ECO 202 Chapter 9-13
When the value of a bank's assets is greater than its liabilities, the bank is said to be When the value of a U.S. bank's assets become less than its liabilities, the government through the FDIC,
Solvent shuts the bank down and makes payouts to its depositors. searches for a healthy bank to take over its operations.
Everything else remaining unchanged, what is likely to happen to the equilibrium real interest rate and quantity of credit if the credit supply curve shifts to the right?
The equilibrium rate of interest will decrease and the quantity of credit will increase.
According to the quantity theory of money, the inflation rate is If the inflation rate is negative, what must be true?
The gap between the growth rate of money supply and the growth rate of real GDP The growth rate of real GDP > the growth rate of money supply
Why is the rise in housing prices between the late 1990s and 2006 characterized as a bubble by some economists? How did the fall in housing prices cause the entire financial system in the United States to freeze up? The fall in housing prices resulted in ______, leading to enormous ________, disrupting the banks' ability and willingness to make loans to __________
The large increase in the price of housing assets did not reflect the true long-run value of the assets. increased defaults, bank losses, consumers and firms
Which of the following is not true regarding the natural rate of unemployment
The natural rate of unemployment is 0 percent when the U.S. economy is not in a recession
Banks usually meet their liquidity needs by
borrowing from each other in the federal funds market.
Real business cycle theory
emphasizes the role of changing productivity and technology in causing economic fluctuations.
Countercyclical policy that seeks to raise GDP growth and the level of employment is appropriate when
excessively pessimistic sentiments about the economy are prevalent. the economy is experiencing a recession.
Households and firms with savings lend money to banks and other financial institutions. The credit supply curve shows the relationship between the quantity of credit supplied and the real interest rate. The credit supply curve slopes upward because a A shift in the credit supply curve can be caused by
higher real interest rate discourages current consumption. higher real interest rate encourages more saving a heightened desire on the part of firms to internally fund their future activities. an elevated perception on the part of households that the future may hold many "rainy days." an aging population that is ill-prepared for retirement.
The real wage is the What is the significance of the real wage as it relates to inflation?
inflation-adjusted wage Since an increase in inflation reduces the real wage that firms must pay, firms are more willing to hire workers, thus stimulating economic activity.
An asset is liquid if:
it can be easily converted into cash without loss of value.
Hyperinflation is most likely caused by
large budget deficits financed by printing more money
Quantitative easing is Central banks undertake quantitative easing programs to
the central bank's purchase of long-term bonds in the open market. a variation on the central bank's traditional manner of conducting open market operations. an attempt by the central bank to more directly impact long-term interest rates. more forcefully and directly impact the interest rates relevant for investment decisions work around the problems when short-term nominal interest rates approach zero
Recall the discussion in the chapter about the "quantity theory of money."The quantity theory of money assumes that This implies that if the money supply grows by 10 percent, then nominal GDP needs to grow by It follows that the growth rate of money supply and the growth rate of nominal GDP will be the same. In this case, inflation is
the ratio of money supply to nominal GDP is exactly constant. 10 percent Yes, the long-run data show a one-for-one growth rate of money supply and inflation.
The Federal Reserve influences the long-run real interest rate through
the short-term federal funds rate
Consider two banks: Bank A and Bank B. Suppose the value of liabilities of both the banks is equal. However, Bank A is solvent but Bank B is insolvent. This would imply that:
the value of Bank A's assets exceeds the value of Bank B's assets.
One major difference between modeling economic busts and booms is that While economic booms are generally positive, they also have a dark side. This is because
there is no issue of rigid nominal wages when modeling booms. if the economy is close to full employment and full capacity utilization before the beginning of the boom, the economy might eventually experience a leftward shift in labor demand, causing a recession rather than a gentle fall to pre-boom levels.
Maturity transformation is the process by which banks
transfer short-term liabilities into long-term investments
In the United States, recessions are informally defined as ________ in real GDP.
two consecutive quarters of negative growth
According to real business cycle theory, the economic impact of changing input prices is similar to the economic impact from If oil, which is a major input to most production processes, abruptly falls in price, the impact on the economy would be similar to
technology changes a productivity increase, with a resultant increase in real GDP. This is the correct answer.B.
