Review

Which of the following is not a function of the Fed?

Advising Congress on fiscal policy

Last year, while an economy was in a recession, government spending was $595 billion and government revenue was $505 billion. Economists estimate that if the economy had been at its full-employment level of GDP last year, government spending would have been $555 billion and government revenue would have been $550 billion. Which of the following statements about this government's fiscal situation are true?

The government has a non-cyclically adjusted budget deficit of $90 billion; The government has a cyclically adjusted budget deficit of $5 billion

Assume that (a) the price level is flexible upward but not downward and (b) the economy is currently operating at its full-employment output. Other things equal, how will each of the following affect the equilibrium price level and equilibrium level of real output in the short run? a. An increase in aggregate demand. b. A decrease in aggregate supply, with no change in aggregate demand. c. Equal increases in aggregate demand and aggregate supply. d. A decrease in aggregate demand. e. An increase in aggregate demand that exceeds an increase in aggregate supply.

a. Price level rises rapidly and little change in real output. b. Price level rises and real output decreases. c. Price level does not change, but real output increases. d. Price level does not change, but real output declines. e. Price level increases somewhat, as does real output.

Suppose that a small country currently has $4 million of currency in circulation, $6 million of checkable deposits, $200 million of savings deposits, $40 million of small denominated time deposits, and $30 million of money market mutual fund deposits. From these numbers we see that this small country's M1 money supply is ____________, while ____________ its M2 money supply is

$10 million; $280 million

In January, the interest rate is 5 percent and firms borrow $50 billion per month for investment projects. In February, the federal government doubles its monthly borrowing from $25 billion to $50 billion. That drives the interest rate up to 7 percent. As a result, firms cut back their borrowing to only $30 billion per month. Which of the following is true?

There is a crowding-out effect of $20 billion.

Refer back to the table in Figure 30.7 in the previous chapter. Suppose that aggregate demand increases such that the amount of real output demanded rises by $7 billion at each price level. By what percent will the price level increase? Will this inflation be demand-pull inflation or will it be cost-push inflation? If potential real GDP (that is, full-employment GDP) is $510 billion, what will be the size of the positive GDP gap after the change in aggregate demand? If government wants to use fiscal policy to counter the resulting inflation without changing tax rates, would it increase government spending or decrease it?

increase by 8 percent; demand-pull inflation; $3 billion; decrease government spending.

Assume that Jimmy Cash has $2,000 in his checking account at Folsom Bank and uses his checking account card to withdraw $200 of cash from the bank's ATM machine. By what dollar amount did the M1 money supply change as a result of this single, isolated transaction?

$0 (zero) The answer is zero. Jimmy withdrew $200 from his checking account, so his checkable deposits are now $1800. This results in a decrease in M1 by an equal amount. However Jimmy now has $200 in cash, which increases M1 by $200.

The Third National Bank has reserves of $20,000 and checkable deposits of $100,000. The reserve ratio is 20 percent. Households deposit $5000 in currency into the bank and that currency is added to reserves. What level of excess reserves does the bank now have?

$4,000

Assume that a hypothetical economy with an MPC of .8 is experiencing severe recession. By how much would government spending have to rise to shift the aggregate demand curve rightward by $25 billion? How large a tax cut would be needed to achieve the same increase in aggregate demand? Determine one possible combination of government spending increases and tax increases that would accomplish the same goal without changing the amount of outstanding debt.

$5 billion; 6.25 billion; Combining the two effects above, we have an increase in aggregate demand of $25 billion

What is the basic determinant of (a) the transactions demand and (b) the asset demand for money? Explain how these two demands can be combined graphically to determine total money demand. How is the equilibrium interest rate in the money market determined? Use a graph to show the impact of an increase in the total demand for money on the equilibrium interest rate (no change in money supply). Use your general knowledge of equilibrium prices to explain why the previous interest rate is no longer sustainable.

