Econ Exam 2
Consider a simple bank that has assets of $100, checking deposits of $80, and capital of $20. Recall from chapter 4 that checking deposits are liabilites of a bank. Now suppose that the perceived value of the bank's assets falls by 10. The new value of the bank's capital is $
$10
Rewrite phillips curve Rewrite this relation as a relation between the deviation of the unemployment rate from the natural rate, inflation, and expected inflation.
(ut-un) = -(pi t -pi et)/(alpha)
Suppose T decreases. In what direction must the central bank change the real policy interest rate to maintain the existing medium-run equilibrium?
A decrease in T shifts the IS curve to the right, causing an increase in output above Yn. To return to Yn, the central bank must increase the real policy rate, causing LM to shift up. This is the correct answer.
Suppose the nominal policy interest rate is 4%. If expected inflation increases from 2% to 3%, in order to keep the LM curve from shifting, the central bank must _______ the nominal policy rate of interest to ____________
increase, 5%
How does the natural rate of unemployment vary with the catchall term z? As the catchall term z increases, the natural rate of unemployment ____________
increases
The economy is initially at the natural rate of unemployment, which is 5%, when the authorities decide to bring the unemployment rate down to 3% and hold it there forever. With theta equal to zero, this will yield a 5% rate of inflation every year. Now suppose that in year (t+6), theta changes to 1. might increase in this way because
inflation expectations adapt to persistently positive inflation.
This expectations structure is probably not realistic because it implies that
inflation expectations are always wrong.
Uncoventional monetary policy: financial policy and quantitative easing Suppose that the IS and LM relations are IS: Y = C(Y-T) + I(Y, r+x) +G LM: r = r bar Interpret the interest rate as the federal funds rate adjusted for expected inflation, the real policy interest rate of the Federal Reserve. Assume that the rate at which firms can borrow is much higher than the federal funds rate, equivalently that the premium , in the IS equation is high. Faced with a zero nominal interest rate, suppose the Fed decides to purchase securities directly to facilitate the flow of credit in the financial markets. This policy is called quantitative easing. If quantitative easing is successful, so that it becomes easier for financial and nonfinancial firms to obtain credit, what is likely to happen to the premium?
it will lower the premium IS shifts right
The monetary policy options that can prevent an increase in the risk premium on risky bonds from decreasing the level of output include
open market purchases lower reserve requirement
If the expected rate of inflation were to increase from 2% to 3%, the IS curve
remains stationary
Okun's Law is written as . What is the sign of u-u(u-1) in a recession? During a recession, unemployment is _____________ , making the sign of u-u(u-1) ________________
rising positive
If the risk premium on risky bonds increases from 6% to 7%, the IS curve
shifts left
Given what we know about the actual price level and the expected price level at the natural rate of unemployment, the equation can be transformed to show the natural rate of unemployment as ____________.
un= m+z/alpha
If you look mainly at what the inflation rate was last year when trying to predict what inflation will be this year, then you believe that is near ___________
1
Suppose that the markup of goods prices over marginal cost is 5%, and that the wage-setting equation is , where u is the unemployment rate. The real wage, as determined by the price-setting equation, ___________ The natural rate of unemployment is ______________
1/(1+0.05)=0.9524 1-0.9524 = .0476 x100 = 4.76%
When the probability of bankruptcy is % and the nominal policy rate of interest is %, the nominal interest rate for a risky borrower is
11.07% (1.05)/(0.94) = (1+i+x)
If the nominal policy interest rate is % and the expected rate of inflation is %, the value for the vertical intercept of the LM curve is
2%
Suppose that the Phillips curve is given by Given this equation find the natural rate of unemployment. pi t=pi et +0.1-2ut The natural rate of unemployment is ________
5% 0.1-2(.05)=0
When the probability of bankruptcy is 1% and the nominal policy rate of interest is 5%, the nominal interest rate for a risky borrower is
6.06% (1.05)/(0.99) = (1+i+x)
The equation of the Phillips curve from 1970 to 1995 is: 7.4-1.2ut The natural rate of unemployment using this curve is
6.2
Calculating the risk premium on bonds : The text presents a formula where (1+i) = (1-p)(1+i+x) +p(0) where i is the nominal interest rate on a riskless bond x is the risk premium p is the probability of default (bankruptcy) When the nominal interest rate for a risky borrower is 11% and the nominal policy rate of interest is 4%, the probability of bankruptcy is
6.31% (1-p) = (1.04)/(1.11)
Assuming the bank cannot raise additional capital, how can it raise the funds necessary to repay its debt coming due? A. The bank must sell some of its assets. Your answer is correct.B. The bank can borrow by issuing bonds. C. The bank can issue more stock. D. The bank can give depositers some of their money back.
