Macro Test 2 Short Answers

What is a credit spread? Why do credit spreads rise during financial crises?

A credit spread is the difference between the interest rate that is charged on loans to firms and that which is charged on risk-less assets that will be surely repaid. Because of adverse selection and moral hazard, lenders cant differentiate between credit worthy borrowers and those who aren't so. Thus, they charge a high interest rate to keep themselves from any losses if the borrower was to default on his repayments. So, during financial crises, credit spread increases even more since there are more risky borrowers in the economy.

What are demand shocks? Distinguish between positive and negative?

A demand shock refers to the abrupt surprise event that momentarily increases or decreases demand for goods or services. Examples are terrorist events, earthquakes, government stimulus, and technological advances programs. Positive demand shocks increase demand while negative demand shocks decrease demand. prices of goods and services are affected in both situations

What are supply shocks? Distinguish between positive and negative supply shocks and between temporary and permanent ones.

A supply shock refers to an occasion that unexpectedly upsurges or shrickages the supply of a product or service. Positive supply shocks decrease inflation and shift the SRAS curve to the right while negative supply shocks increase inflation and shift the SRAS curve to the left. Temporary shocks shift only the SRAS while permanent shocks shift both SRAS and LRAS

Explain why the AD curve slopes downward and the SRAS curve slopes upward

AD curve slopes downward because when prices are low, consumers are left with higher disposable income and will spend more. Also lower prices leads to higher exports which also raises AD. AS curve slopes downward because an increase in supply requires production capacity investment which in turn necessitates a higher price to be made economically feasible.

Some Federal Reserve officials have 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 SRAS?

As people expect the inflation rates to be higher in the economy, the value of expected inflation will increase. This will raise the inflation rate in the economy and the SRAS curve will shift upwards for the given level of output.

One of the main characteristics of financial deepening is that more individuals participate in the financial system: more people open checking and savings accounts, and more firms rely on financial intermediaries as a source of funds. Comment on the effect of financial deepening on a central bank's ability to conduct monetary policy?

As the level of participation in financial markets increase, effectiveness of monetary policy rises simultaneously. Changes in monetary policies are taken as changes in interest rates. This change has an immediate effect on demand of money in the market. Monetary policy tools affect the ability to create loans and therefore affect the money supply in the economy. As more firms are dependent on financial intermediaries for funds, money supply in the market can be controlled by restriction on access to credits. Hence, financial deepening can help in controlling the short-run fluctuations in the monetary aggregates of the economy.

What is asymmetric information? What two asymmetric information problems hinder the operation of the financial system?

Asymmetric information deals with the situation where at least one party involved in a transaction has less accurate information about the other party involved. Adverse Selection and Moral Hazard are the two types

How can the monetary authorities target any inflation rate they want?

By simply executing independent monetary easing to achieve higher rates of inflation and monetary tightening to achieve lower inflation rate. They do not affect potential output or real interest rate in the long run.

Argentina announced that it would not honor its sovereign debt. Do you think investors are currently willing to buy bonds issued by the government of Argentina?

Citizens will not trust their government. Very few people will be willing to buy the bonds issued by them and most of the people will avoid taking this risk

explain the processes of cost-push and demand-pull inflation. How do macroeconomists distinguish between the two?

Cost-push inflation occurs when the unemployment rate is higher than the natural rate of unemployment. When there is a temporary negative supply shock, output decreases and unemployment increases. Policy makers make an autonomous easing of monetary policy, shifting the AD curve to the right. process keeps happening. Demand-Pull inflation occurs when unemployment rate is below the natural level. Often happens because policy makers mistakenly set the target unemployment rate below the natural level. Now potential output is below target so policy makers make autonomous easing of monetary policy to increease aggregate demand. this causes AS to shift upward, leading to a spiraling rise in inflation.

What are the two types of asset-price bubbles? Which type poses a bigger threat to the financial system?

Credit-driven bubbles are driven by credit booms where increased demand for assets, due to high lending activity, increase their prices. This in turn encourages further lending to purchase these assets which further increases demand for the assets, again driving up prices. Optimistic expectation driven bubbles is also called irrational exuberance. Credit driven bubbles are more dangerous because when they burst, asset prices collapse, loans go sour and lenders are reluctant to lend, thus credit supply shrinks. Demand for assets declines even further and so does it price.

Why does the divine coincidence simplify the job of policymakers? In what situations will it prevail?

Divine coincidence means that there is no trade among thee steadiness of inflation and the steadiness of the wellbeing output gap. gap between real output and effective output for central banks of nations. Steadying the output gap is the same as steadying the welfare significant output gap, gap among actual and efficient output. If there is a presence of non trivial actual imperfections in the model, then the gap among natural and efficient output is not constant is overstated by shocks and divine coincidence disappears. Central banks are left with the trade-off option between output and inflation maintenance.

