Second Midterm, November 1998

 

What follows is discussion and explication of the questions that caused the class most difficulty.

  1. Suppose the US Treasury finances a budget deficit by selling securities to the public. The money supply will

    2. Remain unchanged as long as the government spends what is borrowed.

    The Treasury is not the monetary authority, the Federal Reserve is. The Treasury is selling new securities to the public, i.e. borrowing on behalf of the government, to finance a deficit. Bank reserves are not changing; the public buys the securities, the government gets the money from the public and then spends it again, so the public gets it back, the money supply is unchanged.

  2. Suppose the Fed purchases $100 million of U.S. securities from the public. The reserve requirement is 20% and all banks have zero excess reserves before the Fed's purchase. The total impact of this action on the money supply will be at most

    3. $500 million increase in the money supply.

    When the Fed buys securities from the public, the reserves of the commercial banks increase by that amount. So the banks get $100 million of additional reserves. If the required reserve ratio is 20%, $5 of deposits require $1 of reserves, or each $1 of reserves can potentially support $5 of liabilities (deposits). If all banks lend out all excess reserves, and nothing leaks out of the banking system into currency in circulation, the maximum change in money supply (currency in the hands of the public + checking account balances + traveler's checks) is 5 [= 1 divided by 20%, i.e. 1/0.2] times $100 million equals $500 million. When a bank makes a loan, the borrower normally intends to spend the loan, so the money lent comes back into the banking system as a deposit in someone else's checking account.

  3. In the Keynesian aggregate expenditure model, if an economy has lots of unused capacity, which of the following would be the most likely final result of an autonomous $6 billion increase in investment?

    4. An increase in the equilibrium level of income by more than $6 billion.

    OK, this is the other kind of multiplier, the Keynesian expenditure multiplier. The key words in the question are Keynes, unused capacity, and final. The extra $6 billion of investment is extra spending that produces extra output (the unused capacity) and therefore extra income for households of $6 billion; but the households themselves will then spend some fraction [mpc, marginal propensity to consume] of that extra income, and that extra consumption spending will itself generate additional output and income [the unused capacity again], and so on …. So the final result will be a greater increase in the equilibrium level of income (where the level of income and output equals planned level of expenditure on final output) than the initial increase in autonomous expenditure.

  4. If an economy operating in the Keynesian range of its SRAS has a marginal propensity to consume of 2/3 and the government wants to boost real output by $300 billion, by how much should it increase autonomous expenditure?

    5. $100 billion.

    This time you have to do the numerical calculation of the multiplier. In simple models, the expenditure multiplier is 1/(1 - mpc), i.e. one divided by one minus the marginal propensity to consume, or in this case one divided by (1 - 2/3) equals 1/(1/3) equals 3. So if it wants real output up by $300 billion (the final equilibrium change), it needs to increase autonomous expenditure by ($300 billion)/3, i.e. $100 billion [because $100 billion times the multiplier, 3, is $300 billion].

  5. Which of the following best characterizes the circular flow of income?

    6. Businesses buy resources from households, and households use their income to buy goods and services from husinesses.

    This was the fourth response, so perhaps lots of people did not read that far. Otherwise, I am at a loss to explain why this question caused trouble; the other responses all seemed clearly wrong to me -- they did not reflect the circular flow -- check the book or your notes if you don't understand still.

  6. Under what conditions is the Keynesian aggregate expenditure model most relevant?

    7. When an economy operates below its full-employment capacity.

    The major idea of the Keynesian model is that when capacity is not a constraint, output is determined by expenditure on output. Capacity is not a constraint if the economy is operating with unused capacity, i.e. unemployment more than the full employment level, of intersection of AD and SRAS to the left of LRAS.
  7. An increase in the nominal interest rate would

    8. Encourage people to hold smaller money balances

    By convention, money balances means cash (currency) plus checkable deposits plus traveler's checks; none of these earn interest (admittedly, some checkable deposits may earn a little interest, but not nearly as much as alternative less liquid assets, and most earn none). So the nominal interest rate measures the opportunity costs of holding money (it is what you give up by holding money rather than, say, a deposit in a savings account). If the nominal interest rate goes up, it has become more expensive to hold money (you are giving up more interest you don't earn); when things become more expensive, ceteris paribus you do less of them, i.e. hold smaller money balances.

