ECON 2105 Practice Problems Ch. 17, 16, and 18 Answer Key

Flashcards for economics review.

What is M1?

Currency and coins (cash) in the hands of the public + checkable deposits+savings account deposits

Explain how doing a transaction with barter differs from doing a transaction with money.

Barter takes a double coincidence of wants. Money transactions do not.

From an economic standpoint which type of transaction is preferable and why?

Money transactions are preferable because they are more efficient. Thus, workers can spend more of their time producing.

Who is in charge of monetary policy in the US?

The Federal Reserve Bank (FOMC more specifically)

What are the policy tool options for doing monetary policy to fix a recession?

The Fed can buy bonds.

Explain how monetary policy can fix a recession/deflationary gap.

The Fed will buy bonds which will put money into banks’ excess reserves. This will increase the money supply, leading to a right shift in MS. This will cause interest rates in the economy to fall. Firms finance investment spending through borrowing. As i falls, the cost of borrowing falls, and I rises. This leads to a right shift in the AD curve thereby fixing the problem.

How will the market for money be affected if there is a recession in the US?

MS. Equilibrium interest rates fall

How will the market for money be affected if the FOMC sells bonds?

Equilibrium interest rates rise

How will the market for money be affected if the inflation rate increases?

Equilibrium interest rates rise

If you read in the paper that the Federal Reserve increases interest rates, what has the Fed actually done and what kind of problem is the Fed trying to fix?

The Fed has sold bonds in order to try to fix an inflationary gap.

Suggest 2 ways that the government could fix the deflationary gap using traditional fiscal policies.

Increase G or cut taxes

In order to get AD to shift to the right by $2 billion how much will spending in the economy have to change(by $2 billion, less than $2 billion, more than $2 billion)? Explain.

Because of the AD multiplier G will have to increase by less than $2 billion in order to get AD to shift right by $2 billion (or taxes will have to decrease by less than $2 billion).

Compare and contrast automatic and discretionary fiscal policy.

Automatic stabilizers begin to work as soon as there is a change in the economy. They are policies that are already in place and respond to economic downturns and expansions automatically. Discretionary fiscal policy is a change in G or taxes that is used to try to fix inflationary or deflationary gaps. These policies take an act of congress to be implemented. Both policies are aimed at stabilizing the economy.

Which type of fiscal policy—automatic or discretionary—is no longer possible if the federal government is required to balance its budget at the end of each year? Explain.

Automatic stabilizers are not possible if the government must balance its budget at the end of each year. Ex. In a recession tax revenues are falling and welfare payments are rising. This leads to an unbalanced budget. In order to balance the budget, either taxes will have to be increased or payments decreased. The problem is that either of these actions has the opposite effect on the economy from what is desired.

Explain the differences in the results on the economy if policymakers choose to let the self- adjusting mechanism in the economy fix an inflationary gap instead of using policy to fix the inflationary gap.

If the economy is allowed to fix itself, there is a tight labor market which leads to upward pressure on wages. As wages rise, the cost of production rises, leading to a left shift in AS. This leads to a decrease in equilibrium RGDP and an increase in price level (inflation). If policymakers choose to intervene to fix the inflationary gap, then either the government will increase taxes or decrease G or the Fed will sell bonds and thereby increase interest rates. Any of these policies will lead to a left shift in AD. This leads to a decrease in equilibrium RGDP and a decrease in price level in the economy.