Econ 1010

If the Federal Reserve engages in open market operations, will interest rates in the market for bonds of corporations be affected? Explain exactly how or why not.

(Answer can be either an increase in interest rates or a decrease.) If the Federal Reserve is buying bonds (or expanding the money supply), interest rates on government bonds will fall. Corporate bonds will become more attractive as they now pay relatively higher interest rates. Individuals wanting to take advantage of the higher interest rates will buy corporate bonds. The increased demand will cause corporate bond prices to rise. The higher bond prices mean that interest rates will be lower on corporate bonds.

What approximately has been happening to real GDP over the last year?

+2 percent

State EVERYTHING that happens as a result of Fed buying bonds

1. Bond Prices Increase 2. Interest Rates Fall 3. Bank Deposits and Reserves increase 4. Excess reserves increase 5. Banks make more loans 6. Money supply increases 7. Interest Rates Fall 8. Investment Spending increases 9. Income and investment spending increase 10. rGDP increases by a multiplied amount 11. employment is up; employment is down 12. Prices increase

What is the approximate current target federal funds rate?

1.25%

What has the approximate rate of inflation been over the last year?

1.5%

What is the approximate current GDP?

19 trillion

A developing economy's current consumer price index for this year is equal to 300. What is the annual rate of inflation over the last year if the CPI was 250 one year ago?

20 percent

Assume that the U.S. economy is functioning at the natural level of unemployment. What would be the approximate level of unemployment?

4-4.5%

What is the approximate current rate of unemployment?

4.5%

An economy is producing at full employment. Spending in the economy increases. What will happen in the short run? A Real GDP will increase and the price level will rise. B Real GDP will decrease and the price level will rise. C Real GDP will increase and the price level will fall. D Real GDP will decrease and the price level will not change.

A Real GDP will increase and the price level will rise.

A decrease in the savings rate will likely cause an ______________ in the slope of the consumption function in the income expenditure model. & why?

A decrease in the savings rate will increase the marginal propensity to consume. As a result, the slope of the consumption function will increase.

Which is likely to have a larger effect on real GDP - A fiscal stimulus or a fiscal restraint? Both are the same absolute size. Why?

A physical restraint because if individuals and businesses are nervous about expected economic conditions, they may save larger portions of increased incomes with a fiscal stimulus. In that case, the multiplied effect will be smaller than it otherwise would be.

What is a recession?

A recession includes a significant decline in production and employment, lasting for more than a few months. Therefore, in a recession, the short-run equilibrium output is below the full employment output.

Why is a reduction in the Federal deficit an increase in national saving? Why will investment cause higher productivity?

A reduction in the federal deficit means that the federal government is borrowing a smaller portion of overall saving. Thus, that amount of saving left over and available for investment is now greater. Interest rates will decrease and investment spending is likely to increase as a result.

Assume that something causes demand to decrease. Explain exactly why buyers and sellers begin to change their prices. (You do not have to explain why demand decreases. You do not have to go beyond the explanation of why the prices might begin to change.)

A surplus will be created by the decrease in demand. Some sellers will see that they cannot sell all that they are producing at the going price. They will lower their prices in order to be able all that they are producing. Some buyers will see the surplus and see an opportunity to get the product at a lower price and thus make lower offers.

When price of an important input increases, what happens to AS and AD?

AS: Decreases AD: No change

What should the Federal Reserve do about the level of stock prices?

According to the article, "the Fed's job is to influence aggregate demand and help it grow at a sustainable noninflationary rate." Part of that job certainly is to be concerned with factors like the level of stock prices, if the level makes the use of monetary policy more difficult. The challenge, however, is in knowing how or whether anything can be done.

An economy is producing at full-employment. Spending in the economy increases. Prices and output will increase. What will happen in the long run following the short-run changes? Why?

After the short-run effects, the level of output will be above the natural level. Eventually, the tight labor and product markets will result in rising costs and prices, which will reduce real output. That process will continue until the economic returns to its natural level of output, at a higher price level than in the beginning and immediately after the increase in spending; so rGDP will decrease and PL will rise in long run

An increase in spending in the economy will cause which of the following changes in interest rates?