  8. In the aggregate demand/aggregate supply model, when the output of an economy is less than its long-run potential, the economy will experience

    9. Falling real wages and resource prices that will stimulate employment and real output.

    This is simply the adjustment mechanism assumed in this model, namely that if there is excess capacity (output less than potential, intersection of AD and SRAS to left of LRAS), the economy will adjust back to LRAS (full-employment) by input prices (wages and resource prices) falling, increasing demand for them and thus output and employment, until LRAS is reached again. The contrast with the Keynesian model (6. above) is that in the Keynesian model it is assumed that this adjustment process may be very slow, or not occur at all.

  9. The demand curve for money

    10. Shows the amount of money balances that individuals and businesses wish to hold at various interest rates.

    This is just a definition. Remember, the "demand for money" is not how badly you want to get rich, but, given your wealth, how much of your total wealth you wish to hold in the particular asset money, on which you do not earn interest -- so the "price" of holding money is the opportunity cost, the interest rate you could have earned if you had put that wealth in an interest-earning asset instead of money.

  10. If the Fed wanted to use all three of its major monetary control tools to increase the money supply, it would

    11. Buy bonds, reduce the discount rate, and reduce reserve requirements.

    If the Fed buys bonds, people get money, banks get more reserves, the money supply increases;

    If the Fed reduces the discount rate, it signals that it intends to expand the money supply, and it becomes cheaper for banks to borrow reserves from the Fed, so they are likely to plan to have fewer excess reserves, which will expand the money supply;

    If the Fed reduces reserve requirements, each $1 of reserves can support more $s of bank liabilities, i.e. balances in checking accounts, so with the same amount of reserves the money supply can increase so long as the banks make the extra loans they now can with their excess reserves.

    This question was basically definitional; you need to know it.
  11. The Federal Reserve's most frequently used monetary tool is

    12. Open market operations

    i.e. buying/selling existing government securities from/to the public, thereby changing the amount of reserves available to the banking system. This is factual, you should have remembered it.

  12. If unemployment were 3 percent and prices were rising 12 percent annually, which of the following would be the most appropriate policy?

    13. The sale of US securities by the Federal Reserve

    Unemployment of 3 percent is less than what in the US is considered full employment; prices rising 12% a year is more than in the US is normally considered an acceptable rate of inflation. So the economy is "overheated," the appropriate policy will be a restrictionary one, reducing AD or the money supply. If the Fed sells securities, when it is paid money disappears, bank reserves are reduced -- so the money supply is reduced, that is restrictionary monetary policy. All the alternatives offered were expansionary.

  13. When the planned spending of consumers, businesses, government and foreigners (net exports) is less than the income level of the economy, the Keynesian model suggests that

    14. Output will fall

    The Keynesian model suggests that output is determined by expenditure on output; if planned expenditure is less than output, business inventories will increase in an unplanned manner, so next period businesses will produce less to bring their inventories back to the desired level, i.e. output will fall.

  14. Keynesian analysis suggests that a planned budget deficit is

    15. Proper during slack economic conditions but inappropriate if the economy is already operating at capacity

    A planned budget deficit (G > T) tends to increase AD or aggregate expenditure (G is part of AD itself, reduced T increases household income so should increase C). So that should tend to increase aggregate expenditure and therefore output, which is appropriate if conditions are slack, i.e. AD is cutting SRAS to the left of LRAS, we have more than the full-employment level of unemployment. A popular response to this question was "an effective method of dealing with inflation" -- NO, it would not "deal" with inflation, it would tend to exacerbate inflation, i.e. make it worse.
  15. According to the Keynesian view, which of the following would most likely decrease aggregate demand?

A decrease in government expenditures

G is part of aggregate demand, so decreasing it decreases aggregate demand. [AD = C + I + G + (X - M)] All the alternatives offered increased AD.

The questions discussed above were the ones that the most people missed. In most cases, I do not think they were really hard questions. FSU students sometimes do not approach exams with a good game plan; among other things, it is important to NEVER PANIC, and READ ALL THE RESPONSES on multiple choice questions. In most cases, you know much more than you think you do -- take it slowly, think about the responses, you will generally be able to figure out which is best.