ECON 640 Test 3
Why did China fare much better than the United States and the United Kingdom during the 2007-2009 financial crisis? (Check all that apply.)
China pursued an autonomous easing of monetary policy. Your answer is correct. and The Chinese economy is less closely tied to the functioning of financial markets than the economies of the United States and the United Kingdom.
What are the four components of planned expenditure? Why did Keynesian analysis emphasize this concept?
Consumption expenditure, planned investment spending, government purchases, and net exports. Keynes viewed the total amount of output demanded in the economy as being the same as planned expenditure. This is true when the planned expenditure on goods and services is equal to the actual amount of goods and services produced.
The government budget constraint is:
DEF = G-T = MB + B
If financial frictions increase, consider what happens to equilibrium output and explain how it affects the relevant component(s) of planned spending
Equilibrium output will decrease since such an initial change decreases planned investment spending.
"The Fed decreased the fed funds rate in late 2007, even though inflation was increasing. This demonstrates a violation of the Taylor principle." Is this statement true, false, or uncertain? Explain your answer.
False. It was the autonomous component of the fed funds rate that was decreased through an autonomous monetary policy easing. The Fed's distaste for inflation did not change and remained positive.
What is the calculation to find the growth rate between two numbers? Give an example.
From 10 to 11, take 11/10 = 1.1 1.1*100% = 110% 110%-100% = 10%
What is the aggregate demand curve?
It is the relationship between the inflation rate and aggregate output when the goods market is in equilibrium.
Using the line drawing tool, show how the economy will self-correct.
Lower wages reduce production costs, and thus short-run aggregate supply shifts rightward until the natural rate of output is reached.
If velocity (V) and aggregate output (Y) remain constant at $4 and $1,250 billion, respectively, what happens to the price level (P) if the money supply (M) declines from $400 billion to $300 billion?
M x V = P x Y 400*4 = 1600 1600/1250 = 1.28 Originally, the price level is 1.28 After the money supply decreases, the price level is 0.96 since, based on the equation above, 300*4 = 1200 and 1200/1250 = 0.96
Assume that autonomous consumption is $1,680 billion and disposable income is $12,300 billion. Using the consumption function, calculate consumption expenditure if an increase of $1,000 in disposable income leads to an increase of $620 in consumption expenditure.
9306 billion 1680+0.62*12300 0.69 is derived from the 620 increase in consumption expenditure from $1000 in disposable income (move the decimal on 620 three places to the left)
Classify the following situation as a supply or demand shock: Households and firms become more optimistic about the economy. Determine the effects on inflation and output in the short run and the long run using AD/AS graph analysis. In the short run, output_____ and inflation _____ . In the long run, output _____ to potential and inflation _____
A positive demand shock increases; increases; falls; rises
Both the portfolio choice and Keynes's theories of the demand for money suggest that as the relative expected return on money falls, demand for it will fall. Why would the portfolio choice approach predict that money demand is unaffected by changes in interest rates? Why did Keynes think that money demand is affected by changes in interest rates?
A rise in interest rates leads to an increase in the implicit interest paid on checkable deposits, so the relative expected return on money only falls by a small amount. A rise in interest rates leads to a lower relative expected return on money and hence a lower demand for money.
What causes the IS curve to shift?
A shift in the IS curve occurs when equilibrium output changes at each given real interest rate. The factors of shifting are autonomous consumption, autonomous investment, autonomous net exports, taxes, and government purchases.
Suppose a given country experienced low and stable inflation rates for quite some time, but then inflation picked up and over the past decade has been relatively high and quite unpredictable. Explain how this new inflationary environment would affect the demand for money according to the portfolio theories of money demand. What would happen if the government decides to issue inflation-protected securities?
According to the portfolio theories of money demand, the demand for money decreases because individuals will prefer to hold more stable assets and less money. The demand for money will decrease.
Total spending, P X Y, is also known as what?
Aggregate nominal income for the economy or nominal GDP
During and in the aftermath of the financial crisis of 2007-2009, planned investment fell substantially, despite significant decreases in the real interest rate. Which of the following factors related to the planned spending function could explain this? (Check all that apply.)
An increase in financial frictions. A decrease in firms' planned autonomous investment.
Why is it necessary for the MP curve to have an upward slope?
An upward-sloping MP curve keeps inflation from spinning out of control.
