Macroeconomics Mod 3

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E E ALLOCATING CAPITAL MORE EFFICIENTLY HAS BEGUN

APPLICATION: Is China a Counter-Example to the Importance of Financial Development to Economic Growth? Although China appears to be on its way to becoming an economic powerhouse, its financial development remains in the early stages. The country's legal system is weak: financial contracts are difficult to enforce, while accounting standards are lax, making high-quality information about borrowers hard to find. Regulation of the banking system is still in its formative stages and the banking sector is dominated by large state-owned banks. Yet the Chinese economy has enjoyed one of the highest growth rates in the world over the last twenty years. How has China been able to grow so rapidly given its low level of financial development? China's income per person is currently less than $5,000, one-eighth of per capita income in the United States. With an extremely high saving rate, averaging around 40% over the past two decades, the country has nonetheless been able to rapidly build up its capital stock and shift a massive pool of underutilized labor from the subsistence-agriculture sector into higher-productivity activities that use capital. Even though the financial system has not allocated available savings to their most productive uses, the huge increase in capital, combined with the gains in productivity from moving labor out of low-productivity, subsistence agriculture, has been enough to produce high growth. As China gets richer, however, this strategy is unlikely to continue to work. The former Soviet Union provides a graphic example of why this is so. In the 1950s and 1960s, the Soviet Union shared many characteristics with modern-day China: high growth fueled by a high saving rate, a massive buildup of capital, and a large pool of underutilized labor shifting from subsistence agriculture to manufacturing. During this high-growth phase, the Soviet Union was unable to develop the institutions needed for its financial system to allocate capital efficiently. Once the pool of subsistence laborers was used up, the Soviet Union's growth slowed dramatically, and it was unable to keep up with the Western economies. Today no one considers the Soviet Union an economic success story, and its inability to develop the institutions necessary for its financial system to sustain growth was an important reason for the demise of this superpower. To move into the next stage of development, China will need to allocate its capital more efficiently, which requires improving its financial system. The Chinese leadership is well aware of this challenge: in 2003, the government announced plans to put state-owned banks on the path to privatization. In addition, the government is engaged in legal reform to strengthen financial contracts. For example, China has been developing new bankruptcy laws to enable lenders to take over the assets of firms that default on their loan contracts. Whether the Chinese government will succeed in developing a first-rate financial system, thereby enabling China to join the ranks of the developed countries, is a big question mark. You try it... The low level of China's financial development is indicated by the A. formative state of its regulatory mechanism. B. lack of strict accounting standards. C. domination of large state-owned banks. D. difficulty of enforcing legal contracts. E. all of the above. F. A, B, and D only. Which of the following has enabled China to generate one of the world's highest growth rates over the last twenty years? A. A very high rate of saving. B. A centralized political system. C. The ability to shift labor from low- to high-productivity activities. D. All of the above. E. A and C only. China's ability to avoid the Soviet experience (of dramatically slower growth after a period of explosive growth) hinges on the success it has in allocating capital more efficiently . The need to improve its financial system is an issue the Chinese leadership has begun to address.

Financial deepening is another name for financial development. Financial deepening LOADING... in a nation tends to be associated with A. increases in poverty. B. increases in income inequality. C. faster firm growth. D. fewer firms of higher quality.

How did financial innovations in mortgage markets contribute to the 2007-2009 financial crisis? A. Borrowers could get mortgage loans with little or no money down and could borrow more money relative to the value of the house they were buying and relative to their incomes than allowed with traditional mortgages. B. Information technology lowered the cost of packaging numerous subprime mortgages into mortgage-backed securities that could be sold in financial markets, attracting more funds into mortgage finance. C. Advances in information technology and new statistical techniques lowered the cost of evaluating the risk of mortgages to subprime borrowers who did not meet the standards for traditional mortgage loans. D. All of the above are correct.

ADVERSE SELECTION MORAL HAZARD MORAL HAZARD A RESTRICTIVE COVENANT

Identify the type of asymmetric information problem in each of the following: A loan office requests information about your work and credit history before approving your car loan application. The loan office is trying to avoid adverse selection problems. The same loan office explains that there will be a lien placed on your car title up until you pay off the total amount of the loan. The loan office is trying to avoid moral hazard problems. The owner of a football team signs a contract with the new football star. The contract clearly specifies that the player may not skydive. The team owner is trying to avoid moral hazard problems, specifically by using a restrictive covenant .

In recent years, the United States has experienced a sharp increase in obesity rates (in particular amongst teenagers), which is considered to increase the probability of chronic diseases like diabetes. Even if the dependency ratio is constant, what would be the effect of such a trend on the size of the government debt? A. It would likely cause the size of the government debt to increase. B. It would likely have no effect on the size of the government debt. C. It would likely cause the size of the government debt to decrease. D. More information is required to determine the likely effect on the government debt.

D D I D X I D

Increases the availability of funds to domestic borrowers.Increas nothing Enables domestic financial institutions to observe and adopt the "best practices" of foreign firms. nothing Encourages politicians to undertake institutional reforms, such as the adoption of improved accounting standards. nothing Promotes technology transfers from foreign to domestic financial institutions. nothing Creates incentives for the adoption of protectionist measures. nothing Facilitates the adoption of institutional changes that result in a better legal system. nothing Increases investment spending and speeds up economic growth.

Is balancing the budget a contractionary macroeconomic policy? A. Yes, balancing the budget is a contractionary macroeconomic policy because it requires a decrease in government spending and/or an increase in taxes. B. Yes, balancing the budget is a contractionary macroeconomic policy because it requires a decrease in aggregate demand. C. No, balancing the budget is an expansionary macroeconomic policy because it can lower expected future taxes and increase investment and work effort. D. Not necessarily as it does not take into account that balancing the budget may have beneficial future effects that will influence the behavior of households and businesses today.

DECREASE INCREASE MORAL HAZARD INCREASE

Many policymakers in developing countries have proposed implementing systems of deposit insurance like the one that exists in the United States. However, replicating the financial system from one nation may not be successful in other nations due to different economies, politics, histories, etc. Deposit insurance is designed to decrease fears of bank runs and therefore increase confidence in banks and deposits. However, because depositors may feel that the "safety net" of deposit insurance means they no longer need to supervise banks themselves, asymmetric information in the form of moral hazard may increase .

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. Microcredit loans usually lend to borrowers in extremely poor nations, yet in general have higher repayment rates than "regular" loans made by financial intermediaries. Why might this be? A. Poor nations tend to have especially strong property rights and legal systems. B. The moral hazard problem is greatly reduced by providing strong incentives to maintain a good relationship with the group by making loan payments. C. The adverse selection problem is greatly reduced by the screening process. D. Residents of poor nations have higher levels of collateral they can pledge when taking out a microloan.

IRRATIONAL EXUBERANCE NOT SMARTER BOON CAN AND SHOULD INTERVINE HAS A MIZED-BAG OF SUPPORT

POLICY AND PRACTICE: Debate Over Central Bank Response to Bubbles Under Alan Greenspan who was the chairman until 2006, the Federal Reserve took a strong position that it should not respond to asset-price bubbles LOADING... that are driven by irrational exuberance LOADING..., as is often the case for bubbles in the stock market. Greenspan argued that such bubbles are nearly impossible to identify. If central banks or government officials knew that a bubble was in progress, why wouldn't market participants know as well? If they did know, then a bubble would be unlikely to develop, because market participants would know that prices were above their fundamental economic values and so they would not buy them. Unless central banks or government officials are smarter than market participants, which is unlikely given the especially high wages that market participants garner, they will be unlikely to identify when bubbles of this type are occurring. In the aftermath of the 2007-2009 financial crisis, both central bankers and academic economists challenged Greenspan's position, leading to an active debate on what central banks should do about asset-price bubbles. Those who disagree with Greenspan argue that when asset-price bubbles are rising rapidly at the same time that credit is booming, there is a greater likelihood that asset prices are deviating from fundamentals. In this case, central bank or government officials have a greater likelihood than market participants of identifying that a bubble is in progress. This was indeed the case during the U.S. housing market bubble: government officials did have information that financial institutions had weakened lending standards and that credit extension in the mortgage markets was rising at abnormally high rates. Credit-driven bubbles seem possible to identify and are the ones that are capable of doing serious damage to the economy. There is thus a strong case that central banks should respond to possible credit-driven bubbleslong dashbut what is the best policy response? There are three strong arguments against using autonomous tightening of monetary policy to pop credit-driven asset-price bubbles. 1. Higher real interest rates have highly uncertain effects on credit-driven asset-price bubbles. On the one hand, higher real interest rates can be ineffective in restraining the bubble when market participants continue to expect high rates of return from buying bubble-driven assets. On the other hand, if higher real interest rates succeed in bursting the bubble, it can unleash major damage on the economy, as occurred in 1929. 2. The blunt tool of monetary policy tends to push down many asset prices lower, even when a bubble may be present in only a small fraction of assets. 3. To prick a bubble, real interest rates might need to rise to such a high level that the decline in aggregate demand and the resulting economic contraction would create much hardship, as jobs are lost and inflation falls below a desirable level. Although the preceding reasoning suggests that monetary policy should not be used to prick bubbles, as has been argued by Ben Bernanke and other high officials at the Federal Reserve, there are contrary views in both academia and central banks.15 LOADING... If asset-price bubbles are so costly and autonomous tightening of monetary policy can help restrain them, then there can be a case for a response of monetary policy to possible bubbles.16 LOADING... You try it... In Greenspan's view, asset-price bubbles that cannot be addressed by central bankers are those driven by irrational exuberance . Greenspan's belief in a non-interventionist stance toward some asset-price bubbles hinged on the argument that government officials (i.e., central bankers) are not smarter than market participants. The 2007-2009 financial crisis brought attention to asset-price bubbles of a type unlike that of Greenspan's recent experience (at the timelong dashthe 1990s tech stock market bubble). As pointed out by both central bankers and academic economists, the housing price bubble of 2007-2009 was less an instance of irrational exuberance than it was an offshoot of a credit boom . When asset-price bubbles are driven by credit expansions, these same central bankers and academicians argue that government officials can and should intervene . When it comes to choosing a policy (or policies) to "prick" asset-price bubbles driven by credit booms, the use of an autonomous tightening of monetary policy has a mixed-bag of support .

ch 17 problem 6 DEPRECIATE

Suppose that the Federal Reserve cannot convince the public of its commitment to fight inflation in the United States in the near future. What would be the effect on the expected appreciation of the U.S. dollar? Based on this information, the dollar would be expected to depreciate in the future. What would be the effect on the spot exchange rate for the U.S. dollar? Explain your answer using the graph on the right. 1) Using the line drawing tool, show the effect on the spot exchange rate for the U.S. dollar. 2) Using the point drawing tool, identify the new equilibrium value of the dollar. Carefully follow the instructions above, and only draw the required objects.

What are the short-run effects on aggregate output and the inflation rate when the domestic currency appreciates? A. Output rises and inflation falls. B. Output falls and inflation falls. C. Output falls and inflation rises. D. Output rises and inflation rises.

What would happen to revenue from seignorage if the inflation rate is very high? Hint: check Equation 6 LOADING... and assume a quickly rising price level. A. A high inflation rate will lead to a tax on the holders of money balances. B. The revenue from seignorage will eventually decrease as it happens with any tax when the tax rate is high. C. The government will use "new money" to purchase real goods and services, possibly creating more inflation. D. All of the above.

