CH 28, 29, 31, 33 TEST HW
According to the Fisher effect, how does an increase in the inflation rate affect the real interest rate and the nominal interest rate? What are the costs of inflation? Which of these costs do you think are most important for the U.S. economy?
According to the Fisher effect an increase in the inflation rate raises the nominal interest rate by the same amount that the inflation rate increases. This has no effect on the real interest rate. The costs of inflation include shoe leather costs associated with reduced money holdings, menu costs with more frequent adjustment of prices, increased variability of relative prices (etc). For the US economy none of these costs are very high. The most important cost is the interaction between inflation and tax code, which may reduce saving and investment even though the inflation rate is low.
According to the quantity theory of money, what is the effect of an increase in the quantity of money?
According to the quantity theory of money the high price level/ lower value of money increases the quantity of money demanded. It says that the quantity of money available in an economy determines the money and growth in the quantity of money is the primary cause of inflation.
Explain how an increase in the price level affects the real value of money.
An increase in price level affects the real value of money because each dollar in your wallet will now buy a smaller amount of goods and services since the price level has risen.
Why don't banks hold 100 percent reserves? How is the amount of reserves banks hold related to the amount of money the banking system creates?
Banks do not hold 100 percent of the reserves because they get more profit if they use the reserves to make loans. These loans then earn interest instead of leaving the money as reserves which earn no interest. The amount of reserves hold is related to the amount of money the banking system creates through the money multiplier. If the fraction of reserves the bank holds is small, then the larger the money multiplier since each dollar of reserves is used to create more money.
What is commodity money? What is fiat money? Which kind do we use?
Commodity money is money used for the purpose other than just medium of exchange. It is money with intrinsic value like gold. Fiat money is money that has no other value than other using it as a medium for exchange. Our economy uses fiat money.
If the Fed started printing large quantities of U.S. dollars, what would happen to the number of Japanese yen a dollar could buy? Why?
If the Fed started printing large quantities of US dollars, then the US price level would increase, and a dollar would buy fewer Japanese yen.
What are demand deposits and why should they be included in the stock of money?
Demand deposits are the balances in bank accounts that depositors may access on their own demand by writing a check. They should be included in the stock of money since they may be used as a medium for exchange.
Suppose that this year's money supply is $500 billion, nominal GDP is $10 trillion, and real GDP is $5 trillion. What money supply should the Fed set next year if it wants inflation of 10 percent?
If the Fed wants inflation to be 10 percent, it will need to increase the money supply 15 percent. Therefore M x V will rise 15 percent causing P x Y to rise 15 percent with a 10 percent increase in prices and a 5 percent rise in real GDP.
If the Fed wants to increase the money supply with open-market operations, what does it do?
If the Fed wants to increase the supply the supply of money with open-market operations, then it will purchase U.S. government bonds on the public open market. With the purchase of bonds there will be an increase in the number of dollars in the hands of the public, which overall raises the money supply.
Suppose that this year's money supply is $500 billion, nominal GDP is $10 trillion, and real GDP is $5 trillion. Suppose that velocity is constant, and the economy's output of goods and services rises by 5 percent each year. What will happen to nominal GDP and the price level next year if the Fed keeps the money supply constant?
If the M and V are unchanged and Y rises 5 percent, then because M x V= P x Y, P must fall by 5 percent. As a result, nominal GDP is unchanged.
If inflation is less than expected, who benefits— debtors or creditors? Explain.
If the inflation is less than expected creditors benefit and debtors lose. Creditors receive dollar payments from debtors that have a higher real value than expected.
Who is responsible for setting monetary policy in the United States? How is this group chosen?
In the United States the Federal Open Market Committee is responsible for setting the monetary policy. This group is chosen by the president of the U.S. and then must be confirmed by the U.S. Senate. Then the presidents of the Federal Reserve Banks are chosen by each bank's board of directors.
In what sense is inflation like a tax? How does thinking about inflation as a tax help explain hyperinflation?
Inflation is similar to a tax since everyone who holds money loses purchasing power. In hyperinflation the government increases the money supply rapidly which leads to an increase in inflation. Therefore, the government uses the inflation tax instead of taxes to finance its spending.
What distinguishes money from other assets in the economy?
Money is unlike other assets in the economy because it is the most liquid asset. The other assets in the economy have liquidity that varies widely.
Define net exports and net capital outflow. Explain how and why they are related.
Net Exports are imbalances between countries exports and imports. Net Capital Outflow is an imbalance of assets. The two are related because net exports equals net capital outflow.
Suppose that this year's money supply is $500 billion, nominal GDP is $10 trillion, and real GDP is $5 trillion. a. What is the price level? What is the velocity of money
Nominal GDP= P x Y = $10,000 and Y= real GDP = $5,000 so P= (P xY)/Y= $10,000/$500 =20 Because M x V= P x Y, then V= (PxY)/M = $10,000/$500= 20
Explain the difference between nominal and real variables and give two examples of each. According to the principle of monetary neutrality, which variables are affected by changes in the quantity of money?