A. The bank must sell some of its assets.
Consider a simple bank that has assets of $80, short-term credit of $60, and capital of $20. Short-term credit must be repaid or rolled over (borrowed again) when it comes due Now suppose that the perceived value of the bank's assets falls. If lenders become nervous about the solvency of the bank A. making loans become riskier and lenders will not be as willing to provide credit at low interest rates. Your answer is correct.B. making loans become riskier but lenders believe in banks and will be willing to provide credit at low interest rates. C. even though giving the bank a loan is not any riskier, the bank will not have as much collateral to borrow from. D. making loans is not any riskier so lenders will still be willing to provide credit at low interest rates.
A. making loans become riskier and lenders will not be as willing to provide credit at low interest rates.
If the expected rate of inflation were to from % to %, the LM curve A. shifts down unless the central bank acts to offset. B. shifts up unless the central bank acts to offset. C. shifts down regardless of central bank actions. D. will remain in its initial location regardless of central bank actions.
A. shifts down unless the central bank acts to offset
Suppose G increases. In what direction must the central bank change the real policy interest rate to maintain the existing medium-run equilibrium?
An increase in G shifts the IS curve to the right, causing an increase in output above Yn. To return to Yn, the central bank must increase the real policy rate, causing LM to shift up
What is the effect of wage indexation on the relation between
As indexation rises, inflation becomes more sensitive to the gap between the unemployment rate and natural rate.
Efficiency wage theory would predict that relative to the wage of your first job, the job you will have in 10 years will pay ____________. A. less, because it is not efficient for firms to pay workers more than the lowest wage possible. B. more, because firms will want to pay more to increase morale and productivity and reduce turnover. C. more, because over 10 years your increased skills will make you a more valuable worker who must be paid more. D. less, because labor markets will become more competitive over time, putting downward pressure on efficient wages.
B. more, because firms will want to pay more to increase morale and productivity and reduce turnover.
Suppose the deposits are insured by the government. Given the decline in the value of bank capital A. depositors should be concerned that the bank may fail and should withdraw the funds from the deposits. B. the health of the bank is irrelevent to depositers and therefore there is no need to withdraw funds. This is the correct answer.C. even though the health of the bank is irrelevent to depositors, the safe thing to do would be to withdraw the funds from the deposits. D. there is still no need to withdraw funds because it is fine for banks to have a reduction in capital value.
B. the health of the bank is irrelevent to depositers and therefore there is no need to withdraw funds.
The two factors in bond markets that lead to a positive risk premium are (Check only two.)
Bondholders' degree of risk aversion. The probability of default.
If the risk premium on risky bonds increases from 6% to 7%, the LM curve A. shifts down regardless of central bank actions. B. shifts up if the central bank acts to offset. C. shifts down if the central bank acts to offset. D. will remain in its initial location regardless of central bank actions.
C. shifts down if the central bank acts to offset.
Which of the following statements about the reservation wage is correct? A. The wage that you were paid for your first job most likely was less than your reservation wage. B. The wage that you were paid for your first job most likely was equal to your reservation wage. C. The wage that you were paid for your first job most likely was greater than your reservation wage. D. It is not possible to say anything in general about the wage that you were paid for your first job.
C. The wage that you were paid for your first job most likely was greater than your reservation wage.
Given the answers above and the material in the text, why might recapitalization be a better policy than buying the troubled assets? A. Buying trouble assets will at best provide a bank liquidity but not necessarily positive capital. B. The direct infusion of capital improves the solvency of the bank. C. Unless the government is willing to buy assets at above market prices, buying assets does not mean bank capital will remain positive. D. All of the Above
D. All of the above
Why is it so important when the nominal policy interest rate is at the Zero Lower Bound to maintain a positive expected rate of inflation? A. A positive expected rate of inflation enables the central bank to significantly offset any increase in the risk premium. B. A positive expected rate of inflation allows the central bank to keep real borrowing costs relatively low when the risk premium rises. C. A low or negative expected rate of inflation results in an increase in real borrowing costs when the risk premium goes up. D. All of the above.
