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In the consumption function, C = A + b (Y - T + R),

A is autonomous spending, b is the marginal propensity to consume, and the term in parentheses is disposable income.

Which of the following is a counter-cyclical monetary policy?

Selling Treasury bonds during a time of rising inflation.

Suppose the inflation rate was 9.7% and the unemployment rate was 3.8%. Which of the following would be a counter-cyclical monetary policy in this economy?

Selling Treasury bonds to increase the real interest rate.

Here's a typical report about the economy, published after data on one of the major economic indicators is released. Read the following excerpts from "U.S. Economy Gained 126,000 Jobs in March, an Abrupt Slowdown in Hiring," New York Times, April 3, 2015, and answer the question. The yearlong streak of robust monthly job creation was broken on Friday with the Labor Department's report that employers added just 126,000 workers in March, a marked slowdown in hiring that echoed earlier signs that sluggish business investment and punishing weather were exacting a toll on the economy. The unemployment rate held steady at 5.5 percent. The slowdown in job creation reinvigorated the debate about when the Federal Reserve will raise interest rates above their near-zero level, where they have remained since 2008. Many Wall Street analysts argued that the murky jobs picture was likely to reinforce the view among the Fed's more dovish policy makers that rates should stay put at least until the end of the summer because the economy may not be strong enough to stand on its own. Friday's disappointing figures, the weakest showing in two years, mean it will take longer for the economy to reach a level most analysts consider close to full employment. More encouraging outlooks could be found in other quarters this week. McDonald's, in announcing plans to raise wages for employees at its company-owned restaurants, cited a strengthening labor market. And Walmart, the country's largest private sector employer, already said it would raise wages to a minimum of $9 an hour by this month. Also, the number of Americans filing for unemployment last week fell to a 15-year low. That brought the four-week moving average — a better indicator because it smooths out the normal bumps in the road — to a better-than-expected 285,500. What would be the likely effect of this report on the Federal Reserve's decision about monetary policy?

Slower growth in employment would make the Fed more likely to leave the federal funds rate unchanged.

Suppose the home values increase, and people borrow money by taking out home equity loans. The consumption function, C = A + b (Y - T + R), shows that

autonomous spending will rise, consumption spending will increase, and real GDP will grow faster.

Many economists feared that the Great Depression would return once World War II ended. This did not happen, because

consumer spending increased. Consumers had saved a lot during the war, and increased their spending on goods that they hadn't been able to buy during the war and Depression.

To use open market operations to decrease the money supply, the Federal Reserve would

sell Treasury bonds to banks.

Among the functions of money are

to act as a medium of exchange, a unit of account, and a store of value

Which of the following is a procyclical fiscal policy in a recession?

A tax increase.

Consider the following (made up) data for the U.S. economy. Compare the changes in the unemployment rate from year 2 to year 3, and the real GDP growth rate for year 3. What might explain these changes?

Equilibrium output increased, but potential output increased more.

Which of the following did the Federal government use to hold down inflation during World War II.

Price controls and rationing.

Here's an excerpt from the article "Central Banks Act With a New Boldness to Revitalize Economies," New York Times, May 28, 2013. Officials in Britain, too, are debating its central bank's ability to do more. Last month, the departing governor of the Bank of England, Mervyn King, gave a speech at the International Monetary Fund in which he said — a bit acidly — that there was a limit to what monetary policy could do to spur recovery in a country like Britain, where a small number of stingy banks dominate the economy and the government is tightening its spending. Like other central banks around the world, the Bank of England, by far the oldest of them all, has done its part to ward off a depression. It has bought, to date, the equivalent of $569 billion worth of government bonds — a bold use of the printing press for an institution known for its hidebound ways. Which of the following statements explains the economic conditions and policies described in this article?

The Bank of England is using open market operations, buying bonds for money, to try to stimulate aggregate demand. However, banks are holding a large amount of the new money as reserves, decreasing the money multiplier and limiting the growth of the money supply.

