ECON101 Exam 4 Problem Sets & Quizzes

An economy is experiencing a high rate of inflation. The government wants to reduce aggregate demand by $36 billion to reduce inflationary pressure. The MPC is 0.75. By how much should the government raise taxes to achieve its objective?

$12 billion

In an economy, the government wants to increase aggregate demand by $50 billion at each price level to increase real GDP and reduce unemployment. If the MPC is 0.6, then it would increase government purchases by

$20 billion

A commercial bank has required reserves of $60 million and the reserve ratio is 20%. How much are the commercial bank's checkable-deposit liabilities?

$300 million

Answer the next question on the basis of the following consolidated balance sheet of the commercial banking system. Assume that the reserve requirement is 20%. All figures are in billions. Assets: Liabilities: Reserves $200 Checkable deposits $1000 Securities $300 Stock shares $400 Loans $500 Property $400 If the Fed reduced the reserve requirement from 20% to 16%, excess reserves in the commercial banking system would increase by _____ and the monetary multiplier would rise to ____.

$40 billion; 6.25

Assume that the full-employment level of output is $2,000 and the price level associated with full-employment output is 100. Also assume that the economy's current level of output is $1,900 and, at the price level of 100, current aggregate demand is $1,850. If the government moves the economy back to the full-employment level of output by increasing government purchases by $30, then the MPC equals

0.8

How many members can serve on the Board of Governors of the Federal Reserve System?

7

Automatic Stabilizers

An economy is a dynamic system that responds to all kinds of changes that can occur. As a result, when a shock to aggregate demand or aggregate supply occurs, tax revenue, government spending, and prices all start adjusting to help the economy move back to full employment. Progressive taxation increases taxes when output rises; it decreases taxes when output falls. The result in either case is that progressive taxation helps keep output closer to full employment. Similarly, a system of unemployment insurance (in the form of transfer payments) helps put money in people's pockets when they need it most, keeping decreases in output from becoming larger. Policies such as progressive taxation and transfer payments result in changes that occur without any direct action by the government. For that reason, they are called automatic stabilizers. Because of these automatic stabilizers, the highs and lows of the business cycle are smaller than they would otherwise be.

The lending ability of commercial banks increases when the

Fed buys securities in the open market

The part of the Federal Reserve that determines and implements the nation's monetary policy and controls the money supply to promote stable prices and economic growth is the:

Federal Open Market Committee

The Money Multiplier

An increase in reserves in the banking system will generally lead to an even larger increase in the money supply. With more reserves on hand, banks will have additional excess reserves and will make more loans. When banks make more loans, they create even more money. The overall change in the money supply that results depends on the money multiplier, which is equal to 1 divided by the reserve requirement. The smaller the reserve requirement, the more loans banks can make, so the larger the money multiplier will be. Thus, if we know how much reserves increased initially and we know the reserve requirement, we can predict how much the money supply will ultimately increase.

Suppose that Ava withdraws $300 from her savings account at Second Bank. The reserve requirement facing Second Bank is 10%. Assume the bank does not wish to hold any excess reserves of new deposits. Use this information to complete the table below to show how Second Bank's assets and liabilities change when Ava withdraws the $300 from the bank.

Assets Change in Reserves: -$30 Change in Loans: -$270 Liabilities Change in Deposits: -$300

Banking

Banks play a crucial role in our economy and help determine interest rates and the money supply. When someone deposits cash in a bank, the bank is required to keep a portion of that deposit on hand as reserves. These are the bank's required reserves; they are necessary to ensure that the bank has enough money available when its customers withdraw money or write checks. The amount of required reserves is equal to the amount of the deposit times the reserve requirement (rr). The bank can loan out the rest of the deposited funds, called its excess reserves, in order to earn interest.

Money Demand

People hold money for two reasons. The first is to buy the goods and services they want. This is called transaction demand. It does not depend on the interest rate. The second reason to hold money is as a form of saving for the future (although a form of saving that earns little or no interest). This is called asset demand. The higher the interest rate on other assets becomes, the less attractive money becomes as an asset. Thus, all else held constant, a rising interest rate decreases the quantity of money demanded. Likewise, a decreasing interest rate increases the quantity of money demanded. Total money demand is the sum of the two demands for money: transaction demand and asset demand. Because asset demand is negatively related to the interest rate, total money demand is also negatively related to the interest rate.

The Federal Reserve - Structure

The Federal Reserve System, also known as the Fed, is the central bank of the United States. The Federal Reserve System consists of 12 banks, each representing a different geographic area of the United States. The Federal Reserve Board, or Board of Governors, oversees the Fed and regulates the U.S. banking system. The most important function of the Board of Governors is participating in the Federal Open Market Committee, or FOMC. The other members of the FOMC include the president of the New York Fed plus four presidents from the remaining district banks, who serve on a rotating basis. The FOMC determines and implements the nation's monetary policy and controls the money supply in the U.S. economy.

When nominal GDP increases, the __________ will shift to the ___________, creating a ___________ at the original interest rate, causing interest rates to __________ until the new equilibrium is reached

When nominal GDP increases, the money demand curve will shift to the right, creating a shortage at the original interest rate, causing interest rates to increase until the new equilibrium is reached. When nominal GDP increases, the increased desire to make more transactions will cause an increase in money demand. The increased money demand will create a shortage in the money market at the original equilibrium interest rate. Therefore, the interest rate will need to increase to reduce the quantity of money demand until the new equilibrium is reached at a higher interest rate.

When the Federal Reserve wants to decrease the money supply it uses __________ policy, which ___________ interest rates and causes prices to ____________ while in the short run real GDP __________.

