ECO 202 Chapter 9-13

When the value of a bank's assets is greater than its liabilities, the bank is said to be When the value of a U.S. bank's assets become less than its liabilities, the government through the FDIC,

Solvent shuts the bank down and makes payouts to its depositors. searches for a healthy bank to take over its operations.

Everything else remaining​ unchanged, what is likely to happen to the equilibrium real interest rate and quantity of credit if the credit supply curve shifts to the​ right?

The equilibrium rate of interest will decrease and the quantity of credit will increase.

According to the quantity theory of​ money, the inflation rate is If the inflation rate is negative, what must be true?

The gap between the growth rate of money supply and the growth rate of real GDP The growth rate of real GDP > the growth rate of money supply

Why is the rise in housing prices between the late 1990s and 2006 characterized as a bubble by some​ economists? How did the fall in housing prices cause the entire financial system in the United States to freeze​ up? The fall in housing prices resulted in ______, leading to enormous ________, disrupting the banks' ability and willingness to make loans to __________

The large increase in the price of housing assets did not reflect the true​ long-run value of the assets. increased defaults, bank losses, consumers and firms

Which of the following is not true regarding the natural rate of unemployment

The natural rate of unemployment is 0 percent when the U.S. economy is not in a recession

Banks usually meet their liquidity needs by

borrowing from each other in the federal funds market.

Real business cycle theory​

emphasizes the role of changing productivity and technology in causing economic fluctuations.

Countercyclical policy that seeks to raise GDP growth and the level of employment is appropriate when

excessively pessimistic sentiments about the economy are prevalent. the economy is experiencing a recession.

Households and firms with savings lend money to banks and other financial institutions. The credit supply curve shows the relationship between the quantity of credit supplied and the real interest rate. The credit supply curve slopes upward because a​ A shift in the credit supply curve can be caused by​

higher real interest rate discourages current consumption. higher real interest rate encourages more saving a heightened desire on the part of firms to internally fund their future activities. an elevated perception on the part of households that the future may hold many​ "rainy days." an aging population that is​ ill-prepared for retirement.

The real wage is the​ What is the significance of the real wage as it relates to​ inflation?

inflation-adjusted wage Since an increase in inflation reduces the real wage that firms must​ pay, firms are more willing to hire​ workers, thus stimulating economic activity.

An asset is liquid​ if:

it can be easily converted into cash without loss of value.

Hyperinflation is most likely caused by

large budget deficits financed by printing more money

Quantitative easing is Central banks undertake quantitative easing programs to​

the central​ bank's purchase of​ long-term bonds in the open market. a variation on the central​ bank's traditional manner of conducting open market operations. an attempt by the central bank to more directly impact​ long-term interest rates. more forcefully and directly impact the interest rates relevant for investment decisions work around the problems when short-term nominal interest rates approach zero

Recall the discussion in the chapter about the​ "quantity theory of​ money."The quantity theory of money assumes that​ This implies that if the money supply grows by 10​ percent, then nominal GDP needs to grow by It follows that the growth rate of money supply and the growth rate of nominal GDP will be the same. In this​ case, inflation is​

the ratio of money supply to nominal GDP is exactly constant. 10 percent Yes, the​ long-run data show a​ one-for-one growth rate of money supply and inflation.

The Federal Reserve influences the long-run real interest rate through​

the short-term federal funds rate

Consider two​ banks: Bank A and Bank B. Suppose the value of liabilities of both the banks is equal.​ However, Bank A is solvent but Bank B is insolvent. This would imply​ that:

the value of Bank​ A's assets exceeds the value of Bank​ B's assets.

One major difference between modeling economic busts and booms is that While economic booms are generally​ positive, they also have a dark side. This is because

there is no issue of rigid nominal wages when modeling booms. if the economy is close to full employment and full capacity utilization before the beginning of the​ boom, the economy might eventually experience a leftward shift in labor​ demand, causing a recession rather than a gentle fall to​ pre-boom levels.

Maturity transformation is the process by which banks

transfer​ short-term liabilities into​ long-term investments

In the United​ States, recessions are informally defined as​ ________ in real GDP.

two consecutive quarters of negative growth

According to real business cycle​ theory, the economic impact of changing input prices is similar to the economic impact from​ If​ oil, which is a major input to most production​ processes, abruptly falls in​ price, the impact on the economy would be similar to​

technology changes a productivity increase​, with a resultant increase in real GDP. This is the correct answer.B.