Okun's Law states that Okun's Law Which of the following years is an outlier, that is, a year where Okun's Law does not hold?
when growth in real GDP is above 3%, unemployment drops and when it is below 3%, unemployment increases is usually an accurate representation of the data. 2012
According to Okun's Law, the year−to−year change in the rate of unemployment is ________ if the annual growth rate of real GDP is 5%.
-1%
In February 2014, the United States added 175,000 jobs to the economy. Given this information, what can we say about the unemployment rate of the country? Suppose that in January there were 4,000,000 workers in the labor force, with 3,736,000 employed and 264,000 unemployed, implying a 6.6 percent unemployment rate. A month later, there were 4,170,000 workers in the labor force, with 3,911,000 employed and 259,000 unemployed. The unemployment rate in February is
6.21%
Which of the following cannot produce a shift in the credit demand curve?
A change in the real interest rate
What is the shadow banking system?
A group of several thousand disparate nonbank financial intermediaries. Nonbank financial institutions that behave like banks in many respects. Financial institutions that make loans from funds raised by means other than by accepting deposits
Firms, households, and governments use the credit market for borrowing. The credit demand curve shows the relationship between the quantity of credit demanded and the real interest rate. The credit demand curve slopes downward because A shift in the credit demand curve can be caused by
A lower real interest rate raises a borrowing changes in perceived business opportunities for firms. changes in household preferences or expectations. changes in government policy.
Carlos, on the other hand, thinks this way: "The economy has recovered from recession sufficiently that inflationary pressures are likely to build. Likewise, a weaker dollar means that imports are going to be more expensive. I don't think the Fed will risk slowing the recovery and raising unemployment by raising interest rates to fight inflation. So, in light of all these factors, I expect inflation to increase to 5 percent next year." How would you best describe how each investor is forming his expectations of inflation? Sean is forming his forecast based on the ___________ model of inflation and Carlos is forming his forecast based on the _________ model of inflation What are possible criticisms of the way each investor is forming his expectations? Economists might argue that
Adaptive expectations, rational expectations Sean is not maximally rational, and Carlos can not be as good at understanding how the economy works as he thinks he is.
f nominal GDP increases, what might be the cause of this increase? If nominal GDP increases, this could be caused by
An increase in the price level An increase in real GDP
When a bank experiences withdrawals of deposits and short-term loans by firms and other banks, the situation is described as When large firms and the general banking community lose confidence in a weak bank, FDIC insurance is ________ the situation
An institutional bank run, incapable of alleviating
What could explain why a decrease in taxes could lead to a less-than-proportionate increase in output?
As a result of diminishing returns to current consumption, consumers may choose to spread the extra spending over the long term rather than consuming the proceeds of a tax cut all at once. Consumers may choose to save much of the tax cut in anticipation of having to pay higher taxes in the future.
If the value of a government−taxation multiplier is 1.8, which of the following is likely to be true if all other variables remain unchanged?
A $1 reduction in taxation increases gross domestic product by $1.80.
What does it mean to say that an economic fluctuation involves the co-movement of many aggregate macroeconomic variables?
These variables grow or contract together during booms and recessions.
Which of the following factors does not cause a shift in the labor demand curve?
Changes in the wage rate.
The demand for Country X's most important exportable product− electronic goods− is likely to double in the next 5 years. Which of the following is likely to happen in this case?
Consumption in Country X will rise
The goal of a country with a healthy economy is to have ____________ equal to zero.
Cyclical unemployment
The period from 2007 to 2009 was a time of economic contraction that came to be known as the "Great Recession." During periods of recession, most firms experience a decline in demand for their product, as well as a decline in the product's equilibrium price. All other things being equal, macroeconomic theory predicts that the wage of most workers should decline in recessionary periods. However, this was not the case in the Great Recession, or during many other economic downturns throughout recent history. Based on the discussion in the chapter, explain why this might be so, and what the implications are for unemployment.
