Self-Check Assignment 6 Study Notes

1. Classification of Policy Interventions

  • Discretionary Policy Interventions: These require active decision-making by policymakers before implementation.

    • Governments increasing government spending in response to a recession – Answer: discretionary
    • Governments increasing taxes to cool down an overheating economy – Answer: discretionary
    • Central banks buying government bonds (government debt) to stimulate a slowing economy – Answer: discretionary
    • Central banks raising the discount window lending rate to combat inflation – Answer: discretionary

  • Automatic Stabilizers: These are built into the economy and function without direct intervention.

    • The number of unemployment insurance payments increasing as people lose their jobs during a recession – Answer: automatic stabilizer
    • Income tax revenue increasing as people return to work during an economic expansion – Answer: automatic stabilizer

2. Characterization of Economic Policies

  • Expansionary and Contractionary Policies:
    • Monetary Policy: Actions by a central bank to manage the economy by controlling the money supply and interest rates.
    • The central bank increases the interest rate paid on reserve balances from 0% to 0.5% – Answer: contractionary monetary policy
    • The central bank purchases financial assets (including government debt) from commercial banks – Answer: expansionary monetary policy
    • The central bank increases the required reserve ratio – Answer: contractionary monetary policy
    • The central bank decreases the discount window lending rate – Answer: expansionary monetary policy
    • Fiscal Policy: Government policies regarding taxation and spending.
    • The government announces that it will pare back its spending – Answer: contractionary fiscal policy
    • The government announces that it will extend and increase some of its tax cuts – Answer: expansionary fiscal policy
    • The government announces that it will reduce spending on certain transfer programs (e.g., food stamps, child tax credits) – Answer: contractionary fiscal policy

3. Effects of Expansionary Policies

  • Aggregate Demand: Increases
  • Real GDP: Increases
  • Unemployment: Decreases
  • Inflation: Increases

4. Effects of Contractionary Policies

  • Aggregate Demand: Decreases
  • Real GDP: Decreases
  • Unemployment: Increases
  • Inflation: Decreases

5. Types of Money

  • When citizens use gold as a store of value, this is an example of commodity money.
  • Many currencies today are not tied to any physical asset, exemplifying fiat money.

6. Functions of Money

  • Store of Value: Savings accounts maintain money for future consumption.
  • Medium of Exchange: Money facilitates the buying and selling of goods and services.
  • Unit of Account: Money serves as a measuring tool to compare unlike goods and services over time.

7. Money Supply Classification

  • M1 Components:
    • Paper currency – Answer: both
    • Money deposited in transaction accounts such as checking accounts – Answer: both
    • Stocks and bonds – Answer: neither

8. Economic Shocks and GDP Analysis

  • 2007 Shocks to the U.S. Economy:
    • Oil prices and the housing market collapse contributed to the recession of 2007–2009.
    • AD–AS Framework analysis:
    • a. Draw a diagram with aggregate demand and short-run aggregate supply curves labeled correctly (E1, Y1, π1).
    • b. Average price of crude oil rose from $54.63 to $92.93 – results in a supply shock; SRAS curve shifts left (to SRAS2) resulting in a new equilibrium (E2, π2, and Y2).
    • c. Home prices fell by 3.0% – results in a demand shock; AD curve shifts left (to AD2), with a new equilibrium (E3, Y3, π3).
    • d. Comparing E1 and E3: the effect on inflation is indeterminate (due to opposing shocks), while real GDP clearly decreases.

9. Economic Policy Implementation and Outcomes

  • a. Decline in Household Wealth:
    • Effect: Decrease in demand leads to a shift from AD1 to AD2, resulting in a recessionary gap.
    • Long-term correction involves gradual shifts in SRAS to restore potential output (new equilibrium E3 with lower inflation).
  • b. Tax Reduction:
    • Effect: Increases in disposable income shift AD1 to AD2, creating an inflationary gap due to increased consumer spending.
    • Long-term wage adjustments lead to a new equilibrium (E3) at higher inflation.

10. Effects of Supply Shock

  • a. Effects of Oil Shock:
    • Results in stagflation as real GDP decreases and inflation increases as SRAS shifts left (SRAS2).
  • b. Government Responses:
    • Cannot resolve both real GDP decline and inflation rate increase simultaneously, choice of fiscal/monetary policy affects one at the cost of the other.

11. Money Supply Calculation Table**

  • Components of M1 and M2:
    • M1: Currency in circulation + Checkable deposits + Other liquid deposits.
    • M2: M1 + Time deposits + Money market funds.

12. Bank Deposit and Money Multiplier**

  • Tracy Williams’ $500 Deposit:
    • Initial T-Account Change: Reserves increase by $500, net money supply remains unchanged initially.
    • Reserve Response: With a reserve ratio of 10%, bank holds $50, can lend $450.
  • Total Possible Expansion:
    • With 10% reserve ratio: $4,500 expansion
    • With 5% reserve ratio: $9,500 expansion.

13. Closing Economic Gaps**

  • Recessionary Gap:
    • Use expansionary monetary policy to lower interest rates, increase investment spending, and bolster real GDP.
  • Inflationary Gap:
    • Use contractionary monetary policy to decrease money supply.
    • This will raise interest rates, reduce investment spending, and lower GDP.