Download ECON 121 Principles of Macroeconomics Exam II

ECON 121
Principles of Macroeconomics
Exam II
Solutions
Dennis C. Plott
University of Illinois at Chicago
Department of Economics
Summer 2015
ECON 121 – Principles of Macroeconomics
Exam II – Summer 2015 – Solutions
Name (print neatly and clearly): Dennis C. Plott
General Instructions
1. Read and follow all instructions/directions carefully.
2. Make sure your exam consists of 11 pages, not including the cover page.
3. An inability to follow instructions/directions will result in points being deducted.
4. The only device allowed is a simple calculator; i.e., anything that can store or retrieve information
(including a graphing calculator) is NOT allowed.
5. Use of books, notes, another person, and/or aid of any kind is absolutely NOT allowed.
6. Answer all questions in blue or black ink only; i.e., no pencils or colored inks. The only exception: graphs
may be drawn in pencil. Note: use a guide of some sort (e.g., a ruler) for all graphs.
7. Do not use white out or similar products, but neatly cross/scratch out anything you do not want graded.
8. Write, mark, and draw your answers neatly and clearly. If your answer is illegible (i.e., difficult to read
in the least), then it will not be graded. It is your job to clearly communicate.
9. Label all graphs fully and completely; i.e., axes, intersections, curves, etc.
10. Support your answers as thoroughly as possible; i.e., graphically, conceptually, and mathematically. Note:
this may not be feasible for all questions asked. State and define any concept utilized and list and name
any equation used. In other words, show all of your work.
11. For the True/False/Uncertain questions clearly indicate your choice by writing either “True”, “False”, or
“Uncertain” underneath the respective question.
12. Unless explicitly instructed otherwise, all questions require a justification to receive credit.
13. Answer all questions using positive economic reasoning.
14. Unless otherwise noted, assume the nominal wage is fixed in the short-run, all markets begin in long-run
equilibrium, government spending has no impact on total factor productivity, and capital stock is fixed
in both the short-run and long-run except for negative shocks. For changes in the variables of interest,
reference the initial level, unless instructed otherwise, in both the short-run and long-run.
Original Score (%)
Adjustment (%)
Actual Score (%)
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ECON 121 – Principles of Macroeconomics
Exam II – Summer 2015 – Solutions
1. American Banker 1 reported itBit, a bitcoin exchange, formed a partnership with a U.S. bank, thereby
making their clients’ Bitcoin accounts FDIC eligible.
(a) What is the FDIC and what does it do? What would the FDIC provide for Bitcoins? Explain.
• [2 points] The Federal Deposit Insurance Corporation (FDIC) insures deposits, up to a certain
amount, against “bank” failures as long as the “bank” is a member.
• [2 points] As a consequence, the FDIC provides public confidence and encourages stability in
the financial system.
– The Federal Deposit Insurance Corporation (FDIC), an independent agency of the federal
government, was created in 1933 in response to the thousands of bank failures that occurred
in the 1920s and early 1930s. Since the start of FDIC insurance on January 1, 1934, no
depositor has lost a single cent of insured funds as a result of a failure.
– The Federal Deposit Insurance Corporation (FDIC) preserves and promotes public confidence in the U.S. financial system by insuring deposits in banks and thrift institutions for
at least $250,000; by identifying, monitoring and addressing risks to the deposit insurance
funds; and by limiting the effect on the economy and the financial system when a bank or
thrift institution fails.
– The FDIC receives no Congressional appropriations – it is funded by premiums that banks
and thrift institutions pay for deposit insurance coverage and from earnings on investments
in U.S. Treasury securities. The FDIC insures approximately $9 trillion of deposits in U.S.
banks and thrifts – deposits in virtually every bank and thrift in the country.
(b) Are there any potential problems (i.e., cons) with FDIC coverage? Explain.
• [2 points] Deposit insurance produces a moral hazard problem whereby people (institutions)
with insurance may take greater risks than they would do without it because they know they are
protected. Because of deposit insurance, depositors have no incentive to monitor the riskiness
of banks in which they make their deposits; as a result, bankers have an incentive to make
excessively risky loans, knowing they will reap any gains while the deposit insurance system will
cover any losses.
2. The English economist William Stanley Jevons described2 a world tour during the 1880s by a French
singer, Mademoiselle Zélie. One stop on the tour was a theater in the Society Islands, part of French
Polynesia in the South Pacific. She performed for her usual fee, which was one-third of the receipts.