Distinguish between hierarchical and dual mandates. which best describes the US policy making environment?

Hierarchical require stable inflation as a condition of pursuing other goals. Dual is the coequal objectives of price stability and highest sustainable employment. US is dual since LR interest rate will be high only if there is high inflation and employment cannot be beyond its highest sustainable rate in the LR. Adheres to steady inflation and utmost sustainable employment

Suppose the White House decides to sharply reduce military spending without increasing government spending in other areas. What is the effect on AD?

If there is a decrease in government spending, AD will fall and it will shift to the left and down at each inflation rate.

How does direct finance differ from indirect finance? Which form of finance is more important?

In direct finance, borrowers borrow funds directly from the lenders through financial markets by selling them financial instruments. In indirect finance, financial intermediaries such as banks, insurance companies and mutual funds act as a mediator between lenders and borrowers. Indirect is most important because of screening and monitoring, private loans, and restrictive covenants.

According to the modern PC analysis, what factors determine the rate of inflation? How do changes in each factor affect the SR PC?

Inflation rate is determined by expected inflation, unemployment gap, and price shocks. These price shocks occur due to changes in supply or due to changes in the cost of factors of production. Changes in expected inflation will shift the PC curve. Changes in price shocks cause a shift in the PC. A change in unemployment rate will cause movement along the PC.

How do you think the internet has affected the natural rate of unemployment? How does the use of the Internet by job searchers and employers affect the LRAS?

Internet has decrease the cost of job searchers as job seekers are able to connect to the firm and upload their resumes online. This has screased the time taken by an unemployed to find a job according to his potential. As a result, the natural rate of unemployment has decreased in the economy. In the long run, this will increase the amount of labor in the economy and as more labor is utilized in the production process, output will increase. So, the LRAS curve will shift to the right.

What causes the SRAS curve to shift?

It is affected by the expected inflation rate and price shocks. A rise in expected inflation rate or a positive price shock will lead to an upward shift in the curve.

What causes he LRAS curve to shift?

It is unaffected by changes in the inflation rate. It is only affected by the changes in the technology, amount of capital used in the production process, and the amount of labor supplied. Any increases in these will lead to a rise in the amount of output which will shift the LRAS to the right

How might fears of a zero lower bound justify a proactive lowering of federal fund rate policy, even if the economy was not actually in a recession?

It is viewed by policymakers that the danger of economic harm due to deflationary spiral is considerable enough to surmount any significant risk of inflation at the time of implementing the policy.

Financial regulators have been working to improve transparency and reduce risk in the derivatives market. How do you think increased transparency will affect financial intermediaries that trade derivatives? How do you think it will affect the overall performance of the financial system?

It will regulate financial markets and will result in public availability of derivative prices. However, profits of the firms might decrease since it will become more difficult to keep information private within financial markets. Firms will have a strong incentive to disclose inaccurate information which will degrade the performance of the financial market.

Suppose one could measure the welfare gains derived from eliminating output fluctuations in the economy. assuming these gains are relatively small for the average individual, how do you think the conclusion would affect the activist/nonactivist debate.

It would support the case of nonactivists. Non acitivists believe that wages and prices regulate faster than what is believed by activists and think that stabilizing policies should not be adopted since they are time consuming and the economy has a self-correcting mechanism.

Describe two primary objectives of macroeconomic stabilization policy

Monetary policy to cut real interest rates and fiscal policy to tighten monetary policy

Explain why mortgage delinquency rates were higher for subprime mortgages. Explain why adjustable rate mortgages experienced higher delinquency rates.

Mortgage delinquency rates were higher for subprime mortgages because this class was not as credit worthy as the others. When the asset-price bubble in the housing sector burst and the prices of houses went way below their fundamental economic values, these subprime classes were unable to pay back the loans that they had taken from the banks and other financial institutions. Adjustable mortgage rates experience higher delinquency rates since in this case, the interest rates were not fixed beforehand, the interest payments increased drastically due . to the crisis that had struck. Thus, it became even more difficult for the borrowers to repay the loans.

Should policy makers strive to achieve zero rates of unemployment and inflation?

No because these attempts are inconsistent with the intention of price stability. By pursuing a zero target rate of inflation, the risk of deflation is increased and prices fall thereby causing a risk of damage to an economy.

Would it be a good idea for monetary policy makers to set the federal funds rate solely using the Taylor rule?

No. there is no assurance that the coefficients of the Taylor rule are steady across time and no way to know the size of output and inflation gap at any given point of time. Strict adherence to the Taylor rule would forbid independent monetary policy easing or tightening.