During downturns workers are resistant to the lowering of wages and firms try to avoid doing so. This downward wage rigidity keeps the quantity of labor supplied greater than demand, causing unemployment.
How do expansionary policies differ from contractionary policies?
Expansionary policies seek to shift the labor demand curve to the right, while contractionary policies seek to shift it to the left. Expansionary policies seek to reduce the severity of recessions, while contractionary policies seek to slow down the economy when it grows too fast. Expansionary policies seek to increase economic growth and increase employment, while contractionary policies seek to reduce the risk of excessive price inflation.
Bitcoins are defined as a "peer-to-peer decentralized digital currency." The supply of bitcoins is not controlled by the government or any other central agency. The value of each bitcoin is determined on the basis of supply and demand and is defined in terms of dollars. New bitcoins can be generated through a process called "mining." However, new bitcoins will not be created once there are a total of 21 million bitcoins in existence. Some commentators feel that bitcoins can eventually replace most of the major currencies in the world. What are some of the issues with bitcoins replacing major currencies? Traditional currencies are controlled by central banks. What is a potential problem of restricting the creation of bitcoins to a total of 21 million bitcoins?
Fiat money is generally worthless without a government decree that is legal tender. Bitcoin deposits are not insured by the government The value of a bitcoin is highly volatile and so people that hold them may lose money Monetary authorities cannot undertake expansionary monetary policy to stimulate the economy during recessions
How does fiat money differ from commodities like gold and silver that were used as money? In fiat money is intrinsically worthless, then why is it valuable?
Fiat money is intrinsically worthless, whereas gold and silver have intrinsic value Fiat money is used as legal tender by government decree and other people will accept it as payment for transactions
As the Choice and Consequence box on "Too Big to Fail" notes, bank regulators worry about the prospect of the failure of large financial institutions, dubbed "systemically important financial institutions" (SIFIs). How would the failure of a systemically important financial institution (SIFI) affect the economy? What steps do bank regulators take to prevent SIFIs from failing or to minimize the effect of such failures?
Financial intermediation would likely be impaired, with negative consequences for the economy's performance. Mandate that banks hold more stockholders' equity. Require banks to establish "living wills," procedures for their treatment in the event they become insolvent. Require banks to take on less risk.
According to salary.com, the average salary for a software engineer level III (a higher-level position in software design and implementation) in the Silicon Valley area of California is $108,244. However, Google pays its level III software engineers an average salary of $124,258. Why does Google pay a salary higher than the equilibrium salary for equivalent positions in the same area?
Google is paying an efficiency wage in order to minimize worker turnover, increase worker productivity, and attract the top talent
When there is an increase in the wage rate paid to workers, the supply of labor will When there is an increase in acceptance of people taking 5 or 6 years to earn their college degrees instead of 4 years, the supply of labor will
Increase and move up along the curve Decrease and shift to the left
If you have studied microeconomics, you may recall a concept called "moral hazard." Moral hazard occurs when an economic agent is incentivized to take risks because some (or all) of the losses that might result will be borne by other economic agents. How might federal deposit insurance, as administered by the FDIC, lead to moral hazard?
Insurance gives bank managers incentives to pursue added risks since losses can be shifted to the FDIC. Depositors may pay less attention to the lending practices of banks since their deposits are covered up to some cap. Insurance may cause bank shareholders to be less vigilant in monitoring the investment strategies of bank managers.
How does the Federal Reserve obtain a particular value for the federal funds rate?
It finds the point on the demand curve that corresponds to that federal funds rate and makes available the exact level of reserves associated with that point on the demand curve.
How does the zero lower bound on interest rates affect the working of monetary policy?
It makes the implementation of expansionary monetary policy more difficult since it effectively blocks the central bank's use of its primary tool. It complicates the formulation of expansionary monetary policy because it forces the central bank to rely on nontraditional and less familiar tools such as quantitative easing. It reduces the effectiveness of monetary policy by impairing the ability of the public (including investors) to understand the central bank's actions and signals.
