Macroeconomics Final Exam Review
Review for the Final Exam Principles of Macroeconomics
I. Define and Explain
Pigou Effect:
The Pigou effect (also known as the real balance effect) states that as price levels fall, real wealth increases, which leads to increased consumer spending and stimulates aggregate demand. Essentially, deflation can stimulate demand.
Demand-Induced Recession:
A recession caused by a significant decrease in aggregate demand. This leads to lower output, decreased employment, and potentially deflation or disinflation.
Animal Spirits of Capitalists:
A term coined by John Maynard Keynes to describe the psychological factors that drive business investment. These are the emotional and intuitive forces that influence decision-making, such as confidence, fear, and herd behavior, which can lead to volatile investment patterns and economic fluctuations.
Overheating:
An economic condition where aggregate demand exceeds aggregate supply, leading to an unsustainable increase in output, employment, and price inflation. It often occurs when the economy operates above its potential output.
Stagflation:
An economic condition characterized by slow economic growth and relatively high unemployment (economic stagnation) at the same time as rising prices (inflation). This was notably experienced in the 1970s.
Adverse Supply Shock:
An event that suddenly decreases aggregate supply. This can be caused by things like sudden increases in oil prices or natural disasters. It leads to decreased output, increased prices (inflation), and can raise unemployment.
Commodity Money:
Money that has intrinsic value because it is made of a commodity that has uses other than as money (e.g., gold, silver). Its value comes from the material it is made of.
M1 and M2:
M1: A measure of the money supply that includes the most liquid assets, such as currency in circulation, checking accounts, and traveler's checks.
M2: A broader measure of the money supply that includes M1 plus savings accounts, money market accounts, and small-denomination time deposits.
Medium of Exchange:
One of the three functions of money; it is anything that is widely accepted as a means of payment. It facilitates transactions, eliminating the need for barter.
Store of Value:
One of the three functions of money; it is the ability of money to hold its value over time. This allows people to save and defer consumption.
Unit of Account:
One of the three functions of money; it provides a common base for pricing goods and services. It allows for consistent accounting and comparison of value.
Required Reserves and Excess Reserves:
Required Reserves: The fraction of a bank's deposits that they are required by law to keep on hand or with the central bank.
Excess Reserves: Any reserves held by a bank beyond the required amount. Banks can use these for lending.
Excess Reserves = Total Reserves - Required Reserves
Liquidity Problem in Banking:
A situation where a bank has difficulty meeting its short-term obligations because it does not have enough liquid assets (e.g., cash) to pay depositors or creditors. This often leads to selling off assets, sometimes at a loss.
Insolvency Problem in Banking:
A situation where a bank's liabilities exceed its assets, meaning it has a negative net worth. The bank is bankrupt and unable to meet its obligations in the long term. Assets < Liabilities
Lender of Last Resort:
A role of the central bank where it provides emergency loans to commercial banks facing a liquidity crisis to prevent bank runs and systemic risk.
The Fed’s Dual Mandate:
The Federal Reserve's (the Fed's) mandate to promote two co-equal objectives: maximum employment and price stability.
Open Market Operations:
The buying and selling of government securities (bonds) by the central bank to influence the money supply and credit conditions.
Open Market Purchase/Open Market Sale:
Open Market Purchase: The Fed buys government bonds, injecting money into the economy, increasing the money supply, and lowering interest rates.
Open Market Sale: The Fed sells government bonds, taking money out of the economy, decreasing the money supply, and raising interest rates.
Federal Open Market Committee (FOMC):
The committee within the Federal Reserve System that is responsible for making decisions about open market operations and setting monetary policy
Federal Funds Rate:
The target rate that the FOMC wants banks to charge one another for the overnight lending of reserves. The Fed influences this rate through open market operations.
II. True or False and Explain
1) A depreciation of the US dollar on world currency markets raises the price of US exports and imports, typically leading to an expansion of aggregate supply.
False. A depreciation of the US dollar makes US exports cheaper and imports more expensive, leading to an increase in aggregate demand (exports increase, imports decrease) rather than aggregate supply.
2) In a demand-induced recession, aggregate demand collapses bringing output and employment down and price inflation up.
False. In a demand-induced recession, aggregate demand collapses, bringing output and employment down, leading to lower, not higher, price inflation (or even deflation).
3) In the aggregate supply and demand model, an increase in stock and real estate prices expands aggregate supply by increasing household income.
False. An increase in stock and real estate prices leads to an increase in household wealth, which increases aggregate demand, not aggregate supply. This is due to the wealth effect.