What is the total amount of spending on final goods and services produced in the economy?
P X Y Where P = price level and Y = aggregate output
Why do increases in the real interest rate lead to decreases in net exports, and vice versa?
Rises in the real interest rate lead to a higher value of the dollar, which in turn leads to a decline in net exports.
What would be the effect of an increase in U.S. net exports on the aggregate demand curve?
The aggregate demand curve shifts to the right.
What is velocity of money?
The average number of times per year (turnover) that a dollar is spent in buying the total amount of goods and services produced in the economy
In Keynes's analysis of the transactions demand for money, what will happen to money demand if people's incomes increase?
The demand for money will increase because Keynes believed that people would require more money for more transactions.
What is the equation of exchange?
The equation MV=PY, which relates nominal income to the quantity of money. Therefore, quantity of money multiplied by the number of times that money is spent is equal to nominal income.
Monetary theory
The study of the effects of money and monetary policy on the economy
Using the line drawing tool, show the effect of increased oil prices on the short-run aggregate supply curve. Label your new line 'AS2'.
The supply curve shifts to the left
During the first half of 2010, Fed officials discussed the possibility of increasing interest rates as a way of fighting potential increases in expected inflation. If the public came to expect higher inflation rates in the future, what would be the effect on the short-run aggregate supply curve.
The supply curve would shift to the left
What three motives for holding money did Keynes consider in his liquidity preference theory of the demand for real money balances? (Check all that apply.) Based on these motives, what variables did he think determined the demand for money? (Check all that apply.)
Transactions motive Speculative motive Precautionary motive Nominal interest rate Income
What is the equation for velocity of money?
V = P X Y / M
Both short-run and long-run equilibria require that the quantity of aggregate output demanded and the quantity supplied are _____ Beyond this equality, the attainment of a long-run equilibrium also requires that actual output _____ potential output
equal equals
Suppose the economy is starting from a situation of long-run equilibrium. In this case, we know that its equilibrium output (Y*) is _____ its potential output (YP).
equal to
Supply shocks are exogenous events that cause _____ the aggregate supply curve. Supply shocks that are positive are events that induce, at any given inflation rate, _____ in supply, thus shifting the AS curve _____. Compared to positive supply shocks, negative supply shocks have the _____ effect on aggregate supply. Whether positive or negative, supply shocks that ultimately make output and inflation different are _____
shifts in; an increase; rightward; opposite; permanent.
Demand shocks are exogenous events that cause _____ the aggregate demand curve. Demand shocks that are negative are events that induce planned spending at any given inflation rate to _____ thus pushing the AD curve _____. Compared to negative demand shocks, positive demand shocks have _____ effect on aggregate demand.
shifts in; fall; leftward; the opposite;
According to the quantity theory of money, in the long run:
the inflation rate is the growth rate of the money supply minus the growth rate of aggregate output.
If the government deficit is not financed by increased bond holdings by the public
the monetary base and the money supply increase.
The long-run aggregate supply curve is:
vertical because changes in labor, capital, and technology (not the inflation rate) change the output an economy can produce over the long run.
1. What happens to aggregate output if both taxes and government spending are lowered by $300 billion and mpc = 0.5? Explain your answer. (For all of the following, round your responses to the nearest integer.)
1. As a result of the reduction in taxes, consumer expenditure increases by 150 billion (300*0.5) 2. The net change in autonomous spending is −$150 billion 3. Since the multiplier is 2 (1/1-mcp where mcp = 0.5), aggregate output falls by 300 billion (2*150)
If the marginal propensity to consume is 0.90, how much would government spending have to rise to increase output by $5,000 billion? How much will taxes need to decrease to increase output by $5,000 billion?
1/(1-mcp) mcp = 0.90. 1/(1-0.90) = 10 5000/10 = 500 < which is the answer 5,000/(-0.09/(1-0.09)) = -556
Why does the aggregate demand curve slope downward?
A rise in inflation works through the increase in real interest rates to reduce the equilibrium quantity of aggregate output.
Suppose that Dell Corporation has 17,000 computers in its warehouses on December 31, 2012, ready to be shipped to merchants (each computer is valued at $500). By December 31, 2013, Dell Corporation has 23,000 computers ready to be shipped, each valued at $450 A: Calculate Dell's inventory on December 31, 2012. B: Calculate Dell's inventory investment in 2013. C: What happens to inventory spending during the early stages of an economic recession?
