Download (a) Which case gives rise to more inflation, a steep aggregate supply

1. (a) Which case gives rise to more inflation, a steep aggregate supply curve or a flat one? (b)
What happens to the income multiplier if the aggregate supply curve is vertical? (c) What
happens to the income multiplier if the aggregate supply curve is horizontal?
(a) A steeper aggregate supply curve will give rise to more inflation as compared to a flatter supply
curve. If the aggregate supply curve is steeper a small shift in quantity is accompanied by a
large shift in prices giving rise to more inflation. On the other hand if the aggregates supply
curve is flatter it will mark less change in the prices as a response to quantity change.
(b) As inflation reduces the size of the multiplier. If the aggregate supply curve is vertical there
will be less inflation and the size of the multiplier will increase. If the supply curve is vertical
the price level will not affect the quantity supplied and same quantity will be supplied at any
price.
(c) If the aggregate supply curve is horizontal there will be more inflation as high quantity will be
only provided at high prices. So when the multiplier process will start increasing income and
employment, this will also increase prices. This will reduce net exports and reduce the
consumer spending, as the purchasing power will reduce because of the increase in prices and
the multiplier effect will be reduced because of inflation.
2. An economy is described by the following set of equations:
C = 10 + 0.90DI
I = 140
G = 540
T = (1/3)Y
(X - IM) = -90
(a) C + I + G + (X-IM) = Y
10 + 0.90DI + 140 + 540 – 90 = Y
10 + 0.90(Y-1/3Y) + 140 + 540 – 90 = Y
600 + 0.90(2/3Y) = Y
600 + 0.6Y = Y
600 = Y – 0.6Y
600 = 0.4Y
Y = 1500
(b) BD = T – G
BD = 1/3(1500) – 540
BD = 500 – 540
BD = -40
3. In a recent year the Fed decided that interest rates were too high and took steps to drive them
down. What are three tools the Fed could use to push interest rates down? Be very specific in
describing how these tools are used to lower interest rates in the economy?
The three tools used by the Fed are:
i. Open Market Operations: When the Fed sells bonds in the open market, it decreases the supply
of money. Prices are pushed higher and consequently interest rates decrease.
ii. Discount window lending: If the discount window rate is lowered by the Fed then, banks can
borrow more reserves, which lead to these banks making more loans at lower interest rates.
iii. Reserve Requirements: When the Fed lowers it’s reserve requirements, then banks have more
reserves available for lending. When the banks are willing to lend more, the interest rates
will fall.
4. Consider an economy in which government purchases (G) are 200, taxes (T) are 100, net
exports (X-IM) are 20, the consumption function is
C = 300 + 0.80DI
and investment spending (I) depends on the rate of interest (r) in the following way:
I = 500 - 800r
Find the equilibrium GDP if the Fed makes the rate of interest (a) 5 percent (r=0.05), (b) 10
percent (r=0.10), or (c) zero.
Where interest rate= 0.05 or 5%
Investment spending (I) = 500-800(0.05) = 460
Aggregate Expenditure (AE) = C+I+G+(X-IM)
AE= [300+800DI] + 460 + 200 + 20
Remembering that DI = Y - T, where Y = real GDP, we have:
AE= [300+ 0.8(Y-T)] + 680
AE= [300+ 0.8Y-80] + 680
AE= 0.8Y + 900
When an economy is in equilibrium, the overall amount of expenditures will equal the total value of
output produced thus equilibrium would occur when AE = Y. Therefore, we only need to substitute Y
for AE in the equation above:
Y= 0.8Y + 900
(a) The equilibrium GDP is equal to 4500 when interest rate is 5%.
(b) The equilibrium GDP is equal to 4300 when interest rate is 10%.
(c) The equilibrium GDP is equal to 4700 when interest rate is 0%.
