Final For Econ 202
Answers: increase by 8 percent; demand-pull inflation; $3 billion; decrease government spending.
2. Refer back to the table in Figure 30.7 in the previous chapter. Suppose that aggregate demand increases such that the amount of real output demanded rises by $7 billion at each price level. By what percent will the price level increase? Will this inflation be demand-pull inflation or will it be cost-push inflation? If potential real GDP (that is, full-employment GDP) is $510 billion, what will be the size of the positive GDP gap after the change in aggregate demand? If government wants to use fiscal policy to counter the resulting inflation without changing tax rates, would it increase government spending or decrease it? LO1
Answer: c. The AD curve shifting left
3. Suppose that an economy begins in long-run equilibrium before the price level and real GDP both decline simultaneously. If those changes were caused by only one curve shifting, then those changes are best explained as the result of: LO2 a. The AD curve shifting right. b. The AS curve shifting right. c. The AD curve shifting left. d. The AS curve shifting left.
Answer: When a bank makes a loan it also creates a checkable deposit of equal value. This increase in checkable deposits results in an increase in M1. When we apply this logic to the multiple bank-fractional reserve banking system the process (expansion of the money supply) is compounded. The reverse logic applies when a loan is paid off. The individual writes a check to pay off the loan, which reduces checkable deposits. (Recall that cash or reserves held by banks are not part of M1).
6. "When a commercial bank makes loans, it creates money; when loans are repaid, money is destroyed." Explain. LO3
Answers: 10; 25 percent.
7. If the required reserve ratio is 10 percent, what is the monetary multiplier? If the monetary multiplier is 4, what is the required reserve ratio? LO5
Answer: False Feedback: This statement is false because decreases in AD normally lead to falls in output but not the price level. That is the case because the price level in the real world is downwardly inflexible. Thus, when AD shifts left, the economy can only adjust to the fall in aggregate demand with reductions in output (as in Figure 12.9). By contrast, prices are flexible upward so that increases in AD lead to both increases in output and increases in the price level (as in Figure 12.8).
7. True or False: Decreases in AD normally lead to decreases in both output and the price level. LO6
Answers: $5 billion; 6.25 billion; Combining the two effects above, we have an increase in aggregate demand of $25 billion
1. Assume that a hypothetical economy with an MPC of .8 is experiencing severe recession. By how much would government spending have to rise to shift the aggregate demand curve rightward by $25 billion? How large a tax cut would be needed to achieve the same increase in aggregate demand? Determine one possible combination of government spending increases and tax increases that would accomplish the same goal without changing the amount of outstanding debt. LO1
Answer: For macroeconomists the short run is a period in which wages (and other input prices) do not respond to price level changes. There are at least two reasons why nominal wages may remain constant for a while even though the price level has changed. 1. Workers may not be aware of price level changes, and thus have not adjusted their demands. 2. Many employees are hired under fixed wage contracts. Once sufficient time has elapsed for contracts to expire and nominal wage adjustments to occur, the economy enters the long run a period in which nominal wages are fully responsive to changes in the price level. The economy will adjust itself to a long-run equilibrium, but in the short run there may be a positive role for stabilization (fiscal and monetary) policy.
1. Distinguish between the short run and the long run as they relate to macroeconomics. Why is the distinction important? LO1
Answer: a. When the domestic price level rises, our goods and services become more expensive to foreigners; d. When the price level rises, the real value of financial assets (like stocks, bonds, and savings account balances) declines.
1. Which of the following help to explain why the aggregate demand curve slopes downward? LO1 a. When the domestic price level rises, our goods and services become more expensive to foreigners. b. When government spending rises, the price level falls. c. There is an inverse relationship between consumer expectations and personal taxes. d. When the price level rises, the real value of financial assets (like stocks, bonds, and savings account balances) declines.
Answer: d. Medium of exchange, unit of account, and store of value
1. The three functions of money are: LO1 a. Liquidity, store of value, and gifting. b. Medium of exchange, unit of account, and liquidity. c. Liquidity, unit of account, and gifting. d. Medium of exchange, unit of account, and store of value.
Answer: $0 (zero) Feedback: The answer is zero. Jimmy withdrew $200 from his checking account, so his checkable deposits are now $1800. This results in a decrease in M1 by an equal amount. However Jimmy now has $200 in cash, which increases M1 by $200.
2. Assume that Jimmy Cash has $2,000 in his checking account at Folsom Bank and uses his checking account card to withdraw $200 of cash from the bank's ATM machine. By what dollar amount did the M1 money supply change as a result of this single, isolated transaction? LO2
Answer: The correct answers are: b. Interest rates rise and c. The government raises corporate profit taxes.