A: 17,000*500 = 8,500,000 B: 23,000*450 = 10,350,000 10,350,000-8,500,000 = 1850000 < Final Answer C: Inventory spending will be positive for some time, but firms will quickly cut production and try to sell their already manufactured goods before increasing production again.
A: According to the consumption function, what variables determine aggregate spending on consumer goods and services? B: How is consumption related to each of these variables?
A: Consumer spending depends on disposable income, the real interest rate, and other variables such as consumers' optimism and wealth. B: C = C with overhead line + mcp(Y - T) - cr where C with overhead line is the autonomous consumption expenditure, Y is aggregate output, T is taxes, mpc is the marginal propensity to consume, r is the real interest rate, and c is a parameter that reflects how responsive consumption expenditure is to the real interest rate.
Why does the IS curve slope downward?
As the real interest rate rises, consumption expenditure, planned investment spending, and net exports fall, which in turn lowers planned expenditure. Aggregate output must be lower for it to equal planned expenditure and satisfy goods market equilibrium. Hence, the IS curve is downward-sloping.
If the Federal Reserve increases the money supply at the same time that Congress implements an income tax cut, then which of the following is true?
Both of these actions will increase aggregate demand.
Using the line drawing tool, show the effect of increased government spending on the aggregate demand curve. Label your new line 'AD2'.
Draw a line that is parallel, and to the right
According to the portfolio theories of money demand, what are the four factors that determine money demand? (Check all that apply.) What changes in these can increase the demand for money?
Expected return. Liquidity of other assets. Wealth. Risk of other assets. The demand for money increases when wealth or the risk associated with other assets increases, and it decreases when expected return or liquidity of other assets increases or when the risk of inflation increases.
Why can the Fed control the real interest rate in the short run but not in the long run?
It adjusts for inflation, and prices are sticky in the short run. Hence, when a change in the Fed's monetary policy causes the nominal interest rate to change, the real interest rate also changes in the same direction. In the long run, actual and expected inflation change in response to changes in monetary policy, leaving the real interest rate unaffected.
What relationship does the aggregate supply curve describe?
It describes the relationship between the total quantity of output supplied and the inflation rate.
What is the monetary policy curve?
It indicates the relationship between the inflation rate and the real interest rate.
What does the IS curve show?
It shows equilibrium points in the goods market—the combinations of the real interest rate and equilibrium output.
If net exports were not sensitive to changes in the real interest rate, would monetary policy be more or less effective in changing output?
Monetary policy would be less effective in changing output because net exports: represent an additional channel through which interest rate changes can affect output.
Why does the monetary policy curve slope upward? (Check all that apply.)
Monetary policymakers will follow the Taylor principle and respond aggressively to an increase in the inflation rate by raising nominal interest rates by an even greater amount so that the real interest rate also rises. When inflation increases, the supply of real money balances declines. This increases the equilibrium nominal interest rate in the money market, which also increases the real interest rate in the short run.
In Keynes's analysis of the speculative demand for money, what will happen to money demand if people suddenly decide that the normal level of the interest rate has declined? Why?
Money demand will decrease because as interest rates fall, the price of bonds rises. The relative increase in the expected return on bonds makes money less attractive.
The top portion of the following table lists several demand shocks along with several exogenous events that do not affect the position of the aggregate demand curve. A response box is attached to each event. The table's bottom portion contains a labeling key. For a positive demand shock, use the label P; similarly, for a negative demand shock, use the label N. Label any exogenous event that does not impact AD with an X. (Note: Each letter is used three times.)
N The Federal Reserve autonomously tightens monetary policy. X The government adopts ill-advised regulations that diminish the economy's overall efficiency. N The government imposes much higher taxes on households. X A temporary disruption in oil production occurs, pushing oil prices higher. P Consumer optimism surges as the media reports encouraging news about the economy. X The nation's labor unions push forcefully for higher wages and expanded benefits. P Foreign economies rebound, producing a substantial rise in net exports. P Sudden optimism within the business community induces a big jump in planned business expenditures. N Peace breaks out, enabling the government to substantially curtail defense expenditures.