D. All of the above
Identify how m and z may explain variations in the natural rate of unemployment across countries and across time.
Differences in both m and z can explain variation across countries and across time.
The situation(s) that correspond to the case where the nominal policy interest rate is at the Zero Lower Bound is(are)
E
Since 1950, the participation rate in the United States has remained roughly constant at 60%. Each month, the flows into and out of employment are very small compared to the size of the labor force. Fewer than 10% of all unemployed workers exit the unemployment pool each year. The unemployment rate tends to be high in recessions and low in expansions. Most workers are typically paid their reservation wage. Workers who do not belong to unions have no bargaining power. It may be in the best interest of employers to pay wages higher than their workers' reservation wage. The natural rate of unemployment is unaffected by policy changes.
F T F T F F T F
The nominal interest rate is measured in terms of goods; the real interest rate is measured in terms of money. As long as expected inflation remains roughly constant, the movements in the real interest rate are roughly equal to the movements in the nominal interest rate. The nominal policy interest rate was at the zero lower bound in the United States in 2019. When expected inflation decreases, the real rate of interest rises. All bonds have equal risk of default and thus pay equal rate of interest. The nominal policy interest rate is set by the central bank. An increase in a bank's leverage ratio tends to increase both the expected profit of the bank and the risk of the bank going bankrupt. The real borrowing rate and the real policy rate never move in the same direction. It can be difficult to value assets of banks and other financial intermediaries, particularly in a financial crisis. When a bank has low leverage and high liquidity, it may have to sell assets at fire sale prices. Banks and other financial intermediaries have liabilities that are less liquid than their assets. House prices have risen constantly since the year 2000. The fiscal stimulus program adopted by the United States in response to the financial crisis helped offset the decline in aggregate demand and reduce the size of the recession. The fiscal stimulus program adopted by the United States included a large increase in the deficit measured as a percent of GDP.
F T F T F T T F T F F F T T
Consider the following statement: The Phillips curve implies that when unemployment is high, inflation is low, and vice versa. Therefore, we may experience either high inflation or high unemployment, but we will never experience both together. Is this statement true, false, or uncertain? Choose the answer that best explains.
False. If inflation expectations are high, it is possible to have high inflation and high unemployment simultaneously.
Consider the following statement: As long as we do not mind having high inflation, we can achieve as low a level of unemployment as we want. All we have to do is increase the demand for goods and services by using, for example, expansionary fiscal policy. Is this statement true, false, or uncertain? Choose the answer that best explains.
False. This would require not merely high inflation but ever-increasing inflation because expectations adjust.
Suppose there is an increase in consumer confidence in period . How does this impact the IS-LM graph?
IS curve shift right/up
Identifying if an economy is in medium run equilibrium and the necessary central bank action to return the economy to medium run equilibrium. Here are values for a hypothetical economy: and a table describing this economy in various situations: Explain why Situation A is a full medium run equilibrium and Situation B, C, D and E are not a full medium run equilibrium.
In situation A, output is at potential and unemployment is at its natural rate. In all other situations, this is not true.
In the equation for Okun's Law written above, where does the 3% number come from?
It is the sum of the labor-force growth rate and the labor-productivity growth rate in the United States.
Which of the following best explains why the increase in the markup causes the natural rate of unemployment to rise?
It shifts the price-setting relation downward, decreasing the real wage.
Uncoventional monetary policy: financial policy and quantitative easing Suppose that the IS and LM relations are IS: Y = C(Y-T) + I(Y, r+x) +G LM: r = r bar Interpret the interest rate as the federal funds rate adjusted for expected inflation, the real policy interest rate of the Federal Reserve. Assume that the rate at which firms can borrow is much higher than the federal funds rate, equivalently that the premium , in the IS equation is high. Suppose the government takes action to improve the solvency of the financial system. If the government's action is successful, and banks become more willing to lend, what is likely to happen to the premium?