2. Which of the following will shift the aggregate demand curve to the left? LO2 a. The government reduces personal income taxes. b. Interest rates rise. c. The government raises corporate profit taxes. d. There is an economic boom overseas that raises the incomes of foreign households.
Answer: To reduce inflation, the Federal funds rate should be raised. This would be accomplished typically through open-market operations (selling bonds), but could also be achieved with an increase in the reserve ratio or discount rate. The restrictive monetary policy would reduce the lending ability of the banking system, increase the real interest rate, reduce investment spending, reduce aggregate demand, and reduce inflation.
5. Suppose that you are a member of the Board of Governors of the Federal Reserve System. The economy is experiencing a sharp rise in the inflation rate. What change in the Federal funds rate would you recommend? How would your recommended change get accomplished? What impact would the actions have on the lending ability of the banking system, the real interest rate, investment spending, aggregate demand, and inflation? LO5
Answer: The two correct answers are: c. The Fed buys $400 million worth of Treasury bonds from commercial banks and d. the Fed lowers the discount rate from 4 percent to 2 percent.
6. Which of the following Fed actions will increase bank lending? LO3 Select one or more answers from the choices shown. a. The Fed raises the discount rate from 5 percent to 6 percent. b. The Fed raises the reserve ratio from 10 percent to 11 percent. c. The Fed buys $400 million worth of Treasury bonds from commercial banks. d. The Fed lowers the discount rate from 4 percent to 2 percent.
Answer: b. Advising Congress on fiscal policy
6. Which of the following is not a function of the Fed? LO5 a. Setting reserve requirements for banks. b. Advising Congress on fiscal policy. c. Regulating the supply of money. d. Serving as a lender of last resort
Answer: c. $95. Feedback: The correct answer is that $95 could be the equilibrium international price of fish if Iceland and Japan began trading fish with each other. That is true because an equilibrium in international trade can only exist if the international price can adjust so that one country becomes the exporter, the other country becomes the importer, and the quantity exported and supplied by the exporting country exactly equals the quantity imported and demanded by the other country. The $95 price is the only price that could possibly make that happen because it's the only price at which one of the countries will want to export and the other will want to import. In particular, Iceland will want to import at the $95 price because that price for fish is less than its domestic price of $100. At the same time, Japan will want to export at the $95 price because that price is more than the $90 domestic price at which fish can be sold. Thus, it is possible that $95 could be the equilibrium international price because one country will want to export while the other will want to import. By contrast, none of the other prices could possibly work because for each of them, you wouldn't end up with one country wanting to import and one country wanting to export.
11. Suppose that if Iceland and Japan were both closed economies, the domestic price of fish would be $100 per ton in Iceland and $90 per ton in Japan. If the two countries decided to open up to international trade with each other, which of the following could be the equilibrium international price of fish once they begin trading? LO3 a. $75. b. $85. c. $95. d. $105.
Answer: American exports lead to an increase in the foreign currency bank deposit holdings of Americans. These holdings will be decreased through American purchases of imports. Hence, the foreign currency assets earned through exports can be used to finance imports. a. A demand for euros: The U.S. airline must purchase euros before purchasing the Airbus planes. b. A supply of euros: The German automobile firm must purchase U.S. dollars, or supply euros, before building the plant. c. A demand for euros: The U.S. college student must purchase euros before studying in France. d. A supply of euros: The Italian manufacturer must purchase U.S. dollars, or supply euros, to pay the Liberian freighter (which requires payment in U.S. dollars). e. A demand for euros: Since the U.S. economy grows faster than the French economy, U.S. imports from France will grow faster than France's imports from the U.S. holding everything else constant. To buy these additional French goods the U.S. will purchase more (net) euros. f. A demand for euros: The U.S. pays the Spanish citizen in U.S. dollars. The Spanish citizen then purchases euros so she has currency she can use in her home country. g. A supply of euros: Since individuals holding euros expect the currency to depreciate in the near future they sell (supply) the euros today in an attempt to avoid the loss in the future.
2. Explain: "U.S. exports earn supplies of foreign currencies that Americans can use to finance imports." Indicate whether each of the following creates a demand for or a supply of European euros in foreign exchange markets: LO1 a. A U.S. airline firm purchases several Airbus planes assembled in France. b. A German automobile firm decides to build an assembly plant in South Carolina. c. A U.S. college student decides to spend a year studying at the Sorbonne in Paris. d. An Italian manufacturer ships machinery from one Italian port to another on a Liberian freighter. e. The U.S. economy grows faster than the French economy. f. A U.S. government bond held by a Spanish citizen matures, and the loan amount is paid back to that person. g. It is widely expected that the euro will depreciate in the near future.