Suppose we measure the correlation between the Federal Reserve's federal funds interest rate and the CPI core inflation rate Suppose that the correlation coefficient was +0.57 during a period of years. This implies that

The Fed followed counter-cyclical policy during these years.

Suppose we measure the correlation between the Federal Reserve's federal funds interest rate and the unemployment rate. We find that the correlation coefficient is +0.23 during 1961-86, and -0.77 during 1987-2017. This implies that

The Fed followed no consistent policy during 1961-86, and counter-cyclical policy during 1987-2017.

Suppose we measure the correlation between the Federal Reserve's federal funds interest rate and the CPI core inflation rate. We find that the correlation coefficient is 0.18 during 1961-86, and -0.68 during 1987-2017. This implies that

The Fed followed no consistent policy during 1961-86, and pro-cyclical policy during 1987-2017.

Suppose we measure the budget balance as a percentage of GDP, by subtracting Federal government spending from Federal government revenues, and dividing the result by GDP. Then we calculate a correlation between this budget balance percentage and the unemployment rate, and find a correlation of -0.59 for a period of years. This means that

The Federal budget was counter-cyclical during these years.

Here's an excerpt from the article "Central Banks Act With a New Boldness to Revitalize Economies," New York Times, May 28, 2013. Japan's willingness to use huge government spending — despite racking up incredible debt to do so — is unique among the developed economies. Under Prime Minister Shinzo Abe, the country is coupling its central bank action with fiscal stimulus, which means that the new money created by the bank is put to use. Calls for austerity have largely fallen on deaf ears. In the land famous for building bridges to nowhere, Mr. Abe pushed through an emergency stimulus package of 10 trillion yen, or $98.7 billion, and Parliament passed a further 92.6 trillion yen budget for 2013, with heavy spending on public works. But in a happy confluence of policies, because the central bank promises to buy up the bonds that the government issues, interest rates are for now unlikely to soar out of control, while the weakening yen has created a surge in exporter profits, putting Japan in a policy sweet spot. Which of the following best explains the economic conditiions and policies described in this article?

The Japanese government is pursuing an expansionary fiscal policy in an attempt to stimulate aggregate demand. The Bank of Japan is buying government bonds, holding down interest rates. The low interest rates are helping to reduce the exchange value of the Japanese yen, which should help encourage Japanese exports.

Here's an excerpt from the article "Disruptions of Power and Water Threaten Japan's Economy," New York Times, March 13. As the humanitarian and nuclear crises in Japan escalated after the devastating earthquake and tsunami, the impact on the country's economy appeared to be spreading as well. The yen is expected to strengthen against the dollar, as Japanese investors bring money back from overseas to shore up their savings and provide money for the rebuilding campaign. Those financial flows back into Japan will drive up demand for the yen, increasing its value. After the Kobe earthquake in 1995, the yen rose about 20 percent against the dollar over a few months. What might happen in the goods market as a result of this exchange market change?

The rising value of the yen will make Japanese exports more expensive, which could reduce aggregate demand and increase the threat of recession.

Expectations of economic growth can cause stock market values to increase because

growth leads to higher business profits, and owners of stock receive a share of those profits.

Companies issue stock in order to

sell a share of ownership in the company in exchange for money to be used to expand the company's operations.

Unemployment insurance is an automatic fiscal stabilizer because

when recessions occur, spending increases and taxes decline without the need for new legislation.

Consider the following (made up) data for the U.S. economy. Which of the following best analyzes fiscal policy from year 1 to year 2?

Taxes decreased and government spending increased, which was pro-cyclical fiscal policy.

