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Syracuse University
Department of Economics
Wayne A. Grove
Spring 2002
Economics 102: Introductory Macroeconomics
Problem Set #4: Suggested Answers
Grading Instructions: Questions: II#1 (3 pts each; 12 pts); II#2 (5 pts each; 15 pts); II.3, parts (a), (e) and (f)
only (a: 4 pts each for 8 pts; e and f each 4 pts; total 16 pts); III#2 (2 pts each; 12 pts); III#4 a-c only (5 pts
each; 15 pts); IV#3 (5 pts each; 10 pts); V#2 (10 pts). Total of 90 pts plus 10 bonus pts = 100 pts.
I. Aggregate Expenditure Model (Ch. 8)
1. Chapter 8, Problem Set # 1. MPC: marginal propensity to consume; the fraction of additional income that is
spent on consumption. Multiplier: the concept that a sustained increase in one component of aggregate
expenditure (like I) could lead to an increase in the equilibrium level of income that is a multiple of the initial
increase in expenditure. In a simple economy the multiplier is equal to 1/MPS or 1/(1 – MPC). Actual
investment: the actual amount of investment that takes place; it includes items such as unplanned changes in
inventories. Planned investment: those additions to the capital stock and inventory that are planned by firms.
Actual investment and planned investment are equal only in equilibrium; at levels of output below equilibrium
actual investment will be less than planned investment and at levels of output above equilibrium actual
investment will be greater than planned investment. Aggregate expenditure: the total amount of economy
spends in a given period. Real GDP: the value of gross domestic product corrected for the effect of higher
prices. Planned aggregate expenditure determines the equilibrium level of real GDP. Aggregate output: the total
quantity of goods and service produced (or supplied) in an economy in a given period. Aggregate income: the
total income received by all factors of production in a given period. Aggregate output and aggregate income are
the same (just seen from two different points of view).
2. If you want to illustrate how an economy could both be in equilibrium but experience massive unemployment
using Figure 8.11 on page 161 of the textbook, the level of real GDP that would represent an equilibrium below
full employment is point A, Y =500 and full employment point B, Y=600.
(b) Increase C, I or G by 25 to move the economy from unemployment to the full employment level of real
GDP.
(c) If the marginal propensity to consume is 0.75, the size of the multiplier is 4 (1/(1 - .75)).
(d) The changes you propose in (b) have to increase output by 100 to move the economy from its current
equilibrium to full employment.
3. Aside from the formula for the multiplier, the multiplier indicates the total possible magnitude by which a
change in spending causes total output/income to change. The multiplier process is the process by which an
increase of spending, say, by $100 million increases national output by that much initially. But that spending
become income for who ever sells those products/services and when their incomes increase they save some
portion and spend the rest—if the MPC is .75, then in round #2 spending increases by $75m. That increase in
spending creates more income and therefore spending and on and on. When does it end? The maximum
possible increase is $400 m. or $100 m. times the multiplier of 4.
II. Fiscal Policy (Ch. 9)
1. (a) Disposable income is total income minus taxes: it’s what workers actually received and have available to
either save or spend.
(b) A budget deficit means government spending is greater than (tax) revenue—this is an annual amount.
(c) The federal debt is the total amount the government has borrowed and owes to those who lent money to it. It
is the accumulation of all the annual deficits.
(d) Government spending has a larger multiplier because the initial increase of, say, a $100 million increases
spending by that much and then there are all the subsequent rounds of spending. With a cut in taxes, though, of
$100 million, the tax cut increase household incomes. Household save some of the $100 m. and spend the
rest—thus, the initial increase in spending is less and so is the multiplier.
2. Automatic Stabilizers (p.185)
(a) When the economy is growing, tax revenues automatically (that is if Congress and the President take no new
actions) rise because more production means more employment and income which means more tax payments.
When the economy is contracting, tax revenues fall.
(b) When the economy is growing, government spending automatically (that is if Congress and the President
take no new actions) falls because more production means more employment and income which means fewer
people qualify for unemployment compensation, low-income programs life welfare payments and food stamps.
When the economy is contracting, government spending automatically rises.
(c) If the budget balance = revenues – spending (a positive is a surplus and a negative a deficit), during a
recession the budget automatically becomes a deficit (or moves in that directions) and during an expansion
moves toward a surplus.
3. “Remember fiscal policy?” The Economist, 1/19/2002 (it is on the course webpage)
(a) The two arguments against fiscal policy (paragraph 1):
#1: Economic argument: Fiscal policy may have less effect or no effect on the economy.