Which of the following is true regarding wage rigidity? Which of the following is not one of the factors that can increase wage rigidity in the labor market?
It occurs when wages are held fixed above the competitive equilibrium level The economy falling into a recession
What are the important mechanisms that reverse the effects of a recession in a modern economy? What market forces might cause the labor demand curve to shift back to the right?
Labor demand increases due to market forces Labor demand increases due to expansionary government policies The banking system recuperates and businesses are again able to use credit to finance their activities Technological advamces encourage firms to expand their activities Excess inventory has been sold off
Using the chart above, would you describe unemployment as a leading or lagging indicator of an economic downturn?
Lagging, since in every recession the unemployment rate did not peak until very late into the recession, or in some cases, after the recession.
Which of the following characteristics of economic fluctuations does the Great Depression illustrate?
Limited predictability Bank volatility Persistence
Early theories of business cycles assumed that economic fluctuations had a pendulum-like structure with systematic swings in economic growth. Which property of economic fluctuations do these early theories contradict? Using your answer above, how does a pendulum-like structure contradict this property in economic fluctuations?
Limited predictability. Pendulums swing in an easily-measured rhythm that would make predicting fluctuations simple.
Money makes a variety of economic transactions possible. In the following three situations, determine whether money is involved in the transaction. In prison camps during World War II, and in some prisons today, cigarettes circulate among prisoners. For example, an iPod might cost two cartons of cigarettes, whereas a magazine might only cost two cigarettes. Which functions of money are cigarettes fulfilling in this case? Over the last 50 years, credit cards have become an increasingly popular way for people to purchase goods and services. Are credit cards money? Almost every day, many people sign their names to little pieces of paper called checks, which are then accepted in exchange for goods and services. Do these checks constitute money?
Medium of exchange Unit of account Store of value No, because you credit cards are not assets. No, because checks simply represent a means of access to money, not money itself.
Explain whether each of these individuals will be counted as a part of the labor force. Alex recently retired after working for the same company for 30 years. John is a full-time stay-at-home parent while his wife works. We know that Alex is _______, and we know that John is ______.
Not in the labor force; not in the labor force
The Evidence-Based Economics in the chapter identifies three key factors that caused the recession of 2007dash-2009. How would Keynes's concept of animal spirits explain the creation of a housing bubble? The national income identity shows that The recession of 2007dash-2009 affected the components of the national income identity by primarily affecting
People believed that a house was a worthwhile investment, which led to an increased demand for housing and thus pushed prices up. This confirmed to people that housing was a worthwhile investment, which led to more demand, resulting in an upward spiral driven by optimism. output is a function of consumption, investment, government spending, and net exports. the C and I components through a reduction in consumer wealth and a drop in housing construction
When repaying a loan, the payment a borrower makes consists of
Principal and interest
The fact that unemployment is lower among workers with a relatively higher level of education can be explained in part by the: What other reasons might explain why unemployment is lower among workers with a relatively higher level of education
Principle of optimization More educated workers have more human capital More educated workers have a higher opportunity cost of time Workers with a higher level of education are in greater demand by firms
To achieve its target for the federal funds rate, the Fed may
Purchase treasury bonds in the open market Decrease the reserve requirement Decrease the interest rate paid on reserves deposited at the Fed Increase lending from the discount window
Which of the following equations is correct?
Real interest rate = Nominal interest rate − Inflation rate
Which of the following are possible benefits of inflation?
Revenue is generated to the government when it prints money There may be a reduction in real wages There may be a reduction in the real interest rate
According to the graph, when the minimum wage is set at $8 per hour, there will be ____________ unemployment of ____________ workers in this market. The losers when the minimum wage is $88 would be ___________ Using the graph, we can see that if the minimum wage were set at $4 per hour, then The impact of the minimum wage on the labor market as a whole is________, since __________ of workers earn the minimum wage rate
Structural; 4 million Low-skill workers who lose their jobs due to a lack of demand for workers Firms that hire low-skill workers at the new wage Low-skill workers who now cannot find jobs due to increased competition for jobs There would be no structural unemployment due to wage rigidity, since the minimum wage is non-binding at $4 per hour modest, around 1 percent
Lehman Brothers was not insured by the Federal Deposit Insurance Corporation (FDIC) but deposits at Northern Rock were insured by the U.K. government. What could explain why there was still a bank run at Northern Rock?
