-money curve is vertical.

the demand-for-money curve is vertical On the graph that depicts the theory of liquidity preference, the horizontal axis represents the quantity of money, and the vertical axis represents the interest rate. Since the quantity of money supplied is fixed by Fed policy, the supply-of-money curve is vertical. However, the demand for money depends on the interest rate and therefore slopes downward.

According to liquidity preference theory, an increase in money demand for some reason other than a change in the price level causes a.the interest rate to rise, so aggregate demand shifts right. b.the interest rate to fall, so aggregate demand shifts right. c.the interest rate to fall, so aggregate demand shifts left. d.the interest rate to rise, so aggregate demand shifts left.

the interest rate to rise, so aggregate demand shifts left An increase in money demand causes the money-demand curve to shift to the right. This causes a rise in the equilibrium interest rate. Because the interest rate is the cost of borrowing, the increase in the interest rate reduces the quantity of goods and services demanded at a given price, so aggregate demand shifts left.

Refer to the Graphs (Figure H in OneNote). Which of the following statements is NOT true? a.Real output is measured along the horizontal axis of the right-hand graph. b.If the graphs apply to an economy such as the U.S. economy, then the slope of the AD curve is primarily attributable to the interest-rate effect. c.The nominal interest rate is held constant as we move from one point to another on either graph. d.The quantity of money is measured along the horizontal axis of the left-hand graph.

the nominal interest rate is held constant as we move from one point to another on either graph The horizontal axis of the left-hand graph is the quantity of money, and on the right-hand graph it is real output. As we move from one point to another on either graph, the expected inflation rate is held constant according to the theory of liquidity preference. In economies such as the U.S., the slope of the AD curve is primarily due to the interest-rate effect as opposed to the wealth effect or the exchange-rate effect.

According to the theory of liquidity preference, which of the following is NOT true? a.If the interest rate is above the equilibrium level, then the quantity of money people want to hold is less than the quantity of money the Fed has created. b.The supply of money depends on the interest rate. c.The demand for money is represented by a downward-sloping line on a supply-and-demand graph. d.If the interest rate is below the equilibrium level, then the quantity of money people want to hold is greater than the quantity of money the Fed has created.

the supply of money depends on the interest rate Because the quantity of money supplied is fixed by Fed policy, it does not depend on the interest rate. However, the demand for money is represented by a downward-sloping line. According to the theory of liquidity preference, the interest rate adjusts to bring the quantity of money supplied and the quantity of money demanded into balance. If the interest rate is above the equilibrium level, the quantity of money people want to hold is less than the quantity the Fed has created, and vice versa.

Which of the following is an example of an automatic stabilizer? a.an increase in tax rates in response to an expansion b.the minimum wage c.the unemployment compensation system d.an increase in money demand

the unemployment compensation system Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. Some examples of automatic stabilizers include unemployment benefits, the federal income tax, and the welfare system.

According to liquidity preference theory, the money-supply curve would shift if the Fed engaged in open-market operations. True False

true According to liquidity preference theory, the Fed controls the money supply directly. Therefore, in order to shift the money-supply curve, the Fed would need to engage in open-market operations such as buying or selling bonds.

The tax system is the most important automatic stabilizer. True False

true Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. The most important automatic stabilizer is the tax system. When the economy goes into a recession, the amount of taxes collected by the government falls automatically because almost all taxes are closely tied to economic activity. Other examples of automatic stabilizers include the unemployment compensation system and the welfare system.

Keynes would agree with the statement that irrational waves of pessimism cause aggregate demand to be unstable. True False

true Keynes argued that aggregate demand fluctuates because of largely irrational waves of pessimism and optimism. When pessimism exists, households reduce consumption spending and firms reduce investment spending, which causes a reduction in aggregate demand, lower production, and higher unemployment.