An increase in interest rates as the demand for money increases

An increase in interest rates will cause planned total spending to change at each level of output and income. How and why?

An increase in interest rates will raise the cost of making investments. Investment spending will therefore decrease at each level of output. As investment is part of total spending, total spending will fall at each level of output.

Compare the effects on economic growth of an increase in the population with the effects on economic growth of an increase in investment in physical capital.

An increase in population will eventually increase the size of the labor force. If employed, this increase will likely increase real GDP. An increase in the population however will not necessarily increase per capita real GDP. If physical capital increases, not only will real GDP likely increase, real GDP per capita will increase.

Assume the economy is at full employment. An increase in government spending will have what effect over time?

An increase in real GDP and prices, followed in the long run by a period of decreasing real GDP and increasing prices;When there is an increase in aggregate demand, output rises above its full employment level. The low rate of unemployment puts upward pressure on wages as workers begin to demand higher wages. Higher wages, in turn, lower aggregate supply. Thus, output returns to the full employment level.

What effect does productivity have on inflation? Why?

As agregate supply increases due to rise in productivity, downward pressure will be put on prices-- thus, there will be a less inflationary pressure

An increase in interest rates causes the: A Quantity demanded of money to increase B Quantity demanded of money to decrease C Demand of money to increase D Demand of money to decrease

B: Quantity demanded of money to increase

An increase in real GDP will be most likely to cause further increases in __________.

Consumption and investment, but a decrease in net exports

An increase in interest rates will cause investment spending to (increase or decrease). Why?

Decrease. A cost of making an investment is the cost of borrowing the money (the interest that must be paid) or the lost income (the interest that would have been earned) if a business uses its own money. In making a decision to invest, a business will compare the expected benefits with the expected costs. At a higher interest rate, more investments will not be profitable and the total amount of investment spending will be reduced.

A competitive market for a good is in equilibrium. Assume there is an increase in the cost of manufacturing the good. Explain exactly, that is, each and every step in the process, how and why changes occur in the market for the good. Why do the changes stop?

Given that producers' costs increase, businesses will want to produce less at existing prices in order to decrease losses. There will a shortage of goods produced at the current market price. Some producers will raise prices, because they know they can sell all they are producing at a higher price. Some buyers will offer higher prices, because they see that sellers are not going to produce all that consumers want at the existing price. As the price increases, suppliers will increase production (or quantity supplied). There are now greater incentives as prices are above costs of producing. An increase in the amount produced will raise the cost of each additional unit of production. The cause is diminishing marginal product. In this case marginal cost of producing is increasing as production is increasing. As the price increases, buyers will decrease their quantities demanded, because their opportunity costs are higher, that is, they have to give up more other goods to purchase this good. As the quantity demanded falls and the quantity supplied increases, the shortage becomes smaller. The processes of sellers and buyers increasing prices, the decreases in quantity demanded, and the increases in quantity supplied continue until the quantity demanded and quantity supplied are equal. At that point, there is no longer any pressure for buyers or sellers to change prices or quantities. The process ends with a higher equilibrium price and a lower equilibrium quantity than before the increase in the costs of manufacturing.

(Ch 17) explain in your own words why the value of the marginal product at each level of capital used gives us a demand curve for capital.

Given the cost of the capital, machines are going to be purchased or rented up to the point where the value of the marginal product is just equal to the cost of the capital. In other words, the value of the marginal product gives us a demand curve for capital

Assume that the economy is currently producing a level of real GDP above the full employment level of real GDP, and the government lowers taxes as part of a new economic policy. What of the following monetary policies should the Federal Reserve undertake if it wants to encourage the economy to go to a full employment level of output?

If the economy is already producing above the full employment level of real GDP, there is already upward pressure on prices. A tax decrease will shift aggregate demand out putting further upward pressure on prices. To offset this pressure, the federal reserve needs to reduce aggregate demand. One way to do so is to raise the federal funds rate target.

Why is the agregate demand curve downward sloping?

If the price level changes, the real wealth of consumers out of their money holdings changes, which changes consumption. The change in the price level also changes the demand for money, which causes interest rates to change and in turn leads to changes in investment. Furthermore, a change in the price level leads to changes in the relative price of domestic goods, which affects net exports.

