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Unformatted text preview: 31-DCT-ZBBE 12:86 PART 8 SHORT-RUN ECONOMIC FLUCTUATIONS 494 ' a 3 1 {ET-2886 FROM HKCC (Po lgLD QUESTIONS FOR REVIEW does it help explain the downward slope of the aggregatedemand curve? . Use the theory of liquidity preference to explain how a decrease in the money supply affects the aggregate-demand curve. ' . The government spends $3 billion to buy police cars. Explain why. aggregate demand might increase by-more than $3 billion Explain why aggregate demand might increase by less than $3 billion. . PROBLEMS AND APPLICATIONS 1. Explain how each of the following develop- ments Wauld affect the supply of money, the demand for money, and the interest rate. Illus- trate your answers with a diagram. a. The Federal Reserve raises the discount rate. b. A wave of consumer pessimism reduces aggregate demand. ~ c. Banks begin to pay interest on all checkable deposis. d. The Federal Reserve sells bonds in open mar- ket operatiOns. . e Household income rises. . The Federal Reserve expands the money supply by 5 percent. . Use the theory of liquidity preference to illus- trate the impact of this policy on the interest rate. , ' b. Use the model of aggregate demand and aggregate supply to illustrate the impact of this change in the interest rate on output and the price level in the shert run. - c. When the economy makes the transition from its short-run equilibrium to its long-run equi- librium, what will happen to the price level?“ .d. How will this change in the price level affect the demand for money and the equilibrium _ interest rate? e. Is this analysis consistent with the proposi- tion that money has real effects in the short run but is neutral in the long run? 11:48 HKCC (PolgUJ TD 23643145 P I 19 1. What is the theory of liquidity preference? How 4. Suppose that survey measures of consumer confi- dence indicate a wave of pessimism is sweeping the Country If policymakers do nothing, what will happen to aggregate demand? What should the Fed do if it wants to stabilize aggregate demand? If the Fed does nothing, what might Congress do to stabilize'aggregate demand? . Give an example of a government policy that acts as an automatic stabilizer. Explain why the policy has this effect. ' - 3. Suppose banks install automatic teller machines d 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? ‘0. If the Fed wants to stabilize aggregate demand, how should it respond? . Consider two policies—a tax Cut that will last for only 1 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. ' . The economy is in a recession with high unem- ployment and low output. __ _ a. Draw a graph of aggregate demand and aggregate supply to illustrate the current situ- ation. Be sure to include the aggregate— demand curve, the short-run aggregatesupply- curve, and the long-run aggregate-supply curve. ' b. Identify an open—market operation that would restOre the economy to its natural rate. c. Draw a graph of the money market to illus- trate the effect of this open-market operation. Show the resulting change in the interest rate. d. Draw a graph similar to the one in part (a) to show the effect of the open-market operation P.10 3 1-OCT-ZBBS 3 1 [email protected] 12! 86 FROM HKCC (Po lgU) CHAPTER 21 on output and the price level. Explain in words why the policy has the effect that you have shown in thegraph. - 6. In the early 19805, new legislation allowed banks 9. to pay interest on checking deposits, which they . a 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 con- stant money supply in the face of this change, what would have happened to the interest rate? What would have happened to aggre- gate demand and aggregate output? c. If the Federal Reserve had maintained a con-- stant 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? - 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 pmpensity 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? Suppose the government reduces taxes by $20 billion, that there is no crowding Out, and that the marginal propensity to consume is 3A '» a. What is the initial effect of the tax reduction on aggregate demand? b. What additional effects follow this 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 bil- lion increase in government purchases? Why? 11:49 HKCC (PolgU) io. 11. 12. '13. TO 23643145 P. 11 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND Suppose gavernment 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. In which of the follong 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? ' For various reasons, fiscal policy changes auto- matically when output and employment fluc- tuate. 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? 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 respozid to an event that contracted aggregate demand? b. How would the Fed respond to an event that caused an adverse shift in short-run aggre- gate supply? In each case. is there another: monetary policy that would lead to greater stability in output? Go to the website of the Federal Reserve, ht '. wwwfederalgeseflegoz, to learn more about monetary policy. Find a recent report, speech, or testimony by the Pedvchainnan or another Fed governor. What does it say about the state of the economy and recent decisions about monetary policy? . P.11 4s ...
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This note was uploaded on 11/02/2009 for the course FB cc2105 taught by Professor Alan during the Spring '07 term at École Normale Supérieure.

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