Exam #4

Name two multipliers in fiscal policy. How do they work?

A fiscal multiplier is the ratiio in which the change in a nation's income level is affected by government spending. The fiscal multiplier is used to measure the effect of government spending (fiscal policy) on the subsequent income level of that country. In theory, increased fiscal spending can lead to increased consumption, which then leads to a cycle of consumption and wealth creation. Two multipliers in fiscal policy are the multiplier on changes in government purchases, 1(1-MPC) and the multiplier on changes in taxes MPC/(1-MPC). (note that MPC = marginal propensity to consume). In this case, the multiplier on changes in taxes is more because it involves cost savings.

What is a fractional banking system and how does it function?

A fractional banking system is a banking system in which only a fraction of bank deposits are backed up by actual cash on hand are available for withdrawal. This frees up capital that can be loaned to other parties. There must be built in safeguards to prevent such an instance from every happening again as it did during the Great Depression.

Describe how monetary policy and fiscal policy affect aggregate demand. How should these tools be used today in developing a national growth policy?

Aggregate demand measures the demand for an economy's GDP. Fiscal policy determines government spending and tax rates. Expansionary fiscal policy increases government spending in areas like infrastructure, education, and unemployment. In times where aggregate demand is low, it is useful to explore expansionary fiscal policy to stimulate the economy. The opposite is true - in times of economic prosperity, there is very little need for increased government spending in the aforementioned areas. Monetary policy is the way that central banks stimulate the money supply in an economy. The money supply directly influences interest rates and inflation, which are both major determinatns of employment, cost of debt, and employment. In hard times, monetary policy that stimulates growth are policies that include buying treasury notes, decreasing interest rates, or reducing the reserve requirement. This leads to consumers borrowing and spending more, which leads to a higher aggregate demand. The goal of a stimulated money supply is to make spending more attractive than investment.

What is Aggregate Supply and what 4 factors identified by Mankiw would cause long run AS to shift? Give an example of each factor and how that example affects Aggregate Supply.

Aggregate supply is the total supply of goods and services that firms in a national economy plan on selling during a specified time period. It is the total amount of goods and services that firms are willing and able to sell at a given price level in an economy. • Changes in labor - an economy that has more workers (immigration) or less (deimmigration) would change this. More labor moves the curve to the right, less to the left. • Changes in capital - more captital = more productivity. More capital - shift to the right. • Changes in natural resources - more natural resources shifts to the right, less to the left. • Change in tech knowledge - more to the right, less to the left.

Why might the Aggregate-Supply curve shift? List and explain the five influences described by Mankiw.

An increase in the expected price level reduces the quantity of goods and services supplied and shifts the short term aggregate supply curve to the left. A decrease in thee xpected price level rasies the quanityt of goods and services supplied and shifts the short run aggregate supply curve to the right. More - shift to right, less, shift to left. Changes in labor - is more labor available? Is less labor available? Changes in capital - how much physical or human capital is available? Natural resources - is it available? Changes in tech - has there been an advance in technology? Has it been rolled back (due to government regulation?) Expected price level - has the price level changed?

In the graph below we know that L is the demand for money; M is the supply of money; and r is the rate of interest. What is happening at L1? At L0? At L2? What would cause M to shift left or right and what would happen to the equilibrium if either shift materialized?

At L1, the interest rate is higher. As such, the supply of money is more. At L0, the interest rate is a little lower, so you can see that the supply of money has adjusted and has come down. As you can also see, the market is currently at L0, so it is in equilibrium. At L2, the supply of money is lower because the interest rate is lower. If M shifts to the left, the interest rate has risen. Money is available more readily because the demand for money is lower. If M shifts to the right, the interest rate has fallen. Money is more in demand and the supply of it is smaller. A higher interest rate equals a lower demand for money and vice versa - M will adjust based upon the interest rate.

What is the difference between fiscal policy and monetary policy? What tools are used for monetary control? Tell me what they are and how they are used. What tools are used for fiscal policy control? Tell me what they are and how they are used.

