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.

Short Run Economic Fluctuation

 there are question in green I didn't find the answer

2. Suppose that the economy is undergoing a recession because of a fall in aggregate demand.

a. Using an aggregate-demand/aggregate-supply diagram, depict the current state of the economy.

 b. What is happening to the unemployment rate?

 c. “Capacity utilization” is a measure of how intensively the capital stock is being used. In a recession, is capacity utilization above or below its long-run average? Explain.
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 3. Explain whether each of the following events will increase, decrease, or have no effect on long-run aggregate supply.

a. The United States experiences a wave of immigration.

 b. Congress raises the minimum wage to $10 per hour.

 c. Intel invents a new and more powerful computer chip.

 d. Asevere hurricane damages factories along the east coast.

a.      When the United States experiences a wave of immigration, the labor force increases, so long-run aggregate supply shifts to the right. 

         b.           When Congress raises the minimum wage to $10 per hour, the natural rate of unemployment rises, so the long-run aggregate-supply curve shifts to the left.

         c.            When Intel invents a new and more powerful computer chip, productivity increases, so long-run aggregate supply increasesbecause more output can be produced with the same inputs. 

         d.           When a severe hurricane damages factories along the East Coast, the capital stock is smaller, so long-run aggregate supply declines.

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4. In Figure 31-8, how does the unemployment rate at points B and C compare to the unemployment rate at point A? Under the sticky-wage explanation of the short-run aggregate-supply curve, how does the real wage at points B and C compare to the real wage at point A?

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 5. Explain why the following statements are false.

 a. “The aggregate-demand curve slopes downward because it is the horizontal sum of the demand curves for individual goods.”

 b. “The long-run aggregate-supply curve is vertical because economic forces do not affect long-run aggregate supply.”

 c. “If firms adjusted their prices every day, then the short-run aggregate-supply curve would be horizontal.”

 d. “Whenever the economy enters a recession, its long-run aggregate-supply curve shifts to the left.”

a.      The statement that "the aggregate-demand curve slopes downward because it is the horizontal sum of the demand curves for individual goods" is false. The aggregate-demand curve slopes downward because a fall in the price level raises the overall quantity of goods and services demanded through the wealth effect, the interest-rate effect, and the exchange-rate effect.

b.     The statement that "the long-run aggregate-supply curve is vertical because economic forces do not affect long-run aggregate supply" is false. Economic forces of various kinds (such as population and productivity) do affect long-run aggregate supply. The long-run aggregate-supply curve is vertical because the price level does not affect long-run aggregate supply.

c.      The statement that "if firms adjusted their prices every day, then the short-run aggregate-supply curve would be horizontal" is false. If firms adjusted prices quickly and if sticky prices were the only possible cause for the upward slope of the short-run aggregate-supply curve, then the short-run aggregate-supply curve would be vertical, not horizontal. The short-run aggregate supply curve would be horizontal only if prices were completely fixed.

d.     The statement that "whenever the economy enters a recession, its long-run aggregate-supply curve shifts to the left" is false. An economy could enter a recession if either the aggregate-demand curve or the short-run aggregate-supply curve shifts to the left.

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6. For each of the three theories for the upward slope of the short-run aggregate-supply curve, carefully explain the following:

a. how the economy recovers from a recession and returns to its long-run equilibrium without any policy intervention

a.      According to the sticky-wage theory, the economy is in a recession because the price level has declined so that real wages are too high, thus labor demand is too low. Over time, as nominal wages are adjusted so that real wages decline, the economy returns to full employment. 

         According to the sticky-price theory, the economy is in a recession because not all prices adjust quickly. Over time, firms are able to adjust their prices more fully, and the economy returns to the long-run aggregate-supply curve.         

         According to the misperceptions theory, the economy is in a recession when the price level is below what was expected. Over time, as people observe the lower price level, their expectations adjust, and the economy returns to the long-run aggregate-supply curve.

b. what determines the speed of that recovery

b.    The speed of the recovery in each theory depends on how quickly price expectations, wages, and prices adjust.

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7. Suppose the Fed expands the money supply, but because the public expects this Fed action, itsimultaneously raises its expectation of the price level. What will happen to output and the price level in the short run? Compare this result to the outcome if the Fed expanded the money supply but the public didn’t change its expectation of the price level.

If the Fed increases the money supply and people expect a higher price level, the aggregate-demand curve shifts to the right and the short-run aggregate-supply curve shifts to the left, as shown in Figure 9.

         The economy moves from point A to point B, with no change in output and a rise in the price level (to P₂).

         If the public does not change its expectation of the price level,the short-run aggregate-supply curve does not shift, the economy ends up at point C, and output increases along with the price level (to P₃).

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8. Suppose that the economy is currently in a recession. If policymakers take no action, how will the economy evolve over time? Explain in words and using an aggregate-demand/aggregate-supply diagram.