Starting from a situation of LRE, what are the SR and LR effects of a positive demand shock?

Positive demand shocks will cause AD to shift to the right, raising both price level and output. Output is now higher than potential. Firms will contend to employ scarce workers, driving up the wage rate, so SRAS will shift up and to the left. Even though the economy will return to full employment level in the LR, it can lead to higher prices

What nonconventional monetary policies shift the aggregate demand curve and how do they work?

Purchasing the assets of private securities lowers the real interest rate. Purchasing the assets of long term bonds raises the prices of these bonds and long term interest rate is reduced thereby lowering the real interest rate for investments.

How does the condition for SR equilibrium differ from that of LR equilibrium?

SR equilibrium occurs when QD is equal to QS of output. On the other hand, LR equilibrium requires that the economy's SR equilibrium takes place at the potential level of output. So AD and SRAS have to intersect at a point on the LRAS

What causes bank panics and why do they worsen financial crises?

Since asymmetric information exists among depositors, they will not be able to know if their bank is good or one that has gone insolvent. So, all depositors will want to withdraw their deposited money in a rush, as the banks a re anticipated to not be able to repay the same. This will force all banks to sell assets to meet their repayment demands. This is called fire sales of assets, which decreases their prices to a large extent, making most banks go insolvent, thus multiple banks fail. Bank panics worsen the financial crisis since they make banks that are in good positions go insolvent. This increases friction in financial environment and the economy starts to slacken and worsen.

Why does debt deflation make financial crises worse?

The AD curve shifts left, causing a decrease in deflation. This causes a contraction in lending and a slowdown of the economy for a long period of time, worsening the financial crisis. An unexpected decline in prices increase value of the firms' liabilities in real terms but the real value of assets has not increased, causing firms' net worth to fall. This decreased net worth of businesses who would borrow cause adverse selection and moral hazard problems to augment in the market

Identify changes in three factors that will shift the AD curve to the right and changes in three different factors that will shift the AD curve to the left.

The AD curve shifts right due to an increase in consumption spending or an increase in net exports and a decline in taxes. It shifts to the left when there is a decrease in consumer spending and net exports and an increase in taxes.

What relationship does the AS curve describe? How is this relationship depicted with the LRAS curve?

The AS curve represents a positive relationship between total output and the rate of inflation. it is upward sloping which is derived with the help of the PC. In the LR, aggregate output is determines by technology, the amount of labor in the ecnonmy, and the amount of capital used during production. None of these are related to inflation so LRAS is a vertical line. in the LR, total output is supplied at the natural rate of output/potential output.

Do you think the Federal Reserve acted according to its mandate by providing liquidity to corporations and individual market participants? Or that it wrongfully used its ability to support the financial system?

The Federal Reserve is given the ability to lend to businesses or individuals the discounted securities under odd state of affairs. While the Federal Reserve started excessively lending to people, many lending facilities were created by it to direct funds to certain sectors the economy. They were effective in supporting the US financial system. Want to stabilize inflation and get . highest sustainable employment.

What basic realtionship does the SR Phillips curve describe? what trade-offs does this relationship seem to offer policy makers?

The SR Phillips curve represents an indirect relationship relationship between rate of unemployment and inflation rate. during periods of low unemployment, there is a shortage of labor in the economy and employers find it difficult to hire qualified workers so they increase wages in the economy. this increases prices showing that low unemployment implies inflation. When unemployment is high, supply of labor increases and workers are willing to work at any wage, causing wages and prices to fall in the economy. So, policy makers can either choose low unemployment with higher inflation or higher unemployment with low inflation.

An article in the Wall Street Journal reported that inflation-adjusted wages have slumped in recent years. Is this statement consistent with the AD and AS analysis of the recent US economic crisis?

The decline in real wages, that is inflation adjusted wages, reveal he operation of the self-correcting mechanism. As oil price increased there was negative supply shocks and AD decreased as a result of global financial crises. due to the combination of the negative supply shock and the decrease in AD, unemployment increased and output decreased. Due to negative output gap, a slack labor market decreased the bargaining power of workers who agree to work on lower wages. This shifts the SRAS curve to the right. The reduction in real wages should end when the economy returns to its potential output again.

Oil prices declined in the summer of 2008, following months of increases since the winter of2007. Considering only this fall in oil prices, explain the effect on short-run aggregate supply and long-run aggregate supply, if any.

The decrease in oil prices made production possible at lower costs by decreasing the price of energy, transportation, and a number of raw materials. It therefore lessened pressure for firms to raise prices, reducing inflation at every equilibrium level of output. Graphically, the short-run aggregate supply curve shifted downward and to the right. Since neither technology nor factors of production were affected by this price shock, the long-run aggregate supply curve remained unchanged.