Answer: The weight of the debt is not its absolute size. Indeed, if there were no interest to be paid on the debt and refinancing was automatic, there would be no debt load at all. But interest does have to be paid. Lenders expect that, and to pay the interest the government must either use tax revenues or go deeper into debt. Interest on the debt, then, is important and its weight can best be assessed by noting the size of the interest payments in relation to GDP, since the size of the GDP is a measure of total national income or how much the government can raise in taxes to pay the interest
10. Why might economists be quite concerned if the annual interest payments on the U.S. public debt sharply increased as a percentage of GDP? LO6
Answer: a. Country A. Feedback: Country A has a comparative advantage in making bicycles because Country A has a lower opportunity cost of producing bicycles when we measure opportunity cost in terms of the amount of alternative products that must be foregone in order to produce 1 bicycle. To produce 1 bicycle, Country A only has to give up the production of 11 lamps. By contrast, Country B has to give up the production of 15 lamps. Thus, if we had to decide which country should be producing bicycles, we would go with Country A because it can produce bicycles at a lower opportunity cost in terms of lamps foregone.
2. In Country A, the production of 1 bicycle requires using resources that could otherwise be used to produce 11 lamps. In Country B, the production of 1 bicycle requires using resources that could otherwise be used to produce 15 lamps. Which country has a comparative advantage in making bicycles? LO2 a. Country A. b. Country B.
Answer: Options are to reduce government spending, increase taxes, or some combination of both. See the figure blow. If the price level is flexible downward, it will fall. In the real world, the goal is to reduce inflation—to keep prices from rising so rapidly—not to reduce the price level. A person wanting to preserve the size of government might favor a tax hike and would want to preserve government spending programs. Someone who thinks that the public sector is too large might favor cuts in government spending since this would reduce the size of government. The ratchet effect implies that prices are rigid downward.
2. What are government's fiscal policy options for ending severe demand-pull inflation? Which of these fiscal options do you think might be favored by a person who wants to preserve the size of government? A person who thinks the public sector is too large? How does the "ratchet effect" affect anti-inflationary fiscal policy? LO1
Answer: a. False, short run aggregate supply curves reflect a direct relationship between the price level and the level of real output. If there is an increase in the price level, the higher product prices bring an increase in revenue from sales to business firms. Since the nominal wages they are paying are fixed, their profits rise. In response firms collectively increase their output. Producers respond to a decrease in the price level by cutting output. When product prices fall with nominal wages constant firms will discover their revenue and profits have diminished. b. False, by definition, nominal wages in the long run are fully responsive to changes in the price level. c. True, as above.
2. Which of the following statements are true? Which are false? Explain why the false statements are untrue. LO1 a. Short-run aggregate supply curves reflect an inverse relationship between the price level and the level of real output. b. The long-run aggregate supply curve assumes that nominal wages are fixed. c. In the long run, an increase in the price level will result in an increase in nominal wages.
Answer: The banking system in the United States is a fractional reserve bank system because the banks do not hold enough cash or reserves on hand to pay every depositor on demand at the same time. That is, if everyone went to the bank at the same time and tried to close their accounts the bank would not be able to meet this demand. To avoid the potential of these bank runs there is deposit insurance in the United States and other countries. By guaranteeing depositors that they will always get their money, deposit insurance removes the incentive to try to withdraw one's deposit before anyone else can. It thus stops most bank runs.
2. Why is the banking system in the United States referred to as a fractional reserve bank system? What is the role of deposit insurance in a fractional reserve system? LO1
Answer: The Federal funds interest rate is the interest rate banks charge one another on overnight loans needed to meet the reserve requirement. The prime interest rate is the interest rate banks charge on loans to their most creditworthy customers. The Federal funds rate is lower than the prime interest rate for a number of reasons. Federal funds are loaned overnight, so lenders don't have to wait long for repayment. The reserves loaned would otherwise generate no interest, so even loaning at the lower Federal funds rate is beneficial to lenders. Interest rates also depend on risk. It is less risky to lend overnight to other banks than it is to lend for longer periods to non-bank businesses and households. Both rates are related to the relative scarcity or availability of reserves. If there are fewer reserves available for lending, the price to borrow those reserves (the interest rate) will rise whether the customers are banks, businesses, or households.
3. Distinguish between the federal funds rate and the prime interest rate. Why is one higher than the other? Why do changes in the two rates closely track one another? LO4
Answer: a. See the graph. Equilibrium price level = 200; equilibrium real output = $300 billion. No.