Okun's Law states that Okun's Law​ Which of the following years is an​ outlier, that​ is, a year where​ Okun's Law does not​ hold?

when growth in real GDP is above​ 3%, unemployment drops and when it is below​ 3%, unemployment increases is usually an accurate representation of the data. 2012

According to​ Okun's Law, the year−to−year change in the rate of unemployment is​ ________ if the annual growth rate of real GDP is​ 5%.

-1%

In February​ 2014, the United States added​ 175,000 jobs to the economy. Given this​ information, what can we say about the unemployment rate of the​ country? Suppose that in January there were 4,000,000 workers in the labor​ force, with 3,736,000 employed and 264,000 unemployed, implying a 6.6 percent unemployment rate. A month​ later, there were 4,170,000 workers in the labor​ force, with 3,911,000 employed and 259,000 unemployed.​ The unemployment rate in February is

6.21%

Which of the following cannot produce a shift in the credit demand curve?

A change in the real interest rate

What is the shadow banking​ system?

A group of several thousand disparate nonbank financial intermediaries. Nonbank financial institutions that behave like banks in many respects. Financial institutions that make loans from funds raised by means other than by accepting deposits

Firms, households, and governments use the credit market for borrowing. The credit demand curve shows the relationship between the quantity of credit demanded and the real interest rate. The credit demand curve slopes downward because​ A shift in the credit demand curve can be caused by​

A lower real interest rate raises a borrowing changes in perceived business opportunities for firms. changes in household preferences or expectations. changes in government policy.

Carlos, on the other​ hand, thinks this​ way: "The economy has recovered from recession sufficiently that inflationary pressures are likely to build.​ Likewise, a weaker dollar means that imports are going to be more expensive. I​ don't think the Fed will risk slowing the recovery and raising unemployment by raising interest rates to fight inflation. ​ So, in light of all these​ factors, I expect inflation to increase to 5 percent next​ year." How would you best describe how each investor is forming his expectations of​ inflation? Sean is forming his forecast based on the ___________ model of inflation and Carlos is forming his forecast based on the _________ model of inflation What are possible criticisms of the way each investor is forming his​ expectations? Economists might argue that

Adaptive expectations, rational expectations Sean is not maximally​ rational, and Carlos can not be as good at understanding how the economy works as he thinks he is.

f nominal GDP​ increases, what might be the cause of this​ increase? If nominal GDP​ increases, this could be caused​ by

An increase in the price level An increase in real GDP

When a bank experiences withdrawals of deposits and​ short-term loans by firms and other​ banks, the situation is described as​ When large firms and the general banking community lose confidence in a weak​ bank, FDIC insurance is ________ the situation

An institutional bank run, incapable of alleviating

What could explain why a decrease in taxes could lead to a​ less-than-proportionate increase in​ output?

As a result of diminishing returns to current​ consumption, consumers may choose to spread the extra spending over the long term rather than consuming the proceeds of a tax cut all at once. Consumers may choose to save much of the tax cut in anticipation of having to pay higher taxes in the future.

If the value of a government−taxation multiplier is​ 1.8, which of the following is likely to be true if all other variables remain​ unchanged?

A​ $1 reduction in taxation increases gross domestic product by​ $1.80.

What does it mean to say that an economic fluctuation involves the​ co-movement of many aggregate macroeconomic​ variables?

These variables grow or contract together during booms and recessions.

Which of the following factors does not cause a shift in the labor demand​ curve?

Changes in the wage rate.

The demand for Country​ X's most important exportable product− electronic goods− is likely to double in the next 5 years. Which of the following is likely to happen in this​ case?

Consumption in Country X will rise

The goal of a country with a healthy economy is to have​ ____________ equal to zero.

Cyclical unemployment

The period from 2007 to 2009 was a time of economic contraction that came to be known as the​ "Great Recession." During periods of​ recession, most firms experience a decline in demand for their​ product, as well as a decline in the​ product's equilibrium price. All other things being​ equal, macroeconomic theory predicts that the wage of most workers should decline in recessionary periods.​ However, this was not the case in the Great​ Recession, or during many other economic downturns throughout recent history. Based on the discussion in the​ chapter, explain why this might be​ so, and what the implications are for unemployment.

