Econ Ch 15

Monetary policy affects aggregate demand through changes in:

consumer and investment spending.

The graph below shows the aggregate expenditure function (AE1). Assume that the money market is in equilibrium at Y1. Now suppose the Federal Reserve engages in contractionary monetary policy. Illustrate how this monetary policy will affect aggregate expenditures and real GDP (AE2). Using the double drop line tool plot the new equilibrium (Y2).

contractionary monetary policy

The accompanying graph shows the current money demand curve (MD1). Suppose the real GDP increases in the economy. Show how the money demand would change as a result of this change in real GDP. Label the new curve as MD2.

current money demand curve

If Congress places a $5 tax on each ATM transaction, the demand for money will likely:

increase.

Given a recessionary gap, the Federal Reserve will use monetary policy to _______ real GDP and _______ aggregate demand.

increase; increase

An increase in the aggregate price level:

increases the demand for money.

The Taylor rule for monetary policy is a rule for setting

interest rates.

When long-term interest rates are higher than short-term rates, as they were in 2010:

it implies that short-term interest rates are expected to rise.

A decrease in the money supply shifts aggregate demand to the _______, thereby resulting in a _______ level of real output in the short run.

left; lower

In the long run, a monetary contraction

lowers the aggregate price level but has no effect on real GDP.

Monetary neutrality implies that in the long run:

monetary policy does not affect the level of economic activity.

During 2008 the economy of Lugash was at full employment, producing output at the potential GDP level. The full employment position is shown by point E on the graph. It is the point of intersection between the aggregate demand curve (AD1), the short-run aggregate supply curve (SRAS1) and the long-run aggregate supply curve (LRAS). However, from the beginning of 2009, Lugash is experiencing an oil shock. The steep increase in price of oil has caused the short-run aggregate supply curve to shift to the left to SRAS2. As a result, currently, Lugash is producing at point E2, where the output level has fallen below the potential output and the price level has also increased. In other words, in 2009, Lugash is experiencing both a recession and inflation. The central bank of Lugash has two options to deal with this economic adversity. It can try to achieve employment/output stability or price stability. Part 1: Suppose the central bank's primary goal is to achieve employment and output stability, whereby it maintains the level of output at the potential output level. Illustrate the final outcome of the policy by shifting the aggregate demand and/or short-run aggregate supply curves using the copy tool. Label the shifted curve(s) AD2 and/or SRAS3 as appropriate. Using a drop line, locate the new equilibrium point and label it E3. Part 2: Suppose the central bank's primary goal is to achieve price stability in the short-run, whereby it maintains the price level at the level of point E. Illustrate the final outcome of the policy by shifting the aggregate demand and/or short-run aggregate supply curves using the copy tool. Label the shifted curve(s) AD3 and/or SRAS4 as appropriate. Using a drop line, locate the new equilibrium point and label it E4.

new equilibrium point and label it E4.

Figure: Output Gap Reference: Ref 15-8 (Figure: Output Gap) Refer to the information in the figure Output Gap. If the economy is at Y2 due to contractionary monetary policy and no further policy is implemented, in the long run:

nominal wages will decrease and shift the short-run aggregate supply curve to the right, increasing real output.

Figure: Monetary Policy and the AD-SRAS Model Reference: Ref 15-7 (Figure: Monetary Policy and the AD-SRAS Model) Refer to the information in the figure Monetary Policy and the AD-SRAS Model. If the economy is at point h because of an open market purchase by the Federal Reserve and no further monetary policy is implemented, in the long run:

nominal wages will increase, shift SRAS to SRAS', decrease real GDP, and increase the price level.

If the current interest rate is above the target rate, the Federal Reserve will

purchase U.S. Treasury bills.

To decrease the interest rate, the Federal Reserve will _______ U.S. Treasury bills, and this will have the effect of _______ the money supply.

purchase; increasing

A rise in interest rates due to a decrease in the money supply will _______ aggregate demand.

reduce

When the Federal Reserve undertakes actions to increase the money supply, the money supply curve shifts to the _______, and the equilibrium interest rate _______.

right; decreases

Short-term interest rates are rates on financial assets

that mature in less than a year.

According to the Taylor rule, the unemployment rate and inflation rate in 2010 indicated

that the current interest rate should be negative.

The target federal funds rate is established by

the Federal Open Market Committee.

The short-run effect of a decrease in the money supply is that

the aggregate price level decreases, and real output also decreases.