4) Paul Volcker tamed the stagflation of the 1970s by first using expansionary monetary policy to increase output and employment and then contractionary monetary policy to decrease inflation.
False. Paul Volcker tamed the stagflation of the 1970s by primarily using contractionary monetary policy to decrease inflation, even at the cost of increasing unemployment in the short term. He did not use expansionary policy first.
5) In the aggregate supply and demand model, a fall in energy prices, a rise in wages, and an increase in productivity will cause a beneficial demand shock.
False. A fall in energy prices and an increase in productivity would shift the aggregate supply curve to the right (a beneficial supply shock). A rise in wages would shift the aggregate supply curve to the left (an adverse supply shock). These factors primarily affect aggregate supply, not aggregate demand.
6) In the aggregate supply and demand framework, an adverse supply shock is predicted to reduce output, employment, and price inflation.
False. An adverse supply shock is predicted to reduce output and employment but increase price inflation (stagflation).
7) The US macro economy has overheated during major wars because major wars decrease the aggregate supply curve, pushing output above potential output.
False. Major wars typically increase aggregate demand due to increased government spending. While there might be some supply constraints, the primary impact is on the demand side, potentially leading to overheating as output exceeds potential output.
8) In a typical recession, output falls below potential output, the unemployment rate rises above the 4-5% range, and price inflation soars.
False. In a typical recession, output falls below potential output, the unemployment rate rises above the 4-5% range, but price inflation typically decreases or remains low.
9) When money serves as a unit of account it permits traders to make purchases in the future.
False. When money serve as a store of value helps traders to make purchases in the future.
10) Banks can hold their reserves either as vault cash or loans.
False. Banks reserves can be held as vault cash or deposits at the Federal Reserve. Loans are assets that banks make using deposits.
11) The main reason that banks use borrowed funds to finance the acquisition of loans is because borrowed funds are an extremely cheap source of funds.
False. Banks use borrowed funds to finance the acquisition of loans because deposits alone may not be sufficient to meet demand for loans. Borrowed funds may not necessarily be the cheapest source; banks consider the cost, availability, and terms of different funding sources.
12) The Fed acts as a lender of last resort when it raises interest rates in times of financial difficulties to prevent excessive borrowing.
False. The Fed acts as a lender of last resort when it provides loans to banks facing financial difficulties. Raising interest rates is a contractionary monetary policy, which is different from its role as a lender of last resort.
13) The main reason banks hold bonds (securities) is because bonds provide banks with a high return.
False. While return is a consideration, banks hold bonds primarily for their liquidity and safety. Bonds can be easily sold to meet deposit withdrawals or to raise funds.
14) On a routine basis, banks borrow large sums of money from their creditors to pay for the withdrawal of funds by their depositors.
False. Banks maintain reserves to handle routine withdrawals. They typically borrow when facing unexpected or unusually large withdrawals.
15) A run on a bank can lead to a panic if the bank is allowed to stay open and continue lending money to its clients.
False. A run on a bank causes a panic and is usually caused by fear that the bank will not be able to return the depositor's money. A bank should not continue lending money because they need all the money it can get to meet the depositor's demands.
16) If a bank's losses from its bad loans exceed the value of their capital, then the bank is said to have a liquidity problem.
False. The bank would more likely have an insolvency problem because its capital is wiped out by the losses of its loan.
17) Open market operations are controlled in the Fed by the Board of Governors, which consists of the Presidents of the 12 regional Federal Reserve Banks.
False. Open market operations are controlled by the Federal Open Market Committee (FOMC), which includes the Board of Governors and five of the 12 regional Federal Reserve Bank presidents.
18) The main form of money in the U.S. is government issued currency.
False. The main form of money in the U.S. is actually digital, and resides in checking accounts.
19) If a mid-size bank becomes insolvent, then government policy makers are likely to liquidate it.
True. Only for midsize bank. Big banks are more likely not to be liquidated.
20) The Fed’s dual mandate is to maintain price stability and free markets.
False. The Fed's dual mandate is to maintain price stability and maximum employment.
III. Problems-Essays
A. Short Essay Questions
Money
How do economists define money? Explain.
Economists define money as anything that serves as a medium of exchange, a store of value, and a unit of account. It is a social construct that facilitates transactions and economic activity.
What are the three functions of money? Explain each.
Medium of Exchange: Money is widely accepted in exchange for goods and services, eliminating the need for barter.
Store of Value: Money can be saved and hold its value over time, allowing people to defer consumption.
Unit of Account: Money provides a common measure for valuing goods and services, making it easier to compare prices and record transactions.