When the Federal Reserve wants to decrease the money supply it uses contractionary policy, which raises interest rates and causes prices to decrease while in the short run real GDP falls.

When the Federal Reserve wants to increase the money supply it uses ________ policy, which ___________ interest rates and causes the amount of investment to ___________.

When the Federal Reserve wants to increase the money supply it uses expansionary correct policy, which lowers correct interest rates and causes the amount of investment to increase correct.

Which of the following fiscal policy changes would be the most expansionary?

a $40 billion increase in government purchases

Which of the following best describes the cause-and-effect chain of a restrictive monetary policy?

a decrease in the money supply will raise the interest rate, decrease investment spending, and decrease aggregate demand and GDP

If you use $1,000 to purchase silver coins, which you plan to keep in a safe, you are using money as

a medium of exchange

Suppose the reserve requirement is currently 15%. a. Assume First Bank has deposits of $100 million. Calculate the required reserves for First Bank. b. At the end of the day, First Bank finds it has $14 million of reserves. First Bank will ________ reserves of $__________ million in the federal funds market.

a. $15 million b. borrow; $1

The main function of the Federal Reserve System is to

control the money supply

To keep high inflation from eroding the value of money, monetary authorities in the United States

control the supply of money in the economy

The Federal Reserve System performs many functions but its most important one is

controlling the money supply

The M1 measure of money consists of the sum of

currency, checking deposits, and travelers' checks

It is costly to hold money because

in doing so, one sacrifices interest income

In the table, investment is in billions. Suppose the Fed reduces the interest rate from 6% to 4%. As a result of this decrease in the interest rate, using column (2) investment will (1) Interest Rate (2) Investment (3) Investment 4% $100 $80 5 90 70 6 80 60 7 70 50 8 60 40

increase by $20 billion

Assume that the full-employment level of output is $500 and the price level associated with full-employment output is 100. Also assume that the economy's current level of output is $450 and, at the price level of 100, current aggregate demand is $400. If the government wants to move the economy back to the full-employment level of output and the MPC is 0.75, then it should

increase government purchases by $25

When the interest rate increases, the opportunity cost of holding money will ________ and the quantity of money demand will _________

increase; decrease

When the reserve requirement is decreased, the excess reserves of member banks are

increased and the multiple by which the commercial banking system can lend is increased

The lag between the time that the need for fiscal action is recognized and the time action is actually taken is referred to as the

legislative lag

If the Fed were to reduce the reserve requirement, we would expect

lower interest rates, an expanded GDP, and a higher rate of inflation

Which of the following functions does the Federal Reserve System not perform?

providing banking services to the general public

The discount rate is the interest

rate at which the Federal Reserve Banks lend to commercial banks

The multiple by which the commercial banking system can expand the supply of money is equal to the

reciprocal of the reserve ratio

Cash held by a bank in its vault is a part of the bank's

reserves

Use the following table to answer the next question. The money supply and investment are in billions. Money Supply Interest Rate Investment $50 7% $100 60 6 110 70 5 120 80 4 130 90 3 140 Assume that the MPC is 0.8 and the reserve requirement is 0.1. If the Federal Reserve needs to decrease aggregate demand by $100 billion at each price level to move the economy back to full employment and the current interest rate is 5%, then the Federal Reserve should _________ bonds on the open market equal to ________

sell, $2 billion

Generally speaking, the government implements fiscal policy in a

slow and inaccurate manner

If the government knew the precise values of the multiplier and potential income, fine-tuning the economy would

still be very difficult

What policy tool of the Federal Reserve relies on bank borrowing to be effective?

the discount rate

Which of the following varies directly with the interest rate?

the opportunity cost of holding money

Which of the following statements best describes what occurs when monetary authorities sell government securities?

the size of commercial banks' excess reserves decreases, the money supply decreases, and the interest rates rise, thereby causing a decrease in investment spending and real GDP

When government purchases are increased, the amount of the increase in aggregate demand primarily depends on

the size of the multiplier

When a banker records how many dollars each of his borrowers owes the bank, money is serving as a

unit of account

Problem Solving - Government Purchases

Fiscal policy can be used to increase or decrease aggregate demand in response to changing economic conditions. Government purchases is one of the two tools that can be used. The needed change in government purchases depends on whether the government is pursuing expansionary or contractionary fiscal policy: Expansionary fiscal policy expands output by increasing government purchases, which increases aggregate demand. Contractionary fiscal policy contracts output by reducing government purchases, which decreases aggregate demand. The appropriate increase or decrease in government purchases for a given policy will depend on two things: how much aggregate demand needs to increase or decrease and the size of the expenditures multiplier.

Limitations of Fiscal Policy

Fiscal policy has three key limitations that reduce its ability to smooth the business cycle and ensure full employment and low inflation. They are the recognition, legislative, and implementation lags. The effect of each of these is a delay in the time between when a recession starts and when the effects of fiscal policy are felt in the economy. As a result, it may be easier to implement stabilization policies in theory than to actually do so in practice.

Money

Money is any item that people will generally accept in exchange for goods, services, and resources. Money has three primary characteristics: First, as a medium of exchange, it's what people use in transactions. Second, as a unit of account, it's what people use to compare prices of goods and services. Third, as a store of value, money is something people can use to transfer wealth from the present to the future. Money is an integral part of every economy. By making trade easier, it makes specialization more possible, so people can be more productive.

The most important among the Federal Reserve district banks in conducting monetary policy is the

New York bank

Which of the following institutions does not provide checkable-deposit services to the general public?

