MACRO FINAL

A decrease In the value of another countries currency relative to the US dollar will _________ foreign investment into that country and ______exports out of the country

Increase ; Increase

All else equal, a depreciation of the Chinese yuan relative to a currency such as the U.S. dollar should ________ the current account balance in China and therefore ________ the financial account balance in China.

Increase ; decrease

Suppose you withdraw $1,000 from your savings account and put it in your checking account. Briefly explain how this will affect M1 and M2.

M2 will not change and M1 will rise by $1,000. Going from a savings account to checking account would raise M1, but both are part of M2, so M2 would not change.

Suppose you withdraw $1,000 from your savings account and put it under your mattress. Briefly explain how this will affect M1 and M2.

M2 will not change and M1 will rise by $1,000. When under your mattress, the $1,000 would be counted as currency. Going from a savings account to currency would raise M1, but both are part of M2, so M2 would not change.

Suppose you transfer $2,000 from your money market mutual fund account to your checking account. What is the immediate impact of this transfer on M1 and M2?

Money market mutual fund balances are part of M2, but are not part of M1. Checking account balances are included in both money supply measures. Thus M1 will increase by $2,000 with the increase in checking account balances. M2 will not change, as the $2,000 increase in checking account balances is offset by the $2,000 decrease in mutual fund accounts.

53-54 see equations sheet

NA

The current account balance includes...

Net exports + Net income on investments and transfers

Net foreign investment is equal to ______

Net foreign direct investment + Net foreign portfolio investment

When Congress established the Federal Reserve in 1913, what was its main responsibility? When did Congress broaden the Fed's responsibilities?

When Congress established the Fed in 1913, the main responsibility of the Fed was to prevent bank panics by making discount loans to banks. Congress broadened the Fed's responsibilities in the aftermath of the Great Depression.

What is a banking panic, and what role did banking panics play in the decision by Congress to establish the Federal Reserve?

When the Fed was founded, its primary responsibility was to make discount loans to banks in order to deal with the bank panics, which occurred when many banks suffered from large withdrawals by depositors.

List the Fed's four main monetary policy goals.

1. Price stability 2. High employment 3. Stability of financial markets and institutions 4. Economic growth

If 13.5 pesos = 1 US dollar then 1 peso =

1/13.5 = .074 dollars

Give an example of an automatic stabilizer. Explain how automatic stabilizers work in the case of recession.

Examples of automatic stabilizers are unemployment insurance payments and income taxes. (The student only needs to present one example.) Automatic stabilizers change tax receipts and government spending automatically as a result of fluctuations in the business cycle. This occurs without discretionary actions on the part of government. In the case of recession, they would change automatically to stimulate spending in the economy. During a recession, employment declines and government spending on unemployment insurance payments increases. This should raise disposable income and consumer spending above what they would otherwise be. During a recession, income tax receipts decline as incomes decline. This automatic decline in income tax revenues keeps disposable income and consumer spending from falling as much as they would without automatic stabilizers.

How does expansionary monetary policy increase spending in the economy compared to how expansionary fiscal policy increases spending in the economy?

Expansionary monetary policy increases spending by decreasing interest rates which induces households and firms to increase spending on consumer durables and plant and equipment. Expansionary fiscal policy increases spending by directly increasing government spending or by cutting taxes to increase household disposable income which increases consumption spending.

What is the difference between federal purchases and federal expenditures?

Federal purchases refer to federal spending where the federal government receives a good or service in return, like an aircraft carrier. Federal expenditures include federal purchases plus interest on the national debt, grants to state and local governments, and transfer payments.

List the five categories of federal government expenditures.

1. Defense spending 2. Transfer payments 3. Grants to state and local governments 4. Interest payments5. Other expenditures

What is the effect of a decrease in U.S. budget deficits that decrease U.S. interest rates on the demand and supply of U.S. dollars for euros.

A decrease in US interest rates would decrease the desire to invest in financial assets relative to the rest of the world. The demand for dollars would fall, causing the exchange rate for the dollar to fall. The lower exchange rate would increase net exports, leading to a smaller current account deficit.

What is expansionary fiscal policy? What is contractionary fiscal policy?

An expansionary fiscal policy is a decrease in taxes or an increase in government purchases intended to increase aggregate demand. A contractionary fiscal policy is an increase in taxes or a decrease in government purchases intended to decrease aggregate demand.

Present two arguments as to why the Fed should adopt inflation targeting as a framework for monetary policy.