Which of the following would not cause the exchange rate for a currency to rise? A. A decrease in the foreign money supply. B. The expected future exchange rate for the currency rises. C. A decrease in the foreign interest rate. D. An increase in the domestic interest rate.

Why are financial intermediaries willing to engage in information collection activities when investors in financial instruments may be unwilling to do so? A. The free-rider problem reduces gains for financial intermediaries more than it does for investors in financial instruments. B. Decisions made by financial intermediaries are public knowledge, while investments made with financial instruments are not. C. Credit information is asymmetric for investors but not for financial intermediaries. D. Banks make private loans; their conclusions on who is creditworthy are not made public.

2 A

A Starbucks coffee sells for 10 yuan in Beijing, China, and for $5 in Chicago. If the law of one price holds, the nominal exchange rate will be 3 2 yuan per dollar. (Round your response to two decimal places if necessary.) Assume that currently the nominal exchange rate is 1 yuan per dollar. What would be the purchasing power parity theory prediction about the future value of the nominal exchange rate? (Hint: which nominal exchange rate makes the real exchange rate equal to one?) A. The yuan would be expected to depreciate. B. Purchasing power theory does not predict anything about the future value of the nominal exchange rate. C. The value of the yuan would not be expected to change. D. The yuan would be expected to appreciate.

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3 B

A Starbucks coffee sells for 15 yuan in Beijing, China, and for $5 in Chicago. If the law of one price holds, the nominal exchange rate will be 12 3 yuan per dollar. (Round your response to two decimal places if necessary.) Assume that currently the nominal exchange rate is 2 yuan per dollar. What would be the purchasing power parity theory prediction about the future value of the nominal exchange rate? (Hint: which nominal exchange rate makes the real exchange rate equal to one?) A. The value of the yuan would not be expected to change. B. The yuan would be expected to depreciate. C. Purchasing power theory does not predict anything about the future value of the nominal exchange rate. D. The yuan would be expected to appreciate.

Which of the following is associated with asymmetric information in a financial crisis? A. Moral hazard could occur when only borrowers know if the funds will be used to finance high-risk activities. B. Adverse selection can occur if lenders must select from a pool of bad credit risks. C. There is a lack of information about one or more of the parties involved in a transaction. D. All of the above are correct.

Which of the following is not a factor that commonly initiates financial crises? A. Increases in government regulations that make it harder to manage the risks of financial assets. B. Asset-price booms and busts. C. The increased uncertainty that occurs when a major financial institution fails. D. The mismanagement of financial liberalization and innovation.

A CREDIT-DRIVEN BUBBLES

Which of the following is not a type of asset-price bubble? A. Government driven bubbles. B. Credit-driven bubbles. C. Expectations driven bubbles. D. All of the above are asset-price bubbles. Credit-driven bubbles pose a bigger threat to the financial system because a collapse in asset prices then leads to a reversal of the lending loop: loans go sour, lenders cut back on credit supply, the demand for assets declines further, and prices drop even more.

A government can take several steps to reduce asymmetric information problems. Which of the following is least likely to be observed in a nation like the United States? A. Development financial institutions that lend at artificially low rates. B. Provision of a "safety net" via deposit insurance or direct provision of funds to struggling banks. C. Regulations on financial markets that require firms to disclose accurate information about themselves. D. Regulations that limit bank risk combined with supervision to make sure those regulations are followed.

ARE NOT B

Suppose a given country encourages its citizens to save 20% of their income and allocates these funds through government-owned financial intermediaries. As a result, many government officials get mortgages to buy expensive houses (and often default on their payments). In this case, funds are not being allocated to their most productive uses. A more effective way to allocate these funds would be to lend money based on A. the effectiveness of welfare programs in the economy. B. the expected risk and return of the projects for which the loan would be used. C. the votes received by the government official asking for the loan. D. the seniority of the government official asking for the loan.

Figure 1 LOADING..., from the Federal Reserve Monetary Policy Report to the Congress (July 21, 2009), shows the gross issuance of mortgage backed securities (MBS) in the United States between 2007 and the second quarter of 2009. Which of the following does not occur with the changes in the gross issuance of MBS in the United States during this period? A. After the Federal Reserve and the U.S. Treasury provided liquidity and restored confidence in the financial market, trading resumed in the market for MBS and the volume increased during the first quarter of 2009. B. In March 2007, gross issuance of MBS in the United States reached its peak, which coincided with the deterioration of the real estate market. C. When home prices declined and foreclosures increased, the gross issuance of MBS also decreased, as these securities became more risky assets to hold. During the most virulent phase of the housing crisis, there were almost no MBS issued (late 2008-early 2009). D. All of the above.

D NEGATIVE

Financial repression is typically supported by A. governments. B. incumbent financial institutions. C. large established businesses. D. All of the above. E. B and C only. Governments and incumbents (both within and outside the financial sector) often support financial repression since, for them, the perceived consequences of financial progress are negative

DIRECT INDIRECT A

In direct finance, borrowers sell securities to savers; in indirect finance, a financial intermediary obtains funds from savers and then makes loans using those funds. Which of the following is true about the relative importance of direct and indirect finance? A. Indirect finance is more importantlong dashalmost 60 percent of funds supplied to nonfinancial businesses go through a financial intermediary. B. Indirect finance is more importantlong dashsecurities markets are a more significant source of funds for business than are financial intermediaries. C. Direct finance is more importantlong dashsecurities markets are a more significant source of funds for business than are financial intermediaries. D. Direct finance is more importantlong dashalmost 60 percent of funds supplied to nonfinancial businesses go directly from saver to borrower

In December 2001, Argentina announced it would not honor its sovereign (government-issued) debt. Many investors were left holding Argentinean bonds priced at a fraction of their recent value. Which of the following correctly summarizes the situation in Argentina as described above? A. The risk on Argentinean debt rose, its yield rose, and its price fell. B. The risk on Argentinean debt rose, its yield fell, and its price fell. C. The risk on Argentinean debt rose, its yield fell, and its price rose. D. The risk on Argentinean debt fell, its yield rose, and its price fell.A

POINT 1 ' C CH 16 PROBLEM 9

Now show the effects of a decrease in taxes on output for each of these two alternative starting points. 1) Use the multipoint curve drawing tool to produce a new aggregate demand curve resulting from the tax decrease. 2) Use the point drawing tool two times to identify the new short-run equilibria, labeling these points 2 and 2 prime so as to correlate them with the starting equilibria, 1 and 1 prime. Carefully follow the instructions above and only draw the required objects. According to your graph, the potential impact of the American Recovery and Reinvestment Act of 2009 was likely A. reduced below the norm given the economy's 2009 position below the zero lower bound. B. enhanced beyond the norm given the economy's 2009 position above the zero lower bound. C. enhanced beyond the norm given the economy's 2009 position below the zero lower bound. D. not affected since its 2009 position was neither above nor below the zero lower bound.

MORE MORE

One of the main characteristics of financial deepening LOADING... is that more individuals participate in the financial system: more people open checking and saving accounts, and more firms rely on financial intermediaries as a source of funds. When financial deepening takes place, we expect monetary policy to be more effective than it otherwise would be; increases or decreases in the availability of credit would affect more people than it otherwise would.

SPENDING CUTS, AND HIGHER TAXES EXPECTATIONS OF LOWER FUTURE TAX RATES, LESSENED CONCERN ABOUT DEFAULTS, AND REDUCED UNCERTANTY ABOUT POSSIBLE MARKET DISRUPTIONS LARGE NEAR OPPOSE

POLICY AND PRACTICE: The Debate Over Fiscal Austerity in Europe As a condition for financial assistance, European countries experiencing the sovereign debt crises such as Greece, Ireland, Italy and Spain, have been required to reduce their budget deficits immediately by cutting spending and raising taxes. These austerity measures have spawned a contentious debate in Europe, both among economists, the public and the politicians. Proponents of austerity see three important benefits to austerity. First, balancing budgets will ease concerns about defaults, thereby helping bring down interest rates, which will stimulate aggregate demand and help boost economic activity. Second, reducing deficits will lead to an end to the sovereign debt crises, thereby reducing uncertainty about possible disruptions to markets, which should help stimulate investment spending. Third, getting spending under control today will mean that there will not have to be future taxes to pay for it, and expectations of lower future tax rates will then encourage households and businesses to spend more today. As discussed in the previous Policy and Practice case, some fiscal consolidations in the past may well have been expansionary. Critics of austerity argue that cutting spending and raising taxes to reduce budget deficits have been counterproductive because they have led to economic contractions that have produced much hardship. They see fiscal multipliers as being quite high, especially for countries in the euro zone where the policy rate has been near the zero lower bound and is set for the entire euro zone, and so is fixed for each individual country. The analysis in the textbook on fiscal multipliers at the zero lower bound is then relevant because tight fiscal policy in an individual country not only reduces spending directly, but also causes real interest rates in that country to rise as inflation falls, thereby reducing spending and shifting the aggregate demand curve further to the left. Critics of austerity also worry that too tight fiscal policy may not even lead to a successful fiscal consolidation for two reasons. First, the decline in economic activity from the austerity measures may be reduce tax revenue by so much that the budget deficit may not decline. Second, the decline in economic activity reduces nominal GDP and so will result in the debt-to-GDP ratio rising, even if the budget deficit is reduced substantially. The debate over austerity in Europe is not only waged in the hallowed halls of academia or in policymaking institutions, but on the street. Strikes and demonstrations, sometimes violent, have been frequent in Europe, and once unknown political parties that oppose austerity measures have found surprising success at the ballot box. You try it... Which of the following are austerity measures required by European countries troubled with a sovereign debt crisis? (Check all that apply.) A. Spending cuts. Your answer is correct.B. Higher taxes. This is the correct answer.C. Currency devaluation. D. High interest rates. E. Wage and price controls. Your answer is not correct. Proponents of austerity argue that it will produce which of the following benefits? (Check all that apply.) A. Expectations of lower future tax rates. This is the correct answer.B. Greater income equality. Your answer is not correct.C. Lessened concern about defaults. This is the correct answer.D. Enhanced social and political tranquility. Your answer is not correct.E. Reduced uncertainty about possible market disruptions. This is the correct answer. According to the critics of austerity, countries in the euro zone that pursue such policies are likely to experience unusually large declines in aggregate demand because the policy rate in the euro zone is near the zero lower bound.

(24*.75)/12 = 1.50 (10*.75)/12 = .63

Suppose a bottle of wine sells for $24 in California and for euro12 in France. Assuming a nominal exchange rate of 0.75 euro per dollar, calculate the real exchange rate between U.S. wine and French wine. The real exchange rate is 341/231.39 1.50. (Round your response to two decimal places.) Calculate the real exchange rate between U.S. wine and French wine if the domestic price of U.S. wine is now $10 a bottle. The real exchange rate is now 871.50 0.63. (Round your response to two decimal places.)

D HELP REDUCING DECREASE

The Wall Street Journal printed the following on April 14, 2010: "Regulators say they are trying to improve transparency and reduce risk in the derivatives market" with respect to some senators' efforts to modify current regulations. What do regulators mean by transparency? A. Certain assets promised to lenders if a loan is not repaid B. Restrictions on what borrowers can and cannot do with loans C. Credible promises that property rights will be upheld with an effective legal system D. Making financial information available to the public Increased transparency is likely to help the overall financial system by reducing asymmetric information problems. However, because revealing information increases costs and lowers the amount of private information financial intermediaries can use to their advantage, increased transparency may decrease their profits.