The U.K. insurance had upper limits on protected deposits that were relatively low Fully insured depositors at Northern Rock worried the bank's failure would temporarily block them
What are the automatic and discretionary components of fiscal policy?
The automatic components do not require deliberate action on the part of the government, while the discretionary components do.
In April 2012, the Bazanian Daily, a leading newspaper in the country of Bazania, carried a report titled "20,000 jobs added in the last quarter; unemployment rate shoots up from 5 percent to 6.7 percent." How could the unemployment rate in Bazania increase even when new jobs were created?
The new jobs may have made discouraged workers optimistic enough to start applying for jobs, thus re-entering the labor force and being countered as unemployed, which causes the overall unemployment rate to increase
The 1970s saw a period of high inflation in many industrialized countries including the United States. Due to the increase in the rate of inflation, lenders, including credit card companies, revised their nominal interest rates upward. How is the rate of inflation related to the nominal interest rate that credit card companies charge, and why would lenders need to increase the nominal interest rate when the inflation rate increases? Usury laws place an upper limit on the nominal rate of interest that lenders can charge on their loans. In the 1970s, some credit card companies moved to states where there were no ceilings on interest rates to avoid usury laws. Why would credit card companies move to states without usury laws during a period of high inflation, like the 1970s?
The nominal rate of interest is the real rate of interest plus the rate of inflation; lenders need to raise the nominal rate when inflation increases to maintain their desired real return Because usury law ceilings may limit the real return lenders can earn during inflationary periods, lenders have an incentive to move to states without such laws.
In August, 1979, the annual rate of inflation in the U.S. was nearly 12%, and the U.S. short-term nominal interest rate was nearly 10%. Over the next 35 years, both the rate of inflation and short-term nominal interest rate tended to fall. By August 2014, the rate of inflation was about 2% and the short-term nominal interest rate was close to 0%. How has the real short-term interest rate changed from 1979 to 2014? Why do the inflation rate and the nominal interest rate tend to move together over the long-run?
The real rate remained stable at -2% This synchronized movement indicates that credit market conditions have tended to be relatively stable over time Their up and down together movement tells us that the real interest rate is relatively stable in the long run
The sharpest one-day percentage decline in the Dow Jones Industrial Average (DJIA) took place on October 19, 1987. The DJIA fell 23 percent on this one day. Foreign exchange markets and other asset markets also exhibit large fluctuations on a daily basis. Eugene F. Fama, Robert J. Shiller, and Lars Peter Hansen shared the Nobel Prize in Economic Sciences in 2013 for their work on the "empirical analysis of asset prices." Based on the information given in this chapter, which of the following factors could explain why asset prices fluctuate? (Check all that apply.)
There are psychological factors and biases that can produce excessive reactions to booms and busts Fluctuations reflect the rational appraisals by investors of new information relevant to asset profitability
When is the output gap, defined as the percent difference between GDP and potential GDP, negative? According to the Taylor rule, should the Fed raise or lower the federal funds rate when the output gap is negative?
When actual real GDP falls below potential GDP. B. When the economy's capacity to produce exceeds its actual production. C. When the economy experiences a recession. It should lower the federal funds rate.
Structural unemployment is the unemployment that arises
When wage rigidity creates a persistent gap between labor supply and labor demand
In a recent study for the National Bureau of Economic Research (NBER), four researchers looked at the effect of generous unemployment benefits on the local unemployment rate. They compared the unemployment situation in adjoining counties, which happened to lie in two different states that had different laws regarding the amount and duration of unemployment benefits. (Re-read the section on "A Natural Experiment of History" in Chapter 8 of the text to understand how the NBER research is based on a "natural experiment.") The authors of the NBER study found that the unemployment rate "rises dramatically in the border counties belonging to the states that expanded unemployment benefit duration" during the Great Recession. Why might this be so? Based on Hagedorn, Karahan, et al., "Unemployment Benefits and Unemployment in the Great Recession: The Role of Macro Effects." NBER working paper 19499, October 2013.
