Fiscal and Monetary

 Monetary and fiscal

1. Explain how each of the following developments would affect the supply of money, the demand for money, and the interest rate. Illustrate your answers with diagrams.

a. The Fed’s bond traders buy bonds in open-market operations.

ANSWER:

a.                 When the Fed’s bond traders buy bonds in open-market operations, the money-supply curve shifts to the right from MS₁ to MS₂, as shown Figure 1. The result is a decline in the interest rate.

b.                 An increase in credit card availability reduces the cash people hold.

         When an increase in credit card availability reduces the cash people hold, the money-demand curve shifts to the left from MD₁ to MD₂, as shown in Figure 2. The result is a decline in the interest rate.

c.                 The Federal Reserve reduces banks’ reserve requirements.

c.   When the Federal Reserve reduces reserve requirements, the money supply increases, so the money-supply curve shifts to the right from MS₁ to MS₂, as shown in Figure 1. The result is a decline in the interest rate

d. Households decide to hold more money to use for holiday shopping.

      d.           When households decide to hold more money to use for holiday shopping, the money-demand curve shifts to the right from MD₁ to MD₂, as shown in Figure 3. The result is a rise in the interest rate.

d.                 Awave of optimism boosts business investment and expands aggregate demand.

      When a wave of optimism boosts business investment and expands aggregate demand, money demand increases from MD₁ to MD₂ in Figure 3. The increase in money demand increases the interest rate.

f. An increase in oil prices shifts the short-run aggregate-supply curve to the left.

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2. Suppose banks install automatic teller machines on every block and, by making cash readily available, reduce the amount of money people want to hold.

 a. Assume the Fed does not change the money supply. According to the theory of liquidity preference, what happens to the interest rate? What happens to aggregate demand?

b. If the Fed wants to stabilize aggregate demand, how should it respond?

ANSWER:

a.      When more ATMs are available, money demand is reduced and the money-demand curve shifts to the left from MD₁ to MD₂, as shown in Figure 6. If the Fed does not change the money supply, which is at MS₁, the interest rate will decline from r₁ to r₂. The decline in the interest rate shifts the aggregate-demand curve to the right, as consumption and investment increase. 

b.     If the Fed wants to stabilize aggregate demand, it should reduce the money supply to MS₂, so the interest rate will remain at r₁ and aggregate demand will not change.

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3. Consider two policies—a tax cut that will last for only one year, and a tax cut that is expected to be permanent. Which policy will stimulate greater spending by consumers? Which policy will have the greater impact on aggregate demand? Explain.

A tax cut that is permanent will have a bigger impact on consumer spending and aggregate demand. If the tax cut is permanent, consumers will view it as adding substantially to their financial resources, and they will increase their spending substantially.

         If the tax cut is temporary, consumers will view it as adding just a little to their financial resources, so they will not increase spending as much.
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 4. The interest rate in the United States fell sharply during 1991. Many observers believed this decline showed that monetary policy was quite expansionary during the year. Could this conclusion be incorrect? (Hint: The United States hit the bottom of a recession in 1991.)
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5. In the early 1980s, new legislation allowed banks to pay interest on checking deposits, which they could not do previously.

 a. If we define money to include checking deposits, what effect did this legislation have on money demand? Explain.

b. If the Federal Reserve had maintained a constant money supply in the face of this change, what would have happened to the interest rate? What would have happened to aggregate demand and aggregate output?

c. If the Federal Reserve had maintained a constant market interest rate (the interest rate on nonmonetary assets) in the face of this change,what change in the money supply would have been necessary? What would have happened to aggregate demand and aggregate output?

ANSWER:

         a.            Legislation allowing banks to pay interest on checking deposits increases the return to money relative to other financial assets, thus increasing money demand. 

         b.           If the money supply remained constant (at MS₁), the increase in the demand for money would have raised the interest rate, as shown in Figure 10. The rise in the interest rate would have reduced consumption and investment, thus reducing aggregate demand and output. 

         c.            To maintain a constant interest rate, the Fed would need to increase the money supply from MS₁ to MS₂. Then aggregate demand and output would be unaffected.

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 6. This chapter explains that expansionary monetary policy reduces the interest rate and thus stimulates demand for investment goods. Explain how such a policy also stimulates the demand for net exports.
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7. Suppose economists observe that an increase in government spending of $10 billion raises the total demand for goods and services by $30 billion.

a. If these economists ignore the possibility of crowding out, what would they estimate the marginal propensity to consume (MPC) to be?

 b. Now suppose the economists allow for crowding out. Would their new estimate of the MPC be larger or smaller than their initial one?

a.      If there is no crowding out, then the multiplier equals 1/(1 – MPC). Because the multiplier is 3, then MPC = 2/3.

b.     If there is crowding out, then the MPCwould be larger than 2/3. An MPCthat is larger than 2/3 would lead to a larger multiplier than 3, which is then reduced down to 3 by the crowding-out effect. 
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 8. Suppose the government reduces taxes by $20 billion, that there is no crowding out, and that the marginal propensity to consume is 3/4.

 a. What is the initial effect of the tax reduction on aggregate demand?

b. What additional effects follow this initial effect? What is the total effect of the tax cut on aggregate demand?

 c. How does the total effect of this $20 billion tax cut compare to the total effect of a $20 billion increase in government purchases? Why?

