Ch. 20-23 Questions

The government decides to place limits on the interest rates banks can pay their depositors. Seeing that alternative investments pay higher interest rates, depositors withdraw their funds from banks and place them in bonds. What will be the impact on banks' balance sheets? What will be the impact on the bond market?

Banks will be forced to shrink the size of their balance sheets so the supply of loans will fall. The increase in the demand for bonds would drive their yields down, making it cheaper for corporations to borrow.

Explain why the rise in oil prices in 2008 created a particularly difficult situation for Federal Reserve policymakers.

Higher oil prices put upward pressure on inflation. The Fed could not simultaneously combat inflation without damaging economic growth. The financial crisis increased economic uncertainty.

If velocity were constant at 2 while M2 rose from $5 trillion to $6 trillion in a single year, what would happen to nominal GDP? If real GDP rose 4 percent, what would be the level of inflation? Nominal GDP would rise by percent. Inflation would equal percent.

If velocity were constant at 2 while M2 rose from $5 trillion to $10 trillion in a single year, what would happen to nominal GDP? If real GDP rose 4 percent, what would be the level of inflation? growth + velocity growth = growth of nominal GDP. Nominal GDP would rise by (6-5)/5*100% = 20% Nominal GDP growth = inflation + real growth. Inflation would equal 20%-3% = 17%

If velocity were constant at 2 while M2 rose from $5 trillion to $6 trillion in a single year, what would happen to nominal GDP? If real GDP rose 3 percent, what would be the level of inflation? Nominal GDP would rise by percent. Inflation would equal percent.

Money growth + velocity growth = growth of nominal GDP. Nominal GDP would rise by 20 percent. Nominal GDP growth = inflation + real growth. Inflation would equal 17 percent.

The short-run aggregate supply curve is upward sloping due to which of the following factors? Under what circumstances might it be vertical?

Price stickiness Perfectly flexible prices

The diagram below shows money demand and money supply with the nominal interest rate on the vertical axis and money balances on the horizontal axis. Assume the central bank is following a money growth rule where it sets the growth rate of money supply to zero. Reference the graph to explain how fluctuations in velocity imply that targeting money growth results in greater volatility of interest rates. Changes in velocity change money ___ at a given interest rate and so are reflected in ___ the money curve. For example, if financial innovation causes money to fall, this will shift the curve to the ___ . If velocity falls, the curve will shift to the ___ . If the central bank is following a zero growth rule for money supply, then the money supply curve ___ in the face of these changes, leading to volatility in the equilibrium interest rate.

demand shifts in demand demand left right will not shift

Why is inflation higher than money growth in high‑inflation countries and lower than money growth in low‑inflation countries? At very high levels of inflation, the velocity of money dramatically as people rush to spend their currency before it loses value; this causes inflation to be higher than money growth. Inflation is lower than money growth in low-inflation countries because part of the growth of money is by economic growth.

rises offset

Describe the impact of financial innovations on the demand for money and velocity. Financial innovations the demand for money and velocity. By making alternatives to money more liquid, individuals need money as a means of payment. By providing a broader array of financial instruments, innovations have the use of traditional money as a store of wealth. Since we never know exactly when the innovations will occur, it is difficult to predict the path of velocity over .

reduce increase less reduced short-run periods of a year or two

Suppose there was a wave of investor pessimism in the economy. What would the impact be on the dynamic aggregate demand curve? A wave of investor pessimism would investment and therefore aggregate expenditure at each real interest rate. This would be reflected in a the dynamic aggregate demand curve.

reduce reduce shift to the left

Many economists have argued that Japan's economic problems during the 1990s were caused largely by bank failures and the failure of the Japanese government to clean up the banking system. Which of the following factors could cause the collapse of the banking system and, in turn, declining economic output? Can monetary policymakers do anything to revive the economy under such circumstances?

Falling asset prices cause an increase in loan defaults. the asset price and exchange rate channels

Suppose that the aggregate expenditure curve can be expressed algebraically as AE = 3,000 - 2,000r, where AE is aggregate expenditures and r is the real interest rate expressed as a decimal. You check the website of the Congressional Budget Office and learn that the level of potential output is 2,900. What is the long-run real interest rate? The long-run real interest rate is %.

The aggregate expenditure curve shows the real interest rate at each level of desired spending, including the interest rate associated with potential output. The long-run real interest rate is the interest rate where aggregate expenditure equals potential output. To find that rate, set AE equal to 2,900 and solve for r: 2,900 = 3,000 - 2,000r, or 2,000r = 100. Solving for r gives r* = 0.05, or 5%.

