Economics 110: Exam 4 FINAL

At the end of the last fiscal year, the public debt was $14.7 trillion. If this year the government ran a surplus of $.4 trillion, what will be the public debt at the end of this year?

$14.3 trillion

Be able to solve the equation of exchange if given 3 variables.

(the money supply (M))(the velocity (V)) ≡ (the price level (P))(the Real GDP (Q)): MV ≡ PQ

The equation of exchange can be interpreted in different ways:

1. (The money supply)(velocity) = (the price level)(Real GDP): MV ≡ PQ 2. (The money supply)(velocity) = the GDP: MV ≡ GDP 3. Total spending or expenditures = the total sales revenues of business firms: MV ≡ PQ

What are the functions of the federal reserve?

1. Controlling the money supply 2. Supplying the economy with paper money (Federal Reserve notes) 3. Providing check-clearing services 4. Holding depository institutions' reserves 5. Supervising member banks 6. Serving as the government's banker 7. Serving as the lender of last resort 8. Handling the sale of U. S. Treasury securities (auctions)

Can't government purchases continually increase and so cause continued inflation?

1. Government purchases cannot go beyond either real or political limits so once they reach their limit, they can no longer increase 2. Increases in government purchases are not guaranteed to raise total expenditures because consumption may fall to the degree that government purchases have increased

If we drop the assumptions that V and Q are constant, changes in the price level depend on what 3 variables?

1. Money supply (M) 2. Velocity (V) 3. Real GDP (Q) P ≡ MV/Q

What is fractional reserve banking?

A banking arrangement that allows banks to hold reserves equal to only a fraction of their deposit liabilities

What is a unit of account?

A common measure in which relative values are expressed; a function of money

What is a moral hazard?

A condition that exists when one party to a transaction changes his or her behavior in a way that is hidden from, and costly to, the other party

What is continued inflation?

A continued increase in the price level

What kinds of changes in M, V, and Q will bring about deflation?

A decrease in M or V or an increase in Q = the price level will decrease/fall

What is complete crowding out?

A decrease in one or more components of private spending that completely offsets the increase in government spending

What are price controls?

A government regulation establishing a maximum price to be charged for specified goods and services, especially during periods of war or inflation

What is a discount loan?

A loan the Fed makes to a commercial bank

What is direct finance?

A method of transferring money whereby borrowers and lenders come together in a market setting, such as the bond market

What is indirect finance?

A method of transferring money whereby funds are loaned an borrowed through a financial intermediary

What is one-shot inflation?

A one-time increase in the price level; an increase in the price level that does not continue

What is required reserve ratio?

A percentage of each dollar deposited that must be held in reserve form (specifically, as bank deposits at the Fed or vault cash)

What is adverse selection?

A phenomenon that occurs when parties on one side of the market who have information not known to others self-select in a way that adversely affects parties on the other side of the market

What is asymmetric information?

A situation in which an economic agent on one side of a transaction has information that an economic agent on the other side of the transaction does not have

Suppose that this year the government earns $3.43 trillion in tax revenue and spends $4.19 trillion. The deficit will be ... A. $760 billion B. $7.62 trillion C. $7.6 trillion D. $600 billion

A. $760 billion

If the government decided to cut taxes, this would be considered ... A. Expansionary fiscal policy B. Contractionary fiscal policy C. Automatic fiscal policy D. None of the above

A. Expansionary fiscal policy

Suppose that a person with an income of $100 pays $5 in taxes. A person with an income of $200 pays $9 in taxes. This tax system is ... A. Progressive B. Regressive C. Proportional D. We cannot tell

A. Progressive

What is effectiveness lag?

After being implemented, a policy measure takes time to affect the economy; if government spending is increased on Monday, the aggregate demand curve does not shift rightward on Tuesday

What is legislative lag?

After policy makers decide that some type of fiscal policy measure is required, Congress or the president has to propose the measure, build political support for it, and get it passed; the legislative lag can take many months

What shifts the AD curve in the simple quantity theory of money?

Aggregate demand depends on both the money supply (M) and velocity (V): 1&2. An increase in M or V = an increase in AD = shift the AD curve to the right 3&4. A decrease in M or V = a decrease in AD = shift the AD curve to the left BUT in the simple quantity theory of money, velocity is assumed to be constant. THUS, only changes in M can shift the AD curve.