Fiscal policy is the collective term for the taxing and spending actions of governments. (Exec and Leg) Monetary policy is primarily concerned with the management of interest rates and the total supply of money in circulation (central banks like the Fed). Tools used for monetary control include open market operations, where the Fed buys and sells government securities on the open market. When the feds want the funds rate to rise, it sells government securities, and when it wants the funds rate to fall, it buys government securities. Another tool for monetary control is the discount rate. Banks may borrow money from the federal reserve, and the discount rate is the rate that banks must pay to do so. Setting the discount rate higher is designed to keep banks away, while setting it lower encourages more borrowing from the fed. Other monetary policy tools include interest rates and reserve requirements for banks. To control high inflation, governments may raise interest rates thereby reducing money supply. Tools used for fiscal control include government spending and taxes. When demand is low, governments can step in and spend money in an attempt to stimulate demand. Also, when governments want people to spend more money, they can lower taxes to increase disposable income for people as well as corporations.

Suppose that the demand and supply of money are in equilibrium. Then, the Fed increases the money supply. What happens to the value of money and the price level? Explain the change using a graph. Be sure to label all components.

If the Fed increases the money supply after the supply and demand for money are in equilibrium, an increase in the money supply will lead to an increase in the amount of money that people and firms will hold. The value of money falls and people will spend more. The price level rises, which will increase the quantity of money demanded to restore equilibrium.

If the Federal Reserve decided to increase the money supply, what would happen to aggregate demand? Explain your answer in the context of monetary policy (draw a graph) and how it affects aggregate demand.

If the Federal Reserve decided to increase the money supply, it lowers the interest rate and increases the quantity of goods and services demanded for any given price level, shifting the aggregate demand curve to the right. When the fed contracts the money supply, it raises the interest rate and reduces the quantity of goods and services demanded at a given price level.

What is the difference between inflation and deflation? Define what they are and name some of their respective effects. Which one is worse and why? Does the Federal Reserve have an inflation/deflation target? Explain?

Inflation is an increase in the overall level of prices. Deflation is a decrease in the overall level of prices. While it may be assumed that deflation is preferred to deflation because prices are lower, this is not always the case. Controlled inflation is preferred to deflation. Deflation discourages consumer spending, increases the real value of debt, and there may be higher unemployment. The Fed aims for 2% inflation because they feel it represents an equilibrium between a high inflation rate (which would impact the public's ability to make long term financial decisions) and a lower interest rate (which may have the effect of slipping into deflation, thus reducing the value of money.)

Define nominal and real interest rates. Which one matters and why? How would the expected rate of inflation affect either or both if the expectation is for increased inflation?

Nominal interest rates are the "rate you hear about at your bank" and tells you how fast the dollars in your account will rise over time. Real interest rates are adjusted for the inflation rate and are calculated by real interest rate = nominal interest rate - inflation rate. The most important one of these is the real interest rate, because it takes into account real world factors to give the consumer a more accurate interest rate. The expected rate of inflation if the expectation is for increased inflation would not affect the nominal interest rate, but it would affect the real interest rate by decreasing it.

How can short run fluctuations be defined in the context of the AD-AS model (Aggregate Demand and Aggregate Supply)? Be sure to draw the model.

Short run fluctuations can be defined in the context of the AD-AS model to explain short-run fluctuations in economic activity around its long run trend. On the vertical axis is the overall price level in the economy, and on the horizontal axis is the overall quantity of goods and services produced in the economy. The ADC shows the quantity that consumers wanted to buy at each level, and the ASC shows the quantity of goods and services that firms choose to produce and sell at each price level. The price level and the quantity of output adjust to bring demand and aggregate supply into balance.

Who is on the Federal Open market Committee and what is its role?

The FMOC is the branch of the Federal Reserve Board that determines the direction of monetary policy. The FMOC is composed of the board of governors, which has seven members, and five reserve bank presidents. The president of the NY Fed serves continuously, while th other presidents rotate their service of one year terms. The FMOC meets eight times per year to set key interest rates, and to decide whether to increase or decrease the money supply.

Explain the Federal Reserve's organization and role in the US.

The Federal Reserve is the Central Bank of the U.S. It is governed by the Board of Governors, who are appointed by the President and are confirmed by the Senate. The responsibilities of the BoG are to guide monetary action, to analyze domestic and international economic and financial conditions, and to lead committees that study current issues. The Board also exercises control over the financial services industry, administers consumer protection regulations, and oversees the nation's payments system. The Board also participates in the FOMC, which conducts our nation's monetary policy. The Fed has 12 banks and 25 branches as the operating arms of the central bank.