U.S. Treasury

Interest - Market Dynamics

Changes in money supply and money demand affect the price of money, the interest rate: All else held constant, increases in money demand or decreases in money supply will cause a shortage of money in the market. This shortage puts upward pressure on interest rates. As interest rates rise, the shortage is eliminated (as the quantity of money demanded falls due to the higher interest rate). On the other hand, decreases in money demand or increases in money supply cause an initial surplus of money in the market. This surplus causes interest rates to fall, thus helping to increase the quantity of money demanded and eliminate the surplus in the market. In the end, changes in money demand or money supply will result in a new equilibrium interest rate, just as changes in demand or supply in other markets cause a change in the equilibrium price.

Fiscal policy is often initiated on the advice of the

Council of Economic Advisers

Expansionary and Contractionary Fiscal Policy

Fiscal policy is used to help maintain full employment and low inflation in an economy. Fiscal policy can be expansionary or contractionary: If an economy is experiencing high unemployment, the government can use expansionary fiscal policy to increase aggregate demand, stimulate production, and return the economy to its long-run equilibrium. Expansionary fiscal policy consists of increasing government purchases, reducing taxes, or some combination of the two. If an economy is experiencing high levels of inflation, the government can use contractionary fiscal policy to decrease aggregate demand, reduce production, and return the economy to its long-run equilibrium. Contractionary fiscal policy consists of decreasing government purchases, increasing taxes, or some combination of the two.

Fractional Reserve Banking - Reserve Requirements

In the United States, we have a fractional reserve banking system. This means that banks are required to keep on hand, as required reserves, only a certain percentage of deposits. The bank can lend out the remaining reserves, called excess reserves, to earn profit. The loans create other deposits, which are included in the money supply. Thus, banks create money by making loans. In fact, the amount of money created by banks through loans is greater than the amount of money that exists as currency in the economy.

Interest - The Money Market

In the money market, the price we use is the interest rate. Money demand is downward-sloping, and the money supply curve is vertical. As in any market, supply and demand will adjust until the market finds an equilibrium quantity traded and an equilibrium price. In this case: If the initial interest rate exceeds the equilibrium interest rate, a surplus of money will exist. A surplus of money puts downward pressure on the interest rate until it decreases to the equilibrium interest rate. At that point, quantity demanded and quantity supplied are equal. If the interest rate falls below the equilibrium interest rate, a shortage of money will exist. This shortage of money will put upward pressure on the interest rate, until it rises to the equilibrium interest rate. In either case, the ability of the interest rate to decrease (in the case of a surplus) or increase (in the case of a shortage) returns the money market to equilibrium.

Interest Rates and Asset Demand

People typically hold their wealth in a variety of different assets, with varying risks and returns. Money is good for storing wealth, as its value is relatively stable, but money deposits like checking accounts earn little or no interest. Bonds typically pay more interest than money but are riskier since the borrower may default and never pay back the loan. A change to the money supply affects not only the interest rate for money but also bond prices and yield: An increase in the money supply results in excess quantity of money supplied; people use this additional money to purchase more bonds, and this raises bond prices. The result is a decrease in bond yields, or interest rates. A decrease in the money supply lowers bond prices, and this raises bond yields.

The Money Supply

People use money to pay for the goods and services they buy each day. The overall supply of money in an economy is broken down into categories depending on the liquidity of the asset being used as money. M1 consists of the most liquid assets—currency, demand deposits, traveler's checks, and checkable deposits. M2 includes M1 and also assets that are slightly less liquid, such as savings accounts, money market mutual funds, and time deposits.

The Federal Reserve - Functions

The Federal Reserve has several important functions, the main ones being directing monetary policy, supervising member banks, clearing checks, and providing financial services to banks and the federal government: The Fed implements monetary policy by changing the money supply, which it can do in a few different ways. The Fed supervises member banks to prevent disruptions in the banking system. The Fed serves as a bank for the federal government, providing financial services to the U.S. Treasury. The Fed also manages payments between banks, both through paper checks and electronic transfers. By performing these necessary functions, the Fed helps keep the banking and monetary system secure, and this aids in the functioning of the economy as a whole.

The existence of lags in designing and implementing fiscal policy helps illustrate some of the limitations of fiscal policy aimed at easing the burdens of a recession. Which of the following statements best describes a situation when fiscal policy is more appropriate?

The economy is slow to self-correct or the recession is very severe. Because of the recognition lag, legislative lag, and implementation lag associated with enacting fiscal policy, the policies aimed at smoothing the business cycle can sometimes have the opposite effect. The risk of these policies being procyclical instead of being beneficial in a time of recession diminishes when recessions are long and severe. It is more likely that fiscal policies can be developed and implemented in time if it takes a long time for an economy to self-correct.

Problem Solving - Taxes

The government has two fiscal policy tools: changing government purchases and changing taxes. The effects of changing taxes on aggregate demand depend on whether the government is pursuing expansionary or contractionary fiscal policy: Expansionary fiscal policy decreases taxes, which increases consumption, thereby increasing aggregate demand. This policy, in the case of a recession, helps to bring the economy closer to full employment. Contractionary fiscal policy increases taxes, which decreases consumption, thereby decreasing aggregate demand. This policy, in the case of an expansion and a rising price level, helps to bring the price level down by moving the economy back to full employment. Using the tax multiplier, you can determine how much taxes need to change in order to obtain the desired change in aggregate demand.