Suppose that the aggregate expenditure curve can be expressed algebraically as AE = 3,000 - 2,000r, where AE is aggregate expenditures and r is the real interest rate expressed as a decimal. You check the website of the Congressional Budget Office and learn that the level of potential output is 2,910. What is the long-run real interest rate? The long-run real interest rate is ___%.

The aggregate expenditure curve shows the real interest rate at each level of desired spending, including the interest rate associated with potential output. The long-run real interest rate is the interest rate where aggregate expenditure equals potential output. To find that rate, set AE equal to 2,910 and solve for r: 2,910 = 3,000 - 2,000r, or 2,000r = 90. Solving for r gives r* = 0.045, or 4.5%.

Assume the short-run aggregate supply curve can be expressed algebraically as Y = 4,800 + 3,000π and the dynamic aggregate demand curve can be written as Y = 5,000 - 1,000π. Find the numerical value for equilibrium output, Y, in the short run. Find the numerical value, in percent, for the short-run inflation rate, π. %

The answer requires that you solve these two simultaneous equations. To start, rearrange the second equation, solving for π in terms of Y: Y = 5,000 - 1,000π, or π = 5.0 - 0.001Y Substituting this expression for the inflation rate into the first equation gives: Y = 4,800 + 3,000(5.0 - 0.001Y) Y = 4,800 + 15,000 - 3Y 4Y = 19,800 Y = 4,950 Then, using this in the second equation, we obtain: 4,950 = 5,000 - 1,000π 1,000π = 50 π = 0.05, or 5.0%

The economy has been sluggish, so in an effort to increase output in the short run, government officials have decided to cut taxes. They are considering two possible tax cuts of equal size in terms of lost revenue. The first would reduce taxes for one year on people with incomes above the median. The second would cut taxes for one year on people with incomes below the median. Which change would shift the aggregate demand curve further to the right? Why?

The tax cut on lower-income taxpayers would have a greater impact since lower-income households would spend any temporary tax cut because they are credit/liquidity constrained.

Why might you expect the recovery from the 2007-2009 recession to be weaker than normal?

Tighter fiscal policies by governments due to rising deficits. Lower credit demand by households. Tighter lending standards by banks.

How does an open market purchase affect the banking system's balance sheet? What is the intended impact on the supply of bank loans? If the opportunity cost adjusted for risk (the difference between the interest rate on loans and the interest rate paid by the Fed on reserves) of holding excess reserves is too high for banks, they:

When the Fed purchases securities, it increases the amount of reserves in the banking system will increase the volume of loans they make.

How could you use the aggregate demand-aggregate supply (AD/AS) framework to explain the impact of the financial crisis of 2007−2009 on inflation and output in the economy? You can think of the disruption in financial markets as an shock. Lack of access to credit by consumers and businesses and loss of consumer and investor confidence would shift the curve to the . In the absence of other changes, this would put pressure on output and pressure on inflation.

aggregate demand dynamic aggregate demand left downward downward

You read a story in the newspaper blaming the central bank for pushing the economy into recession. The article goes on to mention that not only has output fallen below its potential level but that inflation had also risen. If you were to write to the newspaper defending the central bank, what argument would you make? You should state that monetary policy actions by the central bank affect the curve. Shifts in that curve move output and inflation in . The situation described in the news article is one where inflation rises when output falls. This is most likely the result of a shock that shifted the curve to the .

dynamic aggregate demand the same direction short run aggregate supply left

Will changes in technology affect the rate at which the short-run aggregate supply curve shifts in response to an output gap? Technological advancements will make it to change prices in response to an output gap. Thus, the short-run aggregate supply curve will adjust quickly to a given output gap.

easier more

Countries A and B both have the same money growth rate and in both countries, real output is constant. In Country A velocity is constant while in Country B velocity has fallen. In which country will inflation be higher? Explain why. The equation of tells us that: Money Growth + Velocity Growth = + Real Growth. This tells us that inflation will be lower in Country as the fall in velocity reflects an increase in money demand. This the inflationary pressures from the rise in the stock of money.

