ECON 2120 Exam 3

Contractionary Monetary Policy

Policy that causes a *decrease in money growth*. The ultimate goal is *decreasing aggregate spending*. --Used to "cool down" the economy and *decrease inflation rates*. By decreasing money supplied this can exactly offset the increase in demand.

Expansionary Monetary Policy

Policy that causes an *increase in money growth*. The ultimate goal is *stimulating aggregate demand*; this is done by increasing aggregate spending by shifting the AD curve which stimulates money growth and thus AD.

Nominal

PxY is the ______ GDP.

Aggregate Demand Shock

Refers to a rapid and unexpected shift in the aggregate spending. Unlike supply shocks, these can be PERMANENT or TEMPORARY (Ex: christmas is temporary).

Negative Shock Dilemma

Refers to the tradeoff between unemployment and inflation that occurs when the LRAS and SRAS curves shift to the left (increasing inflation and decreasing GDP growth). --Demonstrates the cost of inflation; *inflation is painful to stop*.

Quota

Restrictions on the quantity of goods that can be imported.

Term Auction Facility

Set up to inject reserves into the system' ultimately is the same as discount window lending by removes the negative stigma surrounding the term. Banks do this to avoid a solvency crisis.

Short Run

Shifts in *aggregate demand* mainly affect the economy in the _____ ______.

3.7%, 2.5%

Since 1950, the average inflation has been about ______. In the last 10 years, inflation has averaged about _______.

INDEPENDENT

Solow Growth Rate is _________ of inflation (regardless of whether inflation is high or low).

Real Shock

Some event that shifts the *SUPPLY CURVE* (NOT the demand curve).

Law of One Price

States that if trade were free, then identical goods should sell for about the same price throughout the world.

B. Increase the impact of positive shocks.

Sticky wages and prices: A. Reduce the impact of negative shocks. B. Increase the impact of positive shocks. C. Have no effect on the impact of negative shocks. D. Offset the impact of positive shocks.

NOT(because people anticipate taxes rising again and save their rebate instead of spending; tax cuts ONLY WORK if they are PERMANENT)

Temporary tax cuts are _______ an effective fiscal policy.

Multiplier Effect

The *additional increase* in AD caused when *expansionary fiscal policy* increases income and thus consumer spending. --The side effects/indirect effects of fiscal policy

Crowding Out

The *decrease* in private spending that occurs when government increases spending. --When new government spending is financed by increased taxes, private individuals have less money to spend

Equal

The ADAS Model (MxV=PxY) tells us that how much we *produce* is directly _____ to how much we *spend*.

Monetary Policy

The Fed can use this to reduce the length and severity of a recession.

Money Supply

The Fed/Central Bank's *most important job* is to regulate this. They have the power to CREATE MONEY (by changing the amount of money commercial banks have in their accounts--not literally printing money).

A. The AD curve.

The Federal Reserve can influence the economy by shifting: A. The AD curve. B. The SRAS curve. C. The LRAS curve. D. The AD, SRAS, and LRAS curves.

1

The REAL exchange rate in the *long-run*.

Protectionism

The economic policy of restraining trade through quotas, tariffs, or other regulations that burden foreign producers but NOT domestic producers.

Discount Rate

The interest rate banks pay when they borrow *directly* from the Fed. This interest rate is typically lower than the market rate (nowadays they are very similar rates but at one point there was a difference so that is where the name comes from). --*Represents the cost of borrowing*(so when it is low it is cheap to borrow and banks will increase money borrowed and thus increase MB and money supplied)

B. There is an underlying assumption of long-run money neutrality.

The long-run aggregate supply curve is represented by a vertical line at the Solow growth rate because: A. Growth depends on the rate of inflation in the long run. B. There is an underlying assumption of long-run money neutrality. C. Growth is affected by changes in the money supply in the long run. D. Growth is not affected by the factors of production.

Currency, Checkable Deposits

The most *liquid* means of payment are _____ and ____.