The Fisher Equation

The nominal interest rate tells you how many dollars a borrower must repay a lender for each dollar borrowed. The real interest rate tells you how much more (or less) the lender can buy once she or he is repaid. The difference arises because prices do not stay the same over the course of a loan. Although we frequently see nominal interest rates in our everyday experiences—such as when we visit banks—real interest rates have a far greater impact on how borrowers and lenders interact. To determine the (approximate) real interest rate when entering into a loan contract, we use the Fisher equation, which states that the nominal interest rate, i, is approximately equal to the real interest rate plus the expected inflation rate: ≈ r + π^e. Suppose the loan is made at the interest rate calculated in Part A but, at the end of the year, inflation turns out to be 8%, not the 3% both Homer and Barney were expecting. What is the real interest rate Homer will receive on the loan? Solution: Since we are at the end of the loan and inflation has actually happened, as opposed to being expected, we remove the superscript e from our Fisher equation: r ≈ i - π ≈ 7% - 8% ≈ -1% The real interest rate Homer receives on the loan is equal to −1%. The negative sign tells us that Homer's purchasing power has actually decreased. Since inflation was 8%, the amount of goods that cost $1,000 last year will actually cost $1,000 × 1.08 = $1,080 this year. Homer receives only $1,070 from Barney, so Homer loses on this loan. Homer made money ($70) but lost purchasing power because his money doesn't buy as much as it could have the year before.

Now suppose, instead, that the prevailing interest rate is 3%. Will there be a surplus or shortage in the money market? How will the interest rate change in the money market?

The prevailing interest rate of 3% is less than the equilibrium interest rate of 5%. Therefore, the quantity of money demanded is greater than the quantity of money supplied, creating a shortage. With more money demanded than what is supplied, the interest rate will increase. People who want to borrow money cannot find lenders willing to lend them money at an interest rate of 3%. Therefore, people wanting money will bid up the price of money, which is the interest rate. The interest rate will continue to rise until it equals the equilibrium rate of 5%. At this rate, all those wanting to borrow money can find a lender, because quantity demanded and quantity supplied are equal.

Suppose that the prevailing interest rate is not 5% but is actually 8%. Will there be a surplus or shortage in the money market? How will the interest rate change in the money market?

The prevailing interest rate of 8% is greater than the equilibrium interest rate of 5%. Therefore, the quantity of money demanded at this higher interest rate will be less than the quantity supplied, creating a surplus. The surplus in the market places downward pressure on the interest rate; the interest rate will decrease until the market is in equilibrium at 5%. People who have money they want to lend cannot find borrowers willing to pay an interest rate of 8%. To attract borrowers, they will lower interest rates to induce more borrowing—that is, to increase the quantity of money demanded. The interest rate will continue to fall until it reaches the equilibrium at an interest rate of 5%. At this equilibrium rate, all those wanting to lend money can find a borrower, because quantity demanded and quantity supplied are equal.

The Money Supply Curve

The supply of money in an economy is largely determined by a central monetary authority. In the United States, that authority is the Federal Reserve. The supply of money is not influenced by its price (the interest rate), so at any point in time, it is equal to a fixed quantity. Because of this unique relationship between interest rates and the supply of money, the money supply curve is a vertical line. If the Fed increases the money supply, the money supply curve shifts to the right by the amount of the increase. A decrease in the money supply has the opposite effect—the money supply curve shifts to the left by the amount of the decrease.

A key feature of all automatic stabilizers is that they:

The term automatic stabilizer refers to a feature of existing government policy that automatically steadies the economy by decreasing government spending through transfer payments and/or increasing taxes as an economy grows, or by increasing government spending through transfer payments and/or reducing taxes when an economy contracts. Automatic stabilizers help to make a recession or inflation less severe, without any direct or new government action.

Suppose that people in the economy are going to spend $4 million in the current period based on nominal GDP. The table shows the demand for money to be saved for future use at a variety of interest rates. Use the information above to complete the "Transaction Demand" column and then complete the "Total Demand" column for this economy. Interest Rate Asset Demand 25% $0 20 4 15 8 10 12 5 16 0 20

Transaction Demand Total Demand $4 $4 4 8 4 12 4 16 4 20 4 24

Assume the reserve requirement is 10% and the MPC = 0.6 for the economy when a stock market downturn reduces aggregate demand by $100 billion. a. Suppose the Federal Reserve wants to increase investment demand to offset the reduction in aggregate demand. To accomplish this goal, how much does investment demand need to increase? b. To increase investment demand by the desired amount, the Fed estimates that interest rates will need to ___________ by 4% and the money supply will need to ___________ by $200 billion. c. In order to achieve the $200 billion change in the money supply, the Fed will make an ___________ of $__________ billion.

a. $20 billion If the Federal Reserve wants to keep output at the full-employment level, then it will need to increase aggregate demand by $100 billion to offset the decrease from before. In order to increase aggregate demand by $100 billion, the Fed can stimulate investment demand and allow the spending multiplier to expand aggregate demand. The spending multiplier is equal to 1/(1 - MPC), which, in this case, with an MPC of 0.6 is equal to 1/(1 − 0.6) = 1/0.4 = 2.5. We know that a total increase in aggregate demand is equal to the spending multiplier times the change in spending. Here we have the desired total increase in aggregate demand and the spending multiplier, which can be used to find the needed change in investment demand. Setting up the equation, we have $100 billion = 2.5 × (Change in Investment Demand). Therefore, to find the change in investment demand, divide both sides by 2.5 and get the needed change in investment demand = $100 billion/2.5 = $40 billion. The Fed would need to increase investment demand by $40 billion to increase aggregate demand by $100 billion. b. To increase investment demand by the desired amount, the Fed estimates that interest rates will need to decrease by 4% and the money supply will need to increase by $200 billion. c. $20 billion To increase the money supply and decrease interest rates, the Fed would conduct an open market purchase. To find the size of the open market purchase, we use the relationship where the total change in the money supply is equal to the money multiplier times the change in reserves. Since the reserve requirement is 10%, we know the money multiplier is equal to 1/(Reserve Requirement) = 1/0.10 = 10. The estimated total increase in the money supply is $200 billion, so $200 billion = 10 × Needed Change in Reserves. Dividing both sides by 10 gives us the needed change in reserves = $200 billion/10 = $20 billion. Thus, the Fed would need to make an open market purchase of $20 billion to increase reserves by $20 billion, causing an increase in the money supply of $200 billion.

