Download EC 132.01 Discussion Session

EC 132 Discussion Note PS6
CHIU
P.1
Disclaimer:
All questions are adapted directly from the textbook and problem sets.
Suggestions from Professor Tresch are used in preparation of this note.
All solutions are just suggestive and tentative comments, not marking criteria actually adopted,
subject to further changes and interpretations.
Question 1 (Q6 Ch.12 P. 341)
(a) Why is the change in the structural federal budget deficit a better measure of the
government’s fiscal policy stance than a change in actual federal budget deficit?
Definition: (Actual budget deficit) The difference between government revenues and
government expenditure. (P.328)
Definition: (Structural budget deficit) An estimate of what the government’s budget
would be if the economy were at full employment (the natural rate of
unemployment), regardless of whre the economy actually is; it increases and
decreases with discretionary changes in government spending on goods and
services, transfer payments, or taxes.(P.329)
Definition: (Cyclical budget deficit) The component of the government’s budget
deficit that fluctuates with the state of economy; the difference between the actual
budget deficit and the structural budget deficit. (P.330)
Since Actual deficit = structural deficit + cyclical deficit, we have Δ Actual deficit = Δ structural
deficit + Δ cyclical deficit. However Δ cyclical deficit would be affected by automatic stabilizers.
[As mentioned in P.328 of the textbook, “Unfortunately, the change in the federal budget deficit or surplus is not a very reliable
measure of government’s fiscal stance. The problem is that changes in the deficit depend on two factors: (1) discretionary changes
in expenditure programs or taxes, which is what we want to measure; and (2) changes in the state of economy, whether the
equilibrium level of national income is increasing or decreasing. The deficit is very sensitive to the state of economy because both
taxes and transfer payments vary with the level of national income.”]
(b) Why is the change in the structural federal budget deficit not a perfect measure of the
government’s fiscal policy stance?
1) Structural deficit is an estimate, not an actual number.
2) Natural rate of unemployment is a moving target.
3) MSpending>MTransfer=-MTax so for the same structural surplus/deficit, the fiscal policy could either
be contractionary or recessionary.
4) Ratio of structural deficit to full employment level of national income is a better indication.
Question 2 (Q8 Ch.12 P. 341)
(a) How does the burden of an external public debt differ from the burden of an internal
public debt?
Definition: (External Debt) Public debt that is held by foreign citizens, business and
government. (P.335)
Definition: (Internal debt) Public debt that is held by U.S. citizens, business, and
government agencies. (P.335)
Internal debt: investment, which might slow down growth of economy
External debt: reduction of future purchasing power with interest payment
(b) Are there any conditions under which neither external debt nor internal debt are a
burden to a nation?
Return from current consumption/investment is greater than the interest payment. Hence, as
long as debt/GDP is being constant it should be fine. (Just like paying minimum payment for
credit card?)
EC 132 Discussion Note PS6
CHIU
P.2
Question 3 (Q4 Ch.13 P. 369)
Why must both the contraction phase and the expansion phase of a business cycle
eventually come to an end, according to the multiplier-accelerator model of the business
cycle?
Definition: (expansion phase) The period of time during which economic activity is
increasing; commonly referred to as a boom. (P.349)
Definition: (contraction phase) The period of time during which economic activity is
declining; commonly referred to as a recession. (P.349)
Definition: (Multiplier-accelerator model) An internal model of the business cycle that
is based on the instability of investment demand and its relationship to national
income through both the demand side and the supply side of the economy.(P.355)
Multiplier-accelerator model is basically investment demand model. A boom starts and ends
because of investment takes time to complete and income increases during the process. The
increase stops when frontier is reached. A recession starts and ends because depreciation takes
time to complete and income decreases during the process. The decrease stops because
depreciation must end!
Question 4 (Q2 Ch.14 P. 397)
What is the difference between money and income?
Definition: (Money) Anything that is routinely used to pay for goods and services or
to pay off debts.(P.376)
Money is defined as above.
Income is usually received in the form of money (rather than goods like bread, butter).
Money is a stock variable and income is a flow variable.
Question 5 (Q3 Ch.14 P. 397)
(a) What is the velocity of circulation, and how is it related to the national product?
Definition: (Velocity of circulation) The ratio of the dollar value of national income or
national product to the money supply; the number of times the money supply
changes hands during the year to buy final goods and services (or primary factors of
production). (P.378)
By equation of exchange: MV = Y = PQ
Definition: (Equation of exchange) The measure of the circular flow of economic
activity in terms of money; a national income accounting identity, which says that the
dollar value of national income or national product equals the product of the money
supply times the velocity of circulation. (P.378)
(b) Suppose that the velocity of circulation is 6 and the dollar value of an economy’s
national product (national income) is $9 trillion. How large is the money supply in the
economy?
Using the equation, M = Y/V = 9/6 = 1.5 trillion.
Question 6 (Q10 Ch.14 P. 397)
Why does the money supply increase when a commercial bank makes a loan to a
business customer as part of a line-of-credit agreement? Show how the balance sheets
of the commercial banks and the business customers are affected by these loans.
Money is not about net debt position. It counts when the business customer has money in the
checking account though the money is borrowed from the bank.
EC 132 Discussion Note PS6
CHIU
Commercial banks
Assets
Liabilities
Loan
Checking Account
$10million
$10million
P.3
Business Borrowers
Assets
Liabilities
Checking account
Loan
$10million
$10million
Question 7 (Q2 Ch.15 P. 418)
(a) Why does the Fed require commercial banks to hold reserves?
Protect depositor and control money creation process.
Definition: (Reserves) A non-interest-bearing account against deposits that
commercial banks (and other depository institutions) must keep with the Fed; used
by the Fed to control the amount of loans and deposits that banks can create.
(P.404)
(b) How do commercial banks acquire reserves? Name as many ways as you can.
Increase in total reserves in the banking system:
1) Public puts money into saving account; (increase FRN for checking accounts)
2) Fed sell bonds to banks (Fed’s open market operations)
Shuffle existing reserve among the banks:
1) Receiving an depositing of checks
2) Borrowing on the federal funds market
(c) What causes commercial banks to lose reserves? Name as many ways as you can.
Increase in total reserves in the banking system:
1) Public withdraw money from saving account; (decrease FRN for checking accounts)
2) Fed buy bonds from banks (Fed’s open market operations)
Shuffle existing reserve among the banks:
1) Writing an depositing of checks
2) Lending on the federal funds market
Question 8 (Q3 Ch.15 P. 418)
What roles does the nonbank public play in determining the size of the money supply?
Money multiplying process:
1) businesses’ borrowing decision
2) households’ borrowing and saving decision
3) Security dealers who engage in open market operations with the Fed
4) Treasury which creates the treasury securities that the Fed trades.)
Definition: (Money multiplier) The ratio that relates the total change in the money
supply to the value of Treasury securities that the Fed purchases or sells on the
Open Market. (P.409)
Question 9 (Q5 Ch.15 P. 418)
Suppose that the Fed wants to decrease the money supply by $15 million. Would the Fed
buy or sell Treasury debt on the Open Market to do this? Would the Fed trade less than,
more than, or exactly $15 million of its Treasury debt to decrease the money supply by
$15 million?
Sell.
Less than $15 due to multiplier process.