Which of the following is not a principal-agent problem resulting from the originate-to-distribute LOADING... business model? A. When investors purchase mortgage-backed securities, it is in their best interest to purchase low-risk securities, which may be contrary to the mortgage brokers' best interest. B. Since mortgage brokers do not intend to hold the mortgage loans they make, they take extra care to gather as much information as possible about the borrower. C. When investors are willing to purchase bundled mortgage-backed securities, it is in the best interest of mortgage brokers to make lots of loans. D. When mortgage brokers do not intend to hold the mortgage loans they make, they have little reason to be concerned whether the borrower can pay off the loan.

Why is a financial crisis likely to lead to a contraction in economic activity? A. Disruptions in the financial system decreases asymmetric information, thereby decreasing the associated problems of adverse selection and moral hazard. B. Those that borrow funds to finance productive investment opportunities will have a greater opportunity to obtain financing. C. A disruption in the financial system diminishes the flow of funds from savers to borrowers. D. None of the above are correct.

__________ occurs when a substantial unanticipated decline in the price level sets in, leading to a further deterioration in a firm's net worth because of the increased burden of indebtedness. A. Adverse selection B. Deleveraging C. Debt deflation D. Moral hazard

D B CREDIT RATING AGENCIES C WEAKENING E DECLINED SIGNIFICANTLY EUROPE B

APPLICATION: The 2007-2009 Financial Crisis Most economists thought that financial crises of the type experienced during the Great Depression were a thing of the past for the United States. Unfortunately, the financial crisis that engulfed the world in 2007-2009 proved them wrong. Causes of the 2007-2009 Financial Crisis We begin our look at the 2007-2009 financial crisis by examining three central factors: financial innovation in mortgage markets, agency problems in mortgage markets, and the role of asymmetric information in the credit rating process. Financial Innovation in the Mortgage Markets. Before 2000, only the most credit-worthy (prime) borrowers could obtain residential mortgages. Advances in computer technology and new statistical techniques, known as data mining, however, led to enhanced, quantitative evaluation of the credit risk for a new class of risky residential mortgages. Households with credit records could now be assigned a numerical credit score, known as a FICO score (named after the Fair Isaac Corporation that developed it), that would predict how likely they would be to default on their loan payments. In addition, by lowering transactions costs, computer technology enabled the bundling together of smaller loans (like mortgages) into standard debt securities, a process known as securitization. These factors made it possible for banks to offer subprime mortgages to borrowers with less-than-stellar credit records The issuance of subprime mortgages was made possible by A. the ability to score the default possibility of households. B. advances in computer technology and statistical techniques. C. the bundling of small loans into standardized debt securities. D. all of the above. E. A and C only. Agency problems are said to arise when agents fail to represent the best interests of those whom they represent, known as the principals. An examination of the roots of the 2007-2009 financial crisis suggests that poorly performing agents included all of the following except A. mortgage brokers. B. the ultimate buyers of structured credit products. C. loan originators. D. commercial and investment banks. The sale (to investors) of complex financial products that posed far more risk than the investors realized was made possible by inflated ratings generated by credit rating agencies . In which one of the following areas was the impact of the financial crisis not significantly evident? A. Global financial markets. B. The U.S. residential housing market. C. The service producing sector of the U.S. economy. D. Financial institution balance sheets. E. The shadow banking system. The asset price boom in housing after the 2000-2001 recession is said to have helped stimulate the growth of the subprime mortgage market, which, in turn, stimulated the demand for houses and thus fueled the boom in prices. A key element in this upward spiral was the weakening of underwriting standards. The decline in housing prices set off a chain reaction that adversely affected the balance sheets of banks and other financial institutions, inducing them to A. sell off assets. B. restrict the availability of credit. C. sue those responsible for the housing price bubble. D. all of the above. E. A and B only. The so-called shadow banking system was also seriously impacted by the falling value of mortgages and other financial assets. The entities making up this important source of financing for auto loans and low-interest mortgages were forced to put up more and more collateral to raise funds, and ultimately had to engage in fire sales of assets to the point that lending to households and businesses declined significantly . Although the 2007-2009 crisis had its inception in the U.S., the "wake-up call" that the situation was quite dangerous came from the region where, ultimately, the economic fallout was most significant, namely, Europe . The roster of financial entities either failing (filing for bankruptcy or being sold) or needing a bailout is a "Who's Who" of iconic American institutions. Which one of the following institutions sufficiently avoided the entanglements of subprime securities to not be on this list? A. Lehman Brothers B. Dow Jones C. Bear Stearns D. Merrill Lynch E. AIG

entitlements c c c health entitlemments

POLICY AND PRACTICE: The Entitlements Debate: Social Security and Medicare/Medicaid Public discussion of the federal budget tends to focus on the current deficit. Another consideration is government commitments to increases in pension and medical spending mandated by legislation for programs such as Social Security, Medicare, and Medicaid. These entitlement programs have grown to close to half of federal spending. At its establishment in 1935, Social Security was intended to operate like a pension plan. Workers would contribute a portion of their paychecks to a trust fund, which would invest and protect the money until they reached retirement age. In fact, the Social Security Administration immediately transfers most workers' contributions to current-day retirees. This "pay-as-you-go" system works fine as long as there are enough workers contributing to pay Social Security benefits in full. However, the demographic situation has changed dramatically since the early years of Social Security: 1. Today's retirees live far longer than they did in the 1930s and thus draw on Social Security's lifetime benefits for much longer. 2. There are far more retirees todaylong dasha result of the baby boom in the years after World War II. 3. U.S. birth rates have declined over the years, increasing the dependency ratio, the ratio of retirees to workers who make Social Security contributions. For these reasons, the Congressional Budget Office projects that Social Security spending will rise from 4.8% of GDP in 2010 to 5.7% in 2050, an over 10% increase. (See Figure 16.2 LOADING... for more details.) In recent years, policy makers and elected officials have debated how to address these challenges and proposed reforms. Proposed reforms of the Social Security system come in three varieties: 1) invest Social Security trust funds in high-return (and thus high-risk) assets, 2) double Social Security taxes on workers, or 3) cut retirement benefits by one-third. All these approaches come with painful tradeoffs. If the Social Security trust fund invests in private assets, rather than in low-yielding U.S. Treasury securities, it will be exposed to crisis if asset prices suddenly fall. Social Security tax rate increases could eventually raise taxes to such high levels that people would have little incentive to work. If reform trims benefits too much or raises the minimum age at which one can receive benefits too high, the safety net of the Social Security system could fail many elderly. Yet if policy makers take no action, budget deficits will almost certainly skyrocket.4 LOADING... With such tough choices, it's easy to see why Social Security has often been described as a "third rail of politics": touch it and you are dead. The longer it takes to reform the Social Security system, the worse the problem becomes, and the more drastic the measures that will be needed to fix it. Growing health care costs and increases in government medical benefits expose the health care entitlements of Medicare and Medicaid to similar issues, although the growth of these programs will impact the government budget far more in the future than Social Security. Projected spending on these two health care programs was expected to rise from around 5% in 2010 to over 12% by 2050, as Figure 16.2 LOADING... shows. After a bruising year-long political debate, Congress passed a health care overhaul in early 2010 that extended medical insurance to thirty million more people, while increasing payroll taxes and trimming subsidies to some health care providers. How this legislation will affect future government spending on health care is far from clear. You try it... According to the text, some portion of government expenditures are not made on a discretionary basis but instead are locked in by earlier legislation. These expenditures, which account for nearly half of federal spending, are known as entitlements . The Social Security system is described as a "pay-as-you-go" system because A. workers receive payments after they retire. B. workers must pay before they are permitted to retire. C. present workers' contributions are immediately transferred to current-day retirees. Your answer is correct.D. retirement is a privilege for which retirees must pay, otherwise they go back into the workforce. The Social Security system is experiencing increasing financial problems largely attributable to changes in the demographic situation of the country. Which of the following is not one of the demographic changes impacting the health of the Social Security system? A. Retirees are living far longer today than they did in earlier decades. B. Declining U.S. birth rates have increased the ratio of retirees to workers. C. Women today are participating in the labor force at a much higher rate than in the past. This is the correct answer.D. A post-World War II baby boom produced a surge in retirees. Your answer is not correct. A variety of generic fixes to the Social Security funding problem have been suggested in recent years. All of the following have been proposed except A. cutting retirement benefits by one-third. B. investing Social Security trust funds in high-return assets. C. funding the program with general tax revenues. Your answer is correct.D. doubling Social Security taxes on workers. In addition to the fiscal challenges posed by Social Security, the health care entitlements of Medicare and Medicaid are adding additional financial burdens upon the federal government. Of these two programs (Social Security vs. health care entitlements), the one imposing the more serious long-term consequences is health entitlements .

STRINGENT A D RIGHTWARD SHIFTS OF AS DECLINE IN PRICES A

APPLICATION: The Mother Of All Financial Crises: The Great Depression With our framework for understanding financial crises in place, we are prepared to analyze how a financial crisis unfolded during the Great Depression and how it led to the worst economic downturn in U.S. history. Stock Market Crash In 1928 and 1929, prices doubled in the U.S. stock market. Federal Reserve officials viewed the stock market boom as excessive speculation. To curb it, they pursued an autonomous tightening of monetary policy to raise interest rates and decrease aggregate demand. The Fed got more than it bargained for when the stock market crashed in October 1929, falling by more than 60%, as shown in Figure 15-2 LOADING.... Our aggregate demand and supply analysis indicates that the autonomous tightening of monetary policy and the stock market crash pushed the economy into a recession. Higher real interest rates from the Fed action caused investment to decline, while lower stock prices reduced household wealth, so that consumer spending fell. As a result of the declines in both these components of aggregate demand, the aggregate demand curve shifted to the left from AD1 to AD2 in Figure 15-3 LOADING.... The aggregate demand and supply analysis then indicates that the economy moved from point 1 to point 2, with both output and inflation declining, and unemployment rising. In seeking to curb the excessive speculation fueling the late 1920s stock market boom, given the events of late 1929, the Fed apparently took actions that were too stringent . One of the Fed's functions is to be a lender of last resort. Given the chain reaction emanating initially from bank losses in agricultural regions and later spreading throughout the economy over 2+ years, the Fed's efforts to provide assistance might be characterized briefly as grossly inadequate . Given the data on stock prices shown in Figure 15-2 LOADING..., any detrimental wealth effect upon consumption attributable to the stock market A. occurred roughly over the 1930-1932 period and to a lesser extent in 1937. B. lasted throughout the 1929-1940 period. C. ended with the presidency of FDR. D. cannot be ascertained without data on stock dividends. The collapse of investment spending and the near cessation of lending during the 1929-1933 period is largely attributable to A. the demise of many financial intermediaries as a result of bank runs. B. the intensification of the adverse selection and moral hazard problems. C. the increase in real rates of interest actually paid by firms and households. D. all of the above. E. A and B only. The self-correcting mechanism of the U.S. economy appeared to at least partly work as evidenced by the rightward shifts of AS . In the years following 1930, the successful operation of the self-correcting mechanism was blocked by the ongoing and severe decline in prices . Had the Keynesian approach to macroeconomics been developed and understood prior to this era, government policy makers might have pursued A. reductions in income taxes. B. increases in government purchases. C. surplus-inducing budget policies. D. all of the above. E. A AND B ONLY

Fiscal policy multiplers are higher when the policy rate has hit the floor of the zero lower bound because once the floor is hit A. the monetary authorities no longer follow the Taylor principle. B. the rise in inflation from a fiscal expansion triggers a fall in the real interest rate. C. the monetary authorities actually prefer that the policy rate be lower. D. all of the above. E. A and B only.