Use the following table to determine the levels of M1 and M2 for the United States. Asset Amount (billions) Currency $82 Demand deposits 80 Money market funds 44 Other checkable deposits 37 Savings deposits 460 Small time deposits 22 Traveler's checks 4 a. Calculate the M1 money supply. b. Calculate the M2 money supply.

a. $203 billion b. $729 billion

Suppose the reserve requirement is currently 20%. a. Assume Second Bank has deposits of $300 million. Calculate the required reserves for Second Bank. b. At the end of the day, Second Bank finds it has $65 million of reserves. Second Bank will __________ reserves of $_________ million in the federal funds market.

a. $60 million b. lend; $5

a. At a reserve requirement of 10%, what is the value of the money multiplier? b. If the reserve requirement is 10% and the Fed increases reserves by $20 billion, what is the total increase in the money supply? c. Suppose the Fed raises the reserve requirement to 16%. What is the value of the money multiplier now? d. Assume the reserve requirement is 16%. If the Fed increases reserves by $20 billion, what is the total increase in the money supply? e. Raising the reserve requirement from 10% to 16% ________ the money multiplier and ________ the money supply.

a. 10 b. $200 billion c. 6.25 d. $125 billion e. decreases; decreases

Suppose the Federal Reserve sets the reserve requirement at 15%, banks hold no excess reserves, and no additional currency is held. a. What is the money multiplier? b. How much will the total money supply increase by if the Federal Reserve increases the amount of reserves by $200 million? c. When the Federal Reserve increases the reserve requirement, the money multiplier will _________ and an increase in reserves will have __________ effect on the money supply.

a. 6.67 b. $1334 million c. decrease; a smaller

Suppose that Karen deposits $500 into her checking account at the bank. The reserve requirement for Karen's bank is 12%. Assume the bank does not want to hold any excess reserves of new deposits. a. Use this information to complete the table below to show how the bank's assets and liabilities change when Karen deposits the $500. b. Why are deposits considered liabilities for a bank?

a. Assets Change in Reserves: $60 Change in Loans: $440 Liabilities Change in Deposits: $500 b. Deposits can be withdrawn at any time

a. The reserve requirement is determined by the: b. Open market operations are determined by the:

a. Board of Governors b. Federal Open Market Committee

a. Suppose there is a surge in consumer confidence that creates an increase in aggregate demand in the economy. The Federal Reserve estimates that a change in the money supply of $120 billion will adjust interest rates enough to offset the change in aggregate demand. If the reserve requirement is 25%, what action should the Fed take to reach the desired change in the money supply? b. Suppose there is a political crisis in Europe that causes a reduction in investment demand in the United States. To stimulate investment demand, the Federal Reserve decides the money supply needs to change by $150 billion. If the reserve requirement is 10%, what action should the Fed take to reach the desired change in the money supply?

a. The Fed should conduct an open market sale of $30 billion. When there is an increase in aggregate demand, then to offset the change, the Fed will need to decrease aggregate demand. To decrease aggregate demand, the Fed causes a reduction in the money supply and an increase in interest rates. The Fed would conduct an open market sale to reduce the money supply. To find the size of the open market sale, we use the relationship where the total change in the money supply is equal to the money multiplier times the change in reserves. Since the reserve requirement is 25%, we know the money multiplier is equal to 1/(Reserve Requirement) = 1/0.25 = 4. The estimated total decrease in the money supply is $120 billion, so $120 billion = 4 × Needed Change in Reserves. Dividing both sides by 4 gives us the needed change in reserves = $120 billion/4 = $30 billion. Thus, the Fed would need to make an open market sale of $30 billion to decrease reserves by $30 billion, causing a decrease in the money supply of $120 billion. b. The Fed should conduct an open market purchase of $15 billion. When there is a decrease in aggregate demand, then to offset the change, the Fed will need to increase aggregate demand. o increase aggregate demand, the Fed causes an increase in the money supply, which then should cause a decrease in interest rates. The Fed would conduct an open market purchase to increase the money supply. To find the size of the open market purchase, we use the relationship where the total change in the money supply is equal to the money multiplier times the change in reserves. Since the reserve requirement is 10%, we know the money multiplier is equal to 1/(Reserve Requirement) = 1/0.10 = 10. The estimated total increase in the money supply is $150 billion, so $150 billion = 10 × Needed Change in Reserves. Dividing both sides by 10 gives us the needed change in reserves = $150 billion/10 = $15 billion. Thus, the Fed would need to make an open market purchase of $15 billion to increase reserves by $15 billion, causing an increase in the money supply of $150 billion.