Here's an excerpt from the article "Disruptions of Power and Water Threaten Japan's Economy," New York Times, March 13, 2011. To help bring electricity back to the devastated areas, utilities across Japan are cutting back and sharing power, imposing rolling blackouts that will affect factories, stores and homes throughout the nation. The emergency effort is expected to last up to two weeks, but could take longer. "The big question is whether this will seriously affect Japan's ability to produce goods for any extended period of time," said Edward Yardeni, an independent economist and investment strategist. The Bank of Japan, in an effort to preempt a further deterioration in the economy, eased monetary policy on Monday by expanding an asset buying program. ''The damage of the earthquake has been geographically widespread, and thus, for the time being, production is likely to decline and there is also concern that the sentiment of firms and households might deteriorate,'' the central bank said in a statement. To try to stabilize the markets and prop up the economy, the central bank earlier Monday poured money into the financial system. "The Japanese economy threatens to suffer another bout of recession," said Mark Zandi, chief economist of Moody's Analytics. Economic activity in Japan contracted in the fourth quarter of 2010, and the country was overtaken by China as the world's second-largest economy, after the United States. Activity may well shrink for the first half of this year, Mr. Zandi said, though he predicted that the rebuilding efforts in the aftermath of the quake would help provide a rebound in the second half. Which of the following best describes what is happening in Japan?

The earthquake has created a supply shock by increasing the costs of inputs such as electricity. Japan's central bank is responding with an increase in the money supply, to try to prevent a new recession.

Consider the following (made up) data for the U.S. economy, and the four money market diagrams. Which money market diagram best represents what happened in the economy from year 2 to year 3?

W

Tax cuts for lower income people often are thought to create bigger increases in aggregate demand than similar tax cuts for upper income people, because

lower income people have higher marginal propensities to consume.

Here are excerpts from a March 21, 2018 Washington Post article, "Federal Reserve Hikes Interest Rate to Highest Level in a Decade Amid Stronger Economy." The Federal Reserve on Wednesday lifted its key interest rate from 1.5 percent to 1.75 percent, the highest level since 2008. The Fed significantly boosted its forecast for U.S. growth this year and next. The U.S. economy is on track to expand 2.7 percent this year and 2.4 percent in 2019, Fed officials now say, a jump from their previous projection done before the December tax cuts were finalized. Americans should expect even faster growth and lower unemployment ahead, Fed officials said. Unemployment is now expected to fall to 3.8 percent this year and 3.6 percent in 2019, which would be the lowest level since 1969. "Fiscal policy has become more stimulative, ongoing job gains are boosting incomes and confidence, foreign growth is on a firm trajectory, and overall financial conditions remain accommodative," Powell said in his first news conference, which was significantly shorter than those of his predecessor, Janet L. Yellen. Which of the following best analyzes the Federal Reserve's expectations for the economy this year and next?

Aggregate demand is increasing. Rising incomes, rising confidence and tax cuts will increase consumer spending, interest rates are still low enough to encourage investment, Federal spending is increasing, and foreign growth will increase exports. Equilibrium output will rise further above potential.

Consider the following paragraph from a Federal Reserve policy statement: Information received since the Federal Open Market Committee met in July suggests that economic activity has been expanding at a moderate pace. Some indicators of labor market conditions have shown further improvement in recent months, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen further and fiscal policy is restraining economic growth. Apart from fluctuations due to changes in energy prices, inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable. Which of the following statements best describes the Fed's view of aggregate demand?

Consumer spending and business investment are increasing aggregate demand, but rising interest rates and government spending cuts are slowing aggregate demand growth.

Here's a typical report about the economy, published after data on one of the major economic indicators is released. Read the following excerpts from "U.S. Economy Gained 126,000 Jobs in March, an Abrupt Slowdown in Hiring," New York Times, April 3, 2015, and answer the question. The yearlong streak of robust monthly job creation was broken on Friday with the Labor Department's report that employers added just 126,000 workers in March, a marked slowdown in hiring that echoed earlier signs that sluggish business investment and punishing weather were exacting a toll on the economy. The unemployment rate held steady at 5.5 percent. Hourly wages, in one of the few bright spots in the report, rose 0.3 percent for private sector workers in March, after a meager 0.1 percent rise in February. But hours worked were down slightly, so overall paychecks were left essentially flat. The slowdown in job creation reinvigorated the debate about when the Federal Reserve will raise interest rates above their near-zero level, where they have remained since 2008. Many Wall Street analysts argued that the murky jobs picture was likely to reinforce the view among the Fed's more dovish policy makers that rates should stay put at least until the end of the summer because the economy may not be strong enough to stand on its own. Friday's disappointing figures, the weakest showing in two years, mean it will take longer for the economy to reach a level most analysts consider close to full employment. More encouraging outlooks could be found in other quarters this week. McDonald's, in announcing plans to raise wages for employees at its company-owned restaurants, cited a strengthening labor market. And Walmart, the country's largest private sector employer, already said it would raise wages to a minimum of $9 an hour by this month. The article calls the winter weather "punishing," and blames it for at least part of the slowdown in job growth. Which of the following could explain why bad weather could reduce output and employment in the goods market?