Explain why a level of production of a good that is greater than or less than the equilibrium amount of output is or is not allocatively efficient.

If we are producing less than the equilibrium quantity, the amount buyers are willing to pay for the last unit produced is greater than the cost of producing the good. The cost of getting the good is the price that would have to be paid to get producers to produce the good. Thus, for allocative efficiency, we should produce more. Consumers value it more than alternatives.If more than the equilibrium amount is being produced, the amount buyers are willing to pay for the last unit produced is less than what we would have to pay producers to produce the good. Thus, for allocative efficiency, we should produce less. Consumers to not place as much value on this product as they have to give up.

What impact does an increase in investment have on AD?

Increases AD

Inflation can result from a change in aggregate demand or a change in aggregate supply. How can one tell which of the two has caused the inflation?

Inflation caused by demand is accompanied by rising real GDP, while inflation caused by aggregate supply comes with relatively low real GDP. This is because Demand-side inflation leads to budget deficits, while supply-side inflation contributes to budget surpluses.

Suppose that a federal budget requirement that the budget be balanced or in surplus passes. What will be the effect on fiscal policy? Why?

It would make fiscal policy more difficult to use to stimulate an economy because A stimulative fiscal policy requires a reduction in taxes or an increase in spending. Depending upon the current status of the budget, either policy could create a budget deficit and therefore not be allowed.

In economy A, we are in the middle of a recession. In economy B, we are experiencing a demand-pull inflation. Assume that total spending increases in both economies. Economy A's price level will change by ______________ economy B's price level. Economy A's real GDP will change by ______________ economy B's real GDP.

Less than; More than

Compare two economies, A and B. Everything is the same except economy A is in recession, and economy B is at full employment. Assume that consumption spending increases. Economy A's price level will change by ______________ than economy B's price level. Economy A's real GDP will change by ______________ than economy B's real GDP level.

Less, more

What expressions describe the full employment level of output?

Long run level of real GDP, Full-employment level of real GDP, Potential level of real GDP

If the aggregate supply is perfectly inelastic in an economy, does an increase in spending change real GDP?

No

Suppose increases in the costs of producing automobiles occur at the same time as a growth in the adult population. What will be the effects on the quantities of automobiles produced? (The next question asks about prices.)

One cannot tell.

What are the major factors in influencing economic growth in per capita real GDP?

Physical capital, technology, and education

What happens to the price level as a result of an increase in spending?

Prices increase

Summarize the potential effects of changes in stock market prices on the "real economy."

Prices of stocks, according to the article, can affect employment and output in three ways. The wealth effect is that a fall in stock prices will decrease wealth and cause consumption to fall. Lower stock prices mean that it is more expensive to raise money for investment and therefore investment spending falls. Confidence may be affected - and if it falls, consumption and investment are likely to fall.

An economy is currently producing at a level of output that is equal to the full-employment level of output. Prices of a fundamental resource, such as oil, increase significantly. What will happen with no policy? Why?

Real GDP will decrease and the price level will increase: Aggregate supply decreases as prices of inputs increase. Spending is greater than production, prices rise, aggregate quantity supplied increases, and aggregate quantity demanded decreases. A short-run equilibrium is reached at less the natural level of output.

If an economy is currently producing at a level of output that is greater than the full-employment level of output, what will eventually happen with no policy? Why?

Real GDP will decrease and the price level will rise: Labor market are extremely tight and prices are likely to have recently increased. As wages are bid up, costs rise and prices increase. As prices increase, interest rates rise, decreasing consumption and investment spending. There is a multiplied decrease in spending and the economy returns to the full-employment level of output.

An economy is currently producing at a level of output that is less than the full-employment level of output. What will eventually happen with no policy? Why?

Real GDP will increase and the price level will decrease: Eventually, the unemployment will put downward pressure on wages and costs. That will permit businesses to lower prices to encourage increased spending.

When the Federal Reserve announces that is increasing the federal funds rate, we would expect to see banks do which of the following?