With the longer duration of unemployment benefits, firms needed to keep wages high to attract people to work. This caused downward wage rigidity, leading to persistent higher unemployment
You and a friend are debating the merits of using monetary policy during a severe recession. Your friend says that the central bank needs to lower interest rates all the way down to zero. According to him, zero nominal interest rates will boost lending and investment; consumers and firms will surely borrow and spend when interest rates are zero. Given that inflation in your country is currently 3 percent, would you agree with his reasoning? Explain your answer.
Yes, a zero nominal interest rate coupled with a 3 percent inflation rate yields a negative value for the real rate, which is the rate that is meaningful for investment decisions.
Does the behavior of the unemployment rate illustrate the principle of co-movement discussed in the chapter? Economic variables are sometimes divided into "leading indicators" and "lagging indicators." Leading indicators are variables that start to change before an economic expansion or contraction. Lagging indicators change only when an expansion or contraction is well underway, or even about to reverse. Based on the graph, is unemployment a leading or lagging indicator of recessions?
Yes, because when real GDP declines, unemployment increases. Lagging indicator
Does the effectiveness of monetary policy depend on inflation expectations? Explain.
Yes, the central bank's ability to influence the long-term expected real interest rate is partly determined by the public's long-term expectations of the inflation rate.
The concept of multipliers was one of the key elements of John Maynard Keynes's theory of fluctuations. A multiplier is An example of a multiplier is when
an economic mechanism that causes an initial shock to be amplified by follow-on effects. an increase in business confidence causes firms to increase production and hire employees, leading to an increase in household spending, causing firms to further increase production and employment a drop in consumer confidence reduces household spending, causing firms to cut production and lay off employees, leading to a greater reduction in household spending
An open market operation is The Federal Reserve conducts open market operations when it wants to When the Fed buys government bonds from private banks, it _____ the electronic reserves that banks hold.
an exchange between a private bank and the Federal Reserve where the Fed buys or sells government bonds to private banks. Influence the federal funds rate increases
A bank run is
an extraordinarily large volume of withdrawals driven by a concern that a bank will run out of liquid assets with which to pay withdrawals.
The Taylor rule states that
central banks should set their policy rates (in the United States, the federal funds rate) according to a formula that incorporates the long-term target for the policy rate, the output gap, and the deviation of inflation from its target
In 2005, $320 million of the federal government's budget was allocated toward building a "bridge to nowhere" in Alaska that connected two small towns. In 2006, $500,000 was allocated toward a teapot museum in North Carolina, $1 million toward a water-free urinal initiative in Michigan, and $4.5 million toward a museum and park at an abandoned mine in Maine. These projects were requested by specific legislators in order to boost their popularity in their constituencies. These types of expenditures are known as Since government spending increases employment by shifting the labor demand curve to the right, is it always a good idea for the government to increase expenditure? Explain your answer.
pork barrel spending No, continual increases in government expenditures will soak up resources that would otherwise be used by households and firms No, government efforts aimed at shifting the labor demand curve to the right should only be used during recessions No, continual increases in government expenditures may result in projects that are not socially desirable
The Internet boom of the 1990's has changed all of our lives and transformed the way business is conducted. During the late 1990's, the economy was described as the "best of all possible worlds" with quite high employment (and low unemployment). Which of the business cycle theories explained in the chapter would best explain how the Internet boom had such a positive effect? The business cycle theory that would best explain how the Internet boom had such a positive effect is How does real business cycle theory best explain the economic boom?
real business cycle theory. Technological innovation leads to increases in productivity, which in turn increases the marginal product of labor and therefore labour demand.
Fiat money is
something that is used as legal tender by government decree and is not backed by a physical commodity.