Consumers didn't shop because of the winter cold, and snow and ice raised the cost of transporting goods from factories to retail stores.

Here is an excerpt from the Federal Reserve's policy statement from March 19, 2014. Information received since the Federal Open Market Committee met in January indicates that growth in economic activity slowed during the winter months, in part reflecting adverse weather conditions. Labor market indicators were mixed but on balance showed further improvement. The unemployment rate, however, remains elevated. Household spending and business fixed investment continued to advance, while the recovery in the housing sector remained slow. Fiscal policy is restraining economic growth, although the extent of restraint is diminishing. Inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable. Which of the following best represents the Federal Reserve's view of the U.S. economy as of March 19, 2014?

Consumption and business investment are growing, but housing investment and government purchases are restraining spending. Aggregate demand is growing slowly, while aggregate supply has been limited by winter weather. Output is growing slowly, and is less than potential, while inflation remains low.

Consider the last paragraph of a Federal Reserve policy statement: Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Charles L. Evans; Jerome H. Powell; Eric S. Rosengren; Jeremy C. Stein; Daniel K. Tarullo; and Janet L. Yellen. Voting against the action was Esther L. George, who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations. The paragraph says that Esther L. George voted against the policy statement. Which of the following is consistent with her reasoning?

Continued increases in the money supply will convince businesses, workers and input supplies that inflation will increase, which could cause decreases in aggregate supply and increases in actual inflation.

Consider the following (made up) data for the U.S. economy, and the four goods market diagrams. Which goods market diagram best represents what happened in the economy from year 1 to year 2?

D

Which of the following is a counter-cyclical monetary policy?

Decreasing the discount rate during a recession.

Which of the following is a pro-cyclical monetary policy?

Decreasing the discount rate during a time of rising inflation.

Here's an excerpt from the article "Central Banks Act With a New Boldness to Revitalize Economies," New York Times, May 28, 2013. The economic stagnation of the major developed nations has driven central banks in the United States, Japan, Britain and the European Union to take increasingly aggressive action. Because governments are not taking steps to revive economies, like increasing spending or cutting taxes, the traditional concern of central bankers that economic growth will cause too much inflation has been supplanted by the fear that growth is not fast enough to prevent deflation, or falling prices. The Fed has announced plans to keep borrowing costs at historic lows until unemployment declines. The staid Bank of England has bought more than a half-trillion dollars' worth of bonds to ignite British business activity. Last month, Haruhiko Kuroda, the new chairman of the Bank of Japan, steered the central bank toward an audacious new policy of reinflating the Japanese economy by doubling the money supply. It is considered the boldest step so far by a central bank. Which of the following statements best explains the economic conditions and policies described in this article?

Equilibrium output is less than potential output, and governments are not using expansionary fiscal policy to increase aggregate demand. Central banks are increasing the money supply, to reduce interest rates and encourage investment spending instead.

Suppose the inflation rate was 10.1% and the unemployment rate was 3.2%. Which of the following would be a counter-cyclical monetary policy in this economy?

Raising the discount rate to decrease bank borrowing from the Federal Reserve.