Reduce their loans because they have fewer reserves due to the Fed's open market sales

An economy is in a long-run equilibrium. Spending in an economy increases. The economy reaches a short-run equilibrium. Explain the natural process of adjustment after the economy reaches that equilibrium. What causes the natural adjustment? What happens as a result? What influences how long it takes, relative to other natural adjustments in the overall economy?

SAMPLE ANSWER 3

Suppose the Federal Reserve buys bonds. Describe what happens in the economy as a result and what determines the sizes of the changes. You do not need to explain exactly why, but do list the steps in the sequence of events.

SAMPLE ANSWER 3

When the federal reserve announces that it is increasing the federal funds rate, it is actually going to ___________.

Sell bonds on the open market until the federal funds rate rises the new target

In our model of aggregate supply and aggregate demand, how does expansionary monetary policy work to increase real GDP and the price level?

The Fed buys bonds Causes bond prices to rise and yields to fall. Federal Funds rate falls because treasury bonds are a close substitute for overnight loans to other banks. Since the Fed bought bonds, banks now have excess reserves and will make more loans, increasing the money supply. Because interest rates are lower and banks are lending more, businesses increase investment spending. This increases income so consumption spending also increases at any given price level. This is an increase in AD. At the old price level, spending exceeds production so inventory falls. Businesses increase production and prices, spending falls until a new equilibrium is reached.

Given an economy in equilibrium, describe exactly, that is, by each step, what will happen to spending and output in an economy if the Federal Reserve causes interest rates to increase. Be sure you explain why each change happens.

The cost of making an investment increases. Investment spending will decrease as some investment projects are no longer profitable to make. Thus, total spending will now be less than output. Inventories will increase, causing business to decrease production. As businesses decrease production, income falls because each dollar of output becomes income. Since consumption depends upon income, consumption will fall also. Consumption spending falls by less than the decrease in income because people decrease saving and consumption as income decreases. Part of the decrease in income comes from saving. (An alternative explanation is that the marginal propensity to consume is less than one.) This process continues. The decrease in spending causes a fall in income which in turn decreases spending by a smaller amount. Output and spending will eventually be equal as the decreases in spending become smaller and smaller. The fall in output and spending stops. There are no longer incentives to decrease output. The total decrease in real GDP will be larger than the original decrease in investment because it is followed by additional decreases in consumption. As this process is continuing, the overall price level should begin to fall as producers cannot sell all that they produce at the initial price level. As the price level decreases, the aggregate quantity demanded increases (from their now lower levels) and the aggregate quantity supplied decreases. The economy will end up with a lower price level and a level of output that is lower than the original level. (That level will be higher than the multiplied fall in spending that would have occurred without a change in prices.)

What is the real cost of inflation?

The economy produces less than it otherwise would

An economy is initially in equilibrium. Suppose that the government decides to increase spending and that simultaneously, consumers become more optimistic.

The first item is the initial change to the model: Aggregate demand increases. Each subsequent item should be a direct result of the previous item. At the old price level, desired spending exceeds production so inventories begin to fall. Businesses respond by increasing output but this causes marginal cost to rise so businesses begin to increase prices. As prices rise, spending on consumption, investment, and net exports decreases until a new equilibrium is reached at a higher price level and a higher level of output.

An economy is initially in equilibrium. Suppose that a natural disaster destroys some of the physical capital in the economy. What changes follow?

The first item is the initial change to the model: With less capital, businesses cannot produce as much as before. Output initially falls and aggregate supply shifts left. Each subsequent item is a direct result of the previous item. At the old price level, desired spending exceeds production so inventories begin to fall. Businesses respond by increasing output but this causes marginal cost to rise so businesses begin to increase prices. As prices rise, spending on consumption, investment, and net exports decreases until a new equilibrium is reached at a higher price level and a higher level of output.

Does the stock market/real economy relationship make a difference for the conduct of normal monetary policy?

The potential effects of the stock market on the "real economy" make monetary policy more difficult. If the Federal Reserve were to slow spending by raising interest rates, one of the side effects is that stock prices would fall and potentially have an additional negative effect on spending. The ultimate effects of a specific monetary policy, then, are more difficult to predict.

