ANSWERS:
1. A
Ø If investment is sensitive to interest rates (elastic investment demand curve), then a small increase in the money supply will result in a small decline in interest rates, but there will be a relatively large increase in investment demand (since it is elastic). And, the more investment changes, the greater the affect on output.
2. A
Ø If we are in long-run equilibrium and decide to run on a deficit (G > T), then AD would increase (shift to the right) and an inflationary gap would exist.
3. D
Ø Productivity is one of the supply factors of economic growth while an increase in consumer spending (AD) is one of the demand factors. Remember, AD must increase for production to expand. And increase in interest rates would not cause economic growth since it would cause investment spending to actually decrease!
4. D
Ø A stagnation in labor productivity would cause AS to decrease thereby causing simultaneous increases in inflation and unemployment.
5. A
Ø Monetarists believe that a monetary rule should be implemented, so I is correct. Monetarists feel fiscal policy is ineffective and destabilizes the economy due to its slowness and crowding-out effect. And, monetarists feel monetary policy directly affects GDP by directly changing AD (since the velocity of money is stable and MV = PQ).
6. E
Ø Supply-side economists believe welfare programs provide incentives for people not to work thereby decreasing the size of the labor force and reducing AS.
7. B
Ø If our goal is to reduce inflation, we’ll implement a contractionary fiscal policy. Thus, since we’ll increase taxes and/or decrease government spending, we’ll be running on a budget surplus and AD will decrease. If AD decreases, people will demand less money since they will be purchasing less.
8. C
Ø Since unemployment is our problem, we’ll want to implement an expansionary policy. Thus, we should lower the reserve requirement (easy money policy) and increase government transfers (expansionary fiscal policy).
9. D
Ø During a recession our resources are underemployed. Thus, we would be somewhere inside the curve (like at point D).
10. C
Ø If we are operating at full employment and the money supply is increased, AD will shift to the right and simply cause prices to rise (since we are located along the vertical portion of the AS curve).
11. E
Ø In the short run, both prices and output will increase since AD shifts to the right. In the long run, nominal wages will increase (so that real wages are restored) and SRAS will decrease (shift left) due to the higher costs of production.
12. B
Ø If there is sharp inflation, we’ll want to implement some sort of contractionary policy. If the government runs on a surplus, tax revenues will be greater than government spending (indicating a contractionary fiscal policy). And, the selling of securities on the open market and a higher discount rate are two tools of the Fed when implementing a tight (contractionary) money policy.
13. A
Ø Since this equation of exchange must remain balanced, if P increases, either M or V has increased or Q has decreased. Thus, the most likely answer would be an increase in the money supply.
14. D
Ø The short run tradeoff illustrated on the Phillips curve is an inverse relationship between inflation and unemployment. These two goals are not compatible with each other and therefore high rates of inflation would coincide with low unemployment rates.
15. C
Ø Keynesians feel fiscal policy is more important than monetary policy because monetary policy works indirectly due to a change in the interest rates. Keynesians feel that lower interest rates do not necessarily stimulate investment.
16. B
Ø Stagflation results when AS decreases. An increase in the price of raw materials represents an increase in the cost of production and therefore a decrease in AS.
17. D
Ø Monetarists support the use of a monetary rule since they feel inappropriate monetary policy is the main cause of macro instability.
18.
Ø Crowding-out exists when the government runs on a budget deficit (while using expansionary fiscal policy). The government must finance its deficit by borrowing funds. This increased borrowing causes the demand for loanable funds to increase (shifts right) thereby causing interest rates to rise. Higher interest rates will cause private investment to decrease (or be crowded-out). This is one of the reasons monetarists feel fiscal policy destabilizes the economy.
19.
Ø Crowding-in exists when the government runs on a budget surplus (while using contractionary fiscal policy). The government does not need to finance its budget through borrowing since they are bringing in more money than they are spending. This decreased borrowing causes the demand for loanable funds to decrease (shifts left) thereby causing interest rates to decline. Lower interest rates will cause private investment to increase (or be crowded-in).
20.
Ø The monetary rule is a requirement for the Fed to expand the money supply each year at the same annual rate as the typical growth of the economy’s production ability.
21.
Ø Short-run: A period in which nominal wages remain constant (fixed) as the price level changes.
Ø Long-run: A period in which nominal wages completely adjust (and are fully responsive) to price level changes.
22.
Ø The LRAS tells us the full-employment capacity of an economy. It tells us our production limits when resources are fully employed and productive (allocatively and productively efficient).
23.
Ø A sudden increase in AD will cause prices and output to rise in the short-run. But, in the long-run nominal wages are fully responsive to price level changes meaning nominal wages will rise in the long-run in order to restore real wages. Thus, higher nominal wages (higher costs of production) cause SRAS to decrease thereby bringing us back into equilibrium on the LRAS curve.
24.
Ø The basics or supply-side economics are that certain events also affect AS and therefore price levels and output. Supply-side economists believe we should lower marginal tax rates because the current tax system provides negative incentives to work, save, and invest. They also argue that unemployment compensation and welfare programs provide the incentive to stay out of the labor force. Lower tax rates would encourage people to work longer, reduce tax avoidance and tax evasion, and reduce the amount of transfer payments.
25.
Ø labor inputs depends on the size of the population and the labor force participation rate.
Ø productivity through technological progress, more available capital goods, improvements in the quality of labor itself, or improvements in the efficiency with which inputs are allocated, combined, and managed.
26.
27.
Ø They can promote policies that lower interest rates thereby encouraging investment and capital spending (which will lead to more technological progress).
Ø They can reduce marginal tax rates to encourage work and increase the size of the labor force.
28.
Ø Monetarists would argue for NO fiscal policy since they feel it destabilizes the economy because it is too slow and that it does not work because of crowding out. Monetarists would argue for a monetary rule since they believe inappropriate monetary policy is the major source of macro instability. Since they believe the velocity of money is stable, changes in the money supply will directly affect aggregate demand (MV = PQ). Monetarists are against discretionary monetary policy since they feel it is the main cause of macro instability.
Ø Keynesians would argue for active discretionary fiscal and monetary policy. They do not believe a monetary rule is appropriate since they think the velocity of money is unstable. Thus, they think changes in the money supply will change interest rates, which will change investment and real GDP. They do not support a balanced budget requirement since that would simply intensify the business cycle by forcing the government to raise taxes and cut spending during a recession. Active fiscal policy will change AD and GDP through a multiplier process. In addition, fiscal policy will be more effective than monetary policy simply because lower interest rates don’t necessarily mean people will invest more.
Ø Keynesians admit that there is the possibility of crowding-out, but they do NOT think it is a real problem during a recession (when business borrowing is down to begin with). Monetarists believe fiscal policy does NOT work because the amount of investment that is crowded out negates the intended effects of the policy in the first place.