Here's an excerpt from the article "Disruptions of Power and Water Threaten Japan's Economy," New York Times, March 13, 2011. To help bring electricity back to the devastated areas, utilities across Japan are cutting back and sharing power, imposing rolling blackouts that will affect factories, stores and homes throughout the nation. The emergency effort is expected to last up to two weeks, but could take longer. "The big question is whether this will seriously affect Japan's ability to produce goods for any extended period of time," said Edward Yardeni, an independent economist and investment strategist. The Bank of Japan, in an effort to preempt a further deterioration in the economy, eased monetary policy on Monday by expanding an asset buying program. ''The damage of the earthquake has been geographically widespread, and thus, for the time being, production is likely to decline and there is also concern that the sentiment of firms and households might deteriorate,'' the central bank said in a statement. To try to stabilize the markets and prop up the economy, the central bank earlier Monday poured money into the financial system. "The Japanese economy threatens to suffer another bout of recession," said Mark Zandi, chief economist of Moody's Analytics. Economic activity in Japan contracted in the fourth quarter of 2010, and the country was overtaken by China as the world's second-largest economy, after the United States. Activity may well shrink for the first half of this year, Mr. Zandi said, though he predicted that the rebuilding efforts in the aftermath of the quake would help provide a rebound in the second half. The article describes a couple of factors that will aid an economic recovery from the effects of the earthquake. What are they?

Rebuilding efforts will require new investment spending, and the Bank of Japan has reduced interest rates. Both of these factors will increase aggregate demand and output growth.

Suppose the inflation rate was 1.1% and the real GDP growth rate was -0.7%. Which of the following would be a counter-cyclical monetary policy in this economy?

Reducing the discount rate to increase bank borrowing from the Federal Reserve.

Here is an excerpt from the Federal Reserve's policy statement from March 19, 2014. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. Which of the following best represents the Federal Reserve's monetary policy as of March 19, 2014?

The Fed is buying bonds to increase the money supply, but improvements in the economy are allowing the Fed to "taper" the amount of bonds it buys. The Fed will hold interest rates near record lows as long as inflation remains low.

Read the following excerpts from a March 21, 2018 Wall Street Journal article, "Fed Raises Rates and Signals Faster Pace in Coming Years." Federal Reserve officials signaled Wednesday they could pick up the pace of interest-rate increases to cool economic growth after next year. The Fed voted unanimously to raise its benchmark federal-funds rate by a quarter-percentage point to a range between 1.5% and 1.75%. Officials said they expected to lift it another two or three times this year, and three times next year. Fed Chairman Jerome Powell, in his first news conference as the central bank's chief, said officials want to balance two risks. One is that they raise rates too much, causing inflation to stay below their 2% target and damaging the Fed's credibility. The other is that they raise rates too slowly, letting the economy overheat and forcing them to move more quickly, triggering a recession. Fed Chair Powell is concerned about balancing the risks of Fed policy, in response to more rapid growth. Which of the following best represents his concerns?

The Fed may increase interest rates too little, causing inflation, or the Fed may increase rates too much, slowing the economy more than necessary.

Consider the following (made up) data for the U.S. economy. At the beginning of year 3, a media report quoted a famous economist, who said "We've been in recession for almost a year, yet policymakers have been asleep at the switch. They have not adopted appropriate fiscal and monetary policies. Economic theory has long advised that the Federal Reserve and the Congress adopt policies to increase spending. Give business a reason to produce goods and services, and they'll hire more employees and bring down unemployment." Analyze the data on the economy and policies in year 2. Is the economists criticism of policymakers correct?

The economist is advocating counter-cyclical policies, and failing to recognize that policymakers adopted counter-cyclical policies in year 2. The economist is not correct.