DOES NOT(this is why we care about the real exchange rate more)

The nominal exchange rate _____ inform you about *purchasing power*.

Exchange Rate

The price of one currency in another currency. If this value is higher then that means our imports are cheaper (the value is higher so we can buy more). This is determined by the *supply and demand* for a currency.

Nominal Exchange Rate

The rate at which you can exchange one currency for another.

Real Exchange Rate

The rate at which you can exchange the goods and services of one country for goods and services of another (**this is what we really care about).

A. Business cycles are driven by real shocks to the economy.

The real business cycle (RBC) model implies that: A. Business cycles are driven by real shocks to the economy. B. Real output fluctuates as a result of demand shocks only. C. The rate of inflation is closely linked to the long-run rate of output growth. D. Business cycles are a result of fluctuations in the money supply.

Systemic Risk

The risk that the failure of one financial institution can bring down other institutions as well (we have discount window lending and FDIC to try and avoid this).

PPP Theorem(Purchasing Power Parity)

Theorem that states the real purchasing power of a currency should be the same, whether it is spent at home or converted into another currency and spent abroad. --idea of how the exchange rate will always get to 1 in the long run because if people can travel then they will just buy the good in whatever country sells it the cheapest until eventually the price is driven up.. --This is an application of the *law of one price*

Reserves

These are needed to meet depositor demands for currency and payment services HOWEVER they involve an *opportunity cost* because this money is being held and thus isn't being lent and lending is where banks earn most of their profits.

Fear(when all depositors want their money back at the same time there can be a problem)

This can turn *solvent* banks into *illiquid banks* very quickly.

Monetary Policy

This causes a change in %deltaM; refers to either a decrease or increase in the money supply. Causes an AD curve shift.

SRAS

This curve shows the *positive relationship* between the inflation rate and real growth during the period when prices and wages are *sticky*.

Solow Growth Rate

This informs us of the long-run aggregate supply potential; it tells us that if we have more capital we will have more output and that growth is related to *real* factors of production (NOT inflation). "An economy's potential growth rate, the rate of economic growth that would occur given the existing real factors of production."

Federal Reserve

This institution has more influence over *aggregate demand* than ANY other institution. It mainly influences *money supply*.

SRAS

This is the main difference between the RBC and New Keynesian models. RBC says prices are *flexible* so this curve is not needed. New Keynesian says prices are *sticky* so we DO have this curve.

RBC Model

This model assumes that prices are *flexible* so they can easily adjust to shocks. Also says that ONLY *supply stock* matters (shifting AD curve does not effect the Solow growth rate). This model suggests the government needs to focus on long-term growth to increase our Solow Growth Rate to provide an environment for long-term growth (but does not address demand management).

Negative

This type of Supply (real) shock will *DECREASE* the ability of an economy to produce (*lower real growth rate*) (decreases the potential growth rate aka Solow) and *increases infaltion*(LRAS moves left and up the AD curve).

Positive

This type of supply (real) shock will *INCREASE* the ability of an economy to produce(*higher real growth rate*) (increases the economy's potential growth rate) and *decreases inflation*(LRAS moves right and down the AD curve).

FDIC(Federal Deposit Insurance Corporation)

To avoid bank runs, this guarantees bank deposits up to $250,000 for each depositor.

International Trade

Trade across national borders.

Fixed(Pegged) Exchange Rate

When a government or central bank has promised to convert its currency into another currency at a fixed rate (usually in countries where trade is very important because the rate effects exports/imports-- usually fixed against the US dollar).

Left

When spending growth *decreases* the AD curve shifts _______. This is due to EITHER a change in %M or %V.

Right

When spending growth *increases* the AD curve shifts _______. This is due to EITHER a change in %M or %V.

Lender of Last Resort

When the Fed loans money to banks and other financial institutions when no one else will.

Quantitative Tightening

When the Fed sells longer-term government bonds or other securities.

