ANSWERS:

1. b

Ø Definition of M1.

2. a

Ø (Have not learned yet.)

3. d

Ø If we are at full employment, we are currently close to the vertical range on the AS curve. Thus, if AD increases (shifts to the right), we’ll most likely see prices rise and output remain relatively unchanged depending on our exact location.

4. b

Ø Labor unions often argue for higher wages. If these unions are the cause of wages increasing, they are responsible for increasing the costs of production for firms. As the price of inputs rise (higher wages), the AS curve is pushed back (to the left) resulting in cost-push inflation.

5. d

Ø Demand deposits are more liquid than time deposits such as certificate of deposits.

6. a

Ø Deflation is a general decline in prices. If you owe money (you’re a debtor) and the prices decline, the value of the dollar has gone up (D = 1 / P) and you now owe back dollars of greater value.

7. c

Ø High inflation and low unemployment signals that our economy is growing too fast. Thus, we’ll want to implement a tight (restrictive/contractionary) monetary policy. The Fed could increase the discount rate, increase the reserve requirement, or sell government securities on the open market. The sale of government bonds reduces the supply of money. In addition, it causes the supply of bonds to increase. This, in turn, decreases the price of bonds. As the price of bonds fall, the effective interest rate increases. This causes investment and output to fall, unemployment to increase, and the price level to fall.

8. c

Ø If the reserve requirement is increased, there will be less excess reserves available for loans. Thus, the money supply will decrease, interest rates will increase, investment and GNP will decrease.

9. d

Ø Assets of the Fed include Federal Securities and the loans made to Commercial banks and Thrifts.

10. d

Ø The reserve requirement prevents banks from loaning out all in deposit. It’s primarily intended to set a limit on the total amount of money creation.

11. b

Ø Currency only consists of coins and Federal Reserve Notes held by the public (not the government). Demand deposits can easily be converted into currency and therefore accepted as a medium of exchange.

12. e

Ø The Fed will want to implement an easy or expansionary monetary policy in order to counteract a recession. Thus, the Fed could lower the reserve requirement, lower the discount rate, or buy securities on the open market.

13. a

Ø The Fed could raise the reserve requirement, raise the discount rate, or sell securities on the open market if it wanted to pursue a contractionary monetary policy.

14. c

Ø Reserves earn no interest and changing reserve requirements can substantially impact a bank’s profits. Changing the reserve requirement would affect banks lending ability immediately thereby creating instability.

15. b

Ø By selling government bonds on the open market, the Fed is decreasing the money supply while increasing the supply of bonds in the bond market. As the supply of bonds increases, the price of bonds falls. This, in turn, causes the interest rate to increase, investment to decrease, and GNP to decrease.

16. b

Ø The reserve requirement is intended to make sure banks don’t loan out all of their deposits and, in doing so, control the money creating capabilities of the banks.

17. e

Ø In order to stimulate growth, we’ll want to implement an expansionary policy. This could entail decreasing taxes, increasing government spending, decreasing the reserve requirement, decreasing the discount rate, or having the Fed buy government bonds on the open market.

18. a

Ø When the Fed buys government bonds on the open market, they are increasing the money supply while decreasing the supply of bonds. As the supply of bonds decreases, the price of bonds increases. This causes interest rate to decrease, investment to increase, and output to increase.

19. e

Ø An inflation rate of 3% and an unemployment rate of 11% signals that we are probably near the horizontal range on the AS curve. Thus, we would want to implement an expansionary policy in order to stimulate the economy. Our tools for expanding the economy include decreasing taxes, increasing government spending, decreasing the reserve requirement, decreasing the discount rate, or having the Fed buy government bonds on the open market.

20. b

Ø Only the Fed can print money. The only way Commercial banks can create money is through the process of extending loans.

21. a

Ø To find the amount of required reserves that the bank must hold, multiply $2 million by 10%. This gives you $200,000 of required reserves. Thus, the amount of excess reserves that the bank could lend out is equal to $2,000,000 - $200,000 or $1,800,000 ($1.8 million).

22. d

Ø The Fed’s expansionary monetary policy tools include lowering the reserve requirement, lowering the discount rate, and buying bonds on the open market.

23. d

Ø When the Fed buys bonds, the money supply increases. As the money supply increases, interest rates fall, investment increases, and output increases. If we are near full employment and investment increases, the increase in AD (shift to the right) will result in primarily higher prices (inflationary pressure).

24. The time lags associated with fiscal policy are the recognition lag,

administrative lag, and operational lag.

25. Monetary policy is extremely flexible and as the Fed can buy and sell securities every day thereby affecting the money supply and interest rates almost immediately.

26. The limitations that could reduce the effectiveness of monetary policy include the concern that there is less control with monetary policy due to financial innovations and global considerations, changes in velocity, and cyclical asymmetry.

27. The Federal Funds rate is the interest rate banks charge one another for over night loans.

28. The members of the Board of Governors are appointed by the President and confirmed by the Senate for 14 year terms.

29. Money is created through the expansion of loans.

30. Asset demand consists of money kept as a store of value for later use; whereas, transaction demand is money kept for purchases.

31. Actual reserves (AR) = $1,000

Required reserves (R) = 15% x $1,000 = $150

Excess reserves (ER) = $1,000 - $150 = $850

Money multiplier (m) = 1 / R = 1 / .15 = 20 / 3

Max. Amount of New Money = ER x m = $850 x (20/3) = $5,666.67

32. In order to decrease the supply of money, the Fed will implement a tight monetary policy. Thus, the Fed will increase the reserve requirement, increase the discount rate, or sell government bonds on the open market. All of these tools will decrease the amount of excess reserves banks possess. And, since the amount of excess reserves has decreased, the ability of banks to grant loans has also decreased.

33. Since we are barely growing with little inflation and the unemployment rate is 7.5%, we know that we are extremely close to the horizontal range on the AS curve. So, we are going to want to stimulate the economy by implementing expansionary policy actions. Two fiscal policy options include decreasing taxes or increasing government spending. Three monetary policy actions include lowering the reserve requirement, lowering the discount rate, or having the Fed buy government bonds on the open market. The fiscal policy actions will increase aggregate demand, inflation, employment, and output. In addition, it will cause interest rates to increase because the government will finance its budget deficit by borrowing loanable funds. This increases the demand for loanable funds and, therefore the interest rate increases. The higher interest rate will crowd out some private investment and reduce the intended results of the fiscal policy. The monetary policy actions will increase the money supply by increasing the amount of excess reserves. As the money supply increases, interest rates decrease and investment increases. This increased amount of investment causes AD, inflation, employment, and output to increase.