What is the equation of exchange?

An identity stating that (the money supply (M))(the velocity (V)) ≡ (the price level (P))(the Real GDP (Q)): MV ≡ PQ

What is a regressive income tax?

An income tax system in which a person's tax rate declines as his or her taxable income rises

What is a proportional income tax?

An income tax system in which a person's tax rate is the same regardless of taxable income

What is a progressive income tax?

An income tax system in which one's tax rate rises as taxable income rises (up to some point)

What kinds of changes in M, V, and Q will bring about inflation?

An increase in M or V or a decrease in Q = the price level will increase/rise

What are savings deposits?

An interest-earning account at a commercial bank or thrift institution; normally, checks cannot be written on savings deposits and the funds in a savings deposit can be withdrawn at any time without a penalty payment

What is a time deposit?

An interest-earning deposit with a specified maturity date; time deposits are subject to penalties for early withdrawal - that is, withdrawal before the maturity date; small-denomination time deposits are deposits of less than $100,000

What is money?

Any good that is widely accepted for purposes of exchange and the repayment of debt

What is the excess reserves?

Any reserves held beyond the required amount; the difference between (total) reserves and required reserves

What is a medium of exchange?

Anything that is generally acceptable in exchange for goods and services; a function of money

Suppose the government were to fund the creation of a $1 million national park. After the park is created, a number of local wildlife centers see their profits fall by a total of $400,000. We would call this ... A. Complete crowding out B. Incomplete crowding out C. The multiplier effect D. Supply side fiscal policy

B. Incomplete crowding out

We are often concerned that government spending may be too high or low because of ... A. Crowding out B. Lags C. Both a and b are correct D. Neither a or b are correct

C. Both a and b are correct

The goal of supply side fiscal policy is to ___ to ___ ... A. Raise government spending, stimulate private spending B. Raise government spending, stimulate businesses to produce more C. Lower taxes, stimulate private spending D. Lower taxes, stimulate businesses to produce more

C. Lower taxes, stimulate private spending

What is an automatic fiscal policy?

Changes in government expenditures and/or taxes that occur automatically without (additional) congressional action

What is currency?

Coins and paper money

If continued increases in aggregate demand cause continued inflation, what causes continued increases in aggregate demand?

Continued increases in the money supply lead to continued increases in the aggregate demand: Continued increases in M leads to continued increases in aggregate demand which leads to continued inflation

What is M1?

Currency held outside banks + checkable deposits + traveler's checks

What is a contractionary fiscal policy?

Decreases in government expenditures and/or increases in taxes in order to achieve economic goals

What is a discretionary fiscal policy?

Deliberate changes in government expenditures and/or taxes in order to achieve economic goals

What are checkable deposits?

Deposits on which checks can be written

What is supply-side fiscal policy?

Example: A reduction in tax rates may alter an individual's incentive to work and produce, thus altering aggregate supply

What is direct crowding out?

Example: The government spends more on public libraries, and individuals buy fewer books at bookstores

What is indirect crowding out?

Example: The government spends more on social programs and defense without increasing taxes; as a result, the size of the budget deficit increases. Consequently, the government must borrow more funds to finance the larger deficit. The increase in borrowing causes the demand for credit to rise (the demand for loanable funds), in turn causing the interest rate to rise. As a result, investment drops. Thus, more government spending indirectly leads to less investment spending

Calculate the excess reserves from a required reserve ratio and the total reserves.

Excess Reserves = Reserves - Required Reserves

What is a barter?

Exchanging goods and services for other goods and services without the use of money

What is the FOMC?

Federal Open Market Committee: The Fed's 12-member policy-making group; the committee has the authority to conduct open market operations

What is a balanced budget?

Government expenditures = tax revenues

What is a budget deficit?

Government expenditures > tax revenues

What is double coincidence of wants?

In a barter economy, a requirement that must be met before a trade can be made. The term specifies that a trader must find another trader who at the same time is willing to trade what the first trader wants and wants what the first trader has

What is an expansionary fiscal policy?

Increases in government expenditures and/or decreases in taxes in order to achieve particular economic goals

How does the Fed control the federal funds rate (OMO)?