Banking
What are the principal assets and liabilities of banks? Explain each.
Assets:
Loans: Money lent to borrowers, generating interest income for the bank.
Reserves: Cash held in the bank's vault or deposits at the central bank to meet reserve requirements and provide liquidity.
Securities (Bonds): Investments in government or corporate bonds, providing interest income and liquidity.
Liabilities:
Deposits: Money owed to depositors who have accounts at the bank.
Borrowed Funds: Money borrowed from other banks or the central bank.
Capital (Equity): The bank's net worth, representing the difference between its assets and liabilities.
What is the liquidity problem in banking? Explain.
A liquidity problem occurs when a bank does not have enough liquid assets (e.g., cash) to meet its short-term obligations, such as deposit withdrawals or payments to creditors. This can result in the bank being unable to honor its commitments, potentially leading to a bank run or even failure.
What is the insolvency problem in banking? Explain.
An insolvency problem occurs when a bank's liabilities exceed its assets, meaning it has a negative net worth (capital). The bank is bankrupt and unable to meet its obligations in the long term. This typically happens when a bank has made bad loans or investments that have resulted in significant losses.
How can government policy makers prevent a liquidity problem at a major bank from starting a panic? Explain.
Lender of Last Resort: The central bank can provide emergency loans to the bank to ensure it has enough liquidity to meet its obligations.
Deposit Insurance: Government-provided deposit insurance (e.g., FDIC) can reassure depositors that their funds are safe, preventing a bank run.
Public Statements: Government officials can make public statements expressing confidence in the bank and the financial system to calm depositors' fears.
How can policy makers deal with insolvency problems in our financial system? Explain.
Recapitalization: Injecting capital into the bank to restore its net worth. This can be done through government investment or by attracting private investors.
Restructuring: Reorganizing the bank's assets and liabilities, such as selling off bad loans or merging with a stronger institution.
Nationalization: Temporarily taking over ownership of the bank to stabilize it and then privatizing it later.
Liquidation: Closing the bank and paying off depositors (up to the insured amount) using the bank's assets.
B. Aggregate Supply and Demand Problem
General Instructions:
Analyze the impact of each shock on the nation's employment rate, real GDP, and price level.
Illustrate the impact of each shock using an aggregate supply and demand diagram.
Analyze the policy options available to the government to offset the harmful impact of each of these shocks.
(1) A dramatic increase in oil prices
Impact: This is an adverse supply shock, shifting the SRAS curve to the left. This leads to a decrease in real GDP, an increase in the price level (inflation), and a rise in unemployment.
Policy Options:
Accommodative: Increase aggregate demand (e.g., tax cuts or increased government spending) to restore output, but at the cost of higher inflation.
Non-Accommodative: Accept the decrease in output and increase in unemployment to fight inflation, possibly through contractionary monetary policy.
Supply-Side Policies: Implement policies to increase aggregate supply, such as investing in alternative energy sources or reducing regulations on energy production.
(2) A collapse in stock and real estate prices
Impact: This decreases household wealth, reducing aggregate demand. The AD curve shifts to the left, leading to a decrease in real GDP, a decrease in the price level (deflation), and a rise in unemployment.
Policy Options:
Expansionary Monetary Policy: Lower interest rates to encourage borrowing and investment.
Fiscal Policy: Increase government spending or cut taxes to stimulate aggregate demand.
(3) A large increase in military spending
Impact: This increases aggregate demand, shifting the AD curve to the right. It leads to an increase in real GDP, an increase in the price level (inflation), and a decrease in unemployment.
Policy Options:
If the economy is already at full employment, the government may choose to offset the inflationary impact with contractionary monetary policy (raising interest rates) or fiscal policy (reducing government spending or increasing taxes).
(4) Business leaders become less certain and pessimistic about their future profits
Impact: This reduces investment spending, decreasing aggregate demand. The AD curve shifts to the left, leading to a decrease in real GDP, a decrease in the price level (deflation), and a rise in unemployment.
Policy Options:
Expansionary Monetary Policy: Lower interest rates to encourage borrowing and investment.
Fiscal Policy: Increase government spending or cut taxes to stimulate aggregate demand.
Confidence-Boosting Measures: Government policies aimed at improving business confidence, such as reducing regulatory burdens or providing tax incentives for investment.
(5) An appreciation of the dollar
Impact: This makes U.S. exports more expensive and imports cheaper, decreasing net exports and aggregate demand. The AD curve shifts to the left, leading to a decrease in real GDP, a decrease in the price level (deflation), and a rise in unemployment.