(a) The level of nominal GDP. The higher this level, the greater the amount of money demanded for transactions. (b) The interest rate. The higher the interest rate, the smaller the amount of money demanded as an asset. On a graph measuring the interest rate vertically and the amount of money demanded horizontally, the two demands for the money curves can be summed horizontally to get the total demand for money. This total demand shows the total amount of money demanded at each interest rate. The equilibrium interest rate is determined at the intersection of the total demand for money curve and the supply of money curve. With an increase in total money demand, the previous interest rate (i0) is unsustainable because with the new demand for money (Dm1), the quantity of money demanded will exceed the quantity of money supplied. There would be a shortage of funds and upward pressure on the interest rate.

If the required reserve ratio is 10 percent, what is the monetary multiplier? If the monetary multiplier is 4, what is the required reserve ratio?

10; 25 percent.

Which of the following will shift the aggregate supply curve to the right?

A new networking technology increases productivity all over the economy Business taxes fall

True or False: Decreases in AD normally lead to decreases in both output and the price level

False: This statement is false because decreases in AD normally lead to falls in output but not the price level. That is the case because the price level in the real world is downwardly inflexible. Thus, when AD shifts left, the economy can only adjust to the fall in aggregate demand with reductions in output (as in Figure 12.9). By contrast, prices are flexible upward so that increases in AD lead to both increases in output and increases in the price level (as in Figure 12.8).

Explain how built-in (or automatic) stabilizers work. What are the differences between proportional, progressive, and regressive tax systems as they relate to an economy's built-in stability?

In a phrase, "net tax revenues vary directly with GDP." When GDP is rising so are tax collections, both income taxes and sales taxes. At the same time, government payouts—transfer payments such as unemployment compensation, and welfare—are decreasing. Since net taxes are taxes less transfer payments, net taxes definitely rise with GDP, which dampens the rise in GDP. On the other hand, when GDP drops in a recession, tax collections slow down or actually diminish while transfer payments rise quickly. Thus, net taxes decrease along with GDP, which softens the decline in GDP. A progressive tax system would have the most stabilizing effect of the three tax systems and the regressive tax would have the least built-in stability. This follows from the previous paragraph. A progressive tax increases at an increasing rate as incomes rise, thus having more of a dampening effect on rising incomes and expenditures than would either a proportional or regressive tax. The latter rate would rise more slowly than the rate of increase in GDP with the least effect of the three types. Conversely, in an economic slowdown, a progressive tax falls faster because not only does it decline with income, it becomes proportionately less as incomes fall. This acts as a cushion on declining incomes—the tax bite is less, which leaves more of the lower income for spending. The reverse would be true of a regressive tax that falls, but more slowly than the progressive tax, as incomes decline.

Which of the following will shift the aggregate demand curve to the left?

Interest rates rise The government raises corporate profit taxes

The three functions of money are

Medium of exchange, unit of account, and store of value

City Bank is considering making a $50 million loan to a company named SheetOil that wants to commercialize a process for turning used blankets, pillowcases, and sheets into oil. This company's chances for success are dubious, but City Bank makes the loan anyway because it believes that the government will bail it out if SheetOil goes bankrupt and cannot repay the loan. City Bank's decision to make the loan has been affected by:

Moral hazard

Suppose that Lady Gaga goes to Las Vegas to play poker and at the last minute her record company says it will reimburse her for 50 percent of any gambling losses that she incurs. Will Lady Gaga wager more or less as a result of the reimbursement offer? What economic concept does your answer illustrate?

More; moral hazard. Since Lady Gaga will get reimbursed for part of her losses she will gamble more. This is referred to as moral hazard.

What are government's fiscal policy options for ending severe demand-pull inflation? Which of these fiscal options do you think might be favored by a person who wants to preserve the size of government? A person who thinks the public sector is too large? How does the "ratchet effect" affect anti-inflationary fiscal policy?