During downturns workers are resistant to the lowering of wages and firms try to avoid doing so. This downward wage rigidity keeps the quantity of labor supplied greater than demand, causing unemployment.

How do expansionary policies differ from contractionary​ policies?

Expansionary policies seek to shift the labor demand curve to the​ right, while contractionary policies seek to shift it to the left. Expansionary policies seek to reduce the severity of​ recessions, while contractionary policies seek to slow down the economy when it grows too fast. Expansionary policies seek to increase economic growth and increase​ employment, while contractionary policies seek to reduce the risk of excessive price inflation.

Bitcoins are defined as a​ "peer-to-peer decentralized digital​ currency." The supply of bitcoins is not controlled by the government or any other central agency. The value of each bitcoin is determined on the basis of supply and demand and is defined in terms of dollars. New bitcoins can be generated through a process called​ "mining." However, new bitcoins will not be created once there are a total of 21 million bitcoins in existence. Some commentators feel that bitcoins can eventually replace most of the major currencies in the world. What are some of the issues with bitcoins replacing major​ currencies? Traditional currencies are controlled by central banks. What is a potential problem of restricting the creation of bitcoins to a total of 21 million​ bitcoins?

Fiat money is generally worthless without a government decree that is legal tender. Bitcoin deposits are not insured by the government The value of a bitcoin is highly volatile and so people that hold them may lose money Monetary authorities cannot undertake expansionary monetary policy to stimulate the economy during recessions

How does fiat money differ from commodities like gold and silver that were used as money? In fiat money is intrinsically worthless, then why is it valuable?

Fiat money is intrinsically worthless, whereas gold and silver have intrinsic value Fiat money is used as legal tender by government decree and other people will accept it as payment for transactions

As the Choice and Consequence box on​ "Too Big to​ Fail" notes, bank regulators worry about the prospect of the failure of large financial​ institutions, dubbed​ "systemically important financial​ institutions" (SIFIs). How would the failure of a systemically important financial institution​ (SIFI) affect the​ economy? What steps do bank regulators take to prevent SIFIs from failing or to minimize the effect of such​ failures?

Financial intermediation would likely be​ impaired, with negative consequences for the​ economy's performance. Mandate that banks hold more​ stockholders' equity. Require banks to establish​ "living wills," procedures for their treatment in the event they become insolvent. Require banks to take on less risk.

According to​ salary.com, the average salary for a software engineer level III​ (a higher-level position in software design and​ implementation) in the Silicon Valley area of California is​ $108,244. However, Google pays its level III software engineers an average salary of​ $124,258. Why does Google pay a salary higher than the equilibrium salary for equivalent positions in the same​ area?

Google is paying an efficiency wage in order to minimize worker turnover, increase worker productivity, and attract the top talent

When there is an increase in the wage rate paid to workers, the supply of labor will When there is an increase in acceptance of people taking 5 or 6 years to earn their college degrees instead of 4 years, the supply of labor will

Increase and move up along the curve Decrease and shift to the left

If you have studied​ microeconomics, you may recall a concept called​ "moral hazard." Moral hazard occurs when an economic agent is incentivized to take risks because some​ (or all) of the losses that might result will be borne by other economic agents. How might federal deposit​ insurance, as administered by the​ FDIC, lead to moral​ hazard?

Insurance gives bank managers incentives to pursue added risks since losses can be shifted to the FDIC. Depositors may pay less attention to the lending practices of banks since their deposits are covered up to some cap. Insurance may cause bank shareholders to be less vigilant in monitoring the investment strategies of bank managers.

How does the Federal Reserve obtain a particular value for the federal funds​ rate?

It finds the point on the demand curve that corresponds to that federal funds rate and makes available the exact level of reserves associated with that point on the demand curve.

How does the zero lower bound on interest rates affect the working of monetary​ policy?

It makes the implementation of expansionary monetary policy more difficult since it effectively blocks the central​ bank's use of its primary tool. It complicates the formulation of expansionary monetary policy because it forces the central bank to rely on nontraditional and less familiar tools such as quantitative easing. It reduces the effectiveness of monetary policy by impairing the ability of the public​ (including investors) to understand the central​ bank's actions and signals.