Any two of the following three reasons are correct. First, an explicit inflation target will draw the public's attention to the fact that the Fed can only have an impact on inflation and not real GDP in the long run. Second, the public announcement of the target makes it easier for households and firms to form accurate expectations about future inflation. This will increase efficiency in the economy. Third,,an inflation target would promote accountability by the Fed. The target would offer a yardstick to measure the performance of the Fed.

How will the purchase of $100 million of government securities by the Federal Reserve change bank reserves and total checking account deposits in the banking system as a whole? Assume that banks do not hold any excess reserves, that households and firms do not change the amount of currency they hold, and that the required reserve ratio is 20 percent.

Bank reserves will increase by $100 million when the seller of the bond deposits the $100 million in its checking account. Total checking account deposits in the banking system as a whole will increase by $500 millionthe $100 million increase in reserves times the simple deposit multiplier of 5.

Why do banks create money? Do they create money to help the Federal Reserve control the money supply or is there a more basic reason?

Banks create money to make a profit. Banks create money when they make loans. The loans take the form of checking account deposits. Asking why banks create money is the same as asking why they make loans.

Current Account + Financial Account = ______=__________

BoP ; 0

Why do countries peg their currencies?

Countries peg their currencies to make planning easier for their firms with extensive trade with another country, to aid their firms that have borrowed foreign investment funds denominated in other currencies, and to prevent inflation that would result from a decline in the value of their currency. Countries that peg can find that their currencies become either overvalued or undervalued relative to the equilibrium exchange rate.

What three real-world complications keep purchasing power parity from being a complete explanation of exchange rate fluctuations in the long run?

First, not all products are traded internationally. As a result, there is no way to take advantage of profit opportunities to buy in one country and sell in another country, so exchange rates will not reflect exactly the relative purchasing powers of currencies. Secondly, products and consumer preferences for products vary across countries. As a result, consumers in one country might be willing to pay different prices for products than consumers in another country, and exchange rates might not adjust for that difference in the long run. Finally, countries sometimes impose barriers to trade. If there are barriers to trade, it may not be possible to take advantage of profit opportunities to buy in one country and sell in another country, so, again, exchange rates will not reflect exactly the relative purchasing powers of currencies.

What is the difference between fiscal policy and monetary policy?

Fiscal policy involves changes in federal taxes and purchases and is implemented by Congress and the President. Monetary policy involves changes in the money supply and interest rates and is implemented by the Federal Reserve. Both are intended to achieve macroeconomic objectives.

What is fiscal policy, and who is responsible for fiscal policy?

Fiscal policy refers to changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives. Congress and the president are responsible for fiscal policy.

If American demand for purchases of British goods has decreased, how would you expect the equilibrium exchange rate in the market for dollars to respond?

If Americans are demanding fewer British goods, they will trade fewer dollars in the foreign exchange market for British pounds. This decrease in the supply of dollars is represented by a shift to the left in the supply of dollars. As the supply of dollars decreases, the equilibrium exchange rate rises (the dollar appreciates).

If American demand for purchases of Mexican goods has increased, how would you expect the equilibrium exchange rate in the market for dollars to respond?

If Americans are demanding more Mexican goods, they must trade their dollars in the foreign exchange market for pesos. This increase in the supply of dollars is represented by the shift to the right of the supply curve for dollars. As the supply of dollars increases, the equilibrium exchange rate falls (the dollar depreciates).

What are the implications of the quantity theory of money for monetary policy and price stability?

If one assumes that the velocity of money is constant, there are clear implications on how to use monetary policy for price stability. If we transform the quantity equation, MV = PY, into an equation about growth rate for these variables, then the quantity equation becomes:growth rate of money + growth rate of velocity = growth rate in prices (inflation rate) + growth rate of real output. Rearranging, we get:inflation rate = growth rate of money + growth rate of velocity - growth rate of real output. If velocity does not change, then the growth rate of velocity is zero. Then, inflation is determined by:growth rate of money - growth rate of output. As long as money does not grow faster than real output, inflation will not occur. If the supply of money grows faster than the growth of real output (see equations notes)

Who bears the burden of the government debt? Explain why. Under what circumstances is there no burden to be borne?

If taxes must be raised in the future to pay off the debt, the distortions from higher tax rates are a burden on future generations. Also, if bondholders are on average wealthier than taxpayers, there will be a redistribution of wealth as the debt is repaid. Finally, if the debt reduces national saving, then investment will be lower, which reduces the capital stock, which means a lower standard of living for future generations. But if taxes are lump-sum and Ricardian equivalence holds, there is no burden, since then private saving rises to prevent the debt from having any effects on national saving.