This turned out to be three pigs, 23 turkeys, 44 chickens, 5,000 coconuts, and “considerable quantities
of bananas, lemons, and oranges”. She estimated that all of this would have had a value in France of
4,000 francs. According to Jevons, “as Mademoiselle could not consume any considerable portion of the
receipts herself, it became necessary in the meantime to feed the pigs and poultry with the fruit”. Do
the goods Mademoiselle Zélie received as payment fulfill the functions of money? Explain ensuring to
reference the three functions of money.
• [2 points] In French Polynesia in the 1880s, the food the French singer received as payment served
as a medium of exchange, but the food did not serve well as a store of value, or a unit of account.
– [1 point] Medium of exchange: Any item sellers generally accept and buyers generally use to
pay for a good or service; money; a convenient means of exchanging goods and services without
engaging in barter.
– [1 point] Unit of account: A standard unit in which prices can be stated and the value of goods
and services can be compared; one of the three functions of money.
– [1 point] Store of value: An asset set aside for future use; one of the three functions of money.
1 American
2 W.
Banker “Bitcoin Exchange itBit Gets N.Y. Trust Charter, Bank Partner” by Sarah Todd, 8 May 2015
Stanley Jevons, Money and the Mechanism of Exchange, New York: D. Appleton and Company, 1889, pp. 1–2.
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ECON 121 – Principles of Macroeconomics
Exam II – Summer 2015 – Solutions
3. A politically active friend posts a commonly circulated meme on Facebook along with the following
statement “If the U.S. were like a household it would be bankrupt! It’s outrageous! We need a balanced
budget amendment now! Like if you agree!”
(a) How would you explain to your friend, using positive economic analysis, why the analogy between the
government budget and a household budget is not as clear as it seems on the surface; particularly
why their (bankruptcy) comment may be a false concern? Can you provide and explain to your
friend at least one substantive reason why a government budget deficit may be problematic?
• [4 points] for any one of the following explanations False Concerns
– The government has the power to tax, which businesses (firms) and individuals (households)
do not have when they are in debt.
– The government does not need to raise taxes to pay back the debt. It can borrow more (i.e.,
sell new “bonds”) to refinance bonds when they mature. Corporations use similar method
– they almost always have outstanding debt.
• [4 points] for any one of the following explanations Substantive Concerns
– Repayment of the debt affects income distribution. If working taxpayers will be paying
interest to the mainly wealthier groups who hold the “bonds”, this probably increases income
inequality.
– Since interest must be paid out of government revenues, a relatively large debt and high
interest can increase the tax burden and may decrease incentives to work, save, and invest
for taxpayers.
– A higher proportion of the debt is owed to foreigners than in the past, and this can increase
the burden since payments leave the country.
– Some economists believe that public borrowing crowds out private investment, but the extent
of this effect is not clear
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ECON 121 – Principles of Macroeconomics
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(b) Later, in response to your above comment, your friend links to an op-ed piece3 , written by a U.S.
Congressman, highlighting recent “calls for Congress to pass a Balanced Budget Amendment to the
Constitution.” Your friend further comments “[i]t must be a good idea if they are trying to get an
amendment passed!” Can you provide and explain to your friend at least one disadvantage of having
a balanced budget amendment?
• [5 points] for any one of the following explanations
• Balanced budget amendments can make economic situations worse. For example, suppose there
is a negative demand shock; e.g., consumer confidence falls. As Y falls, tax revenues fall. As tax
revenues fall, deficits (cyclical) increase. If the government has to balance the budget, it would
either have to cut G or increase T – both of which would cause the AD curve to shift further to
the left.
• If the government spends today it must:
– raise taxes now (changing taxes frequently creates economic uncertainty; distorts signals/incentives)
– raise taxes in the future (higher taxes also cause incentives to be distorted)
– print money in the future which could lead to (hyper)inflation
(c) The article cited by your friend further states “[f]orty-nine out of 50 states . . . have balanced budget
requirements . . . [w]hy should Washington [the Federal Government] be held to a different standard?”
Provide a positive economic answer to the question posed.
• Often, states are viewed as natural laboratories to test out new policies before they are implemented on the national stage. However, the nature and role of federal and state budgets are too
fundamentally different to be covered by similar decision rules.
• All U.S. states have balanced-budget requirements, save Vermont. However, there are several
major differences between the states and the federal government that would make the effects of
a balanced-budget requirement drastically different at the federal level:
– [2 points] for any one of the following explanations
– Unlike the states, the federal government is responsible for a national economy. While the
fiscal austerity forced on states during recessions may not have a major economic effect on
the nation at large, the adoption of similar constraints by the federal government could well
lead to an economic free-fall.