Nominal variables are variables measured in monetary units. Then real variables are variables measured in physical units. Examples of nominal variable include the price of goods, wages and nominal GDP. Then examples of real variables include relative prices, real wages and real GDP. According to the principle of monetary neutrality, nominal variables are affected by changes in the quantity of money.
List and explain the three reasons the aggregate- demand curve is downward sloping.
One reason the aggregate demand curve is downward sloping is the wealth effect. The wealth effect increases the price level while reducing the real value of wealth, which reduces the quantity of aggregate demand. Another reason the curve is sloping downward is the interest rate effect. This states that when the price level goes up, the poorer you are in real terms which results in less saving and less investment. Lastly, the curve is sloping downward because of international trade effect which is when exports become relatively more expensive and imports become relatively cheaper.
List and explain the three theories for why the short-run aggregate-supply curve is upward sloping.
One theory that explains why the short-run aggregate supply curve is upward sloping is the sticky wage theory, in which a lower price level makes employment and production less profitable because wages do not adjust immediately to the price level. Another theory is the sticky price theory in which unexpected fall in the price level leaves some firms with higher than desired prices because not all prices adjust instantly to changing conditions. Lastly the misperceptions theory in which lower price level causes misperceptions about relative prices which induce suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied.
What are reserve requirements? What happens to the money supply when the Fed raises reserve requirements?
Reserve requirements are the regulations on the minimum amount of reserves that a bank must hold against its deposits. If the Fed raises reserve requirements, then it will lower the money multiplier and decrease the money supply.
Why can't the Fed control the money supply perfectly?
The Fed can't control money supply perfectly because the Fed does not control the amount of money that households choose to hold as deposits in banks. Secondly, the Fed doesn't control the amount the bankers choose to lend out. The actions of the households and banks affect the money supply in ways the Fed cannot predict.
What might shift the aggregate-demand curve to the left? Use the model of aggregate demand and aggregate supply to explain the short-run and long-run effects of such a shift on output and the price level.
The aggregate demand curve might shift to the left when something causes a reduction in the consumption spending, a reduction in investment spending, decreased government spending or reduced net exports. When the aggregate demand curve shifts to the level the economy moves from point A to B.
What might shift the short-run aggregate-supply curve to the left? Use the model of aggregate demand and aggregate supply to explain the short-run and long-run effects of such a shift on output and the price level.
The aggregate supply curve might shift to the left because of a decline in the economy's capital stock, labor supply or productivity or an increase in the natural rate of unemployment, all of which both in long run and short run shift aggregate supply curve to the left. An increase in the expected price level shifts just the short-run aggregate supply curve to the left.
What is the discount rate? What happens to the money supply when the Fed raises the discount rate?
The discount rate is the interest rate on loans that the Federal Reserve makes to the banks. If the Fed raises the discount rate, then fewer banks borrow from the Fed. Therefore, both bank's reserves and money supply will decrease.
Describe the economic logic behind the theory of purchasing-power parity.
The economic logic behind the theory of PPP is that nominal exchange rate between the currencies of two prices. This must reflect price levels in those countries. Currencies should be able to buy same quality of all goods in all countries and have the same purchasing power
Explain why the long-run aggregate-supply curve is vertical.
The long-run aggregate supply curve is vertical because in the long run changes in the price level do not affect potential GDP, this depends on the size of the labor force, capital stock and technology.
If a Japanese car costs 500,000 yen, a similar American car costs $10,000, and a dollar can buy 100 yen, what are the nominal and real exchange rates?
The nominal exchange rate is 100 yen per American dollar. The real exchange rate equals the nominal exchange rate times domestic price divided by foreign price, this equals 100 yen per dollar times $10,000 per American car divided by 500,000 yen per Japanese car, which equals two Japanese cares per American car.
Explain the relationship among saving, investment, and net capital outflow.
The relationship among saving, investment and new capital outflow are that savings equals investment plus net exports. To invest, people need to save, by saving they are supplying funds to available investment which increases the net capital outflow. A positive net capital outflow represents that the country is investing more internationally than other countries invests in it.
Suppose that this year's money supply is $500 billion, nominal GDP is $10 trillion, and real GDP is $5 trillion. What money supply should the Fed set next year if it wants to keep the price level stable?
To keep the price level stable, the Fed must increase the money supply by 5 percent, matching the increase in real GDP. Then, because velocity is unchanged, the price level will be stable.
Name two macroeconomic variables that decline when the economy goes into a recession. Name one macroeconomic variable that rises during a recession.
When the economy goes into recession the macroeconomic variables of real GDP and investment both declines. However, the macroeconomic variable of unemployment rises.