ECON 001 Lecture Notes - Lecture 25: Money Supply, Potential Output, Economic Equilibrium

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12 Jun 2018

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Chapter 34 Government Policy and the Economy

Q: What could policy makers do should the economy deviate from its potential output level?

Two Key Tools

1. Fiscal Policy- gov’t spending (G) and/or tax policy (T). In US, fiscal policy

determined by President and Congress.

2. Monetary Policy- control of the money supply (M^s). Fed has control over money

supply.

Key Points

1. Expansionary fiscal policy (increase in G or decrease in T) or expansionary monetary

policy (increase in M^s) will shift AD curve to right.

2. Contractionary fiscal policy (decrease in G or increase in T) or contracting monetary

policy (decrease M^s) will shift AD curve to left.

I. Money Market

A. Money Demand (M^d)

Money Demand- shows us the negative relationship between interest rates and (M^d)

Key Point: Interest rate is going to be opp. cost of holding money

Key Point: A change in r will result in movement along the (M^d) curve. (M^d) will shift if

price level changes or income (Y) changes. (see binder)

B. Money Supply Curve (M^s) Curve

Key Point: The Ms curve determined by Fed. Independent of interest rate. (see graph in

binder)

C. Money Market Equilibrium (see binder)

D. Money Market and AD Curve

●Show how Ms will shift AD curve to the right (see binder)

E. Interest Rate Targets and Fed Policy

●In reality, Fed conducts monetary policy by targeting Fed fund rate (interest rate that

banks charge each other for short-term loans)

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Document Summary

Two key tools: fiscal policy- gov"t spending (g) and/or tax policy (t). In us, fiscal policy: monetary policy- control of the money supply (m^s). Fed has control over money determined by president and congress. supply. Money demand- shows us the negative relationship between interest rates and (m^d) Key point: interest rate is going to be opp. cost of holding money. Key point: a change in r will result in movement along the (m^d) curve. (m^d) will shift if price level changes or income (y) changes. (see binder: money supply curve (m^s) curve. Key point: the ms curve determined by fed. Independent of interest rate. (see graph in binder: money market equilibrium (see binder, money market and ad curve, interest rate targets and fed policy. Show how ms will shift ad curve to the right (see binder)

Related Questions

5. Fiscal policy is enacted through changes in

A. interest rates and the price level.

B. the supply of money and foreign exchange.

C. unemployment and inflation

D. taxation and government spending.

6. In an economy, the government wants to decrease aggregate demand by $48 billion at each price level to decrease real GDP and control demand-pull inflation. If the MPS is 0.25, then it could

A. increase taxes by $16 billion.

B. increase taxes by $24 billion.

C. decrease government spending by $10 billion.

D. decrease government spending by $16 billion.

7. If there is a constitutional requirement to maintain a balanced budget, then during a recession when tax revenues are shrinking, the government will have to implement

A. contractionary fiscal policy.

B. no change in fiscal policy.

C. expansionary fiscal policy.

D. countercyclical fiscal policy.

8. Most economists believe that fiscal policy is:

A. better than the monetary policy for "fine-tuning" the economy.

B. better than the monetary policy for month-to-month stabilization.

C. not as good as the monetary policy for month-to-month stabilization.

D. not very good at pushing the economy in a particular direction.

9. An increase in the legal reserve ratio

A. increases the money supply by increasing excess reserves

B. decreases the money supply by decreasing excess reserves

C. increases the money supply by decreasing excess reserves

D. decreases the money supply by increasing excess reserves

10. The discount rate is the rate of interest at which

A. Federal Reserve Banks lend to commercial banks

B. savings and loan associations lend to some builders

C. Federal Reserve Banks lend to large corporations.

D. commercial banks lend to large corporations

11. Which of the following actions by the Fed most likely increase commercial bank lending?

A. raising the reserve ratio

B. increasing the federal funds rate target

C. reducing the interest paid on excess reserves held at the Fed

D. selling bonds to commercial banks and the public

12. Assume the economy is operating at less than full employment. An expansionary monetary policy will cause interest rates to ______, which will ______ investment spending.

A. decrease; decrease

B. decrease; increase

C. increase; increase

D. increase; decrease

sapphirecrow883

A. In a small open economy in a flexible exchange rate system with perfect capital mobility, there is complete ________ crowding-out of ________ policy.

a) domestic, monetary

b) domestic, fiscal

c) international, fiscal

d) international, monetary

B. If the dollar depreciates against the yen, this tends to ________ our imports of Japanese goods and ________ our exports of goods to Japan, so that our net exports ________.

a) decrease, decrease, decrease

b) increase, decrease, are unchanged

c) decrease, increase, increase

d) decrease, increase, are unchanged

E) increase, increase, increase

C. An increase in the nominal money supply will shift

a) AD up and raise the price level.

b) SAS down and lower the price level.

c) SAS up and raise the price level.

d) AD down and lower the price level.

D. A rise in the price level causes

a) movement down along an LM curve.

b) movement up along an LM curve.

c) the LM curve to shift downward.

d) the LM curve to shift upward.

plumminnow211

MBA502, Economics for Business

Apply and Discover 7.2

You are responsible for economic policymaking in your country. Your desire is to eliminate inflation, keeping prices absolutely stable at P = 100, no matter what happens to output. Currently, the economy is in equilibrium at Q = 3200 (where Q = potential GDP) and P = 100. You can use monetary and fiscal policies to affect aggregate demand but you cannot affect aggregate supply in the short run. How would you respond to the following scenarios?

Explain and illustrate how each of these events would affect aggregate demand, aggregate supply, and prices, then explain how you would respond with economic policies.

1. A surprise increase in investment spending

In the short run, when investment spending increases, it results in an increase in Aggregate Demand (AD), which in turn pushes up both GPD and the price index.

To counterbalance this development, government might pursue contractionary fiscal policy by increasing taxes (to reduce consumption) or decreasing its own investment and spending so that the AD curve shifts back to its original position. Alternatively, the government can pursue contractionary monetary policy by reducing money supply and increasing interest rate to discourage economic activity.

2. Catastrophic floods that cause a sharp food price increase

In this case, sharp food shortages and consequent price increases cause a shock-type adjustment of the aggregate supply curve (it shift up and to the left). The result is a lower GDP and a higher price level.

The government cannot do anything to adjust AS in the short run. However, if the goal is to maintain the price level constant, the government can decide to do something to decrease the aggregate demand to force prices to come down, though it will be accompanies by another contraction in GDP and so it would not be a smart thing to do.

To cause AD to decrease, the government, similar to example above, can pursue fiscal policy (increase taxes, decrease spending) or monetary policy (reduce supply of money to the economy and thus increase interest rates).

3. A productivity decline that reduces potential output

In this case, AS shifts to the left, as was the case in example 2. As a result, price levels go up, as the same amount of money is chasing the reduced amount of goods and services, and GDP declines.

Government remedies here would be centered about causing AD to decrease through contractionary fiscal (higher taxes, lower spending) or monetary (reduce money supply and increase interest rates) policy. Again, this decision reduces inflation but at expense of GDP, as real output shrinks further.

4. A deep depression in East Asia that causes a sharp decrease in net exports to the United States

A decrease in exports of goods to from the United States to Asia will mean that the aggregate demand (which includes net exports

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ECON 001 Lecture Notes - Lecture 25: Money Supply, Potential Output, Economic Equilibrium

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