Which of the following is true regarding wage​ rigidity? Which of the following is not one of the factors that can increase wage rigidity in the labor market?

It occurs when wages are held fixed above the competitive equilibrium level The economy falling into a recession

What are the important mechanisms that reverse the effects of a recession in a modern​ economy? What market forces might cause the labor demand curve to shift back to the​ right?

Labor demand increases due to market forces Labor demand increases due to expansionary government policies The banking system recuperates and businesses are again able to use credit to finance their activities Technological advamces encourage firms to expand their activities Excess inventory has been sold off

Using the chart​ above, would you describe unemployment as a leading or lagging indicator of an economic​ downturn?

Lagging, since in every recession the unemployment rate did not peak until very late into the​ recession, or in some​ cases, after the recession.

Which of the following characteristics of economic fluctuations does the Great Depression​ illustrate?

Limited predictability Bank volatility Persistence

Early theories of business cycles assumed that economic fluctuations had a​ pendulum-like structure with systematic swings in economic growth. Which property of economic fluctuations do these early theories​ contradict? Using your answer​ above, how does a​ pendulum-like structure contradict this property in economic​ fluctuations?

Limited predictability. Pendulums swing in an​ easily-measured rhythm that would make predicting fluctuations simple.

Money makes a variety of economic transactions possible. In the following three​ situations, determine whether money is involved in the transaction. In prison camps during World War​ II, and in some prisons​ today, cigarettes circulate among prisoners. For​ example, an iPod might cost two cartons of​ cigarettes, whereas a magazine might only cost two cigarettes. Which functions of money are cigarettes fulfilling in this​ case? Over the last 50​ years, credit cards have become an increasingly popular way for people to purchase goods and services. Are credit cards​ money? Almost every​ day, many people sign their names to little pieces of paper called​ checks, which are then accepted in exchange for goods and services. Do these checks constitute​ money?

Medium of exchange Unit of account Store of value No, because you credit cards are not assets. No, because checks simply represent a means of access to​ money, not money itself.

Explain whether each of these individuals will be counted as a part of the labor force. Alex recently retired after working for the same company for 30 years. John is a full-time stay-at-home parent while his wife works. We know that Alex is _______, and we know that John is ______.

Not in the labor force; not in the labor force

The ​Evidence-Based Economics in the chapter identifies three key factors that caused the recession of 2007dash-2009. How would​ Keynes's concept of animal spirits explain the creation of a housing​ bubble? The national income identity shows that​ The recession of 2007dash-2009 affected the components of the national income identity by primarily affecting​

People believed that a house was a worthwhile​ investment, which led to an increased demand for housing and thus pushed prices up. This confirmed to people that housing was a worthwhile​ investment, which led to more​ demand, resulting in an upward spiral driven by optimism. output is a function of​ consumption, investment, government​ spending, and net exports. the C and I components through a reduction in consumer wealth and a drop in housing construction

When repaying a​ loan, the payment a borrower makes consists of​

Principal and interest

The fact that unemployment is lower among workers with a relatively higher level of education can be explained in part by the: What other reasons might explain why unemployment is lower among workers with a relatively higher level of education

Principle of optimization More educated workers have more human capital More educated workers have a higher opportunity cost of time Workers with a higher level of education are in greater demand by firms

To achieve its target for the federal funds​ rate, the Fed may​

Purchase treasury bonds in the open market Decrease the reserve requirement Decrease the interest rate paid on reserves deposited at the Fed Increase lending from the discount window

Which of the following equations is​ correct?

Real interest rate​ = Nominal interest rate − Inflation rate

Which of the following are possible benefits of​ inflation?

Revenue is generated to the government when it prints money There may be a reduction in real wages There may be a reduction in the real interest rate

According to the​ graph, when the minimum wage is set at ​$8 per​ hour, there will be​ ____________ unemployment of​ ____________ workers in this market. The losers when the minimum wage is ​$88 would be​ ___________ Using the​ graph, we can see that if the minimum wage were set at ​$4 per​ hour, then​ The impact of the minimum wage on the labor market as a whole is________, since __________ of workers earn the minimum wage rate

Structural; 4 million Low-skill workers who lose their jobs due to a lack of demand for workers Firms that hire low-skill workers at the new wage Low-skill workers who now cannot find jobs due to increased competition for jobs There would be no structural unemployment due to wage rigidity, since the minimum wage is non-binding at $4 per hour modest, around 1 percent

Lehman Brothers was not insured by the Federal Deposit Insurance Corporation​ (FDIC) but deposits at Northern Rock were insured by the U.K. government. What could explain why there was still a bank run at Northern​ Rock?