a. When Lily transfers $100 from her savings account into her checking account b. If Miguel deposits $200 cash into his money market mutual c. If Sam takes $1,000 from his savings account to purchase Microsoft stock

a. When Lily transfers $100 from her savings account into her checking account, M1 increases by $100 and M2 remains the same. When $100 is transferred from a savings account into a checking account, M1 will increase by $100 since checking accounts are included in M1, but M2 will remain the same because both checking accounts and savings accounts are included in M2. b. If Miguel deposits $200 cash into his money market mutual fund, M1 decreases by $200 and M2 remains the same. When $200 of cash is deposited into a money market mutual fund, M1 will decrease by $200 because it is completely leaving M1. However, M2 will remain the same since both currency and money market mutual funds are included in M2. This is simply a reallocation of assets that are included in M2 and not a change in the total value. c. If Sam takes $1,000 from his savings account to purchase Microsoft stock, M1 remains the same and M2 decreases by $1,000. When $1,000 is removed from a savings account, it will have no effect on M1. So M1 will remain the same since M1 does not include savings accounts. M2 will decrease by $1,000 because savings accounts, which are included in M2, are reduced by this amount and the $1,000 is placed into an asset that is not part of M2.

The federal funds market is shown in the graph below. Assume the market is in equilibrium and that the Federal Reserve has established a 5% target for the federal funds rate. a. Suppose that banks are nervous about the next election and hold more excess reserves, causing the amount of reserves at banks to increase. Show this change in the demand for reserves in the federal funds market. b. In order to keep the federal funds rate at the target rate, the Fed will need to conduct an ____________ so the quantity of reserves will ____________ to meet the change in reserve demand.

a. When banks hold more excess reserves, they need to borrow fewer reserves, which decreases the demand for reserves. This causes the demand for reserves curve to shift to the left. A new demand for reserves curve should be drawn to the left of the original curve, showing a decrease in the amount of reserves in the federal funds market. b. Because of the decreased demand for reserves, the Fed will need to decrease the amount of reserves in supply to keep the federal funds rate from decreasing. The Fed will conduct an open market sale, which will decrease the quantity of reserves supplied in the banking system. This will eliminate the excess quantity of reserves from the reduced demand and keep the federal funds rate at the target level.

For each scenario, determine which time lag is most likely to result when designing and implementing fiscal policy. a. In the United States today, the separation of power between the legislative and executive branches of government combined with strong partisanship attitude among our elected politicians demonstrates the: b. The fact that it takes economists, such as those working for the National Bureau of Economic Research (NBER), months to declare the dates of peaks and troughs demonstrates the: c. The time it takes to design and build new infrastructure, such as roads and railroads, passed by the legislature demonstrates the:

a. legislative lag b. recognition lag c. implementation lag

a. Money is a medium of exchange when: b. Money is a store of value when: c. Money is a unit of account when:

a. money is used to facilitate trade between buyers and sellers b. money is used to transfer wealth from the present to the future c. money is used to communicate the market value of goods and services

a. Suppose the Federal Reserve wants to increase the money supply. What should it do to accomplish this goal? b. Now suppose the Fed wants to decrease the money supply. What should it do to accomplish this goal?

a. When the Fed increases the money supply, it engages in open market purchases. An open market purchase occurs when the Fed buys securities from banks and gives banks more reserves in return. Banks will lend the additional reserves and create even more money in the economy through the deposit creation process. If the reserve requirement is 15%, then the money multiplier can be found by taking 1/(Reserve Requirement), which is 1/(0.15) = 6.67. With a money multiplier of 6.67 and an increase in reserves of $30 billion from the open market purchase, the total increase in the money supply is found by multiplying the money multiplier times the increase in reserves. Therefore, the total increase in the money supply is equal to 6.67 × $30 billion = $200 billion. b. When the Fed decreases the money supply, it engages in open market sales. An open market sale occurs when the Fed sells securities to banks and takes reserves from the banks in return. Banks have to reduce lending when reserves are reduced, which will get multiplied in a negative fashion through the deposit creation process, as fewer and fewer loans occur. If the reserve requirement is 15%, then the money multiplier can be found by taking 1/(Reserve Requirement), which is 1/(0.15) = 6.67. With a money multiplier of 6.67 and a decrease in reserves of $40 billion from the open market sale, the total decrease in the money supply is found by multiplying the money multiplier times the decrease in reserves. Therefore, the total decrease in the money supply is equal to 6.67 × $40 billion = $267 billion.

Suppose the reserve requirement is 20% and that the initial federal funds rate target is 5%. The federal funds market and the money market are in equilibrium as shown in the graphs below. a. Suppose the Federal Reserve wants to raise the federal funds rate from 5% to 7%. It will require a $30 billion open market sale to achieve this goal. Show the change in the supply of reserves curve and indicate the new quantity of reserves in the federal funds market. b. If the Federal Reserve makes an open market purchase of $30 billion, the total money supply will decrease by $___________ billion. c. When the total money supply decreases, there will be an adjustment to the interest rate in the money market. Use the money market graph and show the change in the money supply and interest rates in the money market. d. When the Federal Reserve raises the federal funds rate target, reserves __________, causing the money supply to ___________, and interest rates (for borrowing and lending money) will _____________.