"If monetary policy is used to stimulate an economy during a recession, one of the costs will be a permanently higher level of prices." Evaluate this statement.

The statement is correct. Monetary policy lowers interest rates and thus raises investment spending. The higher spending causes businesses to raise prices. The economy returns to full employment at a higher price level. If the economy is left alone, the increased unemployment will eventually cause wages to fall and the economy will return to full employment at a lower price level. On the other hand, if the Fed does nothing, the natural adjustment will take significantly longer to occur and many families will suffer through higher unemployment in the meantime.

An economy is producing at a level of output that is equal to the full-employment level of output. Prices of a fundamental resource, such as oil, increase significantly. After the short-run equilibrium is reached, what will eventually happen to real GDP and prices? Why?

There is unemployment in the short-run equilibrium. Wages begin to come down. Costs of producing fall. Prices begin to fall. Aggregate quantity demand begins to increase. The process continues until there is no longer excess capacity.

What happens to the level of unemployment because of increased spending? Why?

Unemployment falls below the full employment rate of unemployment because output exceeds the full employment rGDP.

When there is high unemployment, what tends to happen to wages?

Wages fall

Compare two possible situations: I. Current real GDP is above the full employment level of real GDP. II. Current real GDP is below the full employment level of real GDP. Which of the following is most likely and why?

Wages will rise in situation I and fall in situation II. Because When output is above its full employment level, the low rate of unemployment puts upward pressure on wages as workers begin to demand higher wages. When output is below its full employment level, the high rate of unemployment puts downward pressure on wages.

Why does a customer repaying a loan shrink the money supply?

When a borrower is paying off a loan, the bank collects the borrower's currency. If no new loans are created from this currency, then the money supply shrinks. For example, if the borrower paid $1 of the loan to the bank, then that $1 is not being lent out to another customer. Recall the simple money multiplier causes the money supply to grow. So when $1 is not loaned, then the growth that was created by the simple money multiplier does not occur. The money supply will decrease if the bank holds the $1 and does not lend it out then that $1 shrinks the economy by the amount of the simple money multiplier.

What is cost-push inflation?

When inflation is caused by changes in higher prices of inputs or higher costs of production

What is demand-pull inflation?

When the cause of inflation is aggregate demand increasing more rapidly than aggregate supply

Describe the appropriate monetary policy to use in a recession caused by a negative aggregate demand shock. How will it work?

When there is a negative aggregate demand shock, the price level and will be below the Fed's target and unemployment level will be above the Fed's target. The Fed should engage in expansionary monetary policy in order to get the aggregate demand curve back to the point at which the economy will be operation at full employment and 2% inflation. The Fed should reduce the federal funds rate by buying bonds on the open market. The lower interest rate will increase planned investment spending and total planned spending at any given price level. If done to the correct degree and if nothing else changes, this will cause output to rise back to the level that is consistent with full employment.

An increase in bond prices will have which of the following effects? a) an increase in investment spending in a GDP sense and a decrease in interest rates b) a decrease in investment spending in a GDP sense and a decrease in interest rates c) an increase in investment spending in a GDP sense and an increase in interest rates d) a decrease in investment spending in a GDP sense and an increase in interest rates e) one cannot tell about either investment or interest rates

a) an increase in investment spending in a GDP sense and a decrease in interest rates

If saving in a country increases, what is likely to happen to the current account balance? a. A trade deficit is likely to decrease. b. A financial account deficit is likely to increase. c. The trade deficit or surplus is unlikely to change, but the financial account surplus or deficit is likely to change. d. The trade deficit or surplus is likely to change, but the financial account surplus or deficit is unlikely to change.

a. A trade deficit is likely to decrease.

The U.S. is currently experiencing which of the following? a. A current account surplus and a financial account surplus. b. A current account surplus and a financial account deficit. c. A current account deficit and a financial account surplus. d. A current account deficit and a financial account deficit.

c. A current account deficit and a financial account surplus.

An increase in real GDP in the U.S. will cause which of the following to happen? Assume that the increase in real GDP is the only change. a. The U.S. trade surplus will likely increase. b. The U.S. trade surplus will likely decrease. c. The U.S. trade deficit will likely increase. d. The U.S. trade deficit will likely decrease. e. Nothing will likely change about a trade deficit or surplus.

c. The U.S. trade deficit will likely increase.

