Chapter 16

Each of these events occurred as a result of falling real estate prices in 2006 and 2007 EXCEPT that:

the Federal Funds rate began to rise. The Federal Funds rate is determined by the Fed, not by events in the broader economy.

Which event is different from the rest? a demand shock a supply shock a real shock a shift of the Solow growth curve

a demand shock This is the only one that involves a shift of the aggregate demand curve.

If the Fed responds to a negative real shock by increasing the money supply, the rate of inflation will be:

higher than if the Fed did nothing. However, the real growth rate would be higher than if the Fed did nothing.

A negative real shock leads to a _____ rate of price inflation and a _____ growth rate for GDP.

higher; lower

A negative real shock leads to a _____ rate of price inflation and a lower _____

higher; real growth rate See Figure 35.3.

In the week before the terrorist attacks of September 11, 2001, the Federal Reserve lent about $34 million to banks. On September 12, 2001, it lent $45.5 billion to banks. This highlights the importance of the Fed's role in boosting:

market confidence. The mere fact that the Federal Reserve sent a countersignal helped stabilize expectations, reduce fear, and raise confidence.

The oil crisis of the early 1970s was a:

negative real shock. Negative real shocks present a policy dilemma for the Federal Reserve.

It's _____ for the Federal Reserve to make booms and busts worse rather than better.

possible For example, a number of economists have argued that the Federal Reserve policy in 2001-2004 contributed to the housing boom and eventual bust that led to the financial crisis in 2007-2008.

The Federal Reserve's response to the oil crisis of the 1970s was to:

primarily address the problem of high inflation. In restricting the money supply, the Fed may have set in motion very high unemployment for the rest of the 1970s.

The Federal Funds rate was at about _____ in 2000 and was _____ by the end of 2001.

6.5 percent; down to 2 percent The Fed was very concerned about unemployment following the recession of 2001.

Which statement is TRUE?

A distorted price signal arises when government policy moves a price in a manner that encourages investors to take risks.

A significant reduction in the rate of inflation is:

Disinflation

If the Fed is able to use monetary policy to perfectly offset a negative aggregate demand shock and end a recession, all else equal, which statement is TRUE?

Inflation expectations in the long run will be the same as before the recession. Figure 35.1 shows this scenario: the economy begins at point "a" before the recession and ends up at point "a" in the long run.

If the Federal Reserve overstimulated the economy, how would this most likely affect inflation?

Inflation would rise. According to Figure 35.2, overstimulation of the economy leads to higher inflation.

What should the Fed probably have done to prevent the housing bubble that led to the financial crisis of 2007-2008?

The Fed could have restrained some of the subprime mortgages that were sold during the boom. These risky mortgages went into default after housing prices began to fall and contributed to the chain reaction that followed.

Which statement is NOT a criticism of the claim that the Federal Reserve should have raised rates more quickly in response to the housing bubble?

The Federal Reserve knew that the housing bubble would be good for the economy in the short run. The Fed, like anyone else, could not have known for certain that it was an unsustainable bubble.

Given a best-case scenario, which statement correctly describes the Federal Reserve's behavior?

The Federal Reserve tries to offset a negative shock to aggregate demand with an increase in the money supply. See Figure 35.1.

What impact would radical disinflation have on unemployment?

Unemployment would rise in the short run only. Paul Volcker's disinflation in the 1980s caused a very bad recession but set the stage for 25 years of strong economic growth.

Disinflation is best defined as:

a significant reduction in the rate of inflation. When Fed chairman Paul Volcker reduced the inflation rate from 13.5 percent to 3 percent in the 1980s, the result was high unemployment.

Monetary policy:

can influence aggregate demand, but it can't push the demand for housing down and at the same time keep the demand for everything else up. Monetary policy is a crude means of popping a bubble.

The central bank can help the inflation rate to decrease after a negative real shock through:

contractionary monetary policy. Figure 35.3 shows this response. The problem is that the real growth rate falls even further.

The central bank can help the real growth rate to improve after a negative real shock through:

expansionary monetary policy. Figure 35.4 shows this response. The problem is that the inflation rate rises even further.

When faced with a negative shock to aggregate demand, the central bank can boost aggregate demand through:

expansionary monetary policy. Increasing the money supply would reduce interest rates, boosting consumption and investment.

One of the Federal Reserve's most powerful tools is its influence over _____, not its influence over _____.

expectations; the money supply Fear and confidence are some of the most important shifters of aggregate demand.

In the late 1990s, the American economy was:

the envy of the world. Economic growth was strong and unemployment was low.

If the Fed responds to a negative real shock by decreasing the money supply, the Fed is addressing:

the problem of inflation, but not the problem of lower real growth. Figure 35.3 shows a negative real shock to which the Fed responds by decreasing the money supply.