What is the Phillips Curve? Give an example of how it was used in economic analysis.

The Phillips Curve is a historical inverse relationship between rates of unemployment and corresponding rates of inflation that result an economy. Decreased unemployment in an economy will correlate with higher rates of inflation. It is used in economic analysis in limited use because many economists feel that it is too simple. Many feel that the Philips curve is a short term phenomenon, and that the Philips curve is limited in its ability to project the relationship between unemployment and inflation in the long run.

Why does the Aggregate-Demand curve slope downward? List and explain the three effects suggested by Mankiw.

The aggregate demand curve slopes downward because all other things being equal, a decrease in the economy's overall level of prices raises the quantity of goods and services demanded. Conversely, an increase in the price level reduces the quality of goods and services demanded. A change in the price level moves the quantity of goods and services in the other direction. The wealth effect a decrease in the price level reduces the real value of money and makes consumers wealthier, which in turn encourages them to spend more. This increase means a larger quantity of goods and services demanded. The opposite is true. The interest rate effect means that a lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby reduces the quantity of goods and services demanded. The converse is true. The exchange rate effect means that a fall in the U.S. price level causes interest rates to fall, the real value of the dollar declines in foreign exchange markets. This means that the value of the U.S. dollar falls and people demand more goods and eservices. The converse is true.

What are the four major components of aggregate demand? How do the following factors affect these components and overall Aggregate Demand: wealth effect; interest rate effect; exchange rate effect; and the policy effect? Be sure to show the cause and effect for each of these items. For example, if wealth increases, which component is affected and what happens to Aggregate Demand?

The four major components of aggregate demand are symbolized in the model Y = C + I + G + NX. Y is GDP, C is consumption, I is investment, G is government purchases, and NX is net exports. The wealth effect means that when the price level falls, the dollars individuals are holding rise in value, which increases real wealth and their ability o buy goods and services. This is an increase in C - consumption. An increase in price level causes a decrease in C - consumption. The interest rate effect means that individuals buy and consume more. A lower interest rate increases the quantity of goods and services demanded. A lower price level increases C, but a higher interest rate decreases C. The exchange rate effect means that when a fall in the U.S. price level causes U.S. interest rates to fall, the real value of the dollar declines in foreign exchange markets. This depreciation stimulates U.S. net exports and thereby increases the quantity of goods and services in NX and C. When the U.S. interest rates rise, the real value of the dollar increases and this appreciation reduces U.S. NX and C. The policy effect may cause an increase or a decrease in demand depending on which way it goes. Contractionary monetary policy reduces price outputs and levels, but expansionary monetary policy does the opposite.

Why does the Short-Run Aggregate-Supply curve slope upward? List and explain the three theories suggested by Mankiw.

The short run aggregate supply curve slopes upward in the short term is because the quantity of output supplied deviates from its long run or natural level when the actual price level in the economy deviates that from the price level that people expected to prevail. Sticky wage theory - an unexpectedly low price level raises the real wage which causes firms to hire fewer workers and produce a smaller quantity of goods and services. Sticky price theory - An unexpectedly low price level leaves some firms with higher than desired prices, which depresses their sales and leads them to cut back production Misperceptions theory - An unexpectedly low price level leads some suppliers to think their relative prices have fallen, which induces a fall in production.

What is the velocity of money? How does it relate to other components in the economy? How has the velocity of money changed over the past 30 years?

The velocity of money is the rate at which money changes hands. It can be simplified as the speed at which the typical dollar bill travels around the economy from wallet to wallet. For the past thirty years, the velocity of money has been relative stable. It relates to other components in the economy because when the quantity of money increases, it must be reflected in one of the following ways - the price level must rise, the quantity of output must rise, or the velocity of money must fall.

As defined by Mankiw, what are the two measures of money stock in the economy? Detail their composition (i.e., define the components) and provide their relative size for September 2014 (http://research.stlouisfed.org/fred2/).

Two measures of money stock in the economy are M1 and M2. M1 includes demand deposits, travelers checks, and other checkable deposits, plus all currency. M2 includes everything in M1 plus "near money," which includes savings deposits, money market mutual funds, and other time deposits which are less liquid but can quickly be converted into liquid cash. For September 2014, M1 and M2, together, equaled about (in billions) 14,350. Out of this, M1 accounted for approximately 20%, while M2 accounted for approximately 80%.