The multiplier effect amplifies the effects of an increase in government expenditures, while the crowding-out effect diminishes the effect. True False

true The multiplier effect is the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending. The crowding-out effect is the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending. Therefore, the multiplier effect amplifies the effects of an increase in government expenditures, while the crowding-out effect diminishes the effect.

The fraction of extra income that a household consumes rather than saves is called a.the savings rate. b.the marginal propensity to consume. c.fiscal policy. d.the multiplier.

the marginal propensity to consume The marginal propensity to consume is the fraction of extra income that a household consumes rather than saves. Fiscal policy refers to the government's choices regarding the overall level of government purchases and taxes, whereas the multiplier effect is the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

Which of the following is an example of an increase in government purchases? a.The government decreases Social Security payments. b.The government builds new bridges. c.The government increases corporate taxes. d.The Federal Reserve sells government bonds.

The government builds new bridges Fiscal policy refers to the government's choices regarding the overall level of government purchases and taxes. When the government builds new bridges, this is an example of an increase in government purchases. However, when the Federal Reserve sells government bonds, this is an example of a monetary policy.

Which of the following policy actions does NOT shift the aggregate-demand curve? a.a change in the price level b.open-market operations by the Fed c.an increase in government spending d.a decrease in taxes

a change in the price level Fiscal policy such as a decrease in taxes or an increase in government spending shifts the aggregate-demand curve. Similarly, monetary policy such as the Fed conducting open-market operations also shifts the aggregate-demand curve. Because the aggregate demand curve represents the relationship between the price level and the quantity of output, a change in the price level causes a movement along the aggregate-demand curve.

Which of the following is an example of crowding out? a.A decrease in the money supply increases interest rates, causing investment to fall. b.A decrease in taxes increases interest rates, causing investment to fall. c.A decrease in government spending increases interest rates, causing investment to fall. d.A decrease in consumption increases interest rates, causing investment to fall.

a decrease in taxes increase interest rates, causing investment to fall The crowding-out effect is the offset in aggregate demand that results when expansionary fiscal policy, such as an increase in government spending or a decrease in taxes, raises the interest rate and thereby reduces investment spending.

Which of the following shifts aggregate demand to the left? a.The price level falls. b.A decrease in the money supply. c.The Fed purchases government bonds on the open market. d.The price level rises.

a decrease in the money supply The aggregate-demand curve shows the relationship between the price level and the quantity of output. Therefore, a change in the price level results in a movement along the aggregate-demand curve, not a shift. When the Fed sells government bonds, it decreases the money supply causing the equilibrium interest rate to rise. Because the interest rate is the cost of borrowing, this results in a leftward shift of the aggregate-demand curve.

Which of the following illustrates how the investment accelerator works? a.An increase in government expenditures increases the interest rate so that the demand for stocks and bonds issued by Starshine Inc. rises. b.An increase in government expenditures increases the interest rate so that the Starshine Inc. decides to open up new car-wash in additional locations. c.An increase in government expenditures decreases the interest rate so that Starshine Inc. finds it profitable to update its car-wash equipment. d.An increase in government expenditures increases aggregate spending so that Starshine Inc. finds it profitable to update its car-wash equipment.

an increase in government expenditures increases aggregate spending so that Starshine Inc. finds it profitable to update its car-wash equipment When higher government spending spurs higher demand for investment goods, this positive feedback from demand to investment is called the investment accelerator. In this case, an increase in government expenditures that increases aggregate spending and encourages Starshine Inc. to invest in newer car-wash equipment is an example of the investment accelerator.

Which of the following Fed actions would increase the money supply? a.Selling bonds b.Increasing the discount rate c.Raising the reserve requirement d.Buying bonds

buying bonds When the Fed buys government bonds, the reserves of the banking system increase, so the money supply increases. When the Fed raises the reserve requirement, banks must keep more funds as reserves so the money supply decreases. Also, an increase in the discount rate (the interest rate at which banks can borrow reserved from the Fed) discourages bank borrowing, which decreases bank reserves and the money supply.