How do open market operations work?

If the FOMC decides to increase the money supply, it will direct the trading desk at the Federal Reserve Bank of New York to buy U.S. Treasury Securities from the public. When the sellers of these securities deposit the funds from the sale into their banks, the reserves of the banking system will rise. This will start the process of expanding the money supply as the increase in reserves expands loans and checking account deposits. If the FOMC wants to reduce the money supply, it will direct the trading desk to sell U.S. Treasury securities. This will decrease reserves, contract loans, contract checking accounts and shrink the money supply.

What actions should the Fed take if it believes the economy is about to experience a high rate of inflation?

If the Fed believes the economy is about to experience a high rate of inflation, it should conduct contractionary monetary policy, decreasing the money supply and raising interest rates. In implementing contractionary monetary policy, the Fed could raise the discount rate, raise the reserve requirement, and/or have the trading desk sell U.S. Treasury securities.

What actions should the Fed take if it believes the economy is about to fall into recession?

If the Fed believes the economy is about to fall into recession, it should conduct expansionary monetary policy, increasing the money supply and reducing interest rates. In implementing expansionary monetary policy, the Fed could lower the discount rate, lower the reserve requirement, and/or have the trading desk purchase U.S. Treasury securities.

What is the difference between a fixed exchange rate system and a managed float exchange rate system?

In a fixed exchange rate system, the value of the currencies of the participating countries is fixed, and in a managed float exchange rate system, the value of currencies is determined by demand and supply, with occasional government intervention.

Describe, in general terms, the lags in the effects of monetary policy on interest rates, output, and prices. Be sure to note how long it takes each variable to respond to policy changes.

Interest rates respond quickly to changes in monetary policy, reacting within the first month. But the effect is transitory, and after 6 to 12 months, the interest rate has returned most of the way to its original value. Output and prices barely respond to a change in monetary policy at first. Output begins to change after about 4 months, with the full effect being felt about 16 to 20 months after the initial policy change. The price level doesn't change much until about a year after the change in policy.

When a government has a budget deficit, it must issue (sell) government bonds to finance the deficit. Does it matter for the rate of inflation if the government sells the government bonds to the public or sells the government bonds to the central bank? Explain why it does or does not matter.

It matters greatly. When the government sells the bonds to the public the money supply does not change, but when they sell the bonds to the central bank the money supply increases. If there are large budget deficits, the money supply will increase substantially when the central bank buys government bonds. Using the quantity theory of money, the increase in money supply from the purchase of the bonds by the central bank will increase the inflation rate.

Does expansionary fiscal policy directly increase the money supply? Isn't it true that the president and Congress fight recessions by spending more money?

No, expansionary fiscal policy does not directly increase the money supply. The president and the Congress fight recessions by increasing spending, not the money supply, by either increasing government spending or cutting taxes to increase household disposable income and, therefore, consumption spending.

69-71 see equations notes

Notes

Give an example of a monetary policy target. Explain why the Fed uses policy targets.

One possible monetary target is the money supply. Another possible target is the interest rate. (Either answer is correct). A monetary policy target is an economic variable that the Fed can affect directly. The Fed uses monetary targets because it cannot directly manipulate and change monetary policy goals such as high employment, economic growth, and price stability. The Fed can affect the targets directly and they in turn affect the variables such as real GDP and the price level, which are closely related to the Fed's policy goals.

Suppose that the required reserve ratio is 20 percent and you deposit $50,000 of currency into Comerica Bank. What is the potential increase in deposits in the banking system brought about by your deposit? What is the potential change in the money supply?

Refer to equations Notes

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Describe the structure of the Fed's Open Market Committee (FOMC). What is this committee's primary responsibility?

The FOMC is comprised of the seven members of the Board of Governors in Washington, D.C., the President of the Federal Reserve Bank of New York, and four Presidents (serving one-year rotating terms) from the remaining eleven district banks. This committee assumes primary responsibility for managing the U.S. money supply.

Describe how the Fed would traditionally use open market operations to change short-term and long-term interest rates.