Options are to reduce government spending, increase taxes, or some combination of both. See the figure blow. If the price level is flexible downward, it will fall. In the real world, the goal is to reduce inflation—to keep prices from rising so rapidly—not to reduce the price level. A person wanting to preserve the size of government might favor a tax hike and would want to preserve government spending programs. Someone who thinks that the public sector is too large might favor cuts in government spending since this would reduce the size of government. The ratchet effect implies that prices are rigid downward.

Why does the Federal Reserve require commercial banks to have reserves? Explain why reserves are an asset to commercial banks but a liability to the Federal Reserve Banks. What are excess reserves? How do you calculate the amount of excess reserves held by a bank? What is the significance of excess reserves?

Reserves provide the Fed a means of controlling the money supply. It is through increasing and decreasing excess reserves that the Fed is able to achieve a money supply of the size it thinks best for the economy. Reserves are assets of commercial banks because these funds are cash belonging to them; they are a claim the commercial banks have against the Federal Reserve Bank. Reserves deposited at the Fed are a liability to the Fed because they are funds it owes; they are claims that commercial banks have against it.

Which group votes on the open-market operations that are used to control the U.S. money supply and interest rates?

The Federal Open Market Committee

Distinguish between the federal funds rate and the prime interest rate. Why is one higher than the other? Why do changes in the two rates closely track one another?

The Federal funds interest rate is the interest rate banks charge one another on overnight loans needed to meet the reserve requirement. The prime interest rate is the interest rate banks charge on loans to their most creditworthy customers. The Federal funds rate is lower than the prime interest rate for a number of reasons. Federal funds are loaned overnight, so lenders don't have to wait long for repayment. The reserves loaned would otherwise generate no interest, so even loaning at the lower Federal funds rate is beneficial to lenders. Interest rates also depend on risk. It is less risky to lend overnight to other banks than it is to lend for longer periods to non-bank businesses and households. Both rates are related to the relative scarcity or availability of reserves. If there are fewer reserves available for lending, the price to borrow those reserves (the interest rate) will rise whether the customers are banks, businesses, or households.

Why is the banking system in the United States referred to as a fractional reserve bank system? What is the role of deposit insurance in a fractional reserve system?

The banking system in the United States is a fractional reserve bank system because the banks do not hold enough cash or reserves on hand to pay every depositor on demand at the same time. That is, if everyone went to the bank at the same time and tried to close their accounts the bank would not be able to meet this demand. To avoid the potential of these bank runs there is deposit insurance in the United States and other countries. By guaranteeing depositors that they will always get their money, deposit insurance removes the incentive to try to withdraw one's deposit before anyone else can. It thus stops most bank runs.

What is the basic objective of monetary policy? What are the major strengths of monetary policy? Why is monetary policy easier to conduct than fiscal policy?

The basic objective of monetary policy is to assist the economy in achieving a full-employment, non-inflationary level of total output.

Define the cyclically-adjusted budget, explain its significance, and state why it may differ from the actual budget. Suppose the full-employment, noninflationary level of real output is GDP3 (not GDP2) in the economy depicted in Figure 13.3. If the economy is operating at GDP2, instead of GDP3, what is the status of its cyclically-adjusted budget? The status of its current fiscal policy? What change in fiscal policy would you recommend? How would you accomplish that in terms of the G and T lines in the figure?

The cyclically-adjusted budget measures what the Federal deficit or surplus would be if the economy reached full-employment level of GDP with existing tax and spending policies. If the cyclically-adjusted budget is balanced, then the government is not engaging in either expansionary or contractionary policy, even if, for example, a deficit automatically results when GDP declines. The "actual" budget is the deficit or surplus that results when revenues and expenditures occur over a year if the economy is not operating at full-employment. Looking at Figure 13.3, if full-employment GDP is GDP3, then the cyclically-adjusted budget is contractionary since a surplus would exist. Even though the "actual" budget has no deficit at GDP2, fiscal policy is contractionary. To move the economy to full-employment, government should cut taxes or increase spending. You would raise G line or lower T line or combination of each until they intersect at GDP3.