– Individual states can receive aid from the federal government whereas the federal government
has no such avenue in cases of budget shortfalls.
– The federal government budgets on a unified basis precisely because it must be accountable
for the total impact of federal budget decisions on the economy. Washington does not
have the option available to the states of focusing on only a general fund to balance. This
flexibility helps states comply with balance requirements by shifting surpluses from other
funds to shore up the general fund, among other accounting shifts.
– The balanced-budget requirements make a difference in the states because they are reinforced
by the bond markets. States are vitally focused on earning the highest credit rating possible
to reduce their borrowing costs. By comparison, the bond market to date has not proven to
be a source of restraint in federal budgeting. Simply put, even in the worst of fiscal times,
federal treasuries are viewed as the quintessential risk-free asset. Thus, federal officials could
feel free to ignore the spirit of a balanced-budget requirement with relative impunity.
4. An article in Forbes 4 reports commercial banks (e.g., Bank of America) are holding more excess reserves.
(a) What are “excess reserves”?
• [2 points] Excess reserves are reserves held by banks above the amount mandated by reserve
requirements.
3 foxnews.com
4 Forbes
“America Urgently Needs a Balanced Budget. Here’s How to Get There”, by Rep. Vern Buchanan, 27 June 2015
“Banks Don’t Lend Out Reserves” 21st January 2014 by Frances Coppola
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ECON 121 – Principles of Macroeconomics
Exam II – Summer 2015 – Solutions
(b) List and explain one possible reason why banks are holding more excess reserves.
• [4 points] for any one of the following explanations
• Banks, households, and businesses have been deleveraging. That means they are paying off (or
writing off) loans and not taking on any more. Damaged banks don’t want to lend, damaged
households don’t want to borrow, and fearful businesses don’t want to invest.
• Regulatory uncertainty and tighter (and to some extent unknown) capital requirements are
preventing banks from extending more credit.
• Exceptionally low rates make some forms of lending unprofitable.
• Banks are running unusually large excess reserve positions with the Fed that are “crowding
out” lending. These reserves are effectively “loans” to the Fed paying 25 basis points, funded
with bank deposits that pay near zero, creating riskless profits with zero regulatory capital
requirement.
(c) True, False, or Uncertain: An increase in excess reserves, ceteris paribus, will cause the money supply
(M1) to decrease. Explain.
• [3 points] True
• [3 points] Conceptually money is “created” in an economy as banks make loans and loans come
from lending excess reserves. Holding more excess reserves implies less loans generated thereby
reducing the money supply.
5. Several bills have recently been introduced in Congress aimed at the Federal Reserve such as Sen. Rand
Paul’s “Federal Reserve Transparency Act 2015” and U.S. Senate Banking Committee Chairman Richard
Shelby’s “Financial Regulatory Improvement Act”. The primary purpose of the proposed legislation is to
“increase congressional oversight of the nation’s central bank, but also shift the balance of power within
the Fed.”.5 Specifically, Shelby’s bill would allow the Fed’s regional (e.g., Chicago) presidents to have
similar authority to the board of governors members. How do these types of proposals relate to the Federal
Board of Governors serving fourteen-year terms and the political business/budget cycle? Explain.
• [4 points] Discussion of the Fed having independence in order to be insulated from political pressure;
particularly so that the Fed can do what it considers “best” for the economy as a whole rather than
what is “best” for a particular politician or political party. If the executive and legislative branches
of government cannot interfere with the central bank, people are more likely to believe that the
central bank is committed to keeping inflation relatively low/stable and will not cause a political
business/budget cycle.
5 The Washington Post “Top Senate Panel Looks to Tighten Oversight of Federal Reserve”, by Yian Q. Mui, 12 May 2015 &
The Washington Post “Audit the Fed? Not so Fast.”, by Catherine Rampell, 29 January 2015
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ECON 121 – Principles of Macroeconomics
Exam II – Summer 2015 – Solutions
6. An article in The Wall Street Journal 6 reports “Federal Reserve Chairwoman Janet Yellen reaffirmed
the central bank’s plan to start raising short-term U.S. interest rates later this year . . . despite economic
headwinds from Greece and China.”
(a) Would expansionary or contractionary monetary policy result in interest rates increasing? Explain.