The primary factor that shifts the short-run aggregate supply curve is changes in:
Production costs
An economy's aggregate demand is shown graphically as a downward-sloping curve. The position of this curve relative to the vertical axis is impacted by six basic factors. The top portion of the following table lists these six factors along with several that do not affect the position of the aggregate demand curve. A response box is attached to each factor. The table's bottom portion contains a labeling key. Label any factor that does not impact AD with an X. For a factor that shifts aggregate demand to the right, use the label R; similarly, for a factor that shifts aggregate demand to the left, use the label L. Keep in mind that each factor is to be assessed on the assumption that all else is constant. (Note: Each letter is used three times.)
R The Federal Reserve autonomously loosens monetary policy. X The government rescinds ill-advised regulations that hamper the economy's overall efficiency. L The government allows previously enacted tax cuts to expire, resulting in much higher taxes for households. X The prospect of worsening inflation induces the Federal Reserve to tighten monetary policy. L Consumer pessimism spreads as the media reports disappointing news about the economy. X Actual output rises above potential output, creating "tightness" in resource markets. L Foreign economies crash, producing a substantial drop in net exports. R Optimism within the business community induces a surge in planned business expenditures. R War breaks out, forcing the government to substantially enhance defense expenditures.
Supply shocks are exogenous events that cause _________ the aggregate supply curve. Supply shocks that are positive are events that induce, at any given inflation rate, _____ in supply, thus shifting the AS curve _____ Compared to positive supply shocks, negative supply shocks have the _____ effect on aggregate supply. Whether positive or negative, supply shocks that ultimately make output and inflation different are _____ The top portion of the following table lists several supply shocks along with several exogenous events that do not affect the position of the aggregate supply curve. A response box is attached to each event. The table's bottom portion contains a labeling key. For a positive supply shock, use the label P; similarly, for a negative shock, use the label N. Label any exogenous event that does not impact AS with an X. (Note: Each letter is used three times.) In the preceding table, the permanent supply shocks are associated with _____
Shifts in and increase ; rightward opposite permanent X The Federal Reserve autonomously tightens monetary policy. N The government adopts ill-advised regulations that diminish the economy's overall efficiency. P The U.S. dollar sharply appreciates, suddenly lowering the prices of imported inputs. X Foreign economies rebound, producing a substantial rise in net exports. P Phenomenally good weather leads to outstanding harvests of most grains. N The nation's labor unions aggressively press for higher wages and expanded benefits. P Startling advances in nanotechnology dramatically raise productivity across the economy. X Sudden optimism among firms induces a big jump in planned business expenditures. N Hurricanes blast the U.S. Gulf Coast, seriously damaging refining facilities. regulations and technology
In its May 9, 2010 edition, the Wall Street Journal printed, "The dollar weakened [...] and stocks [...] followed suit. The Dow industrials fell 139.89 points, or 1.3%." What effect does the weakened dollar have on the IS curve? What effect does the decrease in stock prices have on the IS curve? What is the combined effect of these two events on the IS curve?
The IS curve shifts to the right The IS curve shifts to the left These events may have opposite effects on the IS curve, thus the combined effect on the IS curve is indeterminate.
What effect does the weakened dollar have on the IS curve? What effect does the decrease in stock prices have on the IS curve? What is the combined effect of these two events on the IS curve?
The IS curve shifts to the right The IS curve shifts to the left. These events may have opposite effects on the IS curve, thus the combined effect on the IS curve is indeterminate.
Describe how (if at all) the IS curve, MP curve, and AD curve are affected in the following situation: There is a decrease in financial frictions
The IS curve shifts to the right, the MP curve does not shift, and the AD curve shifts to the right.
Suppose that a new Fed chair is appointed, and his or her approach to monetary policy can be summarized by the following statement: "I care only about increasing employment; inflation has been at very low levels for quite some time; my priority is to ease monetary policy to promote employment." How would you expect the monetary policy curve to be affected, if at all? What would be the effect on the aggregate demand curve?
The MP curve will shift downward because decreasing unemployment results in a loosening of monetary policy. The AD curve will shift to the right.
What evidence is used to assess the stability of the money demand function? What does the evidence suggest about the stability of money demand and how has this affected monetary policymaking?
The data on money supply (which in equilibrium equals money demand), output, and interest rates are used to estimate the money demand function. Until the early 1970s, evidence strongly supported the stability of the money demand function. However, after 1973, there has been substantial instability in estimated money demand functions. Monetary policy makers have downgraded the importance of money supply in setting monetary policy and now think largely in terms of the setting of interest rates.