D LONG-TERM INVESTMENT AT ZERO LOWER SHORT-TERM C CONDITIONAL E CONDITIONAL

POLICY AND PRACTICE: The Federal Reserve's Nonconventional Monetary Policies and Quantitative Easing During the Global Financial Crisis Liquidity Provision During the crisis, the Federal Reserve implemented unprecedented increases in its lending facilities to provide liquidity to the financial markets. 1. Discount Window Expansion: At the outset of the crisis in mid-August 2007, the Fed lowered the discount rate (the interest rate on loans it makes to banks) to 50 basis points (0.50 percentage points) above the federal funds rate target from the normal 100 basis points. It then lowered it further in March 2008 to only 25 basis points above the federal funds rate target. 2. Term Auction Facility: To encourage additional borrowing, the Fed set up a temporary Term Auction Facility (TAF) in which it made loans at a rate determined through competitive auctions. It was more widely used than the discount window facility because it enabled banks to borrow at a rate less than the discount rate, and it was determined competitively, rather than being set at a penalty rate. The TAF auctions started at amounts of $20 billion, but as the crisis worsened, the Fed raised the amounts dramatically, with a total outstanding of over $400 billion. (The European Central Bank conducted similar operations, with one auction in June of 2008 of over 400 billion euros.) 3. New Lending Programs: The Fed broadened its provision of liquidity to the financial system well outside of its traditional lending to banking institutions. These actions included lending to investment banks, and lending to promote purchases of commercial paper, mortgage backed-securities, and other asset-backed securities. In addition, the Fed engaged in lending to AIG to prevent its failure. The enlargement of the Fed's lending programs during the 2007-2009 financial crisis was indeed remarkable, expanding the Fed's balance sheet by over one trillion dollars by the end of 2008, with the balance-sheet expansion continuing into 2009. The number of new programs over the course of the crisis spawned a whole new set of abbreviations, including the TAF, TSLF, PDCF, AMLF, MMIFF, CPFF, and TALF. Asset Purchases (Quantitative Easing) The Fed's open market operations normally involve only the purchase of government securities, particularly those that are short-term. However, during the crisis the Fed started two new asset purchase programs to lower interest rates for particular types of credit. 1. In November 2008, the Fed set up a Government Sponsored Entities Purchase Program in which the Fed eventually purchased $1.25 trillion of mortgage-backed securities (MBS) guaranteed by Fannie Mae and Freddie Mac. Through these purchases, the Fed hoped to prop up the MBS market and to lower interest rates on residential mortgages to stimulate the housing market. 2. In November 2010, the Fed announced that it would purchase $600 billion of long-term Treasury securities at a rate of about $75 billion per month. This purchase program, which became known as QE2 (which stands for Quantitative Easing 2, not the Cunard cruise ship) was intended to lower long-term interest rates. Although short-term interest rates on Treasury securities hit a floor of zero during the global financial crisis, long-term interest rates did not. Since investment projects have a long life, long-term interest rate are more relevant than short-term ones to investment decisions. The Fed's purchase of long-term Treasuries to lower long-term interest rates could therefore help stimulate investment spending and the economy. 3. In September 2012, the Federal Reserve announced a third asset-purchase program, which has become known as QE3, which combined elements of QE1 and QE2 by conducting purchases of $40 billion of mortgage-backed securities and $45 billion of long-term Treasuries. However, QE3 differed in one major way from the previous QE programs in that it was not for a fixed dollar amount, but instead was open-ended, with the purchase plan continuing "if the outlook for the labor market does not improve substantially." The result of these programs of liquidity provision and asset purchases resulted in an unprecedented quadrupling of the Federal Reserve's balance sheet. Management of Expectations: Commitment to Future Policy Actions Although short-term interest rates could not be driven below zero in the aftermath of the global financial crisis, the Federal Reserve could take another route to lower long-term interest rates, which, as we have mentioned above, would stimulate the economy. This route involved a commitment by the Fed to keep the federal funds rate at zero for a long period of time, in order to lower the market's expectations of future short-term interest rates, thereby causing the long-term interest rate to fall. As we have seen in Chapter 13, this strategy is referred to as management of expectations. The Fed pursued this strategy when it announced after its FOMC meeting on December 16, 2008, that not only would it lower the federal funds rate target to between zero and ¼%, but also that "the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time." The Fed then continued to use this language in its FOMC statements for several years afterward, and then moved to announcing specific dates, eventually with the statement that "the exceptionally low levels of the federal funds rate are likely to be warranted until mid-2015." Although long-term interest rates on Treasury securities did subsequently fall with these announcements, it is not clear how much of this decline was due to the Fed's attempt to manage expectations versus weakness in the economy. There are two types of commitments to future policy actions: conditional and unconditional. The commitment to keep the federal funds rate at zero for an extended period starting in 2008 was conditional because it mentioned that the decision was predicated on a weak economy going forward. If economic circumstances changed, the FOMC was indicating that it might abandon the commitment. Alternatively, the Fed could have made an unconditional commitment by just stating that it would keep the federal funds rate at zero for an extended period without indicating that this decision was based on the state of the economy. An unconditional commitment has the advantage of being stronger than a conditional commitment because it does not suggest that the commitment will be abandoned and so is likely to have a larger effect on long-term interest rates. Unfortunately, it has the disadvantage that even if circumstances change in such a way that it would be better to abandon the commitment, the Fed may feel it cannot go back on its word and do so. The problem of an unconditional commitment is illustrated by the Fed's experience in the 2003-2006 period. In 2003, the Fed became worried that inflation was too low and that the probability of a deflation was significant. At the August 12, 2003, FOMC meeting, the FOMC stated, "In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period." Then when the Fed started to tighten policy at its June 30, 2004, FOMC meeting, it changed its statement to "policy accommodation can be removed at a pace that is likely to be measured." Then for the next ten FOMC meetings through June 2006, the Fed raised the federal funds rate target by exactly ¼ percentage point at every single meeting. The market interpreted the FOMC's statements as indicating an unconditional commitment, and this is why the Fed may have been constrained not to deviate from ¼ percentage point moves at every FOMC meeting. In retrospect, this commitment led to monetary policy that was too easy for too long, with inflation subsequently rising to well above desirable levels, and, as discussed earlier in the chapter, it may have helped promote the housing bubble whose bursting led to such devastating consequences for the economy. When the Fed announced a specific date for exiting from exceptionally low rates, many market participants viewed this announcement as an unconditional commitment, despite the Federal Reserve's objections. To avoid the problems with an unconditional commitment, in December of 2012, the Fed changed its statement to be more clearly conditional by indicating that "the exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent and inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal." Although an improvement over the fixed-date commitment, this conditional approach based on thresholds is not without problems. First, it may be viewed as a Federal Reserve commitment to achieve a specific unemployment rate regardless of the monetary stimulus required to reach it. As we saw in Chapter 13, it was exactly this kind of commitment that got the Fed into trouble in the 1970s and produced the escalation in inflation that became known as the "Great Inflation." Second, this approach may be viewed as increasing the inflation target from 2% to 2.5%. and a weakening of the Federal Reserve's credibility to keep inflation low and stable. As we will see in Chapter 21, this loss of credibility can result in worse outcomes for stabilizing not only inflation, but also economic activity. You try it... The Federal Reserve's liquidity provision during the 2007-2009 financial crisis was remarkable owing to its A. enormous monetary magnitude. B. volume of new lending programs. C. extension to institutions other than commercial banks. D. all of the above. E. A and B only. The Fed's various asset purchase programs implemented during and after the financial crisis had as their direct (as opposed to ultimate) objective a reduction in long-term interest rates to which investment spending is generally very sensitive. The strategy referred to as management of expectations involves a commitment by the Fed to keep the federal funds rate at zero for a long period of time in order to lower the market's expectations of future short-term interest rates. If successfully implemented, a management of expectations strategy should stimulate the economy by lowering long-term interest rates A. and reducing the government's debt-servicing burden. B. and encouraging households to save less. C. and increasing investment spending. D. all of the above. If a central bank's commitment to future policy actions is predicated on some circumstance of the economy going forward, that commitment is said to be conditional . Compared to an unconditional commitment to future policy actions, a conditional commitment by the Fed A. is weaker in terms of its impact on long-term interest rates. B. is more easily recinded/abandoned if circumstances change. C. requires coordination with fiscal policymakers. D. all of the above. E. A and B only. The 1970s inflation escalation that became known as the "Great Inflation" was in part the result of the Fed having made a commitment that was conditional

A government committed to long-run fiscal discipline (i.e., low or zero budget deficits) usually conducts contractionary fiscal policy at some point to reduce the government deficit. If that action is interpreted as a commitment to long-run fiscal discipline, A. consumption and investment spending will increase, which will raise aggregate demand, while keeping long-term bond rates constant. B. consumption and investment spending will decrease, which will reduce aggregate demand, and long-term bond rates will increase, allowing the government to pay back its debt. C. consumption and investment spending will increase, which will raise aggregate demand, and long-term bond rates will decrease, allowing the government to pay back its debt. D. consumption and investment spending will decrease, which will raise aggregate demand, and long-term bond rates will decrease, holding the government debt constant.

B EXCESSIVE BUREAUCRATIC RED TAPE ACCEPT MORE RISK

APPLICATION: The Tyranny of Collateral To use property, such as land or capital, as collateral LOADING..., a person must legally own it. Unfortunately, as Hernando De Soto LOADING... documented in The Mystery of Capital, it is extremely expensive and time consuming for the poor in developing countries to make their ownership of property legal. Obtaining legal title to a dwelling on urban land in the Philippines, for example, involved 168 bureaucratic steps and fifty-three public and private agencies, and the process took thirteen to twenty-five years. For desert land in Egypt, obtaining legal title took seventy-seven steps, thirty-one public and private agencies, and five to fourteen years. To legally buy government land in Haiti, an ordinary citizen had to go through 176 steps over nineteen years. These barriers do not mean the poor do not invest: they still build houses and buy equipment even if they don't have legal title to these assets. By De Soto's calculations, the "total value of the real estate held but not legally owned by the poor of the Third World and former communist nations is at least $9.3 trillion."3 LOADING... Without legal title, however, none of this property can be used as collateral to borrow funds, a requirement for most lenders. Even when people have legal title to their property, the legal system in most developing countries is so inefficient that collateral does not mean much. Typically creditors must first sue the defaulting debtor for payment, which takes several years, and then, once obtaining a favorable judgment, the creditor has to sue again to obtain title to the collateral. This process often takes in excess of five years. By the time the lender acquires the collateral, it is likely to have been neglected or stolen and thus has little value. In addition, governments often block lenders from foreclosing on borrowers in politically powerful sectors of a society, such as agriculture. When the financial system is unable to use collateral effectively, the adverse selection problem will be worse, because the lender will need even more information about the quality of the borrower to distinguish a good loan from a bad one. Little lending will take place, especially in transactions that involve collateral, such as mortgages. In Peru, for example, the value of mortgage loans relative to the size of the economy is less than 1/20 that in the United States. The poor have an even harder time obtaining loans because it is too costly for them to get title to their property and they therefore have no collateral to offer, resulting in what Raghuram Rajan and Luigi Zingales, both of the University of Chicago, refer to as the "tyranny of collateral."4 LOADING... Even when poor people have a good idea for a business and are willing to work hard, they cannot get the funds to finance it, making it difficult for them to escape poverty. You try it... The poor in developing countries do invest in real assets; however, their ability to do so is constrained by A. oppressive right-wing governments. B. the high cost of making ownership legal. C. the discriminatory practices of lenders. D. all of the above. The inability of financial systems in many developing countries to use collateral effectively is due to excessive bureaucratic red tape . A consequence of the limited ability of lenders to use collateral effectively is an exacerbation of the adverse selection problem they face. As a result, lenders must either obtain additional information about borrowers or simply accept more risk

According to the Federal Reserve Act of 1913 (Section 13.3): "In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, [...] may authorize any Federal Reserve bank, during such periods as the said board may determine, [...] to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange [...]." The Federal Reserve was highly criticized for providing liquidity to corporations and individual market participants (most notably in the commercial market paper). Which of the following does not support the conclusion that the Federal Reserve acted according to its mandate? A. When the Federal Reserve expanded its lending, the economy was not experiencing unusual or exigent circumstances. B. This section of the act was intended to give the Federal Reserve the opportunity to lend to individuals or corporations under unusual circumstances. C. The Federal Reserve expanded the institutions it lended to during 2008 and 2009 by creating many lending facilities directed to specific sectors of the financial system. D. The Federal Reserve's actions to support the U.S. financial system were very effective in keeping the economy from falling deeper into contractionary directions.