Using the concept of asymmetric information, explain why the debate was centered around financial system regulations. Do you think the Federal Reserve failed in its attempt to properly enforce regulations that were current at the time?

The origin of the crisis was financial institutions. Had they been more prudent while giving out loans to the subprime borrowers, the crisis would not have originated. It started only because loans were given out to not very credit-worthy borrowers who would go on to buy houses and not repay the loans. the Federal reserve failed because its policies promoted irresponsible financial practices like moral hazard.

Evaluate the following statement: "the recent depreciation of the US dollar had a positive effect on the US Ad curve

The statement is correct. A depreciation of the U.S. dollar makes U.S. exports cheaper for foreign consumers at the same time it makes imports into the U.S. more expensive. As a result, exports increase, imports decrease, and net exports increase. According to aggregate demand and supply analysis, the aggregate demand curve shifts upward and to the right. Note that the depreciation of the U.S. dollar might also affect the short-run aggregate supply curve if U.S. firms import many of their inputs. An increase in the price of inputs will shift the short-run aggregate supply curve up and to the left.

explain how output and the inflation rate would be affected in the SR and LR by the consequences of climate changes

These events create a negative supply shock and ouput is decreased and inflation increase in the SR . the SRAS curve shifts to the left. the self-correcting mechanism will re-establish the economy to its original LRE. the increase in inflation and decline in output is only temporary and the AD curve will not be shifted to the right. AS curve will eventually shift back to the righ

Microcredit programs usually target a group of women and assign funds to them under the condition that decisions about the use of funds are made by all women in the group. How do you think this procedure will help solve asymmetric information problems?

These programs are generally informal in nature and tend to build a trust-based relationship with their clients. Since a group of individuals are given a loan together, therefore they can keep a check on each other. if one person has intention to default, others have an incentive to complain about her behavior to the authorized institution. This removes the problem of moral hazard. Also, these loans are made to poor individuals who want to work hard so that their investment is a success. These people take microcredits as a way to escape poverty. Hence, it removes the problem of adverse selection.

Suppose that Congress passes legislation that establishes a tax credit for small businesses and tax incentives for all businesses that invest in new plant and equipment. What is the anticipated effect of these proposals on AD if any?

These proposals will decrease the tax burden on small businesses and will will encourage businesses to employ more employees due to the lower tax burden and to raise investment. More employment of workers will result in higher consumption and planned expenditures, as new employees spend their wages on purchase of goods and services. This will have a positive effect on AD and result in a shift in AD curve to the right. Equilibrium level of output will increase at any given inflation rate.

What steps can governments take to reduce asymmetric information problems and help the financial system function more smoothly and efficiently?

They can issue laws that promote transparency and impose criminal and civil penalties on those who commit fraud or provide wrong information. They can precent bank failures by providing safety nets for the depositors. They can enforce rules and regulations that control the behavior of financial institutions and monitor their activities by engaging in prudential regulations and supervisions.

According to the Reserve Bank of New Zealand Act of 1989: "The primary function of the Bank is to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices". Do you think that this statement constitutes a hierarchical mandate or dual mandate for the conduct of monetary policy? is this mandate consistent with a positive inflation rate target?

This statement constitutes a hierarchical mandate. The central banks mandate puts the motive of price stabilization as priority but as long as this goal is achieved, other goals can be pursued. The statement states that the bank has a clear hierarchical mandate to attain low and stable inflation. This is perfectly reliable with a positive inflation rate target.

Comment on the gross issuance of MBS in the US during 2007 to 2009

This was when the asset-price bubble in the housing sector of the US economy had burst, driving down the prices of these. The asset price bubbles are driven by credit booms, where icreased demand for assets, due to high lending activity, increases their prices. When they burst, asset . prices collapse, loans go sour, and the lender is reluctant to lend, thus credit supply shrinks. Demand for assets decline further and so does its price. This is exactly what happened with the mortgage backed securities in the housing sector. There was very high uncertainty in the markets at this time. Lenders became cautious as they saw that the loan repayments were unlikely due the fall in prices of the houses. They stopped lending. The prices of MBS also fell and they were expected to give low rates of return due to these conditions prevailing in the markets. Thus, with fall in their demand, their gross issuance fell.

According to AD and AS analysis, what would be the effect of appointing a FRS chairman known to have no interest in fighting inflation?

This will result in a rise in expected inflation so the SRAS curve will shift up and left. In the short run, inflation increases and output decreases.

Describe the adjustment to LRE if an economy's SRE output is above its potential output.