Figure 10 depicts an economy in a recession. The short-run aggregate-supply curve is AS₁ and the economy is at equilibrium at point A, which is to the left of the long-run aggregate-supply curve.If policymakers take no action, the economy will return to the long-run aggregate-supply curve over time as the short-run aggregate-supply curve shifts to the right to AS₂. The economy's new equilibrium is at point B.

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9. Suppose workers and firms suddenly believe that inflation will year. Suppose also that the economy begins in long-run equilibrium, and the aggregate-demand curve does not shift.

 a. What happens to nominal wages? What happens to real wages?

b. Using an aggregate-demand/aggregate-supply diagram, show the effect of the change in expectations on both the short-run and long-run levels of prices and output.

 c. Were the expectations of high inflation accurate? Explain.

be quite high over the coming

 10. Explain whether each of the following events shifts the short-run aggregate-supply curve, the aggregate- demand curve, both, or neither. For each event that does shift a curve, use a diagram to illustrate the effect on the economy.

a. Households decide to save a larger share of their income.

.        If households decide to save a larger share of their income, they must spend less on consumer goods, so the aggregate-demand curve shifts to the left, as shown in Figure 12. The equilibrium changes from point A to point B, so the price level declines and output declines.

 b. Florida orange groves suffer a prolonged period of below-freezing temperatures.

If Florida orange groves suffer a prolonged period of below-freezing temperatures, the orange harvest will be reduced. This decline in the natural rate of output is represented in Figure 13 by a shift to the left in both the short-run and long-run aggregate-supply curves.

         The equilibrium changes from point A to point B, so the price level rises and output declines.

If increased job opportunities cause people to leave the country, the long-run and short-run aggregate-supply curves will shift to the left because there are fewer people producing output. The aggregate-demand curve will shift to the left because there are fewer people consuming goods and services. The result is a decline in the quantity of output, as Figure 14 shows. Whether the price level rises or declines depends on the relative sizes of the shifts in the aggregate-demand curve and the aggregate-supply curves.

11. For each of the following events, explain the short-run and long-run effects on output and the price level, assuming policymakers take no action.

a. The stock market declines sharply, reducing consumers’ wealth.

When the stock market declines sharply, wealth declines, so the aggregate-demand curve shifts to the left, as shown in Figure 15. In the short run, the economy moves from point A to point B, as output declines and the price level declines. In the long run, the short-run aggregate-supply curve shifts to the right to restore equilibrium at point C, with unchanged output and a lower price level compared to point A.

b. The federal government increases spending on national defense.

      When the federal government increases spending on national defense, the rise in government purchases shifts the aggregate-demand curve to the right, as shown in Figure 16. In the short run, the economy moves from point A to point B, as output and the price level rise. In the long run, the short-run aggregate-supply curve shifts to the left to restore equilibrium at point C, with unchanged output and a higher price level compared to point A.

c. Atechnological improvement raises productivity.

When a technological improvement raises productivity, the long-run and short-run aggregate-supply curves shift to the right, as shown in Figure 17. The economy moves from point A to point B, as output rises and the price level declines.

d. Arecession overseas causes foreigners to buy fewer U.S. goods.

When a recession overseas causes foreigners to buy fewer U.S. goods, net exports decline, so the aggregate-demand curve shifts to the left, as shown in Figure 18. In the short run, the economy moves from point A to point B, as output declines and the price level declines. In the long run, the short-run aggregate-supply curve shifts to the right to restore equilibrium at point C, with unchanged output and a lower price level compared to point A.

12. Suppose that firms become very optimistic about future business conditions and invest heavily in new capital equipment.

a. Use an aggregate-demand/aggregate-supply diagram to show the short-run effect of this optimism on the economy. Label the new levels ofprices and real output. Explain in words why the aggregate quantity of output supplied changes.

a.     If firms become optimistic about future business conditions and increase investment, the result is shown in Figure 20.

            The economy begins at point A with aggregate-demand curve AD₁ and short-run aggregate-supply curve AS₁. The equilibrium has price level P₁ and output level Y₁.

            Increased optimism leads to greater investment, so the aggregate-demand curve shifts to AD₂. Now the economy is at point B, with price level P₂ and output level Y₂.

            The aggregate quantity of output supplied rises because the price level has risen and people have misperceptions about the price level, wages are sticky, or prices are sticky, all of which cause output supplied to increase.

a.       Now use the diagram from part (a) to show the new long-run equilibrium of the economy. (For now, assume there is no change in the long-run aggregate-supply curve.) Explain in words why the aggregate quantity of output demanded changes between the short run and the long run.

b.     Over time, as the misperceptions of the price level disappear, wages adjust, or prices adjust, the short-run aggregate-supply curve shifts up to AS₂ and the economy gets to equilibrium at point C, with price level P₃ and output level Y₁. The quantity of output demanded declines as the price level rises. 

c. How might the investment boom affect the long- run aggregate-supply curve? Explain.

c.         The investment boom might increase the long-run aggregate-supply curve because higher investment today means a larger capital stock in the future, thus higher productivity and output