• [1 points] Contractionary monetary policy.
• [2 points] for explanation Contractionary monetary policy is a decrease in the quantity of
money in circulation, with corresponding increases in interest rates, for the expressed purpose
of putting the brakes on an overheated business-cycle expansion and to address the problem of
inflation.
– In days gone by, monetary policy was undertaken by decreasing the amount of “paper”
currency in circulation. In modern economies, monetary policy is undertaken by controlling
the money creation process performed through fractional-reserve banking.
(b) Many analysts believe the Fed will gradually raise its target interest rate in 0.25% increments. What
is 0.25% in basis points? Why are basis points, in general, used instead of percentage points?
Explain.
• [1 points] 25 basis points
• [1 points] for explanation One percentage point is equal to 100 basis points.
• [1 point] bonus; unintentionally left out of the calculation Explain changes in interest
rates are often quite small making it cumbersome to use percentage points.
(c) What is the Fed’s “dual mandate”? How would increasing interest rates likely affect the Fed’s dual
mandate? How does the Fed’s dual mandate relate to being a “hawk” or “dove”? Explain.
• [2 points] The Federal Reserve currently has two (primary) goals: price stability and fullemployment; i.e., a dual mandate.
– In 1977, Congress amended The Federal Reserve Act (1913), stating the monetary policy
objectives of the Federal Reserve as:
“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates
commensurate with the economy’s long run potential to increase production, so as to
promote effectively the goals of maximum employment, stable prices and moderate
long-term interest rates.”
This is often called the “dual mandate” and guides the Fed’s decision-making in conducting
monetary policy.
• [2 points] Higher interest rates discourage borrowing and encourage saving and will tend to slow
the economy; i.e., curbs inflationary pressure. This is consistent with price stability if the Fed is
concerned about inflationary pressure, either now or expected in the future. However, as stated,
higher interest rates slow the economy resulting in lower employment. This is still consistent
with the Fed’s dual mandate if the FOMC believes the economy is near full-employment.
• [2 points] The hawks worry more about inflation, the doves about (un)employment.
– The problem is that the Fed can only do one thing at a time. When the Fed stimulates
(i.e., lowers interest rates) the economy, and thus create jobs, the risk that inflation could
become a problem goes up. In general, an inflation rate of about 2% per year is considered
acceptable. The employment targets are less clear.
– Most monetary policymaker classified as a dove would admit that when inflation gets relatively too high, the economy can’t function. Still, in general, doves tend to say temporary
blips in inflation above 2% are a price worth paying for more jobs.
– For example, former Fed Chair Ben Bernanke and current Fed Chair Janet Yellen are considered doves, while Dallas Fed President Richard Fisher and the president of the Philadelphia
Fed, Charles Plosser, are considered hawks.
6 The
Wall Street Journal, “Janet Yellen: Fed on Track for 2015 Rate Hike”, 10 July 2015, by Ben Leubsdorf and Jon Hilsenrath
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ECON 121 – Principles of Macroeconomics
Exam II – Summer 2015 – Solutions
(d) What short-term U.S. interest rate will the Fed target to pursue its monetary policy goals? Define
the interest rate identified.
• [2 points] Federal funds rate.
• [2 points] for definition The federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve – called federal funds – with each other.
That’s the technical definition – but simply put, it’s the interest rate charged by commercial
banks to other banks who are borrowing money, usually overnight.
– Federal funds are funds deposited with the Federal Reserve by commercial banks. The funds
include money that’s in excess of bank reserve requirements.
– Reserve requirements are the amount of funds that a depository institution – a commercial
bank – must hold in reserve against specified deposit liabilities. This is to make sure banks
have enough funds to cover their liabilities. The banks’ reserve funds are held by the Federal
Reserve.
(e) What monetary policy tool will the Fed use to pursue its monetary policy goals, particularly to “begin
normalizing monetary policy”? Explain in detail how this tool is implemented to raise interest rates.
• [4 points] Open-market operations (OMO) refer to the Fed’s purchase or sale of government
securities through transactions in the open market.
– When the Fed buys government securities through securities dealers in the “bond” market,
it deposits the payment into the bank accounts of the banks, businesses, and individuals who
sold the securities. Those deposits become part of the funds commercial banks hold at the
Federal Reserve and thus part of the funds commercial banks have available to lend. Because
banks want to lend money, to attract borrowers they decrease interest rates, including the
rate banks charge each other for overnight loans (the federal funds rate).