exchange inflation B reduces

Explain how money growth reduces the purchasing power of money. By increasing the supply of money, holding demand for money constant, the value of each dollar relative to goods and services in the economy will . The price of money in terms of goods and services has

fall fallen

Explain why monetary policymakers' actions in cutting the Federal Funds rate to almost zero were not sufficient to boost economic activity during the recession of 2007-2009. Monetary policymakers' actions in cutting the Federal Funds rate to almost zero were not sufficient to boost economic activity during the recession of 2007-2009 because the (the key link between monetary policy and the economy) was disrupted. As a result, policymakers turned to unconventional methods to contain the crisis.

financial system

Changes in oil prices shift the short-run aggregate supply (SRAS) curve. Consider how volatility in oil prices may influence the economy's short-run equilibrium, which occurs at the intersection of the dynamic aggregate demand (AD) curve and the SRAS curve. a. Suppose the monetary policy reaction curve is relatively steep. What does this imply about the slope of the AD curve? What does it imply about the variability of output and inflation? The steeper the MPRC, the the AD curve. The in the inflation rate leads to a comparatively in output demanded, so the dynamic AD curve is . With a AD, the variability in output is fairly . b. Suppose the monetary policy reaction is relatively flat. What does this imply about the slope of the AD curve? What does it imply about the variability of output and inflation? If the MPRC is relatively flat, a given in the inflation rate leads to a policy-driven increase in the real interest rate, resulting in a decline of interest-sensitive purchases. The AD curve in this case is relatively , which means the output volatility is . Note, however, that output is associated with inflation fluctuations.

flatter; rise; large fall; relatively flat; flat; large rise; smaller; smaller; steep; smaller; relatively stable; larger

n pursuing stabilization policies, many countries choose monetary responses rather than fiscal responses because:

independent central banks are able to stabilize the economy more quickly. fiscal policy responses require more time to take effect. fiscal policymakers may choose policies that further political goals rather than the economic goals alone.

Stabilization policies are monetary or fiscal policies designed to stabilize and . Monetary and fiscal policy can be used to neutralize shifts only. Stabilization policies improve everyone's welfare.

inflation output aggregate demand do

When monetary policymakers hit the zero nominal-interest-rate bound with their policy rate, they have the option to turn to unconventional tools of monetary policy. How do the following unconventional tools work? ___ : the central bank expresses the intent to keep interest rates low in the future, influencing long-term interest rates if it is credible. ___ : involves buying different assets than usual, such as longer-term Treasury bonds and mortgage-backed securities issued by government agencies, thereby altering the composition of the central bank's balance sheet. ___ : involves open-market purchases and lending that increase bank reserves beyond the level necessary to keep the policy rate at its target (typically near zero), expanding the size of the central bank's balance sheet. Why are policymakers reluctant to use them except in very difficult circumstances?

forward guidance targeted asset purchases quantitative easing Because of a lack of experience with these policies.

Suppose there was a wave of household optimism in the economy. What would the impact be on the dynamic aggregate demand curve? A wave of household optimism would investment and therefore aggregate expenditure at each real interest rate. This would be reflected in a the dynamic aggregate demand curve.

increase increase a shift to the right of

Explain why we observed a fall in the velocity of M2 during the financial crisis of 2007-2009. The ___ in uncertainty during the financial crisis drove investors to hold a portion of their assets in the form of money. money holding relative to the level of economic activity means that each dollar has to be used times, velocity.

increase larger increased fewer lowering

Fiscal policy played a greater role than usual in the response to the 2007-2009 recession because:

interest rates were already near zero and there was the risk of deflation

For each of the following, explain whether the response is theoretically consistent with a tightening of monetary policy and identify which of the traditional channels of monetary policy is at work: a. Firms become more likely to undertake investment projects. This with a tightening of monetary policy, which would make firms likely to undertake investment projects through the channel. b. Households become less likely to purchase refrigerators and washing machines. This with a tightening of monetary policy. In the face of interest rates associated with the tightening, households would become likely to borrow to purchase consumer durables, such as refrigerators and washing machines. This effect works through the channel. c. Net exports fall. This with a tightening of monetary policy. When policy is tightened, interest rates . There is in investor demand for U.S. assets, leading to of the dollar. This would increase demand for and reduce demand for , causing a decrease in net exports through the channel.

is not consistent; less; interest-rate is consistent; higher; less; interest-rate is consistent; rise; an increase; an appreciation; imports; exports; exchange-rate

In India, suppose that changes in short-term interest rates translate quickly into changes in long-term interest rates, while in Canada long-term interest rates do not respond as much to changes in short-term rates. In which country would you expect the interest-rate channel of monetary policy to be stronger? A household's decision to buy a car or house or a firm's decision to engage in long-run investment projects generally depends on interest rates and so the interest-rate channel is likely to be .