As the effects of the 2007-2009 financial crisis became more pervasive, legislators and policymakers debated about the role played by the Federal Reserve as a regulatory agency. While the Federal Reserve argued for more regulatory oversight of the financial system, some policymakers wanted to remove these powers from the Federal Reserve claiming it failed to act as a proper regulator. Using the concept of asymmetric information, which of the following is an argument used as criticism of the Federal Reserve? A. The Federal Reserve failed to act as a proper financial system regulator and as a consequence many firms were allowed to accept too much risk and had to be "rescued" later. B. The Federal Reserve may have failed to encourage nonbanking firms to reduce their exposure to "toxic" assets, but it did not have the power to require the firms to change their assets. C. One of the distinctive characteristics of the U.S. banking system is the number of regulatory agencies of financial intermediaries, so the Federal Reserve may not have oversight of many of the intermediaries. D. The Federal Reserve is mostly in charge of controlling bank holding companies, and thus cannot impose regulations on other financial intermediaries, like investment banks or insurance companies.

CHAPTER 14***********************************

CHAPTER 14*********************

C C

Consider the effect of a tax cut (if government spending remains the same) in a country with an underdeveloped financial system. Assuming individuals are forward looking (i.e., the Ricardian equivalence argument holds), what might happen to national saving in this case? A. Forward-looking individuals will save more in advance of higher future taxes through bond markets, which will raise national saving. B. When the government imposes a tax cut this will always cause national saving to rise as government saving increases. C. National saving will likely decline as developing countries do not have efficient bonds or stock markets that allow individuals to buy assets to postpone current consumption. D. National saving will rise as forward-looking individuals decide to reduce consumption. How might forward-looking individuals overcome the limitations of an underdeveloped financial system? A. They can use the additional funds to purchase more consumption goods today and incur the costs in the future. B. They can request that the government undo tax cuts to keep the future debt burden from occurring. C. They can buy an asset that could be used as a bequest for future generations. D. They will not be able to overcome the limitations and will just consume more today.

E HARM POWERFUL SPECIAL-INTEREST GROUPS

Financial repression may be defined as A. a severe decline in financial activity within an economy. B. the slowing of financial development within an economy. C. the prevention of an economy's financial intermediaries from operating efficiently. D. All of the above. E. B and C only. Financial repression occurs because financial development within an economy is likely to harm powerful special-interest groups .

EXTERNAL OPERATE MORE EFFICIENTLY

Free trade promotes financial development within an economy by causing established domestic firms to become more dependent on sources of finance that are external to the firm, thereby inducing those firms to be more supportive of the reforms needed to make the financial system operate more efficiently .

Most legal systems assume that it is better not to incarcerate a guilty individual than to incarcerate an innocent person (i.e., if you are making a mistake, at least choose the least bad one). As central banks can potentially make a mistake when bursting asset-price bubbles, which of the following support the statement: "it is worse to burst a bubble when it was not necessary then not bursting a bubble when it was needed to." A. Most central banks are quite conservative with respect to taking actions against asset-price bubbles since they cannot guarantee a price bubble has occurred. B. Because central banks have many policy tools to counteract the effect of a price bubble burst, it is usually considered wiser to leave bubbles alone and eventually act if needed. C. The worst mistake would be to burst a bubble when it was not necessary because the central bank may impose harm to the economy when it was not necessary. D. All of the above.

(8*.75)/4=1.50

Suppose a bottle of wine sells for $8 in California and for euro4 in France. Assuming a nominal exchange rate of 0.75 euro per dollar, calculate the real exchange rate between U.S. wine and French wine. The real exchange rate is _____________ Calculate the real exchange rate between U.S. wine and French wine if the domestic price of U.S. wine is now $3 a bottle. The real exchange rate is now_____________

A CREDIT-DRIVEN TRY TO BURST THIS BUBBLE LET THE MARKET SORT ITSELF OUT

Suppose a central bank identifies an increase in lending to the floral industry. In particular, many small businesses are borrowing aggressively to import tulips. As market participants observe a sharp increase in the price of tulips, the central bank considers its actions. This example can be characterized as a credit-driven asset price bubble. The central bank could try to burst this bubble , as this scenario can potentially have a deeper negative effect in the economy than a scenario created by overly optimistic expectations. Suppose in the above scenario, there was no increase in lending to the floral industry. Given that information, the central bank could let the market sort itself out because there is a higher probability that this price bubble is driven by overly optimistic expectations.

C B

Suppose a firm has a great new idea: overnight shipping. This idea can decrease costs for many businesses and therefore result in a more efficient economy. If the entrepreneurs who create the concept cannot get funds to put their idea to work, A. the primary negative consequence will be higher inflation. B. there will be negative consequences in the shipping industry only. C. there will be negative consequences throughout the economy. D. there will be no negative consequences. The situation in which a problem in one industry affects other industries is known as A. adverse selection. B. a negative externality. C. asymmetric information. D. a negative incentive.

3+1+1-3 =2 primary deficit= 3+1-3 =1

Suppose government purchases amount to $3 trillion, transfer payments amount to $1 trillion, net interest payments are $1 trillion, and tax revenue is valued at $3 trillion. The government deficit is $___________trillion The primary deficit is __________trillion

The definition of the government deficit is a matter of debate. What would be the effect on the measurement of the government deficit of considering Social Security taxes a "forced loan to the government" and benefit payments (e.g., Medicare, Social Security benefits, etc) a "repayment of principal plus interest"? A. If Social Security taxes and benefits were measured as described above, then there would be no effect on the government deficit. B. If Social Security taxes and benefits were measured as described above, then there would be an increase in the government deficit. C. If Social Security taxes and benefits were measured as described above, then there would be a reduction in the government deficit. D. More information would be required to determine the effect on the government deficit.

ch 17 problem 5 appreciating (1.4579-1.4908)/1.4908 = 2.2% 1.3608-1.4266)/1.4266 = 4.6 volitile

The following table shows the nominal exchange between the U.S. dollar and the euro (U.S. dollars per euro) at different points in time. The graph to the right depicts the data provided in the table. (Note that the exchange rate is quoted as dollars per euro.) Over this time period, the dollar has been appreciating with respect to the euro during this period. From November 2009 to December 2009, the percentage change in the exchange rate was_____________ From January 2010 to February 2010, the percentage change in the exchange rate was________________- During this period, the exchange rate was relatively___________

for identical goods, the proce should be the same in both countries 1 the relative price of goods in each countrys currency ourchasing power parity d

The law of one price states that for identical goods, the price should be the same in both countries . If the law of one price holds for all goods, the real exchange rate will be 1 , and the nominal exchange rate will be determined by the relative price of goods in each country's currency . This is called purchasing power parity . Why doesn't PPP hold in the short run? A. Because prices are sticky in the short run. B. Because most markets are not in equilibrium in the short run. C. Because exchange rates are not determined by prices. D. Because not all goods are traded and not all products are identical

UNITS OF FOREIGN CURRENCY PURCHASING POWER MOVE TOGETHER A

The nominal exchange rate is denominated in terms of units of foreign currency , and the real exchange rate is denominated in terms of purchasing power . The two exchange rates move together . The appreciation or depreciation of real exchange rates is important because they affect A. the relative prices of imports and exports. B. the inflation rate in the short run. C. the unemployment rate in the long run. D. the value of real GDP.

E B

What arguments should be considered in assessing the burden that government debt imposes on future generations? A. Much of the debt is held by foreigners so that the holders of government bonds are not also taxpayers. B. High levels of debt may lead to debt intolerance and increase the risk of default. C. Government budget deficits may crowd out private investment, lowering the future capital stock with fewer goods and services being produced in the future. D. A and C only. E. All of the above. Your answer is correct. Are there any arguments that might explain how government debt can be beneficial to future generations? A. There is really no way of telling how future generations may be impacted by government debt. B. Yes, government debt issued to invest in government and human capital will increase the economy's future productivity, thereby increasing the incomes of future generations. Your answer is correct.C. No, future generations will be left to bear the burden of government debt with even higher taxes.

A A

What is a credit spread? A. The difference between interest rates on loans to households and businesses and interest rates on completely safe assets such as U.S. Treasury bonds. B. The difference between the net worth of a borrower and the amount of the loan the borrower would like to secure. C. The difference between a borrower's credit score and the score of the most credit-worthy borrower. D. The difference between the interest rate on corporate bonds with different maturities. Why do credit spreads rise during financial crises? A. Credit spreads rise because asymmetric information problems increase, making it more difficult to judge the risk of potential borrowers. B. Credit spreads rise because depositors with productive investment opportunities withdraw their funds from banks, which creates an incentive to lend to borrowers with riskier investment opportunities. C. Credit spreads rise because the government becomes the only institution that is able to lend money to borrowers. D. None of the above are correct.

C B

When the risk that some banks might fail increases, depositors may not have enough information to determine whether their bank is a good one or one of the banks at greater risk to fail. Depositors have an incentive to withdraw their deposits before the bank runs out of funds. If this becomes a widespread occurrence, it is known as: A. moral hazard. B. adverse selection. C. a bank panic. D. debt deflation. Which of the following is not a reason why bank failures worsen financial crises? A. Bank panics reduce the amount of asymmetric information, which makes it more difficult to lend funds. B. A reduction in the number of banks operating reduces the amount of lending that can take place, which creates less economic activity and in turn makes borrowing more difficult. C. As bank panics occur, banks begin to sell so many assets that it can lower asset prices so much that even good banks become insolvent. D. The closing of many banks worsen adverse selection and moral hazard problems.

FINANCING OF THE DEFICIT C

Whether budget deficits lead to inflation in the long run depends on the financing of the deficit . What determines whether budget deficits will result in inflation in the long run? A. If a country cannot finance the deficit by printing money and instead resorts to issuing bonds to finance the debt. B. If a country cannot finance the deficit by printing money and instead resorts to raising taxes to finance the debt. C. If a country cannot finance the deficit by issuing bonds and instead resorts to financing the deficit by printing money. D. A budget deficit only affects a country in the short run.

D C

Why are asymmetric information problems particularly challenging in developing countries? A. Information overload makes it difficult to figure out what information is relevant in a financial transaction. B. Securities markets play a bigger role in developing countries than do banks. C. Businesses in developing countries tend to be inherently corrupt. D. Developing countries tend to have weak information technology. As a nation develops, A. both asymmetric information problems and the importance of banks increase. B. asymmetric information problems decrease and the importance of banks increases. C. both asymmetric information problems and the importance of banks decrease. D. asymmetric information problems increase and the importance of banks decreases.