Unemployment is less than the natural rate so there is extreme tightness in the labor market. This compels wages to go up and causes firms to move up their prices. inflation will increase above the initial inflation rate. So, expected inflation is higher and prices and wages will rise more rapidly and the SRAS curve shifts up and to the left. Continues until actual output equals potential.

Why does the self-correcting mechanism stop working when the policy rate hits the zero lower bound?

When there is negative output gap, this leads to a leftward shift in the AS curve. inflation is reduced rather than increased and aggregate output falls, which further creates a negative output gap. Create a spiral where inflation keeps declining as well as output.

How does the policy rate hitting a floor of zero lead to an upward-sloping AD curve?

When there is zero rates of interest, a lower rate of inflation has caused a higher real interest rate since the nominal interest is set at zero. This high real rate of interest then causes planned expenditure to decrease. This causes a fall in aggregate output. When the inflation falls, there is also a fall in aggregate output causing a rightward shift in AD.

How can a sufficiently large financial panic pull the economy below the zero lower bound into a destabilizing deflationary spiral? How can a sufficient amount of asset purchases reverse the effects of this?

a financial panic will increase f, causing the MP curve to shift upward, shifting the AD curve to the left. As curve will shift down, further decreasing inflation while also decreasing output. Asset purchases lowers f, which cause MP to shift down, shifting the AD curve back to the right. there is no longer a risk for a deflaitionary spiral. As curve shifts right.

What role does the financial system play in promoting economic growth?

a financial system accommodates all the institutions that help the borrowers and lenders to exchange funds in the economy. They act as a mediator between those who have surplus funds and those who have shortage of funds but productive ideas. With a well-functioning financial system, funds are directed to the best productive ideas and maximize efficiency in the economy, thus promoting economic stability and growth in the economy

How can asymmetric information lead to a bank panic?

as banks make private loans, they tend to invest in collecting information about the borrowers. However, the depositors lack information about the banks as they are unaware about the risky projects in which banks are involved. Borrowers lack information about the total assets of the banks and their ability to pay them back. This can lead to bank runs where the individuals withdraw their cash deposits from the bank, which further results in bank failures

How does asymmetric information help us define a financial crises?

asymmetric information increases credit spread. Credit spread refers to the difference between the interest rate that is charged on loans given to businesses, and that charges on assets that are sure to be paid back. When financial markets experience this, they stop functioning leading to a financial crisis where the entire economy can collapse

Suppose a country encourages its citizens to save 20% of their income and then allocates these funds through government owned financial intermediaries. As a result, many government officials get mortgages to buy expensive houses. Do you think funds were allocated to their most productive use?

citizens of the country invested in government owned financial intermediaries in a hope that their savings would be used as a fund for those with productive opportunities. Instead, government officials used these funds to buy expensive homes for themselves. This shows the failure of financial system in the economy due to corruption and improper management of government institutions. funds were not invested in their most productive use, hence inefficiency will prevail in such an economy.

Why are asymmetric problems particularly challenging in developing countries? What does this imply about the importance of financial intermediation and the role of banks in these countries?

developing countries face more problems due to asymmetric information due to low accounting standards and less access to technology. Banks are extremely dominant in these countries' financial systems. Banks are some of the only institutions with enough resources to collect information about borrowers. The only way to decrease banks importance is to advance technology and allow securities markets to gain strength

According to the expectations-augmented PC, what factors determine the rate of inflation? How do changes in each factor affect the SR PC?

expected inflation and the unemployment gap are the two major determinants of the inflation rate. higher expected inflation and lower unemployment gap implies higher inflation in the economy and vice-versa. Changes in expected inflation will shift the SR PC curve while changes in the unemployment gap will cause movement along the curve.

How do you think the process of financial innovation affects the effectiveness of macro prudential regulation?

financial innovation such as a rise in prices may result in credit boom. This provides a signal that a bubble might be forming. As a macro prudential regulation, central bank or government authorities can consider policies to control the credit growth directly. They can also introduce implementing measures to make sure that credit standards are sufficiently high. Therefore, macro prudential regulations can help in controlling credit-driven bubbles. This will further improve the financial system and the economy.