An increase in real GDP will likely cause interest rates to __________. An increase in interest rates will likely cause real GDP to __________. a) increase; increase b) decrease; increase c) decrease; decrease d) Increase; decrease e) at least one part of one of the answers is

d) Increase; decrease

A decrease in unemployment compensation payments would be most likely to do which of the following:? - increase frictional unemployment - decrease frictional unemployment - not change unemployment - decrease structural unemployment - increase structural unemployment

decrease frictional unemployment

A decrease in net exports will likely cause GDP to _________. A separate increase in GDP will likely cause net exports to ___________. Assume everything else remains the same.

decrease; decrease

Suppose a government creates a new subsidy paid to producers of a service in a competitive market. Once the market has time to adjust to a new equilibrium, the amount actually produced in the market will be:

greater than the allocatively efficient amount.

What kind of change in our model results in higher incomes and lower prices?

increase in AS

As income increases in an economy, consumption spending normally does which of the following:? decreases at a slower rate than the increase in income increases at a slower rate than the increase in income decreases at a faster rate than the increase in income increases at a faster rate than the increase in income one cannot tell about the rate of change

increases at a slower rate than the increase in income

Consumers have a large number of substitutes for bananas. An increase in the price of bananas will cause a __________ change in ________ for bananas than would occur in the market if there were few substitutes.

larger; quantity demanded

An increase in supply will cause the equilibrium price to change by _________ and the equilibrium quantity to change by ________ with an inelastic demand than if demand were elastic.

more; less

Consider market with an inelastic demand experiences an increase in supply. Compare the outcome in that first market with a second market that has the same increase in supply, but has an elastic demand.

price will change by less in the second market; quantity will change by more in the second market.

How does a higher cost of production affect rGDP and price level in the short run?

rGDP: Decrease Price Level: Increase

Suppose increases in the costs of producing automobiles occur at the same time as a growth in the adult population. What will be the effects on the prices of automobiles produced?

the equilibrium price will increase

When output is below its full employment level, what type of pressure is put on wages and why?

the high rate of unemployment puts downward pressure on wages.

When output is above its full employment level, what type of pressure is put on wages and why?

the low rate of unemployment puts upward pressure on wages as workers begin to demand higher wages.

If buyers and sellers in financial markets expect the Federal Reserve to increase the federal funds target interest rate, what will be the result in the market for bonds before the Federal Reserve acts? Why?

​As bond traders expect bond prices to fall, they will sell bonds now, pushing the prices of bonds down now. This will cause interest rates to rise before the Fed has acted.

If the Federal Reserve believes the unemployment rate is above the natural rate, what should it do with monetary policy to fix the problem? Explain in detail: each step, why, and exactly how the policy will take the economy to a new short-run equilibrium. That is, demonstrate that you fully understand the process.

​The Federal Reserve should buy bonds (or lower any or all of the following: the interest rate on excess reserves, reserve requirements, or the discount rate). Buying bonds means businesses and individuals deposit the checks received for the bonds in their checking accounts. Deposits and reserves increase. Banks will increase loans in order to increase profits and will find it necessary to lower interest rates to do so. The money supply increases and interest rates fall. (An alternative explanation is the bidding up of bond prices and the simultaneous fall in interest rates.) Lower interest rates mean that the cost of investment decreases. Business will increase investment spending as a result, because now some additional investment projects will be profitable. Total spending will increase by a multiple of the initial increase. The reason is the increase in incomes as a result of the new spending creates additional consumption. Total spending is greater than production. Inventories will fall. Businesses will begin to expand production but will need higher prices to cover the increased costs of doing so. Costs increase if conditions in the economy are such that it becomes more expensive to produce as the economy approaches full employment. Higher prices reduce total spending. The increase in prices reduces real wealth. The fall in real wealth reduces consumption spending. Net exports fall. Investment falls. This process of rising production and falling spending continues until production and spending are equal. At that point, a new short-run equilibrium will have been reached.