The U.K. insurance had upper limits on protected deposits that were relatively low Fully insured depositors at Northern Rock worried the bank's failure would temporarily block them

What are the automatic and discretionary components of fiscal​ policy?

The automatic components do not require deliberate action on the part of the​ government, while the discretionary components do.

In April​ 2012, the Bazanian​ Daily, a leading newspaper in the country of​ Bazania, carried a report titled​ "20,000 jobs added in the last​ quarter; unemployment rate shoots up from 5 percent to 6.7​ percent." How could the unemployment rate in Bazania increase even when new jobs were​ created?

The new jobs may have made discouraged workers optimistic enough to start applying for jobs, thus re-entering the labor force and being countered as unemployed, which causes the overall unemployment rate to increase

The 1970s saw a period of high inflation in many industrialized countries including the United States. Due to the increase in the rate of​ inflation, lenders, including credit card​ companies, revised their nominal interest rates upward. How is the rate of inflation related to the nominal interest rate that credit card companies​ charge, and why would lenders need to increase the nominal interest rate when the inflation rate​ increases? Usury laws place an upper limit on the nominal rate of interest that lenders can charge on their loans. In the​ 1970s, some credit card companies moved to states where there were no ceilings on interest rates to avoid usury laws. Why would credit card companies move to states without usury laws during a period of high​ inflation, like the​ 1970s?

The nominal rate of interest is the real rate of interest plus the rate of inflation; lenders need to raise the nominal rate when inflation increases to maintain their desired real return Because usury law ceilings may limit the real return lenders can earn during inflationary​ periods, lenders have an incentive to move to states without such laws.

In​ August, 1979, the annual rate of inflation in the U.S. was nearly​ 12%, and the U.S.​ short-term nominal interest rate was nearly​ 10%. Over the next 35​ years, both the rate of inflation and​ short-term nominal interest rate tended to fall. By August​ 2014, the rate of inflation was about​ 2% and the​ short-term nominal interest rate was close to​ 0%. How has the real​ short-term interest rate changed from 1979 to​ 2014? Why do the inflation rate and the nominal interest rate tend to move together over the​ long-run?

The real rate remained stable at -2% This synchronized movement indicates that credit market conditions have tended to be relatively stable over time Their up and down together movement tells us that the real interest rate is relatively stable in the long run

The sharpest​ one-day percentage decline in the Dow Jones Industrial Average​ (DJIA) took place on October​ 19, 1987. The DJIA fell 23 percent on this one day. Foreign exchange markets and other asset markets also exhibit large fluctuations on a daily basis. Eugene F.​ Fama, Robert J.​ Shiller, and Lars Peter Hansen shared the Nobel Prize in Economic Sciences in 2013 for their work on the​ "empirical analysis of asset​ prices." Based on the information given in this​ chapter, which of the following factors could explain why asset prices​ fluctuate? ​(Check all that apply​.)

There are psychological factors and biases that can produce excessive reactions to booms and busts Fluctuations reflect the rational appraisals by investors of new information relevant to asset profitability

When is the output​ gap, defined as the percent difference between GDP and potential​ GDP, negative​? According to the Taylor​ rule, should the Fed raise or lower the federal funds rate when the output gap is negative​?

When actual real GDP falls below potential GDP. B. When the​ economy's capacity to produce exceeds its actual production. C. When the economy experiences a recession. It should lower the federal funds rate.

Structural unemployment is the unemployment that arises

When wage rigidity creates a persistent gap between labor supply and labor demand

In a recent study for the National Bureau of Economic Research​ (NBER), four researchers looked at the effect of generous unemployment benefits on the local unemployment rate. They compared the unemployment situation in adjoining​ counties, which happened to lie in two different states that had different laws regarding the amount and duration of unemployment benefits.​ (Re-read the section on​ "A Natural Experiment of​ History" in Chapter 8 of the text to understand how the NBER research is based on a​ "natural experiment.") The authors of the NBER study found that the unemployment rate​ "rises dramatically in the border counties belonging to the states that expanded unemployment benefit​ duration" during the Great Recession. Why might this be​ so? Based on​ Hagedorn, Karahan, et​ al., "Unemployment Benefits and Unemployment in the Great​ Recession: The Role of Macro​ Effects." NBER working paper​ 19499, October 2013.