Why does the foreign exchange market move toward equilibrium when the foreign exchange rate for the dollar is below its equilibrium value? A. The excess demand for dollars causes the exchange rate to fall, decreasing the quantity supplied and increasing the quantity demanded. B. The excess supply of dollars causes the exchange rate to fall, decreasing the quantity supplied and increasing the quantity demanded. C. The excess supply of dollars causes the exchange rate to rise, increasing the quantity supplied and decreasing the quantity demanded. D. The excess demand for dollars causes the exchange rate to rise, increasing the quantity supplied and decreasing the quantity demanded.

Asymmetric information can lead to a bank panic when: A. rumors of government intervention cause mistrust of the government. B. rumors of impending bank failure lead to mass withdrawals of customer deposits. C. rumors that the government will not enact a "safety net" lead to public protests. D. bank managers panic about the economy and begin selling the bank's assets

D C

According to the March 16, 2010, FOMC statement: "The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions [...] are likely to warrant exceptionally low levels of the federal funds rate for an extended period." As the U.S. economy was already showing some signs of recovery by the first quarter of 2010, some people warned that the Federal Reserve's actions might increase expected inflation. Which of the following is a reason why low levels of interest rates might fuel inflation expectations? A. According to the aggregate demand and supply analysis, low levels of interest rates might stimulate aggregate demand and create inflation. B. If Federal Reserve policy continues to stimulate demand, it can lead to subsequent shifts to the left of the short-run aggregate supply curve. C. If the Federal Reserve keeps its policy instrument (i.e., the federal funds rate) at low levels while the output gap is positive, it will be effectively shifting the demand curve to the right. D. All of the above. Which of the following is a policy the Federal Reserve could use to avoid inflation in the future? A. The Federal Reserve could begin to make additional discount loans. B. The Federal Reserve could begin to make open market purchases. C. The Federal Reserve could begin to raise the target federal funds rate. D. All of the above.

According to the FDIC, thirty banks failed or were assisted during 2008: six were based in California, two in Florida, and five in Nevada. The New York Times printed in 2007 that Nevada (-36.1%), Florida (-30.8%), and California (-21.3%) were amongst the top five states where home sales dropped (in parenthesis) the most between the fourth quarter of 2005 until the fourth quarter of 2006. (Source: http://www.nytimes.com/2007/02/16/business/16home.html ) Which of the following explains how real estate market conditions in these areas can explain almost 50% of bank failures in 2008? A. Because California is one of the largest states, it follows that California would have one of the highest rates of bank failures in the country. Since sales only fell 21.3%, California bank failures may not be related to real estate. B. When real estate markets decline, it is more difficult to find a loan and therefore the amount of future sales decline, which makes it more difficult to sell homes. C. These areas experienced the largest decline in housing sales. When housing sales and prices fall, it reduces the value of real estate, which increases the probability that there will be mortgage defaults. Loan defaults reduce bank assets and make it more difficult for a bank to remain solvent. D. All of the above.

GOVERNMENT INVESTMENT D

As announced by the Obama administration, part of the 2009 fiscal stimulus package is directed to make broadband internet access available to most Americans. This type of spending should be considered as government investment . What will be the effect of such expenditures on the government debt burden? A. If the investment does not create increased productivity, then it will cause an increase in debt burden. B. If taxes are increased to pay for this spending, then there will not be an additional debt burden. Your answer is not correct.C. If this type of investment is successful in increasing productivity, it will not create additional debt burden assuming the increased productivity raises income beyond the cost of repayment and interest. D. All of the above.

B C

Assume that Social Security taxes remain constant, but that the number of employed people in the United States declines over time. What will happen to the size of contributions for social insurance and the government deficit in the United States? A. Social insurance contributions will remain constant; however, the size of the U.S. government deficit will increase. B. Social insurance contributions will decrease while the size of the U.S. deficit will increase. C. Social insurance contributions and the size of the U.S. government deficit will both decrease. D. Social insurance contributions and the size of the U.S. government deficit will both increase. Assume that Social Security taxes and employment remain constant, but there is an increase in unemployment insurance benefits. What will happen to the size of contributions for social insurance and the government deficit in the United States? A. Both social insurance contributions and the size of the U.S. government deficit will increase. B. Social insurance contributions will decrease while the size of the U.S. deficit will increase. C. Social insurance contributions will remain constant; however, the size of the U.S. government deficit will increase. D. Both social insurance contributions and the size of the U.S. government deficit will decrease.

INCREASED GOVERNMENT EXPENDITURES AGGREGATE DEMAND C

Assume that the expenditure and tax multipliers can be estimated to be 0.75 and 0.5, respectively. Would you recommend expansionary fiscal policy based on tax cuts or increased government expenditures? Expansionary fiscal policy based on increased government expenditures should be recommended because this will have a larger effect on aggregate demand . Suppose now there is substantial evidence that supports the hypothesis of a crowding out effect in this economy. How would this change your fiscal policy recommendation? A. Continued tax cuts are a good idea to expand aggregate demand as governments are very efficient in their use of expenditures. B. A continued increase in government spending would still be recommended as it will lead to continued increases in aggregate demand. C. A continued increase in government spending may not be a good idea as there may be further cutbacks in private spending. Your answer is correct.D. Continued tax cuts would still be recommended as it will lead to continued consumer spending.

b adverse selection moral hazard

Asymmetric information A. occurs because stockholders know more than managers. B. exists when one party has more information than another. C. helps funds move to the best possible investment opportunities. D. rarely occurs in the real world. There are two types of asymmetric information: adverse selection occurs before the transaction is completed; moral hazard occurs after the transaction is completed.

C D

Figure 1 LOADING..., from the Federal Reserve Monetary Policy Report to the Congress (July 21, 2009) shows mortgage delinquency rates from 2001 to 2009 in the United States. Why were mortgage delinquency rates higher for subprime mortgages? A. Subprime mortgages were made on real estate properties that only saw increases in their values. B. Subprime mortgages were able to be put into security packages and sold to investors who demanded borrowers pay more on their mortgages. C. Subprime mortgages were made to borrowers with a lower probability of paying back their loans and more of these borrowers defaulted on their payments when the economy declined. D. All of the above. Why did adjustable rate mortgages experience higher delinquency rates? A. When interest rates increased from 2004 to 2006, the monthly payments for borrowers with adjustable rate mortgages increased. B. Borrowers with adjustable rate mortgages experienced an increase in monthly payments, which may have raised payments above the borrower's ability to pay. C. Many adjustable rate mortgages were made to borrowers with lower probabilities of paying back their loans. D. All of the above.

A A

Following its regular policy meeting on June 19, 2013, the chair of the FOMC made remarks during its press conference that were widely interpreted in financial markets that the Fed may begin reducing the size of its $85 billion in monthly asset purchases sooner than expected. What effect, if at all, should this have on interest rates and dollar exchange rates? A. U.S. interest rates will increase and the dollar will appreciate. B. U.S. interest rates will increase and the dollar will depreciate. C. U.S. interest rates will decrease and the dollar will depreciate. D. U.S. interest rates will increase but the impact on the dollar is indeterminate. E. Neither would exhibit any movement. In the days following the press conference, the Fed worried that markets overreacted, and several Fed officials including the Chairman strongly reiterated that reductions of asset purchases would begin only if economic conditions warranted, indicating that reductions in asset purchases may not happen sooner than expected. What effect, if at all, should this have on interest rates and dollar exchange rates? A. U.S interest rates will likely recede from their post-press conference rise and the dollar will similarly decline. B. U.S interest rates will likely recede from their post-press conference rise but the dollar will continue to rise. C. No affect on either, since the Fed really wasn't changing course. D. No prediction is possible given the Fed's flip-flop pronouncements.

THERE ARE BARRIERS TO TRADE SUCH AS TARIFFS THE GOODS ARE NOT TRADABLE THE GOODS ARE NOT IDENTICAL

For all of the following examples the law of one price does not hold (i.e., at current nominal exchange rates, the price of these goods or services is not the same). For each case explain what prevents the law of one price from holding: A ton of sugar in the United States and a ton of sugar in Brazil. In this case, the law of one price does not hold because there are barriers to trade such as tariffs . A three bedroom penthouse in Manhattan and a three bedroom apartment in Mexico City. In this case, the law of one price does not hold because the goods are not tradable . A pound of the finest Swiss chocolate and a pound of Hershey's kisses. In this case, the law of one price does not hold because the goods are not identical .

A SAFETY NET B

Government can reduce the chance of a bank panic by implementing a safety net . What are the consequences of the government providing a safety net to depositors? A. Both banks and depositors reduce their risky behavior. B. Both banks and depositors increase their risky behavior. C. Depositors may increase their risky behavior while banks stay at the same risk level. D. Banks may increase their risky behavior while depositors stay at the same risk level.

C B

Gustavo is a young doctor who lives in a country with a relatively inefficient legal and financial system. When Gustavo applied for a mortgage, he found that banks usually required collateral for up to 300% of the amount of the loan. Why might banks require that much collateral in a financial system like Gustavo's country? A. An inefficient legal system implies weak property rights but also high property values, making collateral more highly valued and hence more desirable. B. An inefficient legal system implies strong property rights, and collateral helps banks recoup some of their loan if the borrower defaults. C. An inefficient legal system implies weak property rights, and collateral helps banks recoup some of their loan if the borrower defaults. D. An inefficient legal system implies strong property rights, and under such a strong system, collateral is more highly valued and hence more desirable. As a result, when compared to other countries, we would expect Gustavo's nation to have: A. less investment and faster economic growth. B. less investment and slower economic growth. C. more investment and faster economic growth. D. more investment and slower economic growth.

D A

How can government increase the quantity of aggregate output demanded by changing government spending and taxes? A. Government can increase the quantity of aggregate output demanded by decreasing government spending followed by an increase in taxes. B. Government can increase the quantity of aggregate output demanded by decreasing government spending or by raising taxes. C. Government can increase the quantity of aggregate output demanded by keeping government spending constant and raising taxes. D. Government can increase the quantity of aggregate output demanded by increasing government spending or by cutting taxes. Your answer is correct. Each additional dollar of government spending represents an additional dollar of demand for output; whereas, each additional dollar of tax cuts generates less than an additional dollar of demand for output because a portion of each dollar of increased disposable income will be saved rather than spent to buy output. A. True Your answer is correct. B. False

How does a supply-side analysis of the effects of a tax cut differ from one that focuses solely on aggregate demand? A. Supply-siders believe the offsetting effects of the AD and LRAS curves will have no impact on aggregate output. B. Supply-siders believe that tax cuts shift the AD and AS curves to the right, increasing aggregate output in the short run only. C. Supply-siders believe that tax cuts shift the AD and AS curves to the right, increasing aggregate output in the long run only. D. Supply-siders believe that tax cuts shift the AD and LRAS curves to the right, increasing aggregate output in both the short run and the long run.