When banks were permitted to pay interest on checking account deposits,

the demand for money increased.

If interest rates are at the zero lower bound:

the effectiveness of monetary policy increases.

The money demand curve shows the relationship between

the interest rate and the quantity of money demanded by the public.

If the money supply increases by 10%, in the long run:

the price level increases by 10%.A decrease in the money supply will lead to a short-run _______ in investment spending, due to the resulting _______ interest rate.

If the equilibrium interest rate in the money market is 5%, then at an interest rate of 2%

the quantity of nonmonetary interest-bearing financial assets demanded is less than the quantity supplied.

Short-term interest rates refer to rates on financial assets due within:

1 year or less.

Scenario: Taylor Rule Suppose the Federal Reserve is following the Taylor rule, which takes both inflation and business cycles into account when setting the federal funds rate. Also suppose that the inflation rate in the economy is equal to 3% and the output gap is 5%. Reference: Ref 15-4 (Scenario: Taylor Rule) Consider the information provided in the scenario Taylor Rule. In this case, the Federal Reserve will set the federal funds rate to be equal to:

16%

The graph below shows the money demand curve (MD1) in 1978 before the widespread use of ATM machines. By 2008 ATM machines are common in most nations. Show how the money demand would change in 2008. Label the new curve as MD2

2008 ATM machines

What is currently used by the Federal Reserve as a determinant of monetary policy?

A loosely defined Taylor rule

Draw a money supply curve (MS1) such that the equilibrium short-term rate is 5%. Use the double drop tool to label the equilibrium (E1). Suppose the Fed's target federal funds rate is 3%. Illustrate graphically what the Fed will do to achieve the target (MD2 and/or MS2). Plot the new equilibrium short-term rate and equilibrium quantity of money (E2).

Draw a money supply curve

The money demand curve (MD) for the country of Eastland is given in the graph below. Part 1: Draw the money supply curve if the Central Bank of Eastland maintains the money supply at $400 billion. Label the curve MS1. Using the double drop line tool plot the equilibrium point and label it E. Part 2: The central bank of Eastland wants to raise the money supply to $800 billion. Draw the new money supply curve and label the graph MS2. Using the double drop line tool plot the equilibrium point and label it E2.

Eastland

At the beginning of 2009, the money demand curve in the country of Goalkunda was given by the curve MD1. In Goalkunda ATM withdrawals are a very popular means of getting cash from bank accounts. In 2009, in order to recover the sharp increases in regulatory costs, all banks significantly increased their ATM withdrawal fees from $1 to $4 per transaction for non-account holders and imposed a fee of $2 per transaction for their own account holders. Part 1: Using the copy tool, show the impact of the increase in ATM fees on the money demand curve. Label the new curve MD2. Part 2: Now suppose that at the beginning of 2009, the money demand curve in the country of Goalkunda was given by the curve MD1. In this case, there has not been any change in ATM fees. The country is going through a severe recession. In the first quarter of 2009 income or real GDP fell by an astonishing 10%. Using the copy tool, show the impact of the severe recession on the money demand curve. Label the new curve MD3.

Goalkunda

Figure: The Money Supply and Aggregate Demand Reference: Ref 15-5 (Figure: The Money Supply and Aggregate Demand) Refer to the figure The Money Supply and Aggregate Demand. If the economy is in a recessionary gap, the Federal Reserve will _______ government bonds, which will _______ the money supply and _______ interest rates. This is shown in panel _______.

Inflation targeting is based on

Which of the following is the short-run effect of an increase in the money supply?

Interest rates will decrease, leading to an increase in aggregate demand.

The economy of Northland is experiencing a recession. The diagram shows the current money market equilibrium (E). Suppose the central bank of Northland is entrusted with designing a monetary policy to pull the economy out of recession. Using a line drawing tool, illustrate the underlying monetary policy by shifting the money supply curve. Label the shifted curve MS2. Using the double drop-line tool, plot the new money market equilibrium point and label it E2.

