Practice Questions for Exam#3 - Practice Questions for...

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Practice Questions for Exam #3 Money Demand: 1). Seigniorage is the difference between the value of money and the cost of producing it. In other words, it is the economic cost of producing currency within a given economy or country. If the seigniorage is positive, then the government will make an economic profit. If the seigniorage is negative, the government will have an economic loss. Seigniorage may be counted as revenue for a government when the money that is created is worth more than the costs to produce it. Government will often use this revenue to finance a portion of their expenditure without collecting taxes. For example; if it costs the U.S. government $0.20 to produce a $1 bill, the seigniorage is $0.80, or the difference between the two amounts. In a more modern sense, when a government/central bank funds expenditures through additional money-creation, they create inflation; this inflation typically only occurs after the expenditures, however, and so it impacts the general populace. Money demand drops, but as long as the decline is less than the increase in money or money growth, the government “profits” from the transaction. If the government is too extreme, however, inflation expectations cause money demand to drop significantly, and the government actually ends up worse off. 2). If the central bank unexpectedly announces that the growth in money supply is going to accelerate, inflation will occur in the economy. Meaning that, the general level of prices in that economy are going to rise. Since people see that their money is going to be worth less, they will try to get rid of their cash and buy assets they believe are going to appreciate with the increase in the money supply. This will cause the prices in the economy to rise now, because of the increased demand for appreciating assets. The nominal interest rate will also rise because the real interest rate is fixed. This means that the change in the nominal interest rate is equal to the change in inflation. As the nominal interest rate increases, real money balances (m/p) decreases because people are now demanding less cash. Chapter 10 – income and spending: 1). This statement would be considered to mostly be true. A $1 increase in government purchases (G) will cause output (Y) to increase by about (1/(1-MPC) X 1$). If MPC = .8, then and increase in G of 1$ will lead to Y increasing by 5$. This is only true as long as the average tax rate is 20% AND the fiscal spending multiplier is 5. Both of these are questionable today, especially given the extreme amount of debt financing, and the extremely skewed income distribution in the US. An increase in government purchases will cause an increase (multiplied) in income and therefore increase tax collection. A fraction of this increase in income is collected in the form of taxes, so tax revenues increase. But they only increase at a fraction of the amount spent. The lower the income tax rate and the lower the fiscal spending multiplier, the less money the government will recover from there increased purchases and the lower the budget surplus will be.
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