– When the Fed sells government securities, buyers pay from their bank accounts, which
decreases the amount of funds held in their bank accounts. Banks then have less money
available to lend. When banks have less money to lend, the price of lending that money –
the interest rate – goes up, and that includes the federal funds rate.
[1 point] for each step in the correct order
i. Open-market operations (OMO) sale (of previously issued Treasury securities; specifically
Treasury Bills)
ii. Reserves decrease (↓ RES)
iii. Excess reserves decrease (↓ ER)
iv. Loans decrease (↓ loans)
v. Money decreases [aided by the money multiplier] (↓ M )
vi. Interest rate increases (↑ r)
(f)
A True, False, or Uncertain: raising short-term U.S. interest rates, ceteris paribus, will increase the
U.S. government’s primary deficit. Explain.7
• [1 point] True. [4 points] all or nothing for explanation
• Interest rates tend to move together. When the short-term U.S. interest rates are raised other
short-term rates will be affected. Long-term rates (e.g., 30-year mortgage rates) will also be
affected in the same direction, generally, but to a lesser extent. U.S. debt includes Treasury
securities of both types of interest rates; e.g., Treasury Bond (T-Bond) – long-term interest rate
and Treasury Bill (T-Bill) – short-term interest rate.
– The primary deficit equals outlays (i.e., government spending plus transfer payments minus
interest payments) minus revenue (i.e., income taxes, corporate taxes, etc.). Note the
definition has two parts: outlays AND revenue. The primary deficit’s outlays are unaffected
since it excludes net interest payments, thereby making “false” a seemingly correct response.
– However, an increase in interest rates, ceteris paribus, decreases aggregate demand (e.g., less
investment) thereby reducing output (income). Lower income results in lower tax revenue
thereby increasing the primary deficit.
7 Bonus
question; i.e., do this question last. ©
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ECON 121 – Principles of Macroeconomics
Exam II – Summer 2015 – Solutions
7. When Gerald Ford8 took office, he and his economic advisers considered inflation as the main economic
problem facing the nation. In late 1974, speaking before a joint session of Congress, Ford called for a
tax hike, cuts in federal spending, and the creation of a voluntary inflation-fighting organization, named
“Whip Inflation Now” (WIN). However, in the next few months the unemployment rate soared9 , and in
his State of The Union message in January of 1975, the president abandoned his proposed tax increase
in favor of a significant tax cut to fight recession, which Congress passed by March of that year.
(a) Would expansionary or contractionary fiscal policy be used to fight recession? Explain.
• [1 point] Expansionary fiscal policy.
• [2 points] Expansionary fiscal policy: An increase in government purchases for goods and
services, a decrease in net taxes, or some combination of the two, for the purpose of increasing
aggregate demand and thus boosting output.
(b) The output gap, the difference between current output and potential GDP, was estimated to be
approximately $267 billion in the first quarter of 1975. What information would policymakers need
to successfully close the output gap with a tax cut. [Hint: would the tax cut need to equal the entire
output gap?] Explain in detail; i.e., be specific.
• [4 points] For discussing and explaining the concept of a (tax) multiplier, generally or specifically; MPC/MPS.
• The tax multiplier is the ratio of the change in the equilibrium level of output to a change in
taxes. In an economy with only autonomous taxes the tax multiplier equals
tax multiplier =
MPC
∆Y
=−
∆T
1 − MPC
• Marginal propensity to consume (MPC): The fraction of any change in (disposable) income spent
for consumer goods; equal to the change in consumption divided by the change in (disposable)
income.
(c) What fiscal policy complication explains the Ford Administration’s turn around in policy from late
1974 to early 1975? Identify and explain.
• [2 points] for identification. The Ford Administration suffered from a dramatic case of a
common problem in policy making: recognition lag.
• [2 points] for explanation. Usually policy makers need several months to recognize that a
problem is developing. Although many statistics are available fairly quickly, sometimes within
a few weeks, revisions months later can change the message that they give. Also, there is much
random movement in many series, so that a one or two month movement may not indicate
that anything important is happening. Only when several months have passed can one see any
patterns that are developing.
8 38th
President of the United States, serving from 1974 to 1977.
rose from 4.8% in the fourth quarter of 1973 to 8.9% in the second quarter of 1975. For over five quarters
(from the end of 1973 through March 1975) real GDP per capita fell at an annual rate of 3.8%.
