ECON102 Study Guide - Midterm Guide: Black Market, Aggregate Supply, Output Gap

For the past 55 years or so, governmental economic policies have focused primarily upon the demand side of the economy, and this has resulted in the situation we now find ourselves in.

Demand-side policies are primarily short-run efforts that aim at getting an economy back to full-employment as fast as possible. As such, demand-side policies focusing upon reducing unemployment aim at putting workers back into the jobs that they held before they found themselves unemployed. Demand-side policies attempt to trade off a little inflation for higher levels of employment. As such, demand-side policies create credit inflations that produce financial engineering and innovation rather than business capital investment. We have seen the consequences of demand-side policies in a lower rate of labor participation and credit flows remaining within the financial circuit of the economy rather than going into the industrial circuit. The result is that unemployment, as it is currently measured looks good, but short-run programs of monetary stimulus and fiscal stimulus prove ineffective in terms of achieving higher rates of economic growth. In the future, the government must move to look more toward longer-term, supply-side solutions to labor productivity and economic growth dilemmas.

Question: 'What do you believe will be the long-term effects if aggregate demand policies are used vs. aggregate supply policies?'

Multiple Choice

1. Assume that the money multiplier equals 2.5 and if the Fed purchases $10 million in bonds from a bank, the monetary supply will:

1. Increase by $10 million.
2. Increase by $25 million.
3. Decrease by $10 million.
4. Decrease by $25 million.

2. The monetary base is defined as:

1. all currency in circulation.
2. checkable deposits at depository institutions.
3. excess reserves in the banking system.
4. currency plus total banking reserves.

3. Which of the following means of financing federal government spending will increase the monetary base?

1. raising the corporate income tax.
2. raising the personal income tax.
3. selling bonds to the public.
4. selling bonds to the Fed.

Short Answer

1. Assume the Federal Reserve Board is undertaking an expansionarymonetary policy. Explain the details of how the expansionary Fed impacts each of the following:

1. Open market operations - how does the Fed use open market operations for an expansionary monetary policy?
2. The monetary base.
3. Money Supply.
4. Fed funds interest rate.
5. Long-term interest rates.
6. Business Investment.
7. Aggregate demand.
8. Economic growth.
9. Unemployment rate.

2. Under certain circumstances, expansionary Fed policy may not have much of an effect on the rate of economic growth. Give a reason why, and explain?

3. Regarding the Asian currency crisis, answer the following questions:

1. Describe the normal reasons why a currency undergoes a significant depreciation and what were the important characteristics of the Asian countries involved in the crisis?
2. What are some expected domestic economic consequences of the currency crisis for the countries involved? Focus on:
   • import prices of goods and services into the Asian country.
   • export prices of goods and services from the Asian country.
   • Domestic inflation rates.
3. Assume that the countries involved undertake a tight monetary policy and raise interest rates in response to the crisis. What are the two primary reasons for raising interest rates in their case?
4. Given high domestic interest rates, what is the economic outlook for these Asian countries in the next few years?

In a speech in 2017, Fed Chair Janet Yellen described the long-run federal funds rate that is consistent with achieving the Fed's mandate of high employment and price stability as the "neutral rate," which she estimates to be about 3 percent. Yellen noted that: "Waiting too long to begin moving toward the neutral rate could risk a nasty surprise down the road long dash either too much inflation, financial instability, or both. In that scenario, we could be forced to raise interest rates rapidly, which in turn could push the economy into a new recession."

Source: Janet Yellen, "The Goals of Monetary Policy and How We Pursue Them," Speech at the Commonwealth Club, San Francisco, California, January 18, 2017.

Why is it potentially a problem for the Fed to "wait too long" to raise its target for the federal funds rate? Can't the Fed just wait until inflation increases and begin to slowly increase the target at that time?

A. Monetary policy works with a lag that can be up to 18 months.

B. Prices change slowly due to menu costs.

C. Legislation takes time to implement.

D. Consumers are irrational.

Why might interest rates that are too low lead to financial instability?

A. Interest rates that are too low could result in higher unemployment.

B. Rates that are too low could lead to speculative bubbles in stocks and other financial assets.

C. Low-interest rates could lead to deflation.

D. Rates that are too low could lead to a situation of hyperinflation.

Why might the Fed rapidly increasing its target for the federal funds rate push the economy into recession?

A. In this situation, increasing the target for the federal funds rate increases aggregate demand by increasing investment.

B.A rapidly increasing federal funds rate target would decrease employment by lowering wages.

C.The Fed rapidly increasing its federal funds' rate target increases unemployment by increasing net exports.

D.Increasing the target for the federal funds rate decreases GDP by reducing consumption.