5. Explain what a $50 billion increase in the money supply will do to the real GDP under the
following assumptions:
(a) Each $10 billion increase in the money supply reduces the rate of interest by 0.5
percentage points. Interest reduction o 2.5 percent
The decrease in rate of interest increases the total investment and ultimately increases the
aggregate expenditure. The AE curve shift upwards and the real GDP is increased. If there is a
$ 50 billion increase in the money supply and total reduction of 2.5 percent. The reduction in
interest rate will affect the slope of the AE curve which will in turn affect the increase in the
real GDP.
(b) Each 1 percentage point decline in interest rates stimulates $30 billion of new
investment spending. $75 billion of new investment spending.
The increase of $75 billion in investment spending will also result in increasing the aggregate
expenditure which will further increase the real GDP. The total increase in real GDP will be
total of increase in the money supply and increase in the investment spending
(c) The expenditure multiplier is 2.
The expenditure multiplier is 2 this means that the aggregate expenditure will increase two
times the increase in the money supply and investment spending and hence the real GDP will
also increase two times.
(d) There is so much unemployment that prices do not rise noticeably when demand
increases.
6. The government decides that aggregate demand is excessive and is causing inflation.
(a) What fiscal policy options are open to it to dampen the economy?
A contractionary fiscal policy can be used to dampen the economy and reduce inflation by
preventing inflationary excesses of a business cycle expansion. It can be done by either decreasing
the government spending or increasing taxes. In other words a decrease in money supply or increase
in interest rate is brought about by a contractionary policy.
(b) What if the government decides that aggregate demand is too weak instead?
A business cycle contraction i.e. reduction in unemployment and stimulation of economy can be
done through an expansionary policy. It can be done through an increase in government spending or
a decrease in taxes. In other words, an increase in money supply or decrease in interest rates can
help counter a weak aggregate demand.
7. During the 1980s, early 1990s, and in recent years, a rash of bank failures occurred in the
United States. Briefly explain why these failures did not lead to runs on banks.
Despite of all bank failures in the United States there was no case of runs on banks. This was
because people were interested in more savings because of economic downturn. The savings were
increasing which decreased the interest rate because of decreased interest rate the expenditure
decreased this in turn decreased the real GDP. Decreased interest rate and output resulted in the bank
failures and decrease in the money supply which in turn increase savings creating a cyclic and
multiplying effect
8. Suppose banks keep no reserves and no individuals or firms hold on to cash. (a) If suddenly
$20 billion is deposited in US banks by foreign depositors, what will happen to the money
supply if the required reserve ratio is 10 percent? (b) What if the required reserve ratio is 20
percent?
(a) Change in money supply = (1/m) * change in reserves
Change in money supply = (1/0.1) * 20
Change in money supply = $ 200 billion
(b) Change in money supply = (1/m) * change in reserves
Change in money supply = (1/0.2) * 20
Change in money supply = $ 100 billion
9. What are the three main targets of discretionary fiscal and monetary policy as set forth by the
Employment Act of 1946? Briefly define each of these.
The main target of discretionary fiscal and monetary policy as set forth by the Employment Act of 1946
is to promote:
i.
Maximum employment: A condition of national economy where all or nearly all of the
population is willing and able to work at the existing wages and working conditions.
ii.
Production: The function that specifies output of a firm, an industry or an economy for
all possible combinations of input is known as production function.
iii.
Purchasing power: It is the value of money that is measured by both the quantity and
quality of goods and services that it can buy. The term “Buying Power” is also
interchangeably used with Purchasing power (Baumol & Blinder, 2009).
10.
What is the difference between the budget deficit and the national debt?
The shortfall between the government’s spending during a single year as compared to what it brings in
is called Budget Deficit whereas the accumulation of all the budget deficits of a country since its
existence is what is known as National debt.
Example:
Government spending in a particular year: $3.5 trillion
Income (tax and revenues): $3 trillion
Budget Deficit (or shortfall) = $3 - $3.5 = $500 billion
The government has to borrow $500 billion by selling bonds or other debt instruments. Adding this
$500 billion to existing debts from previous years gives us the amount of National Debt.
REFERENCES
Baumol, W. & Blinder, A. (2009). Macroeconomics: principles and policy. USA: South-western
Cengage learning.