#2: Political argument: Even if the correct action would help the economy, governments are incapable of
designing the right measures or enacting them at the right time.
(b) Low inflation and nominal interest rates suggest that the “scope for monetary relaxation (increasing the
money supply) is more limited.” Why? Because there is little room for the Fed to lower rates to stimulate
output.
(c) In theory, a one time tax cut doesn’t increase consumption enough to boost an economy out of a recession
because “people smooth out their spending over time, rather than swing between famine and feast,” that is
between high levels of consumption one year and low levels of consumption the next.
(d) Laurence Seidman shows that people do not smooth consumption nearly as much as theory suggests they
“should.”
(e) The problem that plagues the use of government spending to stimulate the economy is delay--delay due to
planning and organizing a big rise in spending and organizing political support. These are greater obstacles than
is enacting a tax cut.
(f) Seidman’s solution is to make counter-cyclical fiscal policy more automatic by having pre-approved tax
rebates that automatically occur if GDP falls by a certain amount or unemployment rises by a certain amount.
Alternately, an independent board could be given the authority to make changes in tax rates.
III. Money Supply and the Fed
1. Chapter 10: Problem Set #1. Paying down the debt by buying bonds with tax receipts has no impact on the
supply of money. Money that comes to the Treasury in tax payments is immediately returned to the economy as
the bonds are paid for by the Treasury. The result is that there is no change in reserves. When the Fed buys
bonds in open market operations, it uses what is essentially printed money. The whole point is to expand
reserves and thus the money supply.
2. Chapter 10: Problem Set # 3. Cash: Asset—Bank has it on hand; Demand Deposits: Liability—claims by
depositors can be withdrawn at any time; Savings deposits: Liability—same logic; Reserves: Assets—They are
in the vault as cash or on deposit with the Fed; Loans: Assets—They represent claims of the bank on borrowers;
Deposits at the Fed: Assets—They can be withdrawn at any time; they are owned by the bank.
3. Chapter 10: Problem Set #9. (a) Agree. The two sentences are correct. When the Fed sells bonds, the
proceeds do not go back into circulation. Rather, the proceeds are withdrawn from the economy, reducing the
quantity of reserves in the system and reducing the supply of money. Fed open market operations change the
money supply.
(b) Disagree. The expenditure (fiscal) multiplier is equal to 1/MPS. The expenditure multiplier and the money
multiplier are very different. The expenditure multiplier gives the change in equilibrium output (income) that
would result from a sustained change in some component of aggregate expenditure. The money multiplier gives
the change in the stock of money in circulation resulting from a change in reserves. The money multiplier is
equal to 1/(required reserve ratio). It has nothing to do with the MPS.
4. Chapter 10: Problem Set #11. (a) The bank's required reserves are: (.10)*($3500) = $350.
(b) The bank's excess reserves are: ER=Actual reserves - Required reserves =$500 - $350= $150.
(c) Initially the bank can increase its loans by $150, by loaning out all of its excess reserves.
If money loaned out is always redeposited in the same bank, then the bank will ultimately be able to increase its
loans by: {initial amount of ER} * {money multiplier} = {initial amount of ER} * (1/RRR) = {initial amount of
ER} * (1/.10) = {initial amount of ER} * 10 = $150 * 10 = $1500
(d) If a depositor withdraws $200 in cash, then deposits and reserves both fall by $200, to $3,300 (deposits) and
$300 (reserves). The bank's required reserves will now be: (.10)*($3300) = $330. Its excess reserves will be: ER
= Actual reserves - Required reserves = $300 - $330 = -$30. In other words, the bank does not have excess
reserves but instead has a reserve deficiency, meaning that it is not meeting the required reserve ratio. It will
need to come up with $30 somehow, and can do this by calling in $30 worth of loans or borrowing from Fed or
from another bank. In the long run must decrease loans. Before the complete adjustment to the $200 cash
withdraw occurs, the new T-account will be:
Assets
Liabilities
Reserves $300
Deposits $3,300
Loans
$3,000
Assuming that customers pay back loans by reducing their deposits with the bank, the bank will need to reduce
its loans by $300. After the complete adjustment to the $200 cash withdraw occurs, the T-account will be:
Assets
Liabilities
Reserves $300
Deposits $3,000
Loans
$2,700
5. MO' MONEY
(a) The Bailey Bank's balance sheet:
ASSETS
Reserves
$500
Treasury bonds
$500
Loans to Bedford
Falls home buyers $4000
LIABILITIES AND NET WORTH
Checking deposits
$4500
Savings deposits
$200
Net worth*
$300
TOTAL ASSETS
$5000
TOTAL LIABILITIES
& NET WORTH
$5000
* Net worth = Total assets - Total liabilities = $5000 - ($4500 + $200) = $5000 - $4700 = $300
M1 at Bailey = Checking deposits = $4500
M2 at Bailey = Checking deposits + Savings deposits = $4500 + $200 = $4700
(Reserves are not counted as part of the money supply, because the "currency" component of the money supply
refers only to currency in circulation, i.e. cash held outside of the banks.)