It sets a federal funds rate target and then it uses open market operations to change the federal funds rate so as to "hit" the target

What is M2?

M1 + savings deposits (including money market deposit accounts) + small-denomination time deposits + money market mutual funds (retail)

The simple quantity theory of money in an AD-AS framework

MV = TE MV = C + I + G + (EX - IM)

What is the effect of continued declines in the SRAS? Can continued declines in SRAS cause continued inflation?

No, cases can happen but they just are not likely.

What is the real interest rate?

Nominal interest rate - Expected inflation rate = Real interest rate; When the expected inflation rate is zero, the real interest rate equals the nominal interest rate

Can you get rid of inflation with price controls?

Not exactly.

What is transmission lag?

Once enacted, a fiscal policy measure takes time to go into effect Example: A discretionary expansionary fiscal policy measure mandating increased spending for public works projects requires construction companies to submit bids for the work, prepare designs, negotiate contracts, and so on

Show how government policy influence AD in both Keynesian and Classical models.

P. 292: (a, b)

Evaluate (using the money multiplier) how a change in reserves would increase money supply.

P. 314 & P. 319

Describe and calculate how open market operations increase or decrease the money supply. Analyze the size of the effect using the money multiplier.

P. 334: (13-2b)

Simple Quantity Theory of Money: Describe the assumptions of the model, discuss how monetary policy will effect P and Q, and show these effects on an AD/AS model (note the odd shape of AS).

P. 358: (c) Assumptions: Both V and Q are constant and changes in M lead to strictly proportional changes in P Effect: The higher the growth rate in the money supply, the greater is the growth rate in the price level

Monetarism: Describe the assumptions of the model, discuss how policy will influence the economy, and does the Fed create inflation?

P. 361: (a, b, c, d) Assumptions: 1. Velocity changes in a predictable way: MONETARISTS believe that velocity can and does change, but not randomly 2. Aggregate demand depends on the money supply and on velocity: MONETARISTS focus on the money supply (M) and velocity (V) the way Keynesians focus on the spending components of TE (C, I, G, EX, and IM), MONETARISTS argue that M and V change aggregate demand while Keynesians argue that C, I, G, EX, and IM changes aggregate demand 3. The SRAS curve is upward sloping: MONETARISTS believe Real GDP may change in the short run which would make the SRAS curve upward sloping, not vertical according to the simple quantity theory of money 4. The economy is self-regulating (prices and wages are flexible): MONETARISTS believe the economy can move itself out of a recessionary or inflationary gap and into long-run equilibrium, producing Natural Real GDP Effect: 1. The economy is self-regulating 2. Changes in velocity and the money supply can change aggregate demand 3. Changes in velocity and the money supply will change the price level and Real GDP in the short run but only the price level in the long run

One-shot inflation: demand-side induced

P. 364 1. The aggregate demand curve shifts right 2. As a result, the price level increases 3. Real GDP is greater than Natural Real GDP = the unemployment rate is less than the natural unemployment rate 4. As a result, wage rates rise 5. The short-run aggregate supply curve shifts left reaching long-run equilibrium

One-shot inflation: supply-side induced

P. 365 1. The short-run aggregate supply curve shifts left 2. As a result, the price level increases 3. Real GDP is less than Natural Real GDP = the unemployment rate is greater than the natural unemployment rate 4. As a result, some economists say that wage rates will fall 5. The short-run aggregate supply curve shifts right reaching long-run equilibrium

Changing one-shot inflation into continued inflation

P. 368 a. Continued inflation from the demand side of the economy b. Continued inflation from the supply side of the economy

Market for Loanable Funds: Draw the supply and demand for loanable funds, show how each of the 4 effects changes either supply or demand, and discuss the effect of the Fed on interest rates?

P. 374: (a) P. 374: (b, c, d, e) 1. The Fed says that it will increase the growth rate of the money supply 2. If the expectations effect kick in immediately, then ... 3. Interest rates rise 4. The liquidity effect kicks in 5. As a result of what happened at point 4, the interest rate drops. The interest rate is now lower than it was at point 3.

What is data lag?