3. Suppose that the aggregate demand and aggregate supply schedules for a hypothetical economy are as shown below: LO5 a. Use these sets of data to graph the aggregate demand and aggregate supply curves. What is the equilibrium price level and the equilibrium level of real output in this hypothetical economy? Is the equilibrium real output also necessarily the full-employment real output? b. If the price level in this economy is 150, will quantity demanded equal, exceed, or fall short of quantity supplied? By what amount? If the price level is 250, will quantity demanded equal, exceed, or fall short of quantity supplied? By what amount? c. Suppose that buyers desire to purchase $200 billion of extra real output at each price level. Sketch in the new aggregate demand curve as AD1. What is the new equilibrium price level and level of real output?
Answer: $4,000
3. The Third National Bank has reserves of $20,000 and checkable deposits of $100,000. The reserve ratio is 20 percent. Households deposit $5000 in currency into the bank and that currency is added to reserves. What level of excess reserves does the bank now have? LO3
C. Appreciated; depreciated
3. The exchange rate between the U.S. dollar and the British pound starts at $1 = £0.5. It then changes to $1 = £0.75. Given this change, we would say that the U.S. dollar has _________ while the British pound has _____________. LO3 a. Depreciated; appreciated. b. Depreciated; depreciated. c. Appreciated; depreciated. d. Appreciated; appreciated.
Answer: c. - $5,000, $1,000
4. A bank currently has $100,000 in checkable deposits and $15,000 in actual reserves. If the reserve ratio is 20 percent, the bank has ___________ in money-creating potential. If the reserve ratio is 14 percent, the bank has ___________ in money-creating potential. LO3 a. $20,000; $14,000. b. $3,000; $2,100. c. -$5,000; $1,000. d. $5,000; $1,000.
Answer: a. $2 = £1.
4. A meal at a McDonald's restaurant in New York costs $8. The identical meal at a McDonald's restaurant in London costs £4. According to the purchasing-power-parity theory of exchange rates, the exchange rate between U.S. dollars and British pounds should tend to move toward: LO3 a. $2 = £1. b. $1 = £2. c. $4 = £1. d. $1 = £4.
Answer: c. The government has a non-cyclically adjusted budget deficit of $90 billion; e. The government has a cyclically adjusted budget deficit of $5 billion
4. Last year, while an economy was in a recession, government spending was $595 billion and government revenue was $505 billion. Economists estimate that if the economy had been at its full-employment level of GDP last year, government spending would have been $555 billion and government revenue would have been $550 billion. Which of the following statements about this government's fiscal situation are true? LO3 a. The government has a non-cyclically adjusted budget deficit of $595 billion. b. The government has a non-cyclically adjusted budget deficit of $90 billion. c. The government has a non-cyclically adjusted budget surplus of $90 billion. d. The government has a cyclically adjusted budget deficit of $555 billion. e. The government has a cyclically adjusted budget deficit of $5 billion. f. The government has a cyclically adjusted budget surplus of $5 billion.
Answer: At a price of $1: -15,000; Price $2: -7,000; Price $3: 0; Price $4: 6,000; Price $5: 10,000. Feedback: To calculate the amount of imports or exports subtract quantity supplied from the quantity demanded at each price: Price $1: quantity supplied - quantity demanded = 1,000 - 16,000 = -15,000 (on the import supply schedule below this value will be positive) Price $2: 4,000 - 11,000 = -7,000 Price $3: 7,000 - 7,000 = 0 Price $4: 10,000 - 4,000 =6,000 Price $5: 12,000 - 2,000 = 10,000
4. Refer to Figure 3.6, page 63. Assume that the graph depicts the U.S. domestic market for corn. How many bushels of corn, if any, will the United States export or import at a world price of $1, $2, $3, $4, and $5? Use this information to construct the U.S. export supply curve and import demand curve for corn. Suppose that the only other corn-producing nation is France, where the domestic price is $4. Which country will export corn; which county will import it? LO3
Answer: a. See Figure 18.4 in the chapter, less AD2. Short run: The aggregate supply curve shifts to the left, the price level rises, and real output declines. Long run: The aggregate supply curve shifts back rightward (due to declining nominal wages), the price level falls, and real output increases. b. See F igure 18.3. Short run: The aggregate demand curve shifts to the right, and both the price level and real output increase. Long run: The aggregate supply curve shifts to the left (due to higher nominal wages), the price level rises, and real output declines. c. See F igure 18.5. Short run: The aggregate demand curve shifts to the left, both the price level and real output decline. Long run: The aggregate supply curve shifts to the right, the price level falls further, and real output increases.
5. Use graphical analysis to show how each of the following would affect the economy first in the short run and then in the long run. Assume that the United States is initially operating at its full-employment level of output, that prices and wages are eventually flexible both upward and downward, and that there is no counteracting fiscal or monetary policy. LO2 a. Because of a war abroad, the oil supply to the United States is disrupted, sending oil prices rocketing upward. b. Construction spending on new homes rises dramatically, greatly increasing total U.S. investment spending. c. Economic recession occurs abroad, significantly reducing foreign purchases of U.S. exports.