Label the shifted curve MS2

Initially the economy of Longola is at full employment where the level of output is at the potential GDP level. This would occur at the point of intersection of the aggregate demand curve (AD1), the short-run aggregate supply curve (SRAS1) and the long-run aggregate supply curve (LRAS). The corresponding money market equilibrium is shown by point E in the diagram below. It is where the money supply curve MS1 intersects the money demand curve MD1. Suppose the central bank of Longola adopts an expansionary monetary policy and increases money supply. The increase in money supply increases aggregate demand and shifts the aggregate demand curve to the right. Both GDP and the price level increase. However, over time the increase in price causes nominal wages to increase and consequently shifts the short-run aggregate supply curve upward and to the left. The long-run equilibrium is restored where short-run aggregate supply intersects aggregate demand and long-run aggregate supply. The level of output returns to the potential GDP level, but the price level increases. Using the copy tool, shift the money demand and/or the money supply curve to show the long-run adjustment in the economy as the economy returns to the potential GDP level. Label the shifted curve(s) MD2 and/or MS2 as appropriate. Using a double-drop line, plot the final equilibrium in the money market that corresponds to long-run equilibrium. Label this equilibrium point E2.

Longola

During 2008 the economy of Lugash was at full employment, producing output at the potential GDP level. However, from the beginning of 2009, Lugash is experiencing an oil shock. The steep increase in the price of oil has caused the short-run aggregate supply curve to shift to the left. As a result, currently, Lugash is producing where the output level has fallen below the potential output and the price level has also increased. In other words, in 2009, Lugash is experiencing both a recession and inflation. The central bank of Lugash has two options to deal with this economic adversity. It can try to achieve employment and output stability or just price stability. The diagram shows the equilibrium in the money market at point E. Part 1: Suppose the central bank's primary goal is to achieve employment and output stability, whereby it maintains the level of output at the potential output level. Using the line drawing tool; demonstrate the appropriate monetary policy chosen by the central bank by shifting the money supply curve. Label the shifted curve MS2. Plot the new equilibrium in the money market and label it E2. Part 2: Suppose the central bank's primary goal is to achieve price stability in the short run, whereby it maintains the price level at the level of equilibrium. Using the line drawing tool, demonstrate the appropriate monetary policy chosen by the central bank by shifting the money supply curve. Label the shifted curve MS3. Plot the new equilibrium in the money market and label it E3.

Lugash

The accompanying diagram shows the aggregate demand curve (AD1) for the country of Mythika. Part 1: Suppose the central bank of Mythika adopts an expansionary monetary policy. Illustrate the impact of this policy change on the AD1 curve. If the graph shifts, label the new curve AD2. Part 2: Now suppose that instead of an expansionary monetary policy, the central bank undertakes a contractionary monetary policy. What impact does this have on the initial aggregate demand curve? If you predict that the curve graph shifts, then label the new curve AD3.

Mythika

The economy of Northland is experiencing a recession. The recessionary gap is shown in the graph below where the current equilibrium real GDP (E) falls short of the potential output, shown by the long-run aggregate supply curve (LRAS). Suppose the central bank of Northland is entrusted with designing a monetary policy to pull the economy out of recession. Using a line drawing tool, demonstrate how aggregate demand and/or aggregate supply need to be changed to close the recessionary gap. Label the shifted graph(s) AD2 and/or SRAS2 as appropriate. Using the double-drop line tool, plot the new equilibrium point and label it E2

Northland

Figure: Short-Run and Long-Run Effects of Monetary Policy Reference: Ref 15-6 (Figure: Short-Run and Long-Run Effects of Monetary Policy) Refer to the information in the figure Short-Run and Long-Run Effects of Monetary Policy. If the economy is initially at E2 and the central bank makes no change in its monetary policy:

SRAS1 will eventually shift to the left, closing the existing inflationary gap but raising the aggregate price level.

The economy of Southland is experiencing inflation. The inflationary gap is shown in the diagram below where the current equilibrium real GDP (E) exceeds the potential output, shown by the long-run aggregate supply curve (LRAS). Suppose the monetary authority of Southland is trying to control inflation. Using a line drawing tool, demonstrate how aggregate demand and/or aggregate supply need to be changed to close the inflationary gap. Hint: You'll want to show how they can reduce the price level and ensure that the equilibrium output is at potential GDP. Label the shifted graph(s) AD2 and/or SRAS2 as appropriate. Use the double-drop line tool to plot the new equilibrium point. Label this point E2.

Southland

At the beginning of 2008, the money demand curve in the country of Svolonia was given by the curve MD1.The curve passed through the interest rates, r = 2, 4, 6, 8 and 10%. From the middle of 2008, prices in Svolonia began to increase significantly, primarily due to a sharp increase in the price of oil in the world oil market. By the end of 2008, the price level in Svolonia had doubled. Use the multi-point line tool to show the impact of such an increase in the price level on the money demand curve of Svolonia. If the graph shifts, label the new curve MD2.