ANSWER:

a.     The initial effect of the tax reduction of $20 billion is to increase aggregate demand by $20 billion x 3/4 (the MPC) = $15 billion.

b.     Additional effects follow this initial effect as the added incomes are spent. The second round leads to increased consumption spending of $15 billion x 3/4 = $11.25 billion. The third round gives an increase in consumption of $11.25 billion x 3/4 = $8.44 billion. The effects continue indefinitely. Adding them all up gives a total effect that depends on the multiplier. With an MPC of 3/4, the multiplier is 1/(1 – 3/4) = 4. So the total effect is $15 billion x 4 = $60 billion.

c.      Government purchases have an initial effect of the full $20 billion, because they increase aggregate demand directly by that amount. The total effect of an increase in government purchases is thus $20 billion x 4 = $80 billion. So government purchases lead to a bigger effect on output than a tax cut does. The difference arises because government purchases affect aggregate demand by the full amount, but a tax cut is partly saved by consumers, and therefore does not lead to as much of an increase in aggregate demand.

d.     The government could increase taxes by the same amount it increases its purchases.
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9. Suppose government spending increases. Would the effect on aggregate demand be larger if the Federal Reserve took no action in response, or if the Fed were committed to maintaining a fixed interest rate? Explain.

If government spending increases, aggregate demand rises, so money demand rises. The increase in money demand leads to a rise in the interest rate and thus a decline in aggregate demand if the Fed does not respond. But if the Fed maintains a fixed interest rate, it will increase money supply, so aggregate demand will not decline. Thus, the effect on aggregate demand from an increase in government spending will be larger if the Fed maintains a fixed interest rate.

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10. In which of the following circumstances is expansionary fiscal policy more likely to lead to a short-run increase in investment? Explain.

a. when the investment accelerator is large, or when it is small?

b. when the interest sensitivity of investment is large, or when it is small?

ANSWER:

a.      Expansionary fiscal policy is more likely to lead to a short-run increase in investment if the investment accelerator is large. A large investment accelerator means that the increase in output caused by expansionary fiscal policy will induce a large increase in investment. Without a large accelerator, investment might decline because the increase in aggregate demand will raise the interest rate. 

b.     Expansionary fiscal policy is more likely to lead to a short-run increase in investment if the interest sensitivity of investment is small. Because fiscal policy increases aggregate demand, thus increasing money demand and the interest rate, the greater the sensitivity of investment to the interest rate the greater the decline in investment will be, which will offset the positive accelerator effect.

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11. Assume the economy is in a recession. Explain how each of the following policies would affect consumption and investment. In each case, indicate any direct effects, any effects resulting from changes in total output, any effects resulting from changes in the interest rate, and the overall effect. If there are conflicting effects making the answer ambiguous, say so

. a. an increase in government spending

b. a reduction in taxes c. an expansion of the money supply

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12. For various reasons, fiscal policy changes automatically when output and employment fluctuate.

a. Explain why tax revenue changes when the economy goes into a recession.

b. Explain why government spending changes when the economy goes into a recession.

 c. If the government were to operate under a strict balanced-budget rule, what would it have to do in a recession? Would that make the recession more or less severe?

a.      Tax revenue declines when the economy goes into a recession because taxes are closely related to economic activity. In a recession, people's incomes and wages fall, as do firms' profits, so taxes on these things decline. 

b.     Government spending rises when the economy goes into a recession because more people get unemployment-insurance benefits, welfare benefits, and other forms of income support. 

c.      If the government were to operate under a strict balanced-budget rule, it would have to raise tax rates or cut government spending in a recession. Both would reduce aggregate demand, making the recession more severe.
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 13. Recently, some members of Congress have proposed a law that would make price stability the sole goal of monetary policy. Suppose such a law were passed.

 a. How would the Fed respond to an event that contracted aggregate demand?

there were a contraction in aggregate demand, the Fed would need to increase the money supply to increase aggregate demand and stabilize the price level, as shown in Figure 11. By increasing the money supply, the Fed is able to shift the aggregate-demand curve back to AD₁ from AD₂. This policy stabilizes output and the price level

b. How would the Fed respond to an event that caused an adverse shift in short-run aggregate supply? In each case, is there another monetary policy that would lead to greater stability in output?

If there were an adverse shift in short-run aggregate supply, the Fed would need to decrease the money supply to stabilize the price level, shifting the aggregate-demand curve to the left from AD₁ to AD₂, as shown in Figure 12. This worsens the recession caused by the shift in aggregate supply. To stabilize output, the Fed would need to increase the money supply, shifting the aggregate-demand curve from AD₁ to AD₃. However, this action would raise the price level.