Here are some excerpts from the article, "Fed Raises Interest Rates for Sixth Time Since Financial Crisis," New York Times, March 21, 2018. The announcement underscores the Fed's gathering confidence in the economy as well as its focus on the potential for inflation, which has remained persistently muted throughout the expansion. Officials raised their median estimates for economic growth this year to 2.7 percent, up from 2.5 percent in December. They raised their estimate for growth in 2019 to 2.4 percent, up from 2.1 percent. They now expect the unemployment rate to fall to 3.8 percent this year and 3.6 percent in 2019, a low level by historical standards. In December, officials said they expected unemployment to be 3.9 percent both this year and next. Officials' growing optimism tracks with the expectations of many Wall Street analysts. "We think Fed officials will view the growth and inflation data in recent months as encouraging," analysts at Goldman Sachs wrote in a research note ahead of the meeting, "particularly with tax cuts now implemented and with an additional fiscal boost from federal spending arriving this year." Tax cuts and added federal spending are expected to add a "fiscal boost" to the economy. According to the article, what do the Fed and Wall Street analysts expect to happen in the goods market?

The tax cut and spending increase will increase aggregate demand. Equilibrium output will rise further above potential this year and next.

Here is an excerpt from "As Trump Stimulus Fades, Fed Sees Tight Monetary Policy on the Horizon," New York Times, March 21, 2018. The Fed expects the fiscal stimulus to boost economic growth for two years, but give no apparent permanent help to the economy. Unemployment dives, inflation rises just above the Fed's target, and the central bank responds with interest rates rising to 3.5 percent in 2020, a full half a percentage point above the current estimate of "neutral." [Fed chair Jerome] Powell and his colleagues see the fiscal stimulus pressing unemployment to boomtime lows of 3.6 percent, and appear ready to let that happen without fear of inflation rising too fast. But the effects fade, and long-term growth falls to around 1.8 percent annually. There is "higher growth over the next year or two as a result of fiscal stimulus, not as a result of structural factors, such as a permanent improvement in productivity," Cornerstone Macro analyst Roberto Perli wrote. The Fed's response will not necessarily trigger a recession. But it does indicate that [the tax cut] will exact a cost. "Fiscal stimulus" means the Federal income tax cut passed in December. According to the article, what does the Fed expect to happen in the goods market?

The tax cut will increase aggregate demand, but potential output will not grow faster. Equilibrium output will rise further above potential.

Here are excerpts from a March 21, 2018 Washington Post article, "Federal Reserve Hikes Interest Rate to Highest Level in a Decade Amid Stronger Economy." The Federal Reserve on Wednesday lifted its key interest rate from 1.5 percent to 1.75 percent, the highest level since 2008. There's growing concern among economists that the tax cuts and the additional boost in federal government spending could cause the U.S. economy to overheat, requiring the Fed to hike rates even more than three times this year. Of the 15 Fed board members, six anticipate the Fed will hike four times this year and one believes five hikes will be necessary. It's not quite enough to tip the official forecast to four rate increases, but it's getting close. "I think they will end up tightening four times this year, but they don't have to signal that yet," said Jim O'Sullivan, chief U.S. economist at High Frequency Economics. The Fed hasn't hiked rates four times in a year since 2006. Which of the following is the best analysis of the Fed's possible response to the tax cuts and Federal spending increases?

The tax cuts and Federal spending increases will increase the threat of inflation. The Fed may raise interest rates more in response.

Here's a typical report about the economy, published after data on one of the major economic indicators is released. Read the following excerpts from "U.S. Economy Gained 126,000 Jobs in March, an Abrupt Slowdown in Hiring," New York Times, April 3, 2015, and answer the question. The yearlong streak of robust monthly job creation was broken on Friday with the Labor Department's report that employers added just 126,000 workers in March, a marked slowdown in hiring that echoed earlier signs that sluggish business investment and punishing weather were exacting a toll on the economy. The unemployment rate held steady at 5.5 percent. The slowdown in job creation reinvigorated the debate about when the Federal Reserve will raise interest rates above their near-zero level, where they have remained since 2008. Many Wall Street analysts argued that the murky jobs picture was likely to reinforce the view among the Fed's more dovish policy makers that rates should stay put at least until the end of the summer because the economy may not be strong enough to stand on its own. Friday's disappointing figures, the weakest showing in two years, mean it will take longer for the economy to reach a level most analysts consider close to full employment. More encouraging outlooks could be found in other quarters this week. McDonald's, in announcing plans to raise wages for employees at its company-owned restaurants, cited a strengthening labor market. And Walmart, the country's largest private sector employer, already said it would raise wages to a minimum of $9 an hour by this month. Also, the number of Americans filing for unemployment last week fell to a 15-year low. That brought the four-week moving average — a better indicator because it smooths out the normal bumps in the road — to a better-than-expected 285,500. The unemployment rate did not change in March, which means "it will take longer for the economy to reach a level most analysts consider close to full employment." Yet the article includes evidence that the economy is approaching its potential output level. What is this evidence?