Answer: c. Increasing opportunity costs. Feedback: The correct answer is that we don't see full specialization because of increasing opportunity costs. International trade is indeed driven by specialization, but the benefits of specialization can dissipate as a country specializes more and more in the production of one good. What happens is that diminishing returns set in so that the country will face increasingly high opportunity costs for producing the good in question. As costs rise, so will the price that it has to charge to foreigners for additional units of the good. At some point, the price will rise so high that foreigners will no longer want to buy any more because it will be cheaper for them to produce additional units domestically or purchase them yet another country whose production has not yet been affected by diminishing returns and increasing costs. As a result, what we see in the real world is incomplete specialization, with several countries often dominating an industry but no single country achieving full specialization and 100% control of global production. As an example, consider cars, which are exported to other countries from South Korea, the United States, Japan, Germany, France, Sweden, and so on. Each of these countries has specialized some of its industrial capacity into the production of cars, but diminishing returns implies that none of them has been able to capture 100% of the world car market.
7. We see quite a bit of international trade in the real world. And trade is driven by specialization. So why don't we see full specialization—for instance, all cars in the world being made in South Korea, or all the mobile phones in the world being made in China? Choose the best answer from among the following choices. LO2 a. High tariffs. b. Extensive import quotas. c. Increasing opportunity costs. d. Increasing returns.
Answer: The monetary multiplier is k = 1/(1- required reserve ratio). (a) Thus, a decrease in required reserve ratio will result in an increase in the multiplier because each bank will need to hold less reserves and therefore can make more loans. (b) This also implies that the bank will see an increase in excess reserves after the fall in the required reserve ratio. (c) The ability to make more loans results in an increase in the potential money creation through the fractional reserve banking system.
9. How would a decrease in the reserve requirement affect the (a) size of the money multiplier, (b) amount of excess reserves in the banking system, and (c) extent to which the system could expand the money supply through the creation of checkable deposits via loans? LO5
Answer: b. Down
When bond prices go up, interest rates go_______ . LO1 a. Up. b. Down. c. Nowhere.
Answer: The plus sign (+) indicates a credit to the U.S. balance of payments. The negative sign (-) indicates a debit the U.S balance of payments. U.S. purchases of assets abroad: current account U.S. services imports: current account Foreign purchases of assets in the United States: capital and financial account U.S. good exports: current account U.S. net investment income: current account The balance on the current account and the balance on the capital and financial account must always sum to zero because any deficit or surplus in the current account automatically creates an offsetting entry in the capital and financial account. People can only trade one of two things with each other: currently produced goods and services or preexisting assets. Therefore, if trading partners have an imbalance in their trade of currently produced goods and services, the only way to make up for that imbalance is with a net transfer of assets from one party to the other.
3. What do the plus signs and negative signs signify in the U.S. balance of payments statement? Which of the following items appear in the current account and which appear in the capital and financial account? U.S. purchases of assets abroad; U.S. services imports; foreign purchases of assets in the United States; U.S. good exports, U.S. net investment income. Why must the current account and the capital and financial account sum to zero? LO2
Answer: Official reserves consist of foreign currencies, certain reserves held with the International Monetary Fund, and stocks of gold. These reserves are owned by governments or their central banks. Although the balance of payments must always sum to zero, in some years a net sale of official reserves by a nation's treasury or central bank occurs in the process of bringing the capital and financial account into balance with the current account. In such years, a balance-of-payments deficit is said to occur. This deficit is in a subset of the overall balance statement and is not a deficit in the overall account. Remember, the overall balance of payments is always in balance. But in this case the balancing of the overall account includes sales of official reserves to create an inflow of dollars to the United States. These net sales of official reserves in the foreign exchange market show up as a plus (+) item on the U.S. balance of payments statement, specifically as foreign purchases of U.S. assets. In other years, the capital and financial account balances the current account because of government purchases of official reserves from foreigners. The treasury or central bank engineers this balance by selling dollars to obtain foreign currency, and then adding the newly acquired foreign currency to its stock of official reserves. In these years, a balance-of-payments surplus is said to exist. This payments surplus therefore can be thought of as either net purchases of official reserves in the balance of payments or, alternatively, as the resulting increase in the stock of official reserves held by the government. Again, the balance of payments must always sum to zero. The net sale or purchase of official reserves by a nation's treasury or central bank occurs in the process of bringing the capital and financial account into balance with the current account. The deficit or surplus prior to the sale or purchase of reserves is a subset of the overall balance statement and is not a deficit or surplus in the overall account
4. What are official reserves? How do net sales of official reserves to foreigners and net purchases of official reserves from foreigners relate to U.S. balance-of-payment deficits and surpluses? Explain why these deficits and surpluses are not actual deficits and surpluses in the overall balance of payments statement. LO2
Answer: d. The Federal Open Market Committee
4. Which group votes on the open-market operations that are used to control the U.S. money supply and interest rates? LO4 a. The Federal Reserve System. b. The 12 Federal Reserve Banks. c. The Board of Governors of the Federal Reserve System. d. The Federal Open Market Committee (FOMC).