longer term stronger in India

Explain why giving an independent central bank control over the quantity of money in the economy should reduce the occurrences of periods of extremely high inflation, especially in developing economies. Inflation is a ___ phenomenon and independent ___ are more likely than ___ to consider the consequences for inflation when deciding how much money to print. Central bank independence may be difficult to maintain in developing economies, however, if government is to efficiently collect tax revenues. The central bank may face pressure to and risk high and rising inflation.

monetary central banks governments unable monetize government debt

If velocity were predictable but not constant, would a monetary policy that fixed the growth rate of money work? We know that + velocity growth = inflation + . If velocity is not constant, then fixing the growth rate of money will result in inflation. However, if velocity is predictable, policymakers could money growth at the same rate that velocity is decreasing in order to stabilize inflation.

money growth real growth either rising or falling increase

The European Central Bank's primary objective is price stability. Policymakers interpret this objective to mean keeping inflation below, but close to, 2 percent, as measured by a euro-area consumer price index. In contrast, the FOMC has a dual objective of price stability and high economic growth. How would you expect the monetary policy reaction curves of the two central banks to differ? Why? Because the ECB targets inflation, its monetary policy reaction curve will be that of the FOMC.

more aggressively steeper than

According to real business cycle theory, can monetary policy affect equilibrium output in either the short run or the long run? According to real business cycle theory, business cycle fluctuations arise due to changes in and the curve shifts so rapidly that it is irrelevant. This means that equilibrium in both the short run and the long run is determined by the intersection of the . Shifts in the AD curve do not influence the equilibrium level of output and so monetary policy cannot influence equilibrium output in .

potential output short run aggregate supply aggregate demand and long run aggregate supply either the short run or the long run

Consider the figure below, where the short-run equilibrium occurs at an output level below potential output, YP. Suppose that the initial inflation target was at the level corresponding to point 2, but the central bank chooses to stimulate demand to speed the adjustment to long-run equilibrium. What are the costs and benefits of such a policy? The central bank must its inflation target, shifting both the monetary policy reaction curve and the aggregate demand curve to the . The cost is inflation and the benefit is that the output loss may be eliminated more quickly if the policy returns to YP than if the central bank waited for production costs to

raise right higher faster fall

Suppose there is an unexpected slowdown in the rate of productivity growth in the economy so that forecasters consistently overestimate the growth rate of GDP. If the central bank bases its policy decisions on the consensus forecast, what would be the likely consequences for inflation assuming it maintains its existing inflation target? Suppose, for example, the consensus forecast was for positive productivity growth so that the long-run aggregate supply curve would be expected to while actual productivity growth was zero, resulting in in the long-run aggregate supply curve. Thinking the long-run aggregate supply curve was , the central bank's appropriate policy response to maintain the existing inflation target would be to shift the dynamic aggregate demand curve to the . But given the actual behavior of the long-run aggregate supply curve, the central bank's action would lead to inflation in the short run.

shift to the right no change shifting to the right right increased

Explain how each of the following affects the short-run aggregate supply curve. a. Firms and workers reduce their expectations of future inflation. A reduction in inflationary expectations would lead to a rise in nominal wages, costs and thus production at each level of current inflation. There will be a the short-run aggregate supply curve. b. There is a rise in current inflation. There will be a the short-run aggregate supply curve as current inflation rises. c. There is a fall in oil prices. With lower costs, production will at each level of inflation and there will be a the short-run aggregate supply curve.

smaller; lowering; increasing; a shift to the right in movement up along increase; a shift to the right in

Compare the impact of a given change in monetary policy in two economies that are similar in every way except that, in Economy A, the financial system is very evolved with a large shadow banking system providing many alternatives to bank financing, while in Economy B, bank loans account for almost all of the financing in the economy. Given the reliance on bank loans in Economy B, the bank-lending channel would be than in Economy A, leading to a shift in the dynamic aggregate demand curve in Economy B for a given change in monetary policy.

stronger larger

Explain why monetary policy makers cannot restore the original long-run equilibrium of the economy if, in the short run, the economy has moved to a point where inflation is above target inflation and output is below potential output. If inflation is above target inflation and output is below potential output, the short-run aggregate supply curve has shifted . Monetary policymakers can only shift the dynamic curve. An expansionary monetary policy could restore output to its equilibrium level but this would come at the cost of .

to the left aggregate demand long run permanently higher inflation