Svolonia

The accompanying diagram shows the money market equilibrium in the country of Targetlandia. The equilibrium point is the point of intersection of the money demand curve (MD1) and the money supply curve (MS1). The current equilibrium interest rate (E) is 6%. Part 1: The central bank of Targetlandia wants to maintain an interest rate of 4%. Shift the money demand and/or the money supply curve(s) to show how such a target may be achieved. Label the shifted graphs MD2 and/or MS2. Plot the new equilibrium point and label it E2. Part 2: Suppose instead that the central bank of Targetlandia wants to maintain an interest rate of 8%. Shift the money demand and/or the money supply curve(s) to show how such a target may be achieved. Label the shifted graphs MD3 and/or MS3. Plot the new equilibrium point and label it E3.

Targetlandia

Which one of the following statements is FALSE?

The Taylor rule sets the federal funds rate on the basis of only past inflation rates, whereas inflation targeting constructs monetary policy based on a target interest rate and business cycles.

What is measured on the vertical axis when we draw a money demand curve?

The interest rate

The neighboring countries of Westmoreland and Eastmoreland are very similar. The two countries have the same money supply and rate of interest of 4%. But the money demand curve of Westmoreland is more elastic than the money demand curve for Eastmoreland. Currently, both countries have identical real GDP of $400 billion, as shown by point E in the graph below. E is the point of intersection of the 45-degree line and the planned aggregate expenditure line AE1. Using a line drawing tool, show the impact of the expansionary monetary policy on the income expenditure model for the two countries. Label the new planned aggregate expenditure line of Eastmoreland as AE2 and that of Westmoreland as AE3. Use double drop-lines to plot the respective equilibrium in the two countries. Label the equilibrium point as E2 for Eastmoreland and as E3 for Westmoreland.

Westmoreland and Eastmoreland

Inflation targeting is based on

a forecast of future inflation.

An increase in the demand for money corresponds to

a rightward shift of the money demand curve.

In the liquidity preference model, the money supply is represented by:

a vertical line.

The accompanying graph shows the money market in equilibrium (E1). Suppose that the aggregate price level is rising. Consider how this will affect the money market and the equilibrium interest rate. Illustrate this change by drawing a new curve and by plotting a new equilibrium point (E2).

accompanying graph shows the money market

The Federal Reserve is most likely to engage in expansionary monetary policy when

actual real GDP is below potential output.

Which one of the following events will NOT decrease the demand for money?

an increase in the aggregate price level

When the Federal Reserve buys Treasury bills, this leads to

an increase in the money supply.

The Federal Reserve meets the target for the federal funds rate by

buying and selling U.S. Treasury bills.

Given an inflationary gap, the Federal Reserve will use monetary policy to _______ real GDP and _______ the price level.

decrease; decrease

A decrease in the money supply will lead to a short-run _______ in investment spending, due to the resulting _______ interest rate.

decrease; higher

According to the liquidity preference model, a _________ in the money supply shifts the money supply curve to the _________ and increases the equilibrium interest rate.

decrease; left

An increase in real aggregate spending will shift the money:

demand curve rightward.

Draw and label a money supply curve (MS1) such that the equilibrium short-term rate is 5%. Label this equilibrium (E1). Suppose real GDP then declines substantially. Part 1: Illustrate graphically what happens and label the new equilibrium (E2). Part 2: Illustrate graphically what the Fed will do to if they want to maintain 5% as the target federal funds rate. Illustrate and clearly label the final equilibrium as (E3).

equilibrium short-term rate is 5%

(Figure: Equilibrium in the Money Market) Refer to the information in the figure Equilibrium in the Money Market. If the interest rate is above the equilibrium rate, there will be an _______ money and the interest rate will _______.

excess supply of; fall

The graph below shows the aggregate expenditure function (AE1). Assume that the money market is in equilibrium at Y1. Now suppose the Federal Reserve engages in expansionary monetary policy. Illustrate how this monetary policy will affect aggregate expenditures and real GDP (AE2). Using the double drop line tool plot the new equilibrium (Y2).

expansionary monetary policy

In the income-expenditure model, contractionary monetary policy leads to

higher interest rates, a decrease in planned investment spending, and a decrease in equilibrium GDP.

According to the concept of monetary neutrality, the only long-run effect of an increase in the money supply is to

increase the aggregate price level by the same percentage.

If the Federal Reserve wants to lower the interest rate, it will

increase the money supply.