C D

How does the Ricardian equivalence view the effects of tax cuts and budget deficits? A. It holds that tax cuts increase spending and reduce national saving, resulting in lower inflation and increased national saving, which leads to an increased burden on future generations. B. It holds that tax cuts increase aggregate demand, resulting in higher inflation and reduced national saving, which leads to an increased burden on future generations. C. It holds that tax cuts have no effect on spending and national saving because consumers are forward looking, so when taxes are cut they save their increase in disposable income because they recognize that today's tax cut means higher taxes tomorrow. D. None of the above. Which of the following is not an objection to the Ricardian equivalence view? A. Consumers are not very forward looking in their decision making. B. Borrowing-constrained consumers are likely to spend any additional disposable income received from a tax cut. C. Consumers do not give much thought to how future tax increases will affect future generations. D. When consumers recognize that tax cuts make them no richer, they do not spend more.

How should central banks respond to asset-price bubbles? A. Central banks could implement policies to ensure credit standards are sufficiently high. B. Central banks could pursue financial regulation and supervision on an ongoing basis to prevent excessive risk-taking. C. Central banks could let the market work itself out, especially in the case of expectation-driven bubbles. D. All of the above.

C D

On March 26, 2010, the Wall Street Journal reported the following: "A sudden drop-off in investor demand for U.S. Treasury notes is raising questions about whether interest rates will finally begin a march higher [...], [...] there are signs the spotlight is turning to the ability of the U.S. to finance its own budget deficit." Source: Tom Lauricella, "Debt Fears Send Rates Up: Unease at Deficit Hurts Demand for Treasurys; Mortgage Costs on the Rise," Wall Street Journal, March 26, 2010. http://online.wsj.com/article/ SB10001424052748704094104575144244213486742.html Explain the effect of higher Treasury notes interest rates on the government deficit. A. If net interest payments increase, all else constant, the government deficit would decrease. B. Even if net interest payments increase, all else constant, the government deficit would remain unchanged. C. If net interest payments increase, all else constant, the government deficit would also increase. This is the correct answer.D. There would be no impact on the deficit as interest rates and government spending are not related. Your answer is not correct. What would be the long-run effect of distrust in the U.S. government's ability to finance its own deficit? A. Investors may decide to buy fewer U.S. Treasury notes, causing the government to borrow at higher interest rates. B. The government could resort to increasing the monetary base to pay for the deficit. Your answer is not correct.C. Tax increases may be necessary to reduce the deficit immediately to offset the inability of the government to borrow. D. All of the above.

One of the possible solutions to asset-price bubbles is the enforcement of macroprudential regulation. Financial intermediaries have an incentive to constantly look for profitable opportunities, which often implies the design of new financial instruments and even the circumvention of contemporaneous regulations. When financial innovation occurs: A. regulators are usually involved in the creation of new financial instruments. B. asset-price bubbles should not be created since there are more ways for investors to lend funds. C. new financial instruments are created, which may initially be mismanaged, misunderstood, and difficult to properly regulate. D. banks are usually the first ones to utilize the innovations.

TAX RATES IS NOT D

POLICY AND PRACTICE: Tax Smoothing The distortions of high tax rates provide a rationale for tax smoothing, a policy of keeping tax rates fairly stable when government spending fluctuates. Consider the financing choices of a government that is planning five years of heavy investment in the highway system, followed by five years of normal spending. The government has two options for funding: (1) raise the tax rate from 20% to 30% over the next five years and then return the rate to 20% once the highway spending is complete, or (2) smooth the tax increase, setting a new rate of 25% for ten years. The government would balance the budget over the whole ten-year period, but there would be large deficits in the first five years and large surpluses in the following five years. Setting a constant rate would eliminate the distortion of raising the tax rate from 20% to 30% between the two five-year periods. Tax smoothing can justify deficits when government spending is likely to be temporarily high. For example, during World War II, the U.S. government had budget deficits of 20minus30% of GDP, exactly as tax smoothing predicts. The tax smoothing argument does not, however, justify large government deficits if the rise in spending is expected to be permanent. Expected permanent rises in government spending should be paid for with tax rate increases. Otherwise, the resulting budget deficits will not be matched by surpluses in future years, thereby leading to a permanent rise in government debt, which places a substantial burden on future generations. For this reason, many economists support raising taxes today to help pay for high future spending on entitlement programs such as Social Security and Medicare. You try it... The rationale for keeping tax rates stable when government spending fluctuates is the avoidance of distortions associated with higher tax rates . A government that balances its budget year-in and year-out even when spending fluctuates is not practicing tax smoothing. In which of the following would a policy of tax smoothing not be recommended? A. The government anticipates a surge in retirement and health entitlements as the "baby boomers" live out their retirement years. B. Emulating President Kennedy's drive to put a man on the moon by the end of the 1960s, the government commits to a manned mission to Mars by the end of the decade. C. The government announces an all out push to find a cure for cancer within the next five years. D. Defense analysts and security specialists anticipate the need for heightened vigilance against terrorists and rogue nations for the indefinite future.

IMMEDIACY PRIVATE GOVERNMENT MULTIPLIERS B

POLICY AND PRACTICE: The 2009 Debate over Tax-Based Versus Spending-Based Fiscal Stimulus When the Obama administration proposed a fiscal stimulus package to jump start the economy when it first came to office in 2009, a vigorous debate followed over the relative size of the expenditure and tax multipliers and whether tax cuts or increased government spending should provide more stimulus to the economy. Republicans favored tax cuts, which they argued would immediately boost disposable income and stimulate spending, and reduce distortions in the economy to increase potential output in the future. Democrats, on the other hand, argued that increases in government spending add to aggregate demand directly, and thus would be more effective at stimulating the economy than tax cuts. Democrats also argued that the recession was worsened by shortfalls in physical and human capital, prompting proposals to increase government investment in education, improve health care, and combat global warming. These disagreements were supported by differing views in the economics profession. Christina Romer, the chairwoman of the Council of Economic Advisors and a member of the Obama administration, argued that the expenditure multiplier was well above one, on the order of 1.5, and was larger in absolute value than the tax multiplier. Research of other economists who were not in the Obama administration led to a different conclusion that the expenditure multiplier was less than one, on the order of 0.5, and that the tax multiplier would be larger in absolute value than the expenditure multiplier.9 LOADING... A compromise emerged from the vigorous debate on the size of expenditure and tax multipliers: the $787 billion fiscal stimulus package passed in February 2009, the American Recovery and Reinvestment Act, offered a mix of tax cuts ($288 billion) and government spending increases ($499 billion). You try it... In pressing for tax reductions to stimulate the economy in the short run, Republicans emphasized the immediacy their proposal would have upon the economy. Regarding the long-run effects of the competing proposals, both positions did address the importance of investment, with the Republican approach emphasizing diminished distortions from lower taxes and the resulting positive effect upon private sector investment. The approach by Democrats to enhance the economy's accumulation of physical and human capital centered on more investment by government . A somewhat "mechanical" way to assess the short-run impacts of the competing stimulus proposals (i.e., tax cuts versus more government spending) is to compare their multipliers . Research on the multipliers by economists both inside and outside the government clearly show that A. the multipliers are equal. B. no consensus exists on their relative sizes. C. the tax multiplier is larger. D. the expenditure multiplier is larger

TAX INCREASES FARSIGHTED LLITTLE OR NO A

POLICY AND PRACTICE: The Bush Tax Cuts and Ricardian Equivalence The George W. Bush administration put forward legislation to permanently lower taxes that Congress passed in 2001 and 2003. What does Ricardian equivalence predict should have happened to household saving? According to Ricardian equivalence, household saving should have risen to pay for the future tax increases that the higher budget deficits would require. Instead, household saving, which was at an already-low 3.5% of personal disposable income in 2003, fell even further to an average of 2.2% from 2004 to 2007. At first glance, households did not behave as Ricardian equivalence suggests. Household behavior appears to have been in line with the traditional view of how fiscal policy and government deficits affect the economy. However, as is often the case in economics, the evidence from this period is not definitive due to other factors. The boom in housing prices and the stock market raised wealth and may have induced households to reduce saving. Or maybe people expected that lower taxes would lead to lower future government spending, as President Bush promised, and so felt that they would be better off as a result of the tax cuts because their future disposable income would be higher. The debate still continues on whether the traditional view or Ricardian equivalence view reigns supreme. You try it... Ricardian equivalence holds that tax cuts in the present are equivalent to tax increases in the future. An important element behind the rationale of Ricardian equivalence is that people are farsighted . The so-called "traditional view" of tax cuts sees them as having an expansionary effect on the economy. In the context of the Ricardian equivalence proposition, the traditional view thus envisions little or no feedback from future obligations to present behavior. Since the Bush tax cuts did not produce the household reaction predicted by Ricardian equivalence, it can be concluded that A. perhaps all else was not constant during the period following the tax cuts. This is the correct answer.B. people are indeed shortsighted. Your answer is not correct.C. Ricardian equivalence is fanciful nonsense. D. the evidence unambiguously supports the traditional view.

B E GREECE DISHONESTY B A SEVERE RECESSION, HIGH UNEMPLOYMENT, AND THE IMPOISTION ARE ALL CHECKED

POLICY AND PRACTICE: The European Sovereign Debt Crisis Crisis The global financial crisis in 2007-2009 not only led to a worldwide recession, but also to a sovereign debt crisis that threatens to destabilize Europe. Up until 2007, all the countries that had adopted the euro found their interest rates converging to very low levels, but with the global financial crisis several of these countries were hit very hard with the contraction in economic activity reducing tax revenues, while government bailouts of failed financial institutions required additional government outlays. The resulting surge in budget deficits and rapid rise in debt-to-GDP ratios then led to an adverse feedback loop LOADING... [1] LOADING.... Greece was the first domino to fall in Europe. With a weakening economy reducing tax revenue and increasing spending demands, the Greek government in September 2009 was projecting a budget deficit for the year of 6% and a debt-to-GDP ratio near 100%. However, when a new government was elected in October, it revealed that the budget situation was far worse than anyone imagined because the previous government had provided misleading numbers both about the budget deficit, which was at least double the 6% number, and the amount of government debt, which was ten percentage points higher than previously reported. Despite austerity measures to dramatically cut government spending and raise taxes, interest rates on Greek debt soared, eventually rising to nearly 40%, and the debt-to-GDP ratio climbed to 160% of GDP in 2012. Even with bailouts from other European countries and liquidity support from the European Central Bank, Greece was forced to write down the value of its debt held in private hands by more than half, and the country was subject to civil unrest, with massive strikes and the resignation of the prime minister. The sovereign debt crisis spread from Greece to Ireland, Portugal, Spain and Italy, with their governments forced to embrace austerity measures to shore up their public finances, while interest rates climbed to double-digit levels. Only with a speech in July 2012 by Mario Draghi, the president of the European Central Bank, in which he stated that the ECB was ready to do "whatever it takes" to save the euro, did the markets begin to calm down. Nonetheless, despite a sharp decline in interest rates in those countries, these countries experienced severe recessions, with unemployment rates rising to double-digit levels, with Spain's unemployment rate exceeding 25%. The stresses that the European sovereign debt crisis produced for the euro zone has raised doubts about whether the euro will survive. You try it... Prior to 2007, countries that had adopted the euro experienced interest rates that were A. rigidly linked to the U.S. interest rate. Your answer is not correct.B. converging to very low levels. This is the correct answer.C. converging to zero. D. not susceptible to central bank manipulation. The surge in budget deficits and rapid rise in debt-to-GDP ratios that plagued several countries in the aftermath of the global financial crisis were precipitated by A. recession driven declines in tax revenues. B. government bailouts of failed financial institutions. C. significant enhancements to the social safety net (entitlement spending). D. all of the above. E. A and B only. Your answer is correct. Not only was Greece the first country in Europe to experience sovereign debt difficulties, but it found its situation exacerbated by government dishonesty . Despite internal austerity measures and bailouts from other European countries along with support from the European Central Bank, Greece was forced to _____________ its privately held debt. A. repudiate the whole of B. write down the value of Your answer is correct.C. make in-kind transfers for D. exchange hard currency for From Greece the sovereign debt crisis spread to Ireland, Portugal, Spain and Italy, bringing to each (Check all that apply.) A. a severe recession. This is the correct answer.B. high unemployment. Your answer is correct.C. the imposition of austerity measures. Your answer is correct.D. currency depreciation