B. Checkable deposits in a bank.

Which is MOST liquid? A. A mortgage loan. B. Checkable deposits in a bank. C. A new truck. D. A diamond.

D. Providing loans to small businesses.

Which is NOT a function of the Federal Reserve? A. Serving as the lender of last resort. B. Regulating the U.S. financial system. C. Regulating the U.S. money supply. D. Providing loans to small businesses.

B. A permanent tax cut.

Which is the MOST effective fiscal policy for influencing the economy? A. A temporary tax rebate. B. A permanent tax cut. C. A tax hike with no change in consumption in response to the income change. D. A tax hike that is matched by a government spending cut.

D. All of the statements are correct.

Which of the following is TRUE about the economic policy of "protectionism"? A. It raises the prices of foreign goods in domestic markets. B. It restricts competitive forces in domestic markets. C. It can be achieved through quotas and tariffs. D. All of the statements are correct.

C. An increase in crop production due to more rainfall.

Which of the following most likely causes a shift of the long-run aggregate supply curve to the right? A. An increase in the money supply. B. A decrease in tax revenues. C. An increase in crop production due to more rainfall. D. An increase in oil prices due to a fire in a major oil refinery.

B. Increase.

With a floating exchange rate, and increase in the U.S. demand for Japanese exports would cause the demand for yen to: A. Decrease. B. Increase. C. Remain unchanged. D. Become less elastic.

Quantitative Easing

"When the Fed buys longer-term government bonds or other securities" -When the economy requires an extra boost the Fed may influence long-term rates (usually only fixes short-term) through this process which involves buying longer-term government bonds (or other longer-term securities) in the 10- to 30- year range.

MM(Money Multiplier)

(=1/RR) The *potential* amount the money supply expands with each dollar increase in reserves. --In reality, depositors may not be willing to put money in banks or banks are afraid to lend so this is ONLY the potential maximum.

RR(Reserve Ratio)

(=R/D) The ratio of reserves to deposits; this is determined primarily by how *liquid* banks wish to be (will hold more/have higher reserve ratio if they want to be more liquid and vice versa).

Sticky Wage Theory

(This is one of the reasons we have an upward sloping, positive SRAS curve). Says that many wages are *fixed* by contracts. When product prices increase, production becomes more profitable, and thus, output *increases*, we must think of a wage as a cost. --If inflation is high we can sell our goods at a higher price while at the same time out costs (worker wages) are fixed by a contract SO there is a profit margin. We can sell at a higher price while keeping costs as they were before. *Profitable to produce more when inflation is high and we don't have to pay workers more*.

Sticky Price Theory

(This is one of the reasons we have an upward sloping, positive SRAS curve). Says that retail prices and *menu costs* cannot be adjusted day-by-day. So, when overall price level *increases*, the outdated price will attract consumers as the product becomes relatively cheaper (compared to companies that can adjust price). Productions becomes more profitable and thus output rises.

Factors that change %deltaV(and thus shift the AD curve left or right)

-Consumption Spending -Investment Spending -Government Spending (*fiscal policy*) -Growth in Net Export

Effects of a Tariff

1. Domestic suppliers respond to the higher price by increasing production. 2. Domestic consumers respond to the higher price by buying less. 3. Imports DECREASE 4. *Government Revenue= Tariff $$ Amount x Quantity of IMPORTS*

Limitations of PPP

1. Holds more tightly in the LONG RUN (than the short) 2. Transportation costs 3. Some goods and services cannot be shipped 4. Tariffs or quotas hinder market exchange

Basic Principles of Trade

1. Trade makes people better off when preferences differ. 2. Trade increases productivity through specialization and the division of knowledge 3. Trade increases productivity through comparative advantage.

When to use fiscal policy

1. When the economy needs a *short-run* boost, even at the expense of the long run. 2. When the problem is a *deficiency in aggregate demand* rather than a real shock. 3. When many *resources are unemployed*.