(b) ER = Actual reserves - Required reserves = $500 - (.10)*($4500) = $500 - $450 = $50.
FIRST STAGE, BEFORE LOANS ARE REDEPOSITED:
ASSETS
LIABILITIES AND NET WORTH
Reserves
$450
Checking deposits
$4500
Treasury bonds
$500
Savings deposits
$200
Loans to Bedford
Falls home buyers $4050
Net worth*
$300
TOTAL ASSETS
$5000 TOTAL LIABILITIES
& NET WORTH
$5000
(c) First, we need to compute the money multiplier (1/RR), because the total increase in deposits will be: {total
increase in deposits} = {initial amount of ER} * {money multiplier}
The money multiplier = 1/RRR = 1/.10 = 10. {total increase in deposits} = {initial amount of ER} * {money
multiplier} = ($50)* (10) = $500. Recall from the notes that: total increase in the money supply = total increase
in deposits = total increase in loans.
Total assets (which includes loans) and total liabilities (which includes deposits) will increase by that same
amount, too. The rest of the balance sheet (reserves, bonds, other assets, savings deposits, net worth) will not be
affected. The final balance sheet is:
ASSETS
LIABILITIES AND NET WORTH
Reserves
$500
Checking deposits
$5000
Treasury bonds
$500
Savings deposits
$200
Loans to Bedford
Falls home buyers $4500
Net worth*
$300
TOTAL ASSETS
$5500 TOTAL LIABILITIES
& NET WORTH
$5500
(d) Again, change in the money supply (either M1 or M2) = {initial amount of ER} * {money multiplier} =
($50) * (10) = $500. M1 on the bank's balance sheet = $5000 in Checking deposits (again, we don't include
reserves because only the cash held outside of the banking system, or "cash in circulation," counts toward the
"currency" portion of M1) M2 on the bank's balance sheet = M1 + Savings deposits = $5200. As in #3., the
money multiplier = 1/RRR = 1/.10 = 10 (this question was only incompletely asked on the problem set).
IV. Money Demand and Monetary Policy
1. Chapter 11: Problem Set # 1. (a) Disagree. A rise in Y increases the demand for money as more transactions
take place.
(b) Disagree. Ceteris paribus, a rise in P means that each transaction is more expensive and households and
firms need to hold more money, not less.
(c) Disagree, again. When the Fed buys bonds, it expands the money supply. The supply curve shifts to the
right. When we experience a recession (Y falls) the demand for money falls, shifting the demand curve to the
left. Both tend to push interest rates lower.
2. Chapter 11: Problem Set # 3. If households believe that interest rates will rise, they will desire to hold more
of their wealth as money for the time being, betting that they can get a higher interest rate if they wait. If they
buy bonds now, they risk a capital loss (a decrease in the value of their assets), because bond prices fall when
interest rates rise. When households hold money to speculate in this way, we call their motive for holding
money the “speculation motive.”
3. Chapter 11: Problem Set # 7. (a) Ceteris paribus, an expansionary fiscal policy at a time when the Fed want
to hold the rate of growth of the money supply steady will drive up interest rates. With money supply constant,
more spending means greater money demand; hence, higher interest rates. (b) The Fed could raise rates by
doing nothing since rates are already higher or could boost them more by reducing money supply. (c) The Fed
could lower interest rates by increasing the money supply.
V. Money, Interest Rate and Output
1. Chapter 12: Problem Set #1. A cut in T increases disposable income Y d . C rises as a result as does S. C  I  G
is thus bigger than Y, inventories fall and Y rises. There would be a multiplier. By assuming no change in
interest rates, there would be no direct effect on C, I or G from the debt reduction. (Note: There could be a
portfolio effect. The supply of bonds decreases, households try to shift from money to bonds, and bond prices
rise driving r lower. However, we assumed the Fed holds rates constant which it could do by reducing the
supply of money.) Because the tax cut is more expansionary, Y will rise, driving up the demand for money. To
get the economy to slow r will have to rise more than it would have under the debt reduction story.