A BUDGET DEFICIT SUPPLY SIDERS FUTURE TAKES IS HOLY DEBATED

POLICY AND PRACTICE: Two Expansionary Fiscal Contractions: Denmark and Ireland In 1982, a conservative government came into power in Denmark and began a major program of fiscal retrenchment, lowering the budget deficit by 15% of GDP over the next four years. Instead of causing a contraction in economic activity as the conventional analysis would indicate, real GDP averaged a high 3.6% growth rate from 1983 to 1986. Consumption spending rose rapidly despite a reduction in disposable income due to higher taxes, while investment also boomed. Ireland had a similar experience a few years later. In 1987, the new prime minister, Charles Haughey, launched a tough austerity program that brought down the deficit by 7% of GDP. The Irish economy, which had previously not been growing, began to boom. After this fiscal retrenchment, Ireland experienced what many have called the "Irish miracle," with Ireland characterized as the "Celtic Tiger" because its economy had such impressive growth rates. Both these episodes suggest that fiscal retrenchments can be expansionary because they lower future taxes and boost aggregate demand and long-run aggregate supply. Whether this is the full story behind the Danish and Irish experiences is debated, but it does show that a mechanism to make contractionary fiscal policy expansionary for economic activity is a real possibility.12 LOADING... You try it... Fiscal retrenchment is simply an alternate way to characterize efforts aimed at reducing a budget deficit . The notion that balancing the budget can be an expansionary policy is associated with the group of economists known as supply-siders . The theoretical explanation for the link between fiscal retrenchment and expanding production and employment hinges on the role of future taxes . The idea that fiscal retrenchment can be expansionary is hotly debated by economists

EASY C F

POLICY AND PRACTICE: Was the Fed to Blame for the Housing Price Bubble? Some economistslong dashmost prominently, John Taylor of Stanford Universitylong dashhave argued that the low rate interest policies of the Federal Reserve in the 2003-2006 period caused the housing price bubble.5 LOADING... During this period, the Federal Reserve relied on autonomous easing of monetary policy to set the federal funds rate well below the level that the Taylor rule LOADING... discussed in Chapter 13 suggested was appropriate. The low federal funds rate led to low mortgage rates that stimulated housing demand and encouraged the issuance of subprime mortgages, both of which led to rising housing prices and a bubble. In a speech given in January 2009, the Chairman of the Federal Reserve, Ben Bernanke countered this argument.6 LOADING... He concluded that monetary policy was not to blame for the housing price bubble. First, he said, it is not at all clear that the federal funds rate was below what the Taylor rule LOADING... suggested would be appropriate. Rates only seemed low when current values, not forecasts, were used in the output and inflation calculations for the Taylor rule. Rather, the culprits were the proliferation of new mortgage products that lowered mortgage payments, a relaxation of lending standards that brought more buyers into the housing market, and capital inflows from emerging market countries such as China and India. Bernanke's speech was very controversial, and the debate over whether monetary policy was to blame for the housing price bubble continues to this day. You try it... According to economist John Taylor, the impetus for the issuance of subprime mortgages (and ultimately the housing price bubble and ensuing financial crisis) rested with a monetary policy that was too easy . Federal Reserve Chairman Ben Bernanke responded by A. accepting Taylor's conclusion that monetary policy was indeed too easy. B. attacking the wisdom and usefulness of the Taylor rule. C. presenting an alternative scenario of the origins of the housing price bubble. D. none of the above. According to Bernanke, the housing price bubble and ensuing financial crisis was caused by A. large capital inflows from emerging market economies. B. a relaxation of lending standards. C. political meddling in the housing market. D. the development of new innovative mortgage products. E. all of the above. F. A, B, and D only.

HALVED D A D

POLICY AND PRACTICE: Japan's Lost Decade, 1992-2002 In the early 1990s, Japan seemed poised to overtake the United States as the world's richest country. The average Japanese earned 86% of the typical U.S. worker's income in 1991, up from 73% in 1981. But Japan's economic momentum was squandered over the rest of the 1990s, with GDP growing only 1% a year. The story of Japan's "lost decade" offers a timely lesson in the dangers of underestimating the magnitude of problems in the financial sector. Japan experienced a major banking crisis in 1992 that slowed the economy and reduced inflation. Rather than shuttering insolvent banks and providing sufficient capital to surviving financial institutions, as our framework for analyzing financial crises suggests, the banking regulators in Japan's Ministry of Finance instead followed a path of regulatory forbearance. The government permitted insolvent banks to artificially inflate the value of their assets so as to appear sound, valuing holdings of stocks at much higher historical levels. With regulators' acquiescence, banks acted as if loans to insolvent "zombie firms" would be repaid. The government also allocated too little money to properly recapitalize the banking system.13 LOADING... Not surprisingly, economic growth grinded to a halt and inflation dropped. Deflation struck in 1995 and 1996, returning again in 1998 and lingering for several more years. The crisis subsided in 2003, when the Japanese government finally addressed its broken banking system. By then, the damage had been done: in 2003, per-capita income in Japan had fallen back to 74% of U.S. levels. You try it... In the span of a decade (1981-1991), the discrepancy in living standards between the U.S. and Japan was essentially halved . The core problem faced by Japan during its so-called "lost decade" was a A. misguided fiscal policy. B. meddlesome bureaucracy. C. poorly functioning central bank. D. weakened banking system. An economy's banking system plays a critical role in the intermediation process. A breakdown in this process has both short- and long-run consequences. In the short run, an insufficient flow of credit to households and businesses will mean that aggregate demand A. rises too slowly or perhaps not at all. B. cannot be manipulated with traditional policy tools. C. is limited to net exports and government purchases. D. none of the above. A long-run consequence of a weakened banking system and an impaired intermediation process is slower A. capital accumulation. B. economic growth. C. advances in living standards. D. all of the above. E. B and C only.

A B

What role does the financial system play in promoting economic growth? A. It matches surplus funds to viable investment opportunities. B. It matches lender-spenders with borrower-savers. C. It promotes economic stability by preventing growth from accelerating at an unreasonably fast pace. D. It assists in the location of firms who have both a surplus of funds and productive investment opportunities. If we think of the macroeconomy as a human body, we could say that the financial system acts as A. the hands, holding on to opportunities until the time is right to spend on them. B. the brain, channeling surplus funds to firms with a shortage of funds and productive investment opportunities. C. the heart, pumping funds from poorer parts of the economy to richer parts. D. the skin, protecting the overall economy from economic events in other nations.

AN ADVERSE SELECTION C

Suppose you are about to buy a car and ask to see a vehicle history report to check 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. This example illustrates an adverse selection problem. Given the information above, when there is a lack of information, transactions A. are more likely to occur because people still value the need to make exchanges. B. are just as likely to be completed because the moral hazard problem would still exist. C. are more difficult to complete because the risks involved are greater. D. are less likely to occur because the moral hazard problem is still in existence.

HIGHER THAN C

Suppose you go to a bank, intending to buy a certificate of deposit with your savings. Assume that the bank offers to pay you 2% interest on this certificate of deposit. A customer who comes into the same bank for a car loan is likely to be charged an interest rate higher than the 2% that you will receive. Since the customer will be paying more than you are receiving, would it make sense for you to offer a loan to that individual at a higher rate than you will receive on your certificate of funds (but still competitively lower than the rate currently offered to the car loan borrower)? A. No, the law restricts such lending activities to licensed financial intermediaries. B. Yes, you will make more money and the borrower will pay less. C. No, the bank is more efficient than you at dealing with asymmetric information problems. D. Yes, you are better able to monitor the borrower's activities than the bank.

SURPLUS DEFICIT A

When government revenue exceeds spending, the government runs a surplus ; however, when government spending exceeds revenue, the government experiences a deficit . What are the two main ways the government can finance deficit spending? Which of these methods of financing deficits does the U.S. government most commonly use? A. The government can finance the deficit by selling bonds or by issuing more money, but the U.S. government favors selling bonds. B. The government can finance the deficit by raising taxes or by selling bonds, but the U.S. government favors raising taxes. C. Raising taxes is the only option for the U.S. government to consider if its goal is to quickly retire the deficit. D. The government can finance the deficit by selling bonds or by issuing more money, but the U.S. government favors the creation of more money.

C B

Which of the following best describes the foreign exchange market? A. The exchange of reserve assets among central banks in order to determine exchange rates. B. The trading of import and export goods denominated in units of foreign currency. C. The trading of currencies and bank deposits denominated in particular currencies to determine exchange rates. D. The exchange of goods and services between nations in centralized trading markets in foreign currencies. The two types of transactions that take place in the foreign exchange market are A. import and export transactions. B. spot and forward transactions. C. reserve and exchange transactions. D. nominal and real transactions.

A A

Which of the following correctly lists a procedure used to reduce asymmetric information problems as well as the type of asymmetric information problem it reduces? A. Covenants are used to reduce moral hazard. B. Monitoring is used to reduce adverse selection. C. Screening is used to reduce moral hazard. D. All of the above correctly list a procedure and the type of problem it reduces. Which of the following is true about techniques used to reduce asymmetric information problems? A. Screening is used before the transaction; monitoring is used after the transaction. B. Monitoring is used before the transaction; screening is used after the transaction. C. Both screening and monitoring are used after the transaction. D. Both screening and monitoring are used before the transaction.

Which of the following did not help prevent the financial crisis of 2007-2009 from becoming a depression? A. The use of nonconventional policy by the Federal Reserve to create term auction facilities. B. The purchase of stock and ownership takeovers of troubled banks by the Federal Reserve. C. The Federal Reserve's use of monetary policy to lower the federal funds rate target. D. The creation of new programs, such as lending to investment banks and purchasing commercial paper, by the Federal Reserve.

Which of the following effects on the economy could occur if the Federal Reserve uses monetary policy to burst a wrongfully identified asset-price bubble? A. Investment and consumption expenditures would be expected to decline, while unemployment would increase. B. Some weak sectors of the economy might suffer from increased interest rates, which might create a recession. C. To burst the bubble the Federal Reserve would need to raise interest rates, decreasing access to funds. D. All of the above. E. None of the above.

Which of the following factors has not influenced the debt-to-GDP ratio in the United States since 1940? A. During the 1980s, income tax cuts of the Reagan administration caused the ratio to rise. B. During the 2000s, existing large budget deficits and a large fiscal stimulus of the Obama administration will likely cause the ratio to fall. C. Rapid real GDP growth and inflation contributed to the ratio falling in the post-war era into the 1970s. D. During the late 1990s, large tax increases of the Clinton administration produced such substantial new revenue that the debt-to-GDP ratio declined.

E B

Which of the following is not included in the four main categories of government spending? A. Government Social Security transfer payments B. Government consumption spending on fire protection C. Net interest payments to holders of government bonds D. Government investment spending on highways E. All of the above are included in the four main categories of government spending Which of the following is not included in the four main sources of government revenue? A. Taxes on imports (Tariffs) B. Taxes on exports (Export Tariffs) C. Social Security taxes D. Personal taxes E. All of the above are sources of government revenue

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