Why are financial intermediaries willing to engage in information collection activities when investors in financial instruments may be unwilling to do so?

financial intermediaries have a greater incentive to invest their resources on collecting information. they make private loans that are not traded openly in financial markets, making it difficult to free ride on the information collected by them

What are adaptive expectations? What justifies the assumption of adaptive expectations in PC analysis?

generally households and firms predict the FV of any variable by considering its past values. this form of expectations where past values of a variable are taken into account to forecast the FV is known as adaptive expectations. In PC analysis, inflation rate is determined by expected inflation. It is assumed that households and firms consider the values of past inflation to form their expectations about future inflation. inflation expectations are sticky in nature due to the assumption of sticky prices. So, inflation will not be fully adjusted to the changes in prices and wages in the SR, so this assumption is justified.

suppose the current administration decides to decrease government expenditures as a means of cutting the existing government budget deficit. According to the AD and AS analysis, what will be the effect of such a measure in the short run? What will be the effect on the real interest rate, inflation rate, and output level if the Federal Reserve decides to stabilize the inflation rate?

if government expenditure is reduces, the AD curve will shift to the left. the inflation rate will increase and the the output level will decrease, falling below potential. In order to stabilize the economy, the Fed will use monetary policy that will lower the interest rate, shifting the MP curve down and to the right. This shifts the AD curve to the right and the economy returns to LRE. Inflation reaches its target level and output is at potential while the real interest rate is lowered.

Describe the effects on the economy if the Federal Reserve uses monetary policy to burst a wrongfully identified asset-price bubble

if the Federal Reserve was to use monetary . policy to prick a wrongfully identified asset price bubble, it would be very harmful to the economy. Asset prices will collapse and loans will go sour and lenders are reluctant to lend, causing the credit supply to shrink. demand for assets declines further and so does its price.

Many policy makers in developing countries have proposed the implementation of systems of deposit insurance like the one that exists in the US. Explain why this might create more problems than solutions in the financial system of a developing country.

implementation of deposit insurance in such countries will result in increased deposits at financial intermediaries. However, developing countries don't have financial regulators to deal with problems like moral hazard and adverse selection. Also, developing countries have higher levels of corruption and there are chances that the borrowers will default. This might worse off situations in financial markets instead of improving them.

Assume policy makers are using the Taylor rule as a basis for policy changes. In 1973, the US experienced an unexpected slowdown in productivity, which reduced potential output. The US was experiencing high inflation in the late 1970s. to combat this, Paul Volker significantly reduced the target inflation rate. Show how real interest rate, output, and inflation behave in both the SR and LR in both cases.

in the first case, LRAS shifts left as a result of decline in potential output. This increases the output gap, which prompts independent tightening of policy shifting the MP curve up. This causes the AD curve to shift to the left. The AS curve then shifts left and inflation and real interest rate rise along the new MP curve. End up at new equilibrium point where inflation and interest rate is higher and output is lower. In the second case, a decline in the target inflation rate increases the inflation gap which causes an increase in the real interest rate which shifts the MP curve up. AD shifts to the left which then causes AS to shift right. In the LR, economy will have permanently lower inflation ratte with real interest rate and output unchanged.

starting from a situation of LRE, what are the SR and LR effects of permanent negative supply shock?

it decrease potential output and shifts the LRAS curve to the left. increase in inflation and positive output gap will shift SRAS up and to the left to eliminate output gap. LR consequences are that inflation will be enduringly higher and . output permanently lower.

Starting from a situation of LRE, what are the SR and LR effects of a temporary negative supply shock?

it shifts the SRAS to the left which leads to an increase in inflation and output falls below potential. The output gaps turns negative which increase the unemployment gao which decreases inflation. expected inflation falls which causes the SRAS to shift to the right until LRE is achieved.

If wages were to become more rigid, what would happen to the slope of the Phillips curve?

it would become flatter; More rigid wages mean that prices are less flexible. In this case, a given unemployment gap will have a smaller effect on inflation rates, translating into a more horizontal Phillips curve.

Explain why low levels of interest rates might fuel inflation expectations and what the Federal Reserve should do to avoid such expectations.

lower real interest rates mean the AD curve has shifted to the right, which increases inflation. This makes peoples' expectations of inflation increase. The federal funds target will have to be amplified as soon as inflationary pressure is seen to be building up. Federal Reserve needs to keep a check on inflation.

Is stabilization policy more likely to be conducted with monetary policy or fiscal policy? Why?

monetary policy. Monetary policy will be used in order to remove output gap and inflation gap by raising AD to its initial level and return the economy to its pre-shock conditions. They will cut real interest rate at any certain level of inflation rate. Monetary policy fastens inflation prospect at a level reliable with price stability.

How do financial innovations in mortgage markets contribute to the 2007-2009 financial crisis?

new technology enabled securitization where smaller loans were clubbed together into standard debt securities. This led to . subprime mortgages being made to not so highly credit worthy households. The US residential housing market saw prices skyrocketing. the subprime borrowers started to refinance their houses with even larger loans. This is a major reason why the not so credit worthy households were given out loans, which later ended up not repaying these.