Answer: The two answers for which aggregate supply would actually shift right are: a. A new networking technology increases productivity all over the economy; c. Business taxes fall.
4. Which of the following will shift the aggregate supply curve to the right? LO4 a. A new networking technology increases productivity all over the economy. b. The price of oil rises substantially. c. Business taxes fall. d. The government passes a law doubling all manufacturing wages.
Answer: Reserves provide the Fed a means of controlling the money supply. It is through increasing and decreasing excess reserves that the Fed is able to achieve a money supply of the size it thinks best for the economy. Reserves are assets of commercial banks because these funds are cash belonging to them; they are a claim the commercial banks have against the Federal Reserve Bank. Reserves deposited at the Fed are a liability to the Fed because they are funds it owes; they are claims that commercial banks have against it.
4. Why does the Federal Reserve require commercial banks to have reserves? Explain why reserves are an asset to commercial banks but a liability to the Federal Reserve Banks. What are excess reserves? How do you calculate the amount of excess reserves held by a bank? What is the significance of excess reserves? LO2
Answer: In a phrase, "net tax revenues vary directly with GDP." When GDP is rising so are tax collections, both income taxes and sales taxes. At the same time, government payouts—transfer payments such as unemployment compensation, and welfare—are decreasing. Since net taxes are taxes less transfer payments, net taxes definitely rise with GDP, which dampens the rise in GDP. On the other hand, when GDP drops in a recession, tax collections slow down or actually diminish while transfer payments rise quickly. Thus, net taxes decrease along with GDP, which softens the decline in GDP. A progressive tax system would have the most stabilizing effect of the three tax systems and the regressive tax would have the least built-in stability. This follows from the previous paragraph. A progressive tax increases at an increasing rate as incomes rise, thus having more of a dampening effect on rising incomes and expenditures than would either a proportional or regressive tax. The latter rate would rise more slowly than the rate of increase in GDP with the least effect of the three types. Conversely, in an economic slowdown, a progressive tax falls faster because not only does it decline with income, it becomes proportionately less as incomes fall. This acts as a cushion on declining incomes—the tax bite is less, which leaves more of the lower income for spending. The reverse would be true of a regressive tax that falls, but more slowly than the progressive tax, as incomes decline.
5. Explain how built-in (or automatic) stabilizers work. What are the differences between proportional, progressive, and regressive tax systems as they relate to an economy's built-in stability? LO2
Answer: If Waxwania is producing $600 of real GDP, the budget deficit equals $40 (= $160 (government spending at $600) - $120 (government revenue at $600)). If potential real GDP (= full-employment real GDP) is $700, then the cyclically adjusted budget deficit is $20 (= $160 (government spending at $700) - $140 (government revenue at $700)). The cyclically adjusted budget deficit as a percentage of potential real GDP equals 2.86 percent (= $20/$700 = 0.02857, or approximately 2.86 percent).
5. Refer to the table for Waxwania above. Suppose that Waxwania is producing $600 of real GDP, whereas the potential real GDP (or full-employment real GDP) is $700. How large is its budget deficit? Its cyclically adjusted budget deficit? Its cyclically adjusted budget deficit as a percentage of potential real GDP? Is Waxwania's fiscal policy expansionary or is it contractionary? LO3
Answer: More; moral hazard. Feedback: Since Lady Gaga will get reimbursed for part of her losses she will gamble more. This is referred to as moral hazard.
5. Suppose that Lady Gaga goes to Las Vegas to play poker and at the last minute her record company says it will reimburse her for 50 percent of any gambling losses that she incurs. Will Lady Gaga wager more or less as a result of the reimbursement offer? What economic concept does your answer illustrate? LO7
Answer: b. Iceland; Canada. Feedback: The correct answer is that Iceland should specialize in producing fish while Canada should specialize in producing lumber. This is true because Iceland has a comparative advantage in producing fish while Canada has a comparative advantage in producing lumber. Those comparative advantages imply that if each country specializes in the production of the product for which it has a comparative advantage, total output between the two countries can rise. It is for that reason—increasing the total amount of output that can be produced—that the two countries should specialize and trade. To see that Iceland has a comparative advantage in producing fish, divide both sides of its opportunity-cost ratio by 2. Doing so yields, 1F ≡ ½L. That version of Iceland's opportunity cost ratio demonstrates that in order to produce one ton of fish, Iceland has to give up only ½ ton of lumber. By contrast, Canada's opportunity cost ratio of 1F ≡ 1L indicates that in order to produce one ton of fish, Canada must give up one ton of lumber. Thus, Iceland has the comparative advantage in producing fish because it can produce fish at a lower opportunity cost in terms of lumber foregone. A similar analysis demonstrates that Canada has the comparative advantage in producing lumber because it has the lower opportunity cost in terms of fish foregone. You can see this by comparing Canada's opportunity-cost ratio of 1F ≡ 1L with Iceland's opportunity cost ratio of 2F ≡ 1L. Canada only has to give up one ton of fish to produce a ton of lumber whereas Iceland has to give up 2 tons of fish to produce a ton of lumber.