Change in Money Supply

= Change in Reserves x MM

Imports

=Domestic Quantity Demanded - Domestic Quantity Supplied

10%, 2

A _______ increase in the price of oil, lowers the GDP growth rate for just over _____ years.

Insolvent Bank

A bank that has liabilities GREATER than its assets.

Illiquid Bank

A bank that has short-term liabilities that are greater than its short-term assets but OVERALL has assets greater than its liabilities. (A bank can be illiquid but still solvent and healthy--if everyone withdraws money at the same time they don't have liquid currency but still have the virtual assets to cover liabilities).

Dirty(Managed) Float

A currency whose value is not pegged/fixed, BUT governments will intervene extensively in the market to keep the value within a certain range. --usually this technique fails because other countries won't trust you to trade with you

Wealth Effect

A decrease in the price level that makes consumers feel wealthier (because their *purchasing power increases*), this in turn encourages them to spend more.

Depreciation

A decrease in the price of one currency in terms of another currency. (we can buy less with the same amount). --An *increase in the supply* of a currency causes the currency to do this (lose value).

M2

A definition of Money Supply: M1 (currency+checkable deposits) plus savings deposits, money market mutual funds, and small-time deposits.

M1

A definition of Money Supply: currency plus checkable deposits.

Monetary Base

A definition of Money Supply: the currency and total reserves held at the Fed.

Business Cycle

A fluctuation in the growth rate of *real GDP* around its *trend growth*.

Demand Shock

A sudden event that increases or decreases *demand* for goods and services. (Ex: Christmas-- increases the demand for goods.)

Supply(Real) Shock

A sudden event that increases or decreases *production* of goods and services. (Ex: a hurricane--destroys farmland and kills workers so they produce less goods.)

Fractional Reserve Banking

A system where banks hold only a fraction of deposits in reserve, using the rest to make loans. (Banks create money by lending with interest).

Tariff

A tax on imports

Implementation Lag

A type of Fiscal policy lag: Bureaucracies must implement the plan.

Legislative Lag

A type of Fiscal policy lag: Congress must propose and pass a plan.

Effectiveness Lag

A type of Fiscal policy lag: The plan takes time to work. --This is the only time fiscal policy> monetary policy since fiscal has automatic stabilizers built into the tax and transfer system.

Recognition Lag

A type of Fiscal policy lag: The problem must actually be *recognized*.

Evaluation and Adjustment Lag

A type of Fiscal policy lag: did the plan work? Have conditions changed?

Long-Run Aggregate Supply Curve

A vertical line AT the Solow growth rate, independent of the inflation rate.

Money

A widely accepted means of payment.

Dollarization

Adopting the money of another country (Ex: Zimbabwe and Ecuador using the US dollar)--this country will usually follow the monetary policy of its adopted currency.

Liquid Asset

An asset that can be used for payments or, quickly without loss of value, be converted into an asset that can be used for payments. (Ex: a house is NOT this because you cannot easily pay for Starbucks with your house..).

World Bank

An entity that lends money for SPECIFIC projects in *developing/low income* countries. Aims to alleviate poverty.

Floating Exchange Rate

An exchange rate determined primarily by market forces.

Appreciation

An increase in the price of one currency in terms of another currency. (We can buy more with the same amount). --a *decrease in supply* (can be caused by tighter monetary policy) will cause this (increase in the value of the currency).

B. The short-run aggregate supply curve to shift left.

An increase in the rate of expected inflation causes: A. The short-run aggregate supply curve to shift right. B. The short-run aggregate supply curve to shift left. C. An upward movement along the short-run aggregate supply curve. D. A downward movement along the short-run aggregate supply curve.

A. Become more liquid.

An increase in the reserve ratio means banks want to: A. Become more liquid. B. Make more loans. C. Purchase real estate. D. Lend in the federal funds market.

B. Depreciate against other currencies.

An increase in the supply of euros will cause the euro to: A. Appreciate against other currencies. B. Depreciate against other currencies. C. Maintain its value against other currencies.