Debt Deflation

occurs when a substantial unanticipated decline in the price level sets in, leading to a further deterioration in firms' net worth because of the increased burden of indebtedness

What is Okun's law? how do we combine it with the PC to derive the SRAS?

okun's law states that there is an inverse relationship between output gap and unemployment gap. So, an inverse relationship between unemployment rate and inflation rate means a direct relationship between aggregate output and inflation rate.

What specific procedures do financial intermediaries use to reduce asymmetric information problems in lending?

screening, monitoring, and restrictive covenants

Assuming policy results in positive technological change for the US economy, what does AD and AS analysis predict in terms of inflation and output?

technological change has an effect on the LRAS. These innovations result in a shift in SRAS. So in the long run, inflation decreases and output increases

What basic relationship does the LR Phillips curve describe? How does this relationship differ from that of the SR PC.

the LR PC says that in the LR, the level of unemployment will be equal to the natural rate of unemployment and will be unaffected by the inflation rate. The main difference between the SR and LR PC is that in the LR prices and wages are flexible and firms and workers only care about real wages. therefore, the curve stands vertically while the SR PC is downward sloping

The recent debate about about healthcare reform in the US includes argument about how the proposed reform might affect the efficiency of the US economy. Based on AS and AD, do you think that a more or less efficient economy is an important issue in this debate?

the LRE of less competent and efficient economies will . end upat a lower level of output. Due to the monetary policy response, the inflation rate might be higher than prior to the realization of reforms that will reduce the efficiency of the economy. output is low in the LR as compared to the SR. Advocators believe The reforms will increase efficiency by encouraging the reduction of cost in the healthcare industry. Disbelievers think that it would mean less efficient economy due to the government interference.

How does the Taylor rule relate to the MP curve?

the Taylor rule recommends the Fed to increase the real Federal funds rate when the inflation gap rises and lessen it when the gap decreases. its advice to vary the real interest rate in reaction to changes in the output gap is a proposal for implementing independent monetary policy easing or tightening to shift he MP curve up or down as it is suitable shift output closer to potential output.

Why is a financial crisis likely to lead to a contraction in economic activity?

the balance sheets of financial institutions are worsened due to the decline in asset price and increase in uncertainty from adverse selection and moral hazard. This result in the AD curve shifting to the left, causing inflation and output to decline. This causes banks to panic, creating friction in the financial system, shifting AD to the left even further. AS curve then shifts down, making the fall in inflation and output even greater. This large deflation triggers a phenomenon called debt deflation which shifts the AD curve to the left even further as well as shifts the AS curve furtther down. This causes an even greater fall in inflation and output. Thus financial crisis leads to reduction in economic activity

What are the benefits of financial deepening?

the benefits of financial deepening will be extended to industries and private firms which rely on external sources of funds. it will help in growth of these firms. It will help in developing new firms in the economy. it will stimulate economic growth by providing efficiency in allocation of capital which will promote higher investment and productivity in the economy.

Suppose that in an effort to reduce the current federal government budget deficit, the White House decides to sharply decrease government spending. Assuming the economy is at its LR equilibrium, carefully explain the shorthand LR consequences of this policy?

the decline in government spending will result in a reduction in aggregate output at each inflation rate and will shift the AD curve to the left and downward in the SR. The economy will be in a SRE with output lower than its potential and a lower inflation rate. This decrease in expected inflation and a higher unemployment rate will shift the SRAS downward and to the right. The self-correcting mechanism has brought the economy back to its LRE. now output is at its potential level and the inflation rate has decreased further. Therefore, the SR effect of this policy is a momentary reduction in output and inflation, while inflation decreases further in the LR while output does not

What is the equilibrium real interest rate and how does it influence the interest rate decisions of FR policy makers?

the equilibrium real interest rate is the interest rate where QD equals QS. no unemployment or output gaps exist here. if real interest rate is below equilibrium, output exceeds potential thereby increasing inflation in the economy. leads fomc members to think of varying the federal funds rate target

Describe the three factors that commonly initiate financial crises and explain how each one contributes to a crisis.

the first is credit booms and busts which occurs when en economy introduces new loans or financial products. Also occurs when a country removes restrictions on financial markets and institutions. This makes the economy go on a lending spree leading to risky lending. Eventually, banks start . running losses, and they start cutting down their lending creating a credit bust. The second is asset-price booms and busts where the prices of assets increase beyond their fundamental economic values. This is driven by credit booms where increased demand for assets increases their prices.

what prevented the financial crisis of 2007-2009 from becoming a depression?

the intervention of the government of the US and other countries. autonomous easing of Monetary policy was undertaken by lowering the federal funds rate target, which led to decreases in real interest rate at any given inflation rate, shifting the AD curve to the right. Kept doing this until the Federal Funds rate reached the lower bound of zero. Also enacted a liquidity provision using instruments like discount window expansion, term auction facility, and new lending programs.