5. Suppose that the opportunity-cost ratio for fish and lumber is 1F ≡ 1L in Canada but 2F ≡ 1L in Iceland. Then _______________ should specialize in producing fish while ___________ should specialize in producing lumber. LO2 a. Canada; Iceland. b. Iceland; Canada.
Answer: The cyclically-adjusted budget measures what the Federal deficit or surplus would be if the economy reached full-employment level of GDP with existing tax and spending policies. If the cyclically-adjusted budget is balanced, then the government is not engaging in either expansionary or contractionary policy, even if, for example, a deficit automatically results when GDP declines. The "actual" budget is the deficit or surplus that results when revenues and expenditures occur over a year if the economy is not operating at full-employment. Looking at Figure 13.3, if full-employment GDP is GDP3, then the cyclically-adjusted budget is contractionary since a surplus would exist. Even though the "actual" budget has no deficit at GDP2, fiscal policy is contractionary. To move the economy to full-employment, government should cut taxes or increase spending. You would raise G line or lower T line or combination of each until they intersect at GDP3.
6. Define the cyclically-adjusted budget, explain its significance, and state why it may differ from the actual budget. Suppose the full-employment, noninflationary level of real output is GDP3 (not GDP2) in the economy depicted in Figure 13.3. If the economy is operating at GDP2, instead of GDP3, what is the status of its cyclically-adjusted budget? The status of its current fiscal policy? What change in fiscal policy would you recommend? How would you accomplish that in terms of the G and T lines in the figure? LO3
Answer: A change in the nation's money supply (achieved by changing reserves in the banking system) will cause an opposite change in the interest rate. A reduction in the money supply will make funds increasingly scarce and drive up their price (interest rate). The interest rate and investment spending are also inversely related. A rising interest rate will make some investments (capital spending projects) unprofitable, so spending on those will decline. Investment spending is part of aggregate demand, so they will move together, as will real GDP. A decline in spending (AD) will reduce inflationary pressure (and will reduce prices if they are downwardly flexible).
6. Explain the links between changes in the nation's money supply, the interest rate, investment spending, aggregate demand, real GDP, and the price level. LO5
Answer: (b) There is a crowding-out effect of $20 billion
6. In January, the interest rate is 5 percent and firms borrow $50 billion per month for investment projects. In February, the federal government doubles its monthly borrowing from $25 billion to $50 billion. That drives the interest rate up to 7 percent. As a result, firms cut back their borrowing to only $30 billion per month. Which of the following is true? LO6 a. There is no crowding-out effect because the government's increase in borrowing exceeds firm's decrease in borrowing. b. There is a crowding-out effect of $20 billion. c. There is no crowding-out effect because both the government and firms are still borrowing a lot. d. There is a crowding-out effect of $25 billion.
Answer: Proponents of supply-side economics argue that cuts in the marginal tax rate on earned income will make work more attractive because the opportunity cost of leisure is higher. Thus, individuals choose to substitute work for leisure. Critics of supply-side reasoning contend that workers are just as likely to reduce their efforts because the after-tax pay increases their ability to "buy leisure." They can meet their after-tax income goals by working fewer hours.
6. Why might one person work more, earn more, and pay more income tax when his or her tax rate is cut, while another person will work less, earn less, and pay less income tax under the same circumstance?