IMF(International Monetary Fund)

An organization independent of any single government. Serves as an international lender of last resort, organizing rescue packages for countries experiencing financial troubles.

Money Neutrality

Because of this, increase in money supply has NO EFFECTS on real GDP growth. The only effect of *increasing money supply* is *increasing inflation*.

C. Growth rate of real GDP around its trend growth rate.

Business fluctuations are fluctuations in the: A. Level of real GDP around its long-term trend. B. Level of nominal GDP around its long-term trend. C. Growth rate of real GDP around its trend growth rate. D. Growth rate of nominal GDP around its trend growth rate.

Net Job Loss

Calculated by: Job Creation - Job Destruction. This is commonly high during a recession.

Automatic Stabilizers

Changes in fiscal policy that stimulate AD in a recession without the need for explicit action by policymakers. --Consumption smoothing, credit, and high private spending all act as these.

Expected Inflation

Each SRAS curve is associated with a particular rate of this. At ANY point along the entire SRAS curve this rate will be the *same*. If our expectations change then the ENTIRE SRAS curve shifts.

LRAS

Events that affect *proximate and ultimate causes* can shift this curve. Business cycles and recessions are primarily due to shifts in the curve.

Fiscal Policy

Federal *government* policy on taxes, spending, and borrowing that is designed to influence business fluctuations.

B. Decrease.

For a given money multiplier, a decrease in the banking system's reserves will cause the money supply to: A. Increase. B. Decrease. C. Remain constant. D. Become difficult to predict.

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If *Actual inflation _______ expected inflation*: Expected inflation adjusts *downward* and SRAS shifts *downward*.

>

If *Actual inflation _______ expected inflation*: Expected inflation adjusts *upward* and SRAS shifts *upward*.

B. Purchasing power parity would hold more closely.

If a teleportation device were invented, which of the following would happen? A. Purchasing power parity would cease to hold. B. Purchasing power parity would hold more closely. C. There would be no change in the degree of purchasing power parity. D. Currencies would depreciate.

Higher(will hold more money in reserve)

If banks wish to be *more liquid* (better fulfill depositor demand), then they will have a _________ *reserve ratio*.

C. Will expand.

If instead of buying short-term Treasury securities the Fed decided to purchase the country's supply of paper clips, the money supply: A. Will not change. B. Might expand or contract. C. Will expand. D. Will contract.

D. 6%

If nominal spending growth is 5% and the economy is in recession at a -1% real growth rate, what is the inflation rate? A. -1/5% B. 4% C. 5% D. 6%

D. rising; 2%

If spending grows by 3% while real growth is 1% and the velocity is stable, then prices will be ______ at a rate of ____ according to the aggregate demand curve. A. falling; 3% B. falling; 2% C. rising; 3% D. rising; 2%

A. Real GDP did not increase.

If spending growth is 6% and inflation is also 6%, this means that: A. Real GDP did not increase. B. Economic growth was 12%. C. More money is chasing an increased number of goods. D. A positive supply shock occurred.

C. Aggregate demand will increase because of the lower interest rates.

If the Fed engages in an expansionary monetary policy, what would you expect to happen in the short run? A. Aggregate supply will decrease because of higher wages. B. Aggregate demand will decrease because of higher interest rates. C. Aggregate demand will increase because of the lower interest rates. D. The economy will move along the AD curve to a lower inflation rate.

Decrease, increase

If the Fed wants to stimulate the economy they will _____ the RR which will *increase the MM* and thus _______ our money supplied.

B. The growth rate is higher than the Solow growth rate.

If the actual rate of inflation turns out to be higher than the expected rate of inflation, what happens to the growth rate of output before expectations are updated? A. The growth rate stays at the Solow growth rate. B. The growth rate is higher than the Solow growth rate. C. The growth rate is lower than the Solow growth rate. D. The growth rate could go up or down.