It will lower the premium Shifts IS to the right
What do we know about your process of the formation of expected inflation when
Last year's inflation rate will be the only input for you to revise your estimates for this year's expected rate regardless of what the long-run average inflation rate is.
Fill in the following response boxes for situations A through E. Then answer the questions below that relate to the data in the table.
Nominal Borrowing Interest Rate = Nominal Policy Interest Rate+ Risk Premium Real Borrowing Interest Rate = Real Policy Interest Rate + Risk Premium
Assume that the central bank does not change the real policy rate. How will the short-run equilibrium in period compare to the equilibrium in period t?
Output will be above potential and inflation will be above expected inflation.
What do you conclude about the central bank policy of keeping the real policy rate unchanged in period ? Is it sustainable?
Output will increase above the natural rate. Inflation will remain above 2% and the target rate of inflation will eventually fall apart.
Assume quantitative easing does increase expected inflation and the nominal policy rate is constant. How does that affect the LM in the to the right?
Shift the LM down
The text proposes the following model of expected inflation πet = (1 − θ) π + θ πt−1 What do we know about your process of the formation of expected inflation when θ = 0?
Regardless of what inflation was last year, you would expect it to be at the long-run average inflation rate this year.
The original Phillips curve is the negative relation between unemployment and inflation that was first observed in the United Kingdom. The original Phillips curve relation has proven to be very stable across countries and over time. For some periods of history, inflation has been very persistent between adjacent years. In other periods of history, this year's inflation has been a poor predictor of next year's inflation. Policy makers can exploit the inflation-unemployment trade-off only temporarily. Expected inflation always equals actual inflation. In the late 1960s, the economists Milton Friedman and Edmund Phelps said that policy makers could achieve as low a rate of unemployment as they wanted. If people assume that inflation will be the same as last year's inflation, the Phillips curve relation will be a relation between the change in the inflation rate and the unemployment rate. The natural rate of unemployment is constant over time within a country. The natural rate of unemployment is the same in all countries. Deflation means that the rate of inflation is negative.
T F T T F F T F F T
If the government pays 45 for the troubled assets, but the true value turns out to be much lower, who bears the cost of this mistaken valuation?
Taxpayers
The medium-run equilibrium is characterized by four conditions: 1. Output is equal to potential output and the real policy rate must be chosen by the central bank so: 2. The unemployment rate is equal to the natural rate . 3. The real policy interest rate is equal to the natural rate of interest where is defined as the policy rate where . 4. The expected and actual rate of inflation is equal to the anchored or target rate of inflation, . This implies the nominal policy rate . The IS relation is . Suppose is %. If x increases from to %, how must the central bank change to maintain the existing medium-run equilibrium?
The central bank needs to decrease the real policy interest rate by 3% in order to keep r + x unchanged.
The equation of the Phillips curve from 1996 to 2018 is: 2.8%-0.16ut Which of the following explains why the natural rate of unemployment cannot immediately be calculated from the Philips curve? Draw the graph
The equation does not include a specific value for expected inflation. goes from 2.8 on vertical to 17.5 on horizontal
The formula assumes that payment upon default is zero. In fact, it is often positive. How would you change the formula in this case?
The final term would become p "times" some fraction of (1+i+x).
What happens to inflation when theta= 1 and unemployment is kept at the natural rate of unemployment?
The inflation rate stays constant from one year to the next.
In the previous chapter, we derived the natural rate of unemployment. What condition on the price level and the expected price level was imposed in that derivation?
The natural rate is the unemployment rate at which the actual price level is equal to the expected price level.
What happens to inflation when theta= 1 and unemployment is kept below the natural rate of unemployment?
There will be an increasing inflation rate.
Why is the coefficient on the term equal to 0.4 and not 1?
Training new employees is costly so firms hoard workers during recessions. An increase in the employment rate does not lead to a one-for-one decrease in the unemployment rate
If quantitative easing has some effect, then the Fed has policy options to stimulate the economy even when the federal funds rate is zero.
True
This example shows that financial policy can be a kind of macroeconomic policy.
True
Suppose that for given labor-market conditions, worker bargaining power throughout the economy increases. What happens to PS-WS graph
WS Shifts to the right, new equilibrium is where they intercept
How does the natural rate of unemployment vary with the markup?