During 2007, the U.S. economy was hit by a price shock when the price of oil increased from around $60 per barrel to around $130 per barrel by June 2008. While inflation increased during the fall of 2007 (from around 2.5% to 4.0%), unemployment did not change significantly (it even increased slightly). Explain the relationship between inflation and unemployment in 2007 using the modern Phillips curve concept.

the modern Phillips curve is derived by adding price shocks to the expectations augmented PC. Pi = pi,e - w(U - U,n) + p A price shock therefore increases prices and inflation but has no affect on unemployment. An increase in oil prices will result in an increase in the value of p. This increase in p will increase inflation without affecting the unemployment gap. the Philips curve will shift when hit by a price-shock. PC will shift upwards and raise inflation for every given level of unemployment. That is why while unemployment stayed the same, inflation rose from 2.5% to 4%

Asset-Price Bubble

the rise of asset prices above their fundamental economic values

Explain how real estate market conditions in Nevada, Florida, and California can explain almost 50% of bank failures in 2008.

these were the states where the housing bubble had burst majorly and housing prices started to fall sharply. The people who had taken out loans from the banks to invest in the housing sector were not in a position to repay the loans and they ran such large losses that they had to shut down. The net worth of the . banks started to fall due to this and made the depositors at those banks anticipate that their banks had gone insolvent so all the depositors started to demand their money back in a rush. When banks were unable to pay the depositors as well as the creditors, they had no option but to shut down.

Why do governments provide safety nets for bank depositors and what are their consequences?

they do this to maintain trust between banks and depositors. this is done by providing insurances on their deposits. they make sure that the funds are available to the financial institutions that are facing trouble in the market. This assurance builds confidence amongst the depositors as they feel protected and no longer have any reasons to withdraw their deposits. Instead, they are more willing to provide more funds to the banks. The consequences are that there are chances the banks will take on projects with greater risks. This will increase the problem of moral hazard.

Suppose you are about to buy a car and ask to see a vehicle history report to check on previous accidents or problems reported for that car. When you are told that this information is not available, you decide not to buy the car. Do you think this example illustrates an adverse selection or moral hazard problem? What is the connection between lack of information and the probability that a transaction will occur?

this is an adverse selection problem. There is a direct relationship between lack of information and probability of transaction not occurring. high correlation between the two

Suppose a firm has the great idea of overnight shipping. This will decrease costs for many businesses and will therefore result in a more efficient economy. If they cant get funds for this project, what do you think the consequences will be for the economy?

this will create inefficiency in business due to lack of resources. This will discourage entrepreneurs to engage in R&D. individuals will not have an incentive to create new idea. This will lead to the economy not functioning even further.

Why does the SRAS curve slope upward?

when output is greater than potential output, output gap increases which will lead to a fall in the unemployment gap, according to Okun's law. This tightening of the labor market will increase inflation in the economy. the SRAS curve shifts upward because as the output increases, unemployment will fall which will increase the inflation in the economy.

Although Okun's law holds for different countries, those with more flexible labor markets experience a higher response . of unemployment to changes in GDP. During the recent financial crisis, real GDP decreased in the US, Germany, and France. considering that the US labor market is more flexible than European labor markets, would you expect the same increase in unemployment in these three countries?

when the labor market is flexible, there is a greater response of unemployment to the variability in output. in countries like Germany and France which have rigid labor markets, changes in output have less impact on the unemployment. the US economy has a flexible labor market so during the financial crisis, there is a decline in output and firms lay off their workers which results in an increase in unemployment. in European economies, there are strict labor laws that do not allow firms to fire workers so even though GDP fell, unemployment was not affected.

The Taylor rule suggests that the policy rate target should be increased when the output gap is positive. Do you think the Taylor rule encourages or discourages demand-pull inflation? Which might me a limitation of the Taylor rule with respect to demand-pull inflation?

when the output gap is positive, unemployment is below its natural rate. So, when the MP curve shifts up, there is an increase in interest rate at every inflation rate and the AD curve shifts to left, increasing unemployment. Troubles with this rule is that policymakers could fail to correctly estimate potential output and they might choose to leave the target unaffected for too long at a low level. This will lead to increases in output and will create conditions for demand pull inflation.

Suppose you go to a bank intending to buy a certificate of deposit with your savings. explain why you would not offer a loan to the next individual who applies for a car loan at the bank at a higher interest rate than the rate the bank pays on certificates of deposit.

while banks makes loans with your savings at a lower rate, they have a better ability to make sure you actually earn something. Banks go through a long process of screening and monitoring to determine the net worth and credit history of a person. they are very efficient at this. Also, banks can generate restrictive covenants to control the behavior of the borrower.