a. When the Federal Reserve raises the federal funds rate target, it requires a decrease in reserves. Since the original federal funds rate target was 5% and the Fed wants to raise the rate to 7%, the supply of reserves curve will need to be drawn at the higher interest rate. A new horizontal supply of reserves curve should be drawn at 7% and should intersect the demand for reserves curve at a quantity of reserves of $60 billion. The new equilibrium will occur in the federal funds market at the higher 7% interest rate and the quantity of reserves where the reserves supply intersects the reserves demand at $60 billion. Therefore, the new equilibrium should be plotted at an interest rate of 7% and quantity of reserves of $60 billion. b. If the reserve requirement is 20%, then the money multiplier can be found by taking 1/(Reserve Requirement), which is 1/(0.20) = 5. With a money multiplier of 5, a decrease in reserves of $30 billion from an open market sale will cause a total decrease in the money supply by the money multiplier times the decrease in reserves. Therefore, the total decrease in the money supply is equal to 5 × $30 billion = $150 billion. c. Since we know the total decrease in the money supply is $150 billion, the money supply curve will shift to the left. The original money supply curve was at $300 billion but since the money supply decreased by $150 billion, the new money supply curve should be drawn as a vertical line at a level of $150 billion. The new interest rate and money market equilibrium will occur where the new money supply curve intersects the money demand curve. At this point, the new equilibrium should be plotted. This should occur at an interest rate of 12% and quantity of money of $150 billion. d. When the Federal Reserve raises the federal funds rate target, it decreases the level of reserves, which leads to a decrease in the money supply. The decrease in the money supply will increase interest rates.

The federal funds market is shown in the graph below. Assume the market is in equilibrium and that the Federal Reserve has established a 3% target for the federal funds rate. a. Suppose that people want to hold more currency to go on vacation such that banks experience a large number of unexpected withdrawals, causing the amount of reserves at the banks to fall. Show this change in the demand for reserves in the federal funds market. b. In order to keep the federal funds rate at the target rate, the Fed will need to conduct an ____________ so the quantity of reserves will _____________ to meet the change in reserve demand.

a. When there are unexpected withdrawals from banks and banks are left with fewer reserves, banks will need to replenish their reserves. Since banks need additional reserves, it will increase the demand for reserves, which will cause the demand for reserves curve to shift to the right. A new demand for reserves curve should be drawn to the right of the original curve, showing an increase in the amount of reserves in the federal funds market. b. To meet the increased demand for reserves and to keep the federal funds rate from rising above the target level, the Fed will need to increase the amount of reserves in supply. The Fed will conduct an open market purchase, which will increase the quantity of reserves supplied in the banking system. This will meet the increased demand for reserves and keep the federal funds rate at the target level.

Assume the economy is currently in equilibrium at its full-employment level of output, the money market is in equilibrium, and the MPC = 0.75. a. Suppose there is an increase in government spending that causes aggregate demand to increase by $16 billion. Show the increase in aggregate demand on the graph. b. Now suppose the Federal Reserve wants to keep inflation from hurting the economy and maintain output at the full-employment level. To restore this economy to its long-run equilibrium, the Federal Reserve needs to shift the aggregate demand curve to the left by ______________ c. If the Federal Reserve were to reduce investment demand to cause the shift in aggregate demand, with an MPC = 0.75, investment demand would need to decrease by ____________ to achieve the needed change in aggregate demand. d. For investment demand to decrease by the necessary amount, the Federal Reserve would need to cause interest rates to rise from 5% to _________ e. Use the money market and investment demand graphs to illustrate the monetary policy change the Federal Reserve would need to make in order to restore aggregate demand and real GDP back to the long-run equilibrium levels.

a. When there is an increase in aggregate demand of $16 billion, the aggregate demand curve will shift to the right by exactly $16 billion. This means a new aggregate demand curve needs to be drawn to the right of the original aggregate demand curve, and at every price level, the amount of real GDP should increase by $16 billion. We should see that on the old AD curve at a price level of 100, real GDP was $80 billion. However, after the shift, the price level of 100 intersects the new AD curve at $96 billion. To show the new equilibrium, we plot a point at the intersection of the new AD curve and the original short-run AS curve. The new equilibrium should occur at a price level of 110 and real GDP of $88 billion since the AD curve increases by $16 billion. b. If the Federal Reserve wants to keep prices from increasing and keep output at the full-employment level, then it will need to decrease aggregate demand by $16 billion to offset the increase from before. Thus, the Fed will have to shift the AD curve back to the left by $16 billion. c. In order to shift the AD curve to the left by $16 billion, the Fed can reduce investment demand and allow the spending multiplier to contract aggregate demand. The spending multiplier is equal to 1/(1 - MPC), which, in this case, with an MPC of 0.75 is equal to 1/(1 - 0.75) = 1/0.25 = 4. We know that a total decrease in aggregate demand is equal to the spending multiplier times the change in spending. Here we have the desired total decrease in aggregate demand and the spending multiplier, which can be used to find the needed change in investment demand. Setting up the equation, we have $16 billion = 4 × (Change in Investment Demand). Therefore, to find the change in investment demand, divide both sides by 4 and get the needed change in investment demand = $16 billion/4 = $4 billion. The Fed would need to decrease investment demand by $4 billion to decrease aggregate demand by $16 billion. d. Using the investment demand graph, currently at 5%, the level of investment demand is $10 billion. Since investment demand needs to decrease by $4 billion, total investment would then need to equal $6 billion. In order to get investment of $6 billion, using the investment demand curve, we see that $6 billion of investment occurs at an interest rate of 7%. So the Fed would need to increase interest rates from 5% to 7% to get the desired effect on investment demand. e. Because we know that interest rates need to increase from 5% to 7%, we need to draw a new money supply curve such that it intersects the money demand curve at an interest rate of 7%. Drawing a vertical money supply curve at a quantity of money of $80 billion, it would intersect the money demand curve at 7%. Then we can plot the new equilibrium in the money market where the money supply and money demand curves intersect. This point would be plotted at an interest rate of 7% and quantity of money of $80 billion. Since the new equilibrium interest rate is 7%, a new quantity of investment demand needs to be shown on the investment demand curve. Originally, the quantity of investment demand was $10 billion at an interest rate of 5%, but now that the interest rate increased to 7%, the new investment point needs to be plotted on the investment demand curve at an interest rate of 7%. The new point should show a new level of investment demand of $6 billion at 7%. With the higher interest rate and decreased investment demand, the Fed should achieve its goal of decreasing aggregate demand and keeping output at the full-employment level.