How would a decrease in the reserve requirement affect the (a) size of the money multiplier, (b) amount of excess reserves in the banking system, and (c) extent to which the system could expand the money supply through the creation of checkable deposits via loans?

The monetary multiplier is k = 1/(1- required reserve ratio). (a) Thus, a decrease in required reserve ratio will result in an increase in the multiplier because each bank will need to hold less reserves and therefore can make more loans. (b) This also implies that the bank will see an increase in excess reserves after the fall in the required reserve ratio. (c) The ability to make more loans results in an increase in the potential money creation through the fractional reserve banking system.

Why might economists be quite concerned if the annual interest payments on the U.S. public debt sharply increased as a percentage of GDP?

The weight of the debt is not its absolute size. Indeed, if there were no interest to be paid on the debt and refinancing was automatic, there would be no debt load at all. But interest does have to be paid. Lenders expect that, and to pay the interest the government must either use tax revenues or go deeper into debt. Interest on the debt, then, is important and its weight can best be assessed by noting the size of the interest payments in relation to GDP, since the size of the GDP is a measure of total national income or how much the government can raise in taxes to pay the interest

Explain why a single commercial bank can safely lend only an amount equal to its excess reserves but the commercial banking system as a whole can lend by a multiple of its excess reserves. What is the monetary multiplier, and how does it relate to the reserve ratio?

When a bank grants a loan, it can expect that the borrower will not leave the proceeds of the loan sitting idle in his or her account. Most people borrow to spend. Therefore the lending bank can expect that checks will be written against the loan and that the bank will shortly lose reserves to other banks, as the checks are presented for payment, to the full extent of the loan. In short, when a bank grants loans to the full extent of its excess reserves, it can shortly expect to lose these excess reserves to other banks. From this it can be seen why a bank cannot safely lend more than its excess reserves. If it did, it would soon find that its cash reserves were below its legal reserve requirement. From the above it can be seen why the commercial banking system can safely lend a multiple of its excess reserves. Whereas one bank loses reserves to other banks, the system does not. With a legal cash reserve requirement of, say, 20 percent, Bank "B" on receiving as a new deposit the $100 loaned by Bank "A" (the excess reserves of Bank "A"), may safely lend $80 (80 percent of $100). Bank "C", on receiving as a new deposit the $80 loan of Bank "B", loans 80 percent of that, namely $64. Note that the $100 initial excess reserves of the banking system have already resulted in the money supply increasing by $244 (= $100 + $80 + $64). The money supply will continue to increase, at a diminishing rate (Bank "D" will increase the money supply by $51.20 in loaning this amount), until the total increase in the money supply is $500. The algebra underlying the monetary multiplier is that of an infinite geometric progression. Designating the fixed fraction of the previous number as b (0.8 in our case) and k as the sum of the progression, we have: In our example, the multiplier k is 1/(1 - 0.8) = 1/.2 = 5. And 5 is the reciprocal of the reserve ratio of 20 percent of 0.2. The multiplier is inversely related to the reserve ratio.

"When a commercial bank makes loans, it creates money; when loans are repaid, money is destroyed."

When a bank makes a loan it also creates a checkable deposit of equal value. This increase in checkable deposits results in an increase in M1. When we apply this logic to the multiple bank-fractional reserve banking system the process (expansion of the money supply) is compounded. The reverse logic applies when a loan is paid off. The individual writes a check to pay off the loan, which reduces checkable deposits. (Recall that cash or reserves held by banks are not part of M1).

Which of the following help to explain why the aggregate demand curve slopes downward?

When the domestic price level rises, our goods and services become more expensive to foreigners. When the price level rises, the real value of financial assets (like stocks, bonds, and savings account balances) declines.