When the markup increases, the natural rate of unemployment will increase.
In equilibrium, the effect of an increase in worker bargaining power is ___________________ in the natural rate of unemployment and ______________ in the real wage.
an increase no change
Explain the difference between central bank policies using the two assumptions about expected inflation. Part 11 Under anchored inflation expectations, the central bank would have to raise the policy rate enough to eliminate the output gap . This higher rate will cause inflation to return to the anchored rate . Once the inflation goal has been achieved, the central bank will not need to make any further changes . Under lagged inflation expectations, the central bank would have to raise the policy rate significantly higher than if expectations were anchored . This significantly higher rate will cause a recession, causing large reductions in inflation . Once the inflation goal has been achieved, the central bank can return the policy rate to its original level .
answer
Explain the difference between central bank policies using the two assumptions about expected inflation. Part 16 Under anchored inflation expectations, the central bank would have to raise the policy rate enough to eliminate the output gap . This higher rate will cause inflation to return to the anchored rate . Once the inflation goal has been achieved, the central bank will not need to make any further changes . Under lagged inflation expectations, the central bank would have to raise the policy rate significantly higher than if expectations were anchored . This significantly higher rate will cause a recession, causing large reductions in inflation . Once the inflation goal has been achieved, the central bank can return the policy rate to its original level .
answer
When facing a zero lower bound, fiscal consolidation can lead to decreasing output and deflation , which will lower tax revenue, making it harder to reduce the deficit.
answer
Compute the real interest rate using the exact formula and the approximation formula for each set of assumptions listed below. (round responses to two decimal places)
approximation formula = nom. IR - expected rate of inflation exact formula = (1 + nom. IR) / (1 + expected inflation) -1
Suppose many banks cannot raise additional capital and hold similar assets, given this, it is likely that the value of the assets will _____________ and make lenders more nervous and ________________ to lend credit.
decrease, less likely
liquidity trap happened when
expected inflation was negative (situation E)
Suppose the number of immigrants per year allowed to enter the United States is sharply . How would Okun's Law change? If the number of immigrants sharply decreased, there would be a _____________ in __________________ , causing the number ______________ in the equation to become ____________ .
fall potential output 3 smaller
The natural rate of unemployment _________to __________ between 1970-1995 and 1996-2018? What are the possible explanations for the change in the natural rate of unemployment between the 1980s and the 2000s? A. The population has aged. B. Workers could have weaker bargaining power. C. There could be more efficient search mechanisms in the labor force. D. All of the above.
fell, 5% d. all of the above
Suppose the unemployment rate is very low. It will be _______ for firms to find workers to hire, and it will be ___________ for workers to find jobs. Thus, ____________ will have relatively more bargaining power than ___________ . As the unemployment rate gets low, the wage will ___________ . Thus, if the unemployment rate were ever to approach zero, the wage rate would _________________________________ .
hard easy workers firms increase become extremely high, discouraging further hiring
The fiscal policy options that can prevent an increase in the risk premium on risky bonds from decreasing the level of output include (Check all that apply.)
higher government spending lower taxes
Calculating the risk premium on bonds : The text presents a formula where (1+i) = (1-p)(1+i+x) +p(0) where i is the nominal interest rate on a riskless bond x is the risk premium p is the probability of default (bankruptcy) If the probability of bankruptcy is zero, the rate of interest on the risky bond is:
i
Part of the policy response to the crisis-induced recession in 2009 was to extend the length of time workers could receive unemployment benefits. If this change were made permanent, it would be expected that reservation wages would ____________
increase
To keep the real policy rate unchanged, the central bank would need to ______________ the nominal policy rate.
increase actual inflation would be greater than in period 1
Consider the table below. Is the data presented consistent with the Phillips curve model of wage determination? ____________ . The natural rate of unemployment is 5%
uncertain Money wage decreases do not take place as expected inflation is negative even at the same rate of unemployment, a rate far above the natural rate of unemployment. This set of data could capture the phenomenon or rigid money wages in a Phillips curve framework.
Is it true that in the medium run, a fiscal expansion leads to an increase in the natural rate of interest?
Yes, when the central bank increases the real policy rate to address a fiscal expansion, the new rate results in stable inflation and a return to Yn, thus making the new rate, rn.