9 Unemployment
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ECON 121 – Principles of Macroeconomics
Exam II – Summer 2015 – Solutions
8. In September 2014 Narendra Modi, India’s prime minister, announced the “Make in India” campaign10 .
A primary goal of the campaign is to increase manufacturers’ share of GDP by cutting red tape for firms;
i.e., less business regulations. Assume the program is successful.
(a) [12 points] Demonstrate the change in business regulations using the closed AD −AS model, ceteris
paribus, in both the short-run and long-run. State explicitly what occurs to the (i) price level, (ii)
natural rate of output, (iii) output, (iv) nominal wage, (v) and money supply; i.e., increase, decrease,
unchanged, or ambiguous. Clearly explain the economic rationale for why the curve(s) shift, if at
all, and for the change in the variables of interest. [Note: this is the self-correcting version.]
P
LRAS
AS1 (W1 )
AS0 (W0 )
z
P2
b
P1
a
P0
AD1 (I1 )
AD0 (I0 )
Y0 = Y2 = Y0n
Y1
Y
• Short-Run (a − b)
– ↓
(i)
(ii)
(iii)
ceteris paribus
business regulations −−−−−−−−−−→↑ I −→ AD curve shifts rightward
∆P > 0 (P1 > P0 )
∆Y n = 0
∆Y > 0 (Y1 > Y0 )
· Y > Y n ; expansionary pressure
(iv) ∆W = 0
· Fixed in the short-run as part of the model’s assumptions.
(v) ∆M = 0
· Unchanged; M is an exogenous (given) monetary policy variable.
• Long-Run (b − z)
– Nominal wages become flexible in the long-run. In the short-run, due to increased investment
expenditure, Y > Y n ; i.e., expansionary pressure. When contracts are renegotiated or new
workers hired, workers will receive a higher nominal wage (↑ W ). ↑ W −→ raises input
prices for firms, thereby decreasing production. The SRAS will subsequently shift leftward
until the economy returns to long-run equilibrium (Y = Y n ).
(i) ∆P > 0 (P2 > P0 )
(ii) ∆Y n = 0
(iii) ∆Y = 0 (Y2 = Y0 )
(iv) ∆W > 0
(v) ∆M = 0
10 Financial
Times “Narendra Modi Issues a ‘Make in India’ Plea to Business”, by Amy Kazmin 25 September 2014
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ECON 121 – Principles of Macroeconomics
Exam II – Summer 2015 – Solutions
(b) [12 points] Assume the Reserve Bank of India (RBI), India’s central bank, wants to target inflation.
Suggest a monetary policy (i.e., expansionary and/or contractionary) and demonstrate the change
in monetary policy using the closed AD − AS model, ceteris paribus, after the initial short-run shock
(i.e., short-run from part (a) above), but before the nominal wages and prices are fully flexible. State
explicitly what occurs to the (i) price level, (ii) natural rate of output, (iii) output, (iv) nominal
wage, (v) and money supply; i.e., increase, decrease, unchanged, or ambiguous. Clearly explain the
economic rationale for why the curve(s) shift, if at all, and for the change in the variables of interest.
How does the monetary policy situation differ, comparing the variables of interest, from the selfcorrecting version [part (a)]?
P
LRAS
AS0 (W0 )
b
P1
P2 = P0
z0
AD1 (I1 , M0 )
Y0 = Y2 = Y0n
Y1
AD0 (I0 , M0 ) = AD2 (I1 , M1 )
Y
• Short-Run [Identical to part (a) above]
• (Contractionary) Monetary Policy (b − z 0 )
(i) ∆P = 0 (P2 = P0 )
(ii) ∆Y n = 0
(iii) ∆Y = 0 (Y2 = Y0 )
(iv) ∆W = 0
(v) ∆M < 0 [contractionary monetary policy]
• Comparison (Long-Run [self-correcting mechanism (sc)] vs. Monetary Policy (mp))
Psc > Pmp
Wsc > Wmp
Ysc = Ymp
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ECON 121 – Principles of Macroeconomics
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Bonus Questions
1. [1 point] What year was the FDIC established?
1933/1934
2. [1 point] Under the complications of fiscal policy three lags were listed. Of the three, which is
not a problem for conducting monetary policy?
Law-making or legislative lag
3. [1 point] In what year did Congress pass the
Federal Reserve Act thereby creating the Federal
Reserve?
1913/1914
4. [2 points] What is commodity money? Provide
one example.
• commodity money: goods used as money
that also have value independent of their
use as money.
• There are several. For example, animal
skins or precious metals.
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