The Fed would try to achieve a target level for the federal funds rate by using open market operations. If it wants to lower the federal funds rate, it would buy Treasury bills using open market operations. This purchase would inject the banking system with reserves. The increased supply of reserves would lower the overnight loan rate on these reserves, which is called the federal funds rate. Changes in the federal funds rate will usually result in changes in the interest rates on other short-term financial assets such as Treasury bills, and eventually affect longer-term rates such as the rate of corporate bonds and mortgages. However, the effect on these longer-term rates is usually smaller than the impact on short-term rates and occurs with a lag.

Consider the following statement, "The Federal Reserve fights recessions by increasing the money supply so people will have more money to spend." What is wrong with the statement and how can it be corrected?

The Federal Reserve fights recessions by increasing the money supply to lower interest rates, which in turn increases spending. It is not that people will have more money to spend, but that interest rates will be lower, which stimulates spending.

Why is the Social Security system in crisis at a time when it's running large surpluses? What's the source of the problem? What solutions have been proposed?

The Social Security system is in a crisis even though it's running large surpluses because its surpluses will turn to large deficits within the next 20 years. The source of the problem is that the baby-boom generation will begin to retire, greatly increasing the Social Security benefits that will be paid out. Potential solutions include reducing benefits, increasing taxes, or getting a higher return for the Social Security trust fund by investing in the stock market.

Describe the Taylor rule. If the Fed were following the rule, what would the nominal Fed funds rate be if inflation over the past year were 4% and output were 1% below its full-employment level?

The Taylor rule is a rule for monetary policy that allows the Fed to respond to the state of the economy. The rule sets the nominal Fed funds rate as the sum of the inflation rate over the past year plus 2% plus one-half times the percentage deviation of output from its full-employment level plus one-half times the amount by which inflation over the past year exceeds 2%. If inflation were 4% and output were 1% below its full-employment level, the nominal Fed funds rate would be 0.04 + 0.02 + (0.5 × -0.01) + [0.5 × (0.04 - 0.02)] = 0.065 = 6.5%. See equations notes

Write out the expression for the Taylor rule. Use the Taylor rule to explain how a decline in real GDP below potential GDP will affect the Federal Reserve's target for the federal funds rate.

The Taylor rule states that the Fed should set the federal funds target so that it is equal to: the real equilibrium federal funds rate + the current inflation rate + (w1) × inflation gap + (w2) × output gap. The inflation gap is the difference between the current inflation rate and the target rate. The output gap is the percentage difference between real GDP and potential GDP. The values w1 and w2 are weights determined by the Fed. If the growth rate in real GDP is below potential GDP, then the output gap will be negative. This will lower the federal funds target. (see equations sheet)

What does it mean if there is a current account deficit?

The deficit must be offset by a surplus in the financial account. Likely received the difference from foreign investors.

How effective is discount policy as compared to open market operations in managing the money supply? Explain how The Federal Reserve uses discount policy today.

The effectiveness of discount policy in changing the money supply depends upon banks' willingness to borrow reserves. The Fed may lower the discount rate of interest, encouraging bankers to borrow reserves and increase loans. But bankers are not required to increase their borrowing. In contrast, an open market purchase of securities will increase reserves in the banking system and encourage lending. The Fed prefers to limit the use of discount policy to help banks that are temporarily in need of reserves. That is, the Fed uses the policy to serve as a lender of last resort for banks. It did so after the stock market crash in 1987 and after the terrorist attacks on September 11, 2001.

What are the four functions of money? Can something be considered money if it does not fulfill all four functions?

The four functions are medium of exchange, unit of account, store of value, and standard of deferred payment. In the long run, something will not serve as money if it does not fulfill all four functions.

Would the Federal Reserve respond more aggressively with interest rate cuts in a recession caused by a decrease in spending, as in the 2001 recession, than in a recession caused by an increase in oil prices, as in the 1974-75 recession?

The inflation rate responds differently in the two recessions. A large increase in oil prices decreases real GDP, but increases inflation. The large decrease in spending decreases real GDP and decreases inflation. The Fed wants to increase real GDP, but they also want to prevent an increase in inflation. Cutting interest rates increases aggregate demand which increases real GDP and increases inflation. With a recession caused by a drop in spending, the rate of inflation declines, which allows the Fed to more aggressively cut interest rates.

In countries that have experienced hyperinflation, what role have large government budget deficits played in causing the very high inflation rates?

The large government budget deficits lead to the massive increases in the money supply necessary to generate the hyperinflation. The public, especially in the developing world, will not buy the government bonds necessary to finance the large budget deficits. The central bank has had to purchase the government bonds, which has sent the money supply through the roof, leading to hyperinflation.