Answer: The U.S. demand for pesos is downward-sloping: When the peso depreciates in value (relative to the dollar) the United States finds that Mexican goods and services are less expensive in dollar terms and purchases more of them, demanding a greater quantity of pesos in the process. The supply of pesos to the United States is upward-sloping: As the peso appreciates in value (relative to the dollar), US. goods and services become cheaper to Mexicans in peso terms. Mexicans buy more dollars to obtain more U.S. goods, supplying a larger quantity of pesos. a. The peso will appreciate. Mexican goods will become cheaper, so U.S. demand for pesos for will increase. b. The peso will depreciate. The high rate of inflation in Mexico (relative the U.S.) will cause the price Mexican goods and services to increase (relative the U.S.). The U.S. demand for pesos will fall. The supply of pesos will also increase because U.S. goods are relatively cheaper. This will reinforce the depreciation of the peso. c. The peso will depreciate. The reduction in U.S. tourism in Mexico reduces the demand for pesos. d. The peso will depreciate. The recession in the U.S. economy will reduce imports from Mexico. This, in turn, will decrease the demand for the peso. e. The peso will depreciate. The high interest rate in the U.S. will attract investors from Mexico. This will increase the demand for U.S. dollars or the supply of pesos. f. The peso will appreciate. U.S. consumers purchase more goods from Mexico. This increases the demand for the peso. g. The peso appreciates. The U.S. firms must purchase pesos to invest in Mexico. This increases the demand for pesos. h. The peso appreciates. The sharp decline in U.S. productivity reduces investment in the U.S. by firms in Mexico. This decreases the supply of pesos.
7. Explain why the U.S. demand for Mexican pesos is downsloping and the supply of pesos to Americans is upsloping. Assuming a system of flexible exchange rates between Mexico and the United States, indicate whether each of the following would cause the Mexican peso to appreciate or depreciate, other things equal: LO3 a. The United States unilaterally reduces tariffs on Mexican products. b. Mexico encounters severe inflation. c. Deteriorating political relations reduce American tourism in Mexico. d. The U.S. economy moves into a severe recession. e. The United States engages in a high-interest-rate monetary policy. f. Mexican products become more fashionable to U.S. consumers. g. The Mexican government encourages U.S. firms to invest in Mexican oil fields. h. The rate of productivity growth in the United States diminishes sharply.
Answer: b. Moral hazard
8. City Bank is considering making a $50 million loan to a company named SheetOil that wants to commercialize a process for turning used blankets, pillowcases, and sheets into oil. This company's chances for success are dubious, but City Bank makes the loan anyway because it believes that the government will bail it out if SheetOil goes bankrupt and cannot repay the loan. City Bank's decision to make the loan has been affected by: LO7 a. Liquidity. b. Moral hazard. c. Token money. d. Securitization.
Answer: a.$10 million; $280 million
Suppose that a small country currently has $4 million of currency in circulation, $6 million of checkable deposits, $200 million of savings deposits, $40 million of small denominated time deposits, and $30 million of money market mutual fund deposits. From these numbers we see that this small country's M1 money supply is ____________, while ____________ its M2 money supply is. LO2 a. $10 million; $280 million. b. $10 million; $270 million. c. $210 million; $280 million. d. $250 million; $270 million.
Answer: In the short-run there is probably a tradeoff between unemployment and inflation. The government's expansionary policy should reduce unemployment as aggregate demand increases. However, the government has misjudged the natural rate and will continue its expansionary policy beyond the point of the natural level of unemployment. As aggregate demand continues to rise, prices begin to rise. In the long-run, workers demand higher wages to compensate for these higher prices. Aggregate supply will decrease (shift leftward) toward the natural rate of unemployment. In other words, any reduction of unemployment below the natural rate is only temporary and involves a short-run rise in inflation. This, in turn, causes long-run costs to rise and a decrease in aggregate supply. The end result should be an equilibrium at the natural rate of unemployment and a higher price level than the beginning level. The long-run Phillips curve is thus a vertical line connecting the price levels possible at the natural rate of unemployment found on the horizontal axis.
Suppose the government misjudges the natural rate of unemployment to be much lower than it actually is, and thus undertakes expansionary fiscal and monetary policies to try to achieve the lower rate. Use the concept of the short-run Phillips Curve to explain why these policies might at first succeed. Use the concept of the long-run Phillips Curve to explain the long-run outcome of these policies. LO4
Answer: The basic objective of monetary policy is to assist the economy in achieving a full-employment, non-inflationary level of total output. The major strengths of monetary policy are its speed and flexibility compared to fiscal policy, the Board of Governors is somewhat removed from political pressure, and its successful record in preventing inflation and keeping prices stable. The Fed is given some credit for prosperity in the 1990s and early 2000s. Monetary policy is formed by the 7 members of the Board of Governors. Fiscal policy requires the consent of both houses in Congress, plus the President. One of the implications is that monetary policy has a much shorter administrative lag than fiscal policy.
With an increase in total money demand, the previous interest rate (i0) is unsustainable because with the new demand for money (Dm1), the quantity of money demanded will exceed the quantity of money supplied. There would be a shortage of funds and upward pressure on the interest rate. 2. What is the basic objective of monetary policy? What are the major strengths of monetary policy? Why is monetary policy easier to conduct than fiscal policy? LO3