Wages at McDonalds and Walmart were rising. Input prices were beginning to rise, which happens when resources are fully employed.

Consider the following (made up) data for the U.S. economy, and the four money market diagrams. Which money market diagram best represents what happened to this economy from year 1 to year 2?

Y

Read the following excerpts from "As U.S. faces potential downgrade, markets flash alarm over debt-ceiling impasse," Washington Post, October 15, 2013, and answer the question. Stock and bond markets — as well as the system of daily borrowing that helps banks operate and companies make payroll — are flashing increasing concern about whether Congress will find agreement to raise the federal debt ceiling, suggesting that investors may not give lawmakers much more time to haggle before markets swoon. Financial executives said the growing skepticism about the safety of U.S. government debt also threatens to undermine little-known markets that serve as a critical source of funding for all sorts of companies. In these markets, Treasury bills are considered risk-free — equivalent to cash — and are often pledged by companies as collateral to get loans that help pay salaries or finance other expenses. These markets have already shown signs of stress, with interest rates rising. "If that starts to spread, you're going to start seeing the opportunity for a real crisis," said Bob Rice, general managing partner with Tangent Capital Partners, an investment firm. Independent analysts suggest the government will probably have another week before missing payments, though they are not certain. The first significant danger date is Oct. 23, when the government is scheduled to make $12 billion in Social Security payments. By November 1 — when the government has tens of billions of dollars of payments to make toward Social Security and other programs — no analysts expect the administration to be able to make all payments. Some economists thought that if the debt ceiling had not been raised on October 17, the United States could have experienced another recession. The article implies two causes for such a recession. They are

a decline in investment as businesses find it more difficult and expensive to borrow, and a decline in consumption as social security payments are reduced.

The Great Depression of the 1930's may have been caused by a goods market shock, because

an inventory recession started in 1929, then a stock market crash caused uncertainty for businesses and a wealth effect for consumers. Then the Hoover administration increased taxes and the Smoot-Hawley tariff reduced trade.

In 1933 President Franklin Roosevelt declared a "bank holiday." He did this because

bank runs were causing widespread bank failures, so he closed the banks to allow time to adopt new policies.

The Federal Reserve increased the monetary base during 1929-33, yet the money supply decreased. The reason was

banks increased their reserves, so the money multiplier decreased.

When the Federal Reserve uses open market operations and buys Treasury bonds from banks,

banks sell the bonds for money, the money supply increases, and the real interest rate goes down.

Federal Reserve chair Marriner Eccles thought that the Fed needed to buy Treasury bonds to finance a Federal budget deficit. If the Fed did not,

banks would buy the bonds, and would have little left to lend for private investment. Investment spending would be crowded out.

Budget Director Lewis Douglas feared that Federal budget deficits would cause inflation. He reasoned that

big, continuing deficits would require selling Treasury bonds to the Federal Reserve, which would print money to buy them. The added money would lead to inflation.

The goal of counter-cyclical monetary policy during rising inflation is to

decrease aggregate demand, to decrease inflation even if it increases unemployment.

In the consumption function, if disposable income is unchanged, a decrease in the marginal propensity to consume will

decrease consumption spending.

In the consumption function, if the marginal propensity to consume is unchanged, an increase in taxes will

decrease consumption spending.