a. An increase in the money supply in the money market will cause b. An increase in the money supply in the bond market will cause c. Assume the original price of bonds at P1 = $900 and bonds provide an interest payment of $100 per year. What is the yield on bonds at P1? d. Suppose that after the increase in the money supply, the price of bonds increases to $1,100. What is the yield on bonds now?

a. When there is an increase in the money supply, the money supply curve will shift to the right. The new equilibrium will be found where the new money supply curve intersects the money demand curve. This should occur down and to the right of the original equilibrium so the interest rate will decrease when the money supply increases. b. With the increase in the money supply, people will have more money in the money market than their desired money holdings. This will create a surplus of money and decrease the interest rate on money, as shown in the money market. But the surplus of money will affect more than just assets in the money market. To adjust to the surplus of available money, people will use some of their money to purchase more bonds. In doing this, the demand for bonds will increase, causing the price of bonds to increase. This will cause the bond demand curve to increase, or shift to the right. A new bond demand curve will need to be drawn to the right of the original bond demand curve. c. The yield or interest rate on the bond can be found by taking the interest paid by the bond divided by the price of the bond. With an interest payment of $100, at a price of $900, the yield (in percent terms) on the bond will be $100/$900 × 100% = 0.111 × 100% = 11.1%. d. The yield or interest rate on the bond can be found by taking the interest paid by the bond divided by the price of the bond. With an interest payment of $100, at a price of $1,100, the yield (in percent terms) on the bond will be $100/$1,100 × 100% = 0.091 × 100% = 9.1%.

a. The discount rate is the: b. If the Fed were to decrease the discount rate, banks will borrow:

a. interest rate at which banks can borrow reserves from the Federal Reserve b. more reserves, causing an increase in lending and the money supply

Suppose the reserve requirement is 10%. a. If the Federal Reserve decreases the reserve requirement, banks can lend out: b. The Federal Reserve:

a. more reserves, thus increasing the money multiplier and increasing the money supply When the Fed decreases the reserve requirement, banks are able to lend out a greater percentage of the deposits. As banks increase lending, the additional loans will create many more deposits through the deposit creation process and increase the money supply. Thus, the reduction in the reserve requirement leads to an increase in the money multiplier and an increase in the money supply. b. rarely changes the reserve requirement and does not use the reserve requirement as a major monetary policy tool Even though changing the reserve requirement can greatly affect the money multiplier and money supply, the Fed rarely changes the reserve requirement and does not use the reserve requirement as a monetary policy tool. Because banks need stability and need to make long-term planning, constantly changing the reserve requirement would make it almost impossible for banks to know how much of their deposits they could lend. This would greatly disrupt the banking system and stability of the economy, which is why the Fed does not use the reserve requirement for monetary policy.

a. The Federal Reserve's purchase or sale of government securities to change the money supply. b. The fraction of checkable deposits that banks must keep on hand, either as currency or on deposit with the Federal Reserve. c. The interest rate at which banks can borrow money directly from the Federal Reserve

a. open market operations b. reserve requirement c. discount rate

Financial markets pay close attention to changes in the federal funds rate because these changes

affect other interest rates in the economy

The Federal Reserve System regulates the money supply primarily by

altering the reserves of commercial banks, largely through sales and purchases of government bonds

Which combination of fiscal policy actions would most likely offset each other?

an increase in taxes and an increase in government purchases

The Federal Reserve Banks sell government securities to the public. As a result, the checkable deposits

and reserves of commercial banks both decrease

Money is:

anything that both buyers and sellers will accept in exchange for goods and services

As the economy declines into recession, the collection of personal income tax revenues automatically falls. This phenomenon best illustrates how a progressive income-tax system

are not subject to the timing problems of discretionary fiscal policy

One advantage of automatic stabilizers over discretionary fiscal policy is that automatic stabilizers

are not subject to the timing problems of discretionary fiscal policy

When the Fed acts as a "lender of last resort," like it did in the financial crisis of 2007-2008, it is performing its role of

being the bankers' bank

Suppose that, for every 1 percentage point decline of the discount rate, commercial banks collectively borrow an additional $2 billion from Federal Reserve Banks. Also assume that the reserve requirement is 20%. If the Fed increases the discount rate from 4.0% to 4.25%, bank reserves will

decline by $0.5 billion and the money supply will decline by $2.5 billion

When the federal government changes purchases and/or taxes to stimulate the economy or rein in inflation, such policy is

discretionary fiscal policy

A newspaper headline reads: "Fed Cuts Federal Funds Rate for Fifth Time This Year." This headline indicates that the Federal Reserve is most likely trying to

ease monetary policy

If a government wants to pursue an expansionary fiscal policy, then a tax cut of a certain size will be more expansionary when the

economy's MPC is large

If Congress passes legislation to increase government purchases to counter the effects of a recession, then this would be an example of a(n)

expansionary fiscal policy

Traditionally, the Fed often communicated its intentions to restrict or expand monetary policy by announcing a change in its target for the

federal funds rate

When comparing the two options for restoring the economy to its full-employment level of output, the benefit of allowing the economy to return to full employment on its own is that:

full employment is reached with a higher price level