Does the money demand curve have a positive slope or a negative slope? Why does it have this slope? Explain why an increase in the variable on the vertical axis of the money demand curve causes either an increase or a decrease in the variable on the horizontal axis of the money demand curve.

The money demand curve has a negative slope. An increase in the interest rate, the variable on the vertical axis, causes a decrease in the quantity of money demanded, the variable on the horizontal axis, because an increase in the interest rate increases the opportunity cost of holding money. Money earns little or no interest, so an increase in the interest rate induces people to reduce their holdings of money and switch into interest-bearing financial assets.

Was the money multiplier stable during the Great Recession? Why would an unstable money multiplier pose a problem for monetary policy?

The money multiplier was not stable during the Great Recession. The money multiplier declined sharply, because the currency-deposit ratio and especially the reserve-deposit ratio both rose dramatically, as people increased their demand for currency, and banks increased their demand for excess reserves. Instability in the money multiplier creates instability in the money supply for a given monetary base.

What problems can high inflation rates cause for the economy?

The problems that inflation causes for the economy include the loss of purchasing power of money, menu costs, and an unintended redistribution of income.

What are the three main exchange rate systems, and how do they operate?

The three main exchange rate systems are the floating exchange rate, the fixed exchange rate, and the managed float. The floating exchange rate is determined solely by equilibrium of demand and supply in the foreign exchange market. The fixed exchange rate exists when the government maintains one fixed rate at which currency can be exchanged. Under a managed float, the exchange rate is mostly determined by demand and supply in the market for foreign exchange, with occasional government intervention.

What is the principle monetary policy tool used by the Fed. Why?

The tool that the Fed primarily uses is open market operations. There are three reasons. First, because the Fed is the party that initiates the open market operations, it completely controls the volume. Second it can make the volume large or small, depending on how many U.S. Treasury securities it decides to buy or sell. Finally, it can implement this policy tool quickly. It does not have to change regulations and the administrative machinery is in place for it to make changes quickly.

What does the Trade Balance do?

The trade balance measures the difference between the value of goods a country exports and the value of goods a country imports.

What is purchasing power parity theory?

Theory that explains how over the long run, it seems reasonable that exchange rates should move to equalize the purchasing powers of different currencies.

Would the maximum loan that a bank can make be different when receiving a discount loan from the Federal Reserve of $1 million versus receiving a checking account deposit of $1 million? Explain why or why not.

They are different. Both increase the reserves at the bank by $1 million, but the bank does not have to hold required reserves against the discount loan because it is not a deposit. The entire $1 million of the discount loan is excess reserves, which the bank can loan out.

The problem typically during a recession is not that there is too little money, but too little spending. If the problem was too little money, what would be its cause? If the problem was too little spending, what could be its cause?

Too little money would be caused by too small of a money supply by the Federal Reserve. Too little spending could be caused by a variety of reasons such as a decrease in consumption spending by households because they become pessimistic about the future, a decrease in investment spending by firms because they lower their estimates of the future profitability of new factories and machinery, or a decrease in U.S. exports because a major trading partner is in a recession.

If a countries exports of goods are greater than its imports there is a ________ , which __________ the current account balance.

Trade Surplus; Increases

Describe the strategy of inflation targeting. Why have many countries begun to use this strategy instead of targeting money growth? What are the advantages and disadvantages of inflation targeting?

Under inflation targeting, the central bank announces the inflation rate that it will try to achieve over the next 1 to 4 years. Countries have moved to inflation targeting because money-growth targeting had problems in the 1980s as money demand became unstable. Inflation targeting has the advantage of sidestepping the problem of instability in money demand, of being easier to explain to the public, and of increasing the central bank's accountability to the public. But the major disadvantage of inflation targeting is that the long lags through which inflation responds to monetary policy make it difficult for the central bank to judge what policy actions are needed.

According to the quantity theory of money, if the money supply is growing at a rate of 5 percent, real GDP is growing at a rate of 2 percent, and velocity is constant, what will the inflation rate be?

Using the growth rate version of the quantity equation, we have:growth rate of the price level (or inflation rate) = growth rate of money + growth rate of velocity - growth rate of real output. If velocity does not change, then the growth rate of velocity is zero. Then:growth rate of the price level (or inflation rate) = growth rate of money - growth rate of output. Substituting in our values:growth rate of the price level (or inflation rate) = 5 percent - 2 percent = 3 percent. (see equations notes)

Lowering interests rates in other countries will cause their currency exchange value to

decline