Policy makers are not aware of changes in the economy as soon as they happen Example: If the economy turns downward in January, the decline may not be apparent for 2-3 months

If given income and taxes, evaluate if a system is progressive or regressive.

Progressive: Suppose Davidson pay taxes at the rate of 15% on a taxable income of $20,000. When his taxable income rises to $30,000, he pays at a rate of 28%. When his income rises to $55,000, he pays at a rate of 31%. Regressive: Lowenstein's tax rate is 10% when her taxable income is $10,000. When her taxable income rises to $20,000, she pays at a rate of 8%.

What is a budget surplus?

Tax revenues > government expenditures

What is the TAF program?

Term Auction Facility Program: a program under which the Fed auctions funds to depository institutions; each TAF auction is for a fixed amount, with the TAF interest rate determined by the auction process (subject to a minimum rate bid)

What is the reserve requirement?

The Fed rule that specifies the amount of reserves a bank must hold to back up deposits

What is store of value?

The ability of an item to hold value over time; a function of money

What is the velocity of money?

The average number of times a dollar is spent to buy final goods and services in a year or: First, calculate GDP and/or PxQ. Then, calculate the average money supply (M). Finally, divide GDP by the average money supply to obtain velocity.: V ≡ GDP/M

What are open market operations?

The buying and selling of government securities by the Fed

What is the federal reserve?

The central bank of the United States

What is the income effect?

The change in the interest rate due to a change in Real GDP

What is the expectations effect?

The change in the interest rate due to a change in the expected inflation rate

What is the price level effect?

The change in the interest rate due to a change in the price level

What is the liquidity effect?

The change in the interest rate due to a change in the supply of loanable funds

What is the laffer curve?

The curve, named after economist Arthur Laffer, that shows the relationship between tax rates and tax revenues; according to the laffer curve, as tax rates rise from zero, tax revenues rise, reach a maximum at some point, and then fall with further increases in tax rates

What is crowding out?

The decrease in private expenditures that occurs as a consequence of increased government spending or the need to finance a budget deficit

What is the loanable funds market?

The demand for loanable funds is downward sloping and the supply of loanable funds is upward sloping

What is the board of governors?

The governing body of the Federal Reserve System

What is a tax revenue?

The income that is gained by governments taxation: the individual income tax, the corporate income tax, Social Security, and Medicare taxes

What is the nominal interest rate?

The interest rate actually charged (or paid) in the market; the market interest rate: Nominal interest rate = Real interest rate + Expected inflation rate

What is the federal funds rate?

The interest rate in the federal funds market; the interest rate banks charge one another to borrow reserves

What is a discount rate?

The interest rate the Fed charges depository institutions that borrow reserves from it; the interest rate charged on a discount loan

What are the required reserves?

The minimum dollar amount of reserves a bank must hold against its checkable deposits, as mandated by the Fed

What is the government expenditure?

The sum of government purchases and government transfer payments

What is the simple quantity theory of money?

The theory which assumes that velocity (V) and Real GDP (Q) are constant and predicts that changes in the money supply (M) lead to strictly proportional changes in the price level (P)

What is public debt?

The total amount that the federal government owes its creditors

Suppose that currently the government charges 60% taxes on a base of $100 million. The government is considering stimulating the economy by cutting taxes. They estimate that if the tax rate were 50%, the tax base would be $120 million. Would this tax cut be worthwhile? Explain why or why not. Hint: A Laffer curve might help, but is not necessary.

This tax cut would not be worth while because the tax revenues would stay the same, $60 million.

What is the supply of loans?

Upward sloping, indicating that lenders will lend more funds as the interest rate rises; A Fed open market purchase increases reserves in the banking system and therefore increases the supply of loanable funds = the interest rate declines

If $4,800 billion worth of transactions occurs in a year (GDP) and the average money supply during the year is $800 billion (M), then a dollar must have been used an average of how many times (V) during the year to purchase goods and services?

V ≡ GDP/M V ≡ $4,800/$800 V ≡ 6 A dollar must have been used an average of 6 times during the year to purchase goods and services.

What is wait and see lag?

When policy makers become aware of a downturn in economic activity, they rarely enact counteractive measures immediately; instead, they usually adopt a relatively cautious wait-and-see attitude to be sure that the observed events are not just short-run phenomena