2. Chapter 12: Problem Set #3. Taxes (T) rise, causing disposable income Yd to fall. When Yd falls, C falls,
causing AE  Y . When AE  Y , inventories rise and firms cut back on output/income: Y falls and unemployment
rises. If I were the central bank and I wanted to counteract these effects, I might lower interest rates to try to
stimulate investment with expansionary money policy.
3. Chapter 12: Problem Set #5. (a) Because these two policies have opposite effects on aggregate spending, the
result is ambiguous. The tax cut raises Y d and thus C. C  I  G  Y . Inventories fall and Y rises. At the same
time, if M s is cut by the Fed, r rises. Higher r leads planned investment (I) to fall. Lower I implies C  I  G  Y
inventories rise and Y falls. The only thing certain is that r will rise because the tax cut leads to an increase in
Md .
(b) In 1998, the tax cuts cause disposable income to rise. When Y d rises, C increases and C  I  G  Y .
Inventories contract, causing Y to rise. Higher Y causes money demand M d to rise. If M s is fixed, that will cause
r to rise. In 1999–2000 the story is reversed. The expenditure cuts kick in, causing G to fall. C  I  G  Y ,
inventories rise, Y falls. That causes money demand to fall and with M s constant, r will fall.
(c) The tax increase reduced disposable income and thus consumption. C  I  G  Y , so inventories build and
output falls. A lower Y means lower money demand. At the same time that the Fed is increasing the money
supply, interest rates will fall sharply, causing I to rise, perhaps offsetting the effects of the initial tax increase
on Y. (Final result: ambiguous Y, lower r.)
(d) The drop in consumption cuts aggregate expenditure: C  I  G  Y , so inventories rise and Y falls. As Y falls,
money demand drops. If the Fed holds M s constant, r will fall. Here again, the lower r may stimulate I, causing
I to rise, partially offsetting the initial decline in Y. (Final result: lower Y, lower r.)
(e) The Fed expands the money supply. M s  M d , so r falls. Normally, the lower r might be expected to cause I
to rise, but gloomy expectations and no need for new plant and equipment keep I low. Thus the link to the goods
market is broken, and the monetary policy doesn’t have much impact. (Final result: lower r, little or no change
in Y.)
4. WSJ article ”Shock Absorbers: Lessons of Expansion are Helping Economy Beat Recession, Too” by Greg Ip
and Russell Gold on 3/4/2002
(a) Two pieces of Friday’s news: manufacturing surged in Feb. and household spending rose sharply in Jan.
(b) The shocks had made a robust recovery seem unlikely until now: bursting of the stock market bubble, spike
in energy prices, terrorist attacks, collapse of Enron and Argentina.
(c) The business cycle may have become “easier for business executives and economic officials to tame”
because of increased flexibility: (1) manufacturers quicker to adjust; (2) financial markets better able to parcel
out risk, and (3) policy makers faster to cut interest rates and taxes.
(d) The factors that might prevent a rapid recovery are high consumer debt restraining C and low profit margins
restraining I.
(e) The labor force must be growing faster than 2.5-3%.
(f) Auto sales continued strong through the recession due to 0% financing because they continued to have access
to the “bond and commercial paper markets,” that is they were able to borrow plenty of money to finance lowcost loans to car buyers.
(g) The purchasing managers’ index rose from 49.9 in Jan. to 54.7 in Feb. and more than 50 means an
expanding industrial sector.
(h) A key argument about why the U.S. economy is more flexible today than in the past is than manufacturers
have tightened their control of inventories reducing waste, interest payments and lead times.
(i) Manufacturers’ inventories peaked at 44 days’ worth of shipments last year vs. 53 days in the 1991 recession.
(j) Suzanne Thomas because she’s more optimistic about the economy landscaped her yard and replaced her
1920s era sewage pipes by refinancing her mortgage and cashing out $50,000 in equity—that is, if her home is
valued at $200,000 and she owed $100,000 on the existing loan, her new loan was for $150,000.
(k) The downside of the financial system’s willingness to keep lending during the recession means than the
recovery will be weaker than it would be if debt had not been accumulating during the recession. That is, some
of the income increases that will come with a growing economy will be used to pay debts instead of spurring
output.