A tax hike during a recession will

decrease disposable income, decrease consumer spending, decrease aggregate demand, and decrease equilibrium output.

Wars often create rapid expansions of output, and high inflation, because

governments increase their purchases of military goods, which increases aggregate demand, but pay for these goods by printing money, which adds to inflation.

The Hoover administration increased taxes in 1932 to try to balance the Federal budget. This is now seen as a policy mistake, because

higher taxes reduced disposable income, cutting consumption and reducing aggregate demand.

An increase in Federal spending on road construction during a recession will

increase aggregate demand, and increase equilibrium output.

In the consumption function, if the marginal propensity to consume is unchanged, an increase in transfer payments will

increase consumption spending.

Money can be interpreted as a kind of technology that increases the production of goods and services, because

money allows people to specialize in the productive activities they do best.

Suppose our model produces a hypothesis, that increases in the money supply cause decreases in the real federal funds interest rate. We calculate a correlation between this money supply growth and the real federal funds rate for a period of years, and find a correlation of +0.81. This is evidence that

rejects the hypothesis that increases in the money supply reduce the real federal funds rate.

Suppose our model produces a hypothesis, that increases in the money supply cause decreases in the real federal funds interest rate. We calculate a correlation between this money supply growth and the real federal funds rate for a period of years, and find a correlation of -0.08. This is evidence that

rejects the hypothesis that increases in the money supply reduce the real federal funds rate.

Among the reasons that policymakers in the 1930's decided not to build a Social Security trust fund were

tax hikes without benefit payments would cause recession, and currently retired people demanded benefits.

The reform in the Social Security system passed in 1983 created "crowding in." This means that

taxes were increased, which reduces income and money demand. This decreases the real interest rate, which increases investment, which increases potential output growth in the long run.

Suppose we measure the correlation between the Federal Reserve's federal funds interest rate and the CPI core inflation rate Suppose that the correlation coefficient was -0.12 during a period of years. This implies that

the Fed did not follow consistent pro- or counter-cyclical policy during these years.

Suppose we measure the correlation between the Federal Reserve's federal funds interest rate and the CPI core inflation rate Suppose that the correlation coefficient was -0.56 during a period of years. This implies that

the Fed followed pro-cyclical policy during these years.

Suppose we measure the budget balance as a percentage of GDP, by subtracting Federal government spending from Federal government revenues, and dividing the result by GDP. Then we calculate a correlation between this budget balance percentage and the unemployment rate, and find a correlation of +0.05 for a period of years. This means that

the Federal budget was not consistently pro- or counter-cyclical during these years.

In the 2010's Social Security payroll taxes will begin to fall short of benefit payments. As a result,

the Treasury bonds that make up the trust fund will be redeemed, and the Treasury will be obligated to cover the shortfall.

The Federal Reserve thought that interest rates should be increased to fight inflation after World War II. The Treasury prevented this, because

the Treasury had to refinance the huge World War II debt, and higher interest rates would have made this expensive.

During and after World War II, the U.S. Treasury effectively controlled monetary policy, because

the Treasury set the interest rate at which it wanted to borrow, and the Fed had to set the money supply to achieve that interest rate.

In the macroeconomic model, Social Security policy changes affect the economy through

the consumption function, because both taxes and transfer payments affect disposable income.

Using fiscal policy to offset recessions presents a number of problems to policymakers, including

the fact that households may save their tax cuts rather than spend them, and added spending on infrastructure sometimes takes years to plan.

Consider the following paragraph from a Federal Reserve policy statement: Information received since the Federal Open Market Committee met in July suggests that economic activity has been expanding at a moderate pace. Some indicators of labor market conditions have shown further improvement in recent months, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen further and fiscal policy is restraining economic growth. Apart from fluctuations due to changes in energy prices, inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable. The phrase "labor market conditions have shown further improvement in recent months, but the unemployment rate remains elevated" probably means that

the unemployment rate has been falling, but it's still higher than the unemployment rate when equilibrium output equals potential output.