Policy Options:
Intervention in Foreign Exchange Markets: The government could try to depreciate the dollar by buying foreign currency.
Expansionary Monetary Policy: Lower interest rates to make the U.S. less attractive to foreign investors, potentially weakening the dollar.
Fiscal Policy: Increase government spending or cut taxes to stimulate aggregate demand.
(6) An economic boom in the rest of the world
Impact: This increases demand for U.S. exports, increasing net exports and aggregate demand. The AD curve shifts to the right, leading to an increase in real GDP, an increase in the price level (inflation), and a decrease in unemployment.
Policy Options:
If the economy is already at full employment, the government may choose to offset the inflationary impact with contractionary monetary policy (raising interest rates) or fiscal policy (reducing government spending or increasing taxes).
(7) An open market purchase of bonds by the Federal Reserve
Impact: This increases the money supply, lowering interest rates and increasing aggregate demand. The AD curve shifts to the right, leading to an increase in real GDP, an increase in the price level (inflation), and a decrease in unemployment.
Policy Options:
The Fed could later conduct open market sales to reverse the effects if inflation becomes a concern. The government can also use fiscal policy tools to stabilize the economy.
C. Long Essay Question
What is the Fed’s Dual Mandate? Explain.
The Fed’s dual mandate refers to the two primary goals that the Federal Reserve is charged with achieving: maximum employment and price stability. Maximum employment means maintaining a level of employment close to the economy's potential, without causing undue inflation. Price stability means keeping inflation at a moderate and predictable level, typically around 2%. The Fed aims to balance these goals, as policies that promote one goal can sometimes conflict with the other.
What is the Fed’s open market operations? Explain.
Open market operations (OMOs) are the buying and selling of U.S. government securities (bonds) by the Federal Reserve in the open market to influence the money supply and credit conditions. These operations are the Fed's primary tool for implementing monetary policy.
How can the Federal Reserve use its open market operations to expand or contract the nation’s money and credit supply? Explain.
Expanding the Money Supply (Open Market Purchase): When the Fed wants to increase the money supply, it buys government bonds from banks and other financial institutions. This injects money into the economy, increasing banks' reserves and enabling them to make more loans.
Contracting the Money Supply (Open Market Sale): When the Fed wants to decrease the money supply, it sells government bonds to banks and other financial institutions. This takes money out of the economy, decreasing banks' reserves and reducing their ability to make loans.
Describe the chain of command at the Federal Reserve which oversees its open market operations.
The chain of command for open market operations starts with the Federal Open Market Committee (FOMC). The FOMC consists of:
The seven members of the Board of Governors of the Federal Reserve System.
The president of the Federal Reserve Bank of New York.
The presidents of four other Federal Reserve Banks, who serve on a rotating basis.
The FOMC meets regularly to assess economic conditions and determine the appropriate stance of monetary policy. It sets the federal funds rate target and provides guidance on open market operations.
The Federal Reserve Bank of New York's Trading Desk carries out the FOMC's directives by buying or selling government securities in the open market.
The Board of Governors provides overall supervision and sets reserve requirements for banks.
Give a detailed account of how monetary policy works to impact interest rates, aggregate demand, and the macroeconomy.
The Fed uses monetary policy to influence interest rates and credit conditions, which in turn affect aggregate demand and macroeconomic outcomes. Here’s a detailed account:
Open Market Operations and Interest Rates:
Open Market Purchase: The Fed buys bonds, which increases the money supply, lowers the federal funds rate (the rate at which banks lend reserves to each other overnight), and puts downward pressure on other interest rates.
Open Market Sale: The Fed sells bonds, which decreases the money supply, raises the federal funds rate, and puts upward pressure on other interest rates.
Impact on Aggregate Demand:
Lower Interest Rates: Lower interest rates reduce the cost of borrowing for businesses and consumers, encouraging investment and spending. This increases aggregate demand (AD).
Higher Interest Rates: Higher interest rates increase the cost of borrowing, discouraging investment and spending. This decreases aggregate demand (AD).
Impact on the Macroeconomy:
Increased Aggregate Demand: The AD curve shifts to the right.
Real GDP increases, leading to higher employment and economic growth.
The price level may increase (inflation), depending on the state of the economy.
Decreased Aggregate Demand: The AD curve shifts to the left.
Real GDP decreases, leading to lower employment and slower economic growth.
The price level may decrease (disinflation or deflation), depending on the state of the economy.
Monetary Policy Lags: It's important to note that monetary policy operates with a lag. The full effects of a policy change may not be felt for several months or even years.