C. The dollar has depreciated.

If the dollar per euro exchange rate rises, this means that: A. It takes more euros to purchase a dollar. B. The demand for euros must have fallen. C. The dollar has depreciated. D. The supply of euros must have also risen.

D. Can $16.

If the exchange rate between the U.S. dollar and the Canadian dollar was U.S. $1.25 for Can $1, then a shirt that costs U.S. $20 would cost: A. Can $25. B. Can $21.25. C. Can $18.75. D. Can $16.

C. The aggregate demand curve will shift to the right.

If the growth rate of spending increases from 3% to 5%, then: A. The inflation rate will rise 2%. B. The growth rate of real output will rise 2%. C. The aggregate demand curve will shift to the right. D. The slope of the aggregate demand curve will increase.

A. 225 euros

If the purchasing power parity holds and the nominal exchange rate is 1 euro for $2, then an iPhone that cost $450 in New York should cost _______ in London. A. 225 euros B. 450 euros C. 675 euros D. 900 euros

D. $2 million.

If the reserve ratio is 5%, then an increase in bank deposits by $100,000 could expand the money supply by: A. $5,000. B. $100,000. C. $500,000. D. $2 million.

Weather

In *agricultural economies*, when this fluctuates, so does output and therefore does GDP.

Low, high(ex: this occurred during the 1970s oil crisis)

In bad economic times we have a ______ rate of GDP growth and a ______ rate of inflation.

Oil

In each of the last 6 U.S. recessions, there was a *large increase in the price* of this *input* just prior to or coincident with the onset of recession. (shows that this input is important in many sectors and can thus hurt many American industries).

A. They both target aggregate demand to overcome business fluctuations.

In what way are monetary and fiscal policies similar? A. They both target aggregate demand to overcome business fluctuations. B. They are both effective when the economy suffers from real shocks. C. Both are insulated from the political process. D. Neither involves a lag.

AD(the ultimate goal of expansionary monetary policy)

Increasing money growth leads to a shift/increase/stimulate in _________.

Fall(down)

Inflation will do this if *spending growth* and *real growth* *increase*.

B. Take on too much risk, believing that the Fed and regulators will bail them out.

Moral hazard occurs when banks and other financial institutions: A. Hesitate to lend because of concern over excessive risk. B. Take on too much risk, believing that the Fed and regulators will bail them out. C. Fail to maintain their assets exceeding the liabilities. D. Fail, then bring down other institutions in the system.

Aggregate Spending

MxV is known as ______ __________.

Open Market Operations

Occur when the Fed buys or sells government bonds from the bond market.

Great Depression

Occurred in 1929 primarily due to a large *fall in AD*. When the stock market crashed people felt poorer and decreased spending which caused a fall in AD and a bank run. Fear also caused a decrease in investment spending which even further decreased AD.

Moral Hazard

Occurs when banks and other financial institutions take on too much risk, hoping that the Fed and regulators will later bail them out. This is the notion of *"too-big-to-fail"*.

Liquidity Crisis

Occurs when banks are illiquid (only refers to SHORT TERM liabilities and assets, liabilities>assets in this case)

Solvency Crisis

Occurs when banks become *insolvent*(liabilities>assets).(Ex: the central bank might decrease their discount rate to encourage borrowing and thus increase their assets to AVOID this).

Ricardian Equivalence

Occurs when people see lower taxes TODAY means higher taxes in the future, so instead of spending their tax cut, they save it to pay future taxes. When this holds, a tax cut doesn't increase aggregate demand even in the short run.

Open Market Operation

One *tool* the Fed has for controlling money supply: The Fed *increases* the money supply by *buying bonds* and *decreases* the money supply by *selling bonds*. --Limitation: Fed can control the MB but cannot control how much or how quickly banks will lend, this can cause the MM to be low and a change in MB won't really change the money supply by much.

Nature and Causes

One of the most contested areas in economic policy is the ____________ of *business cycles*. We need something to relate real GDP growth and inflation.

RBC Model(Real Business Cycle)

Only involves the LRAS and AD curves