With the longer duration of unemployment benefits, firms needed to keep wages high to attract people to work. This caused downward wage rigidity, leading to persistent higher unemployment

You and a friend are debating the merits of using monetary policy during a severe recession. Your friend says that the central bank needs to lower interest rates all the way down to zero. According to​ him, zero nominal interest rates will boost lending and​ investment; consumers and firms will surely borrow and spend when interest rates are zero. Given that inflation in your country is currently 3​ percent, would you agree with his​ reasoning? Explain your answer.

Yes, a zero nominal interest rate coupled with a 3 percent inflation rate yields a negative value for the real​ rate, which is the rate that is meaningful for investment decisions.

Does the behavior of the unemployment rate illustrate the principle of​ co-movement discussed in the​ chapter? Economic variables are sometimes divided into​ "leading indicators" and​ "lagging indicators." Leading indicators are variables that start to change before an economic expansion or contraction. Lagging indicators change only when an expansion or contraction is well​ underway, or even about to reverse. Based on the​ graph, is unemployment a leading or lagging indicator of​ recessions?

Yes, because when real GDP​ declines, unemployment increases. Lagging indicator

Does the effectiveness of monetary policy depend on inflation​ expectations? Explain.

Yes, the central​ bank's ability to influence the​ long-term expected real interest rate is partly determined by the​ public's long-term expectations of the inflation rate.

The concept of multipliers was one of the key elements of John Maynard​ Keynes's theory of fluctuations. A multiplier is An example of a multiplier is when​

an economic mechanism that causes an initial shock to be amplified by​ follow-on effects. an increase in business confidence causes firms to increase production and hire employees, leading to an increase in household spending, causing firms to further increase production and employment a drop in consumer confidence reduces household spending, causing firms to cut production and lay off employees, leading to a greater reduction in household spending

An open market operation is The Federal Reserve conducts open market operations when it wants to When the Fed buys government bonds from private banks, it _____ the electronic reserves that banks hold.

an exchange between a private bank and the Federal Reserve where the Fed buys or sells government bonds to private banks. Influence the federal funds rate increases

A bank run is

an extraordinarily large volume of withdrawals driven by a concern that a bank will run out of liquid assets with which to pay withdrawals.

The Taylor rule states that

central banks should set their policy rates​ (in the United​ States, the federal funds​ rate) according to a formula that incorporates the​ long-term target for the policy​ rate, the output​ gap, and the deviation of inflation from its target

In​ 2005, $320 million of the federal​ government's budget was allocated toward building a​ "bridge to​ nowhere" in Alaska that connected two small towns. In​ 2006, $500,000 was allocated toward a teapot museum in North​ Carolina, $1 million toward a​ water-free urinal initiative in​ Michigan, and​ $4.5 million toward a museum and park at an abandoned mine in Maine. These projects were requested by specific legislators in order to boost their popularity in their constituencies. These types of expenditures are known as​ Since government spending increases employment by shifting the labor demand curve to the​ right, is it always a good idea for the government to increase​ expenditure? Explain your answer.

pork barrel spending No, continual increases in government expenditures will soak up resources that would otherwise be used by households and firms No, government efforts aimed at shifting the labor demand curve to the right should only be used during recessions No, continual increases in government expenditures may result in projects that are not socially desirable

The Internet boom of the​ 1990's has changed all of our lives and transformed the way business is conducted. During the late​ 1990's, the economy was described as the​ "best of all possible​ worlds" with quite high employment​ (and low​ unemployment). Which of the business cycle theories explained in the chapter would best explain how the Internet boom had such a positive​ effect? The business cycle theory that would best explain how the Internet boom had such a positive effect is How does real business cycle theory best explain the economic​ boom?

real business cycle theory. Technological innovation leads to increases in​ productivity, which in turn increases the marginal product of labor and therefore labour demand.

Fiat money is

something that is used as legal tender by government decree and is not backed by a physical commodity.