When aggregate output is below the natural rate, what will happen to the inflation rate over time if the aggregate demand curve remains unchanged?
The inflation rate will fall because the slackness of the labor market will eventually cause wages to fall.
If the Fed lowers the money supply at the same time that government spending increases, how would this change your answer above?
The lower money supply would cause the aggregate demand curve to shift leftward, removing some or all of the effect of the increase in government spending.
What happens to nominal GDP if the money supply grows by 15%, but velocity declines by 23%?
The nominal GDP declines by 8% 23-15
What is the real interest rate?
The nominal interest rate minus expected inflation.
The link between M (quantity of money) and P X Y is what?
The velocity of money
Suppose a new "payment technology" allows individuals to make payments using U.S. Treasury bonds (i.e., U.S. Treasury bonds are immediately cashed when needed to make a payment and that balance is transferred to the payee). How do you think this payment technology would affect the transactions component of the demand for money?
This would lead to a decreased need to hold cash for transactions, thus the transactions demand for money would decrease.
How does an autonomous tightening or easing of monetary policy by the Fed affect the MP curve?
When the Fed decides to raise the real interest rate at any given inflation rate, the MP curve shifts upward. Monetary policy easing, a decision to lower the real interest rate at any given inflation rate, shifts the MP curve downward.
The top portion of the following table lists a variety of factors that shift some component of the aggregate demand and supply model. A response box is attached to each factor. The table's bottom portion contains a labeling key. Label any factor that shifts the short-run aggregate supply curve with an S. Use an X to label any factor that does not shift the short-run aggregate supply curve. (Note: Each label is used multiple times.) Of the factors identified above that shift the short-run aggregate supply curve, the only factor that possibly also shifts the long-run aggregate supply curve is ______________ but only if this factor is ___________ .
X Firms alter their plans for investment expenditures. S Households and businesses come to expect an acceleration in inflation. S A negative price shock occurs in the form of higher oil prices. X An autonomous easing of monetary policy is implemented by the Federal Reserve. S Output remains persistently high relative to potential output left parenthesis Upper Y greater than Upper Y Superscript Upper P right parenthesis (Y>YP). X Consumer and business optimism spread as the media reports encouraging news about the economy. Price Shocks; Permanent
The top portion of the following table lists several supply shocks along with several exogenous events that do not affect the position of the aggregate supply curve. A response box is attached to each event. The table's bottom portion contains a labeling key. For a positive supply shock, use the label P; similarly, for a negative shock, use the label N. Label any exogenous event that does not impact AS with an X. (Note: Each letter is used three times.)
X The Federal Reserve autonomously tightens monetary policy. N The government adopts ill-advised regulations that diminish the economy's overall efficiency. P The U.S. dollar sharply appreciates, suddenly lowering the prices of imported inputs. X Foreign economies rebound, producing a substantial rise in net exports. P Phenomenally good weather leads to outstanding harvests of most grains. N The nation's labor unions aggressively press for higher wages and expanded benefits. P Startling advances in nanotechnology dramatically raise productivity across the economy. X Sudden optimism among firms induces a big jump in planned business expenditures. N Hurricanes blast the U.S. Gulf Coast, seriously damaging refining facilities.
Suppose the economy is starting from a situation of long-run equilibrium. In this case, we know that its equilibrium output (Y*) is _____ its potential output Compared to its original state, the economy in the short-run equilibrium at point 2 has output that is _____ and inflation that is _____ .In this short-run equilibrium at point 2, labor markets would likely see increasing _____ and corresponding weaker pressure on wages and costs that enable firms to raise their _____ at a less rapid rate. Graphically, this chain reaction from wages to costs to prices produces shifts in the short-run aggregate supply curve (AS2) that are_____ These shifts in the short-run aggregate supply curve result in output gaps that are _____ and the economy is evolving toward an eventual new long-run equilibrium at which inflation and output are, compared to their original values, _____
equal to lower; higher slack; prices down and to the right narrowing; unchanged
Assume that π = 1.5%.
r = 1, so equation = 1 + 1π = 2.5%
Would an increase in net exports affect the monetary policy curve?
No, the monetary policy curve does not shift.
