Problem Set #6 (Spring 2008) 1/10Name: _______________________ SID: _______________________ Discussion Section: _______________________ Problem Set #6 ANSWERS Due Tuesday, May 6, 2008 Problem Sets MUST be word-processed except for graphs and equations. When drawing diagrams, the following rules apply: 1. Completely, clearly and accurately label all axes, lines, curves, and equilibrium points. 2. The original diagram and any equilibrium points MUST be drawn in black or pencil. 3. The first change in any variable, curve, or line and any new equilibrium points MUST be drawn in red. 4. The second change in any variable, curve, or line and any new equilibrium points MUST be drawn in blue. 5. The third change in any variable, curve, or line and any new equilibrium points MUST be drawn in green.Problem Set #6 (Spring 2008) 2/10QUESTIONS A. Multiple Choice Questions. Circle the letter corresponding to the best answer. (1 point each.) 1. Assume that the currency holding ratio is 0.15, the required reserve ratio is 0.1, and the excess reserve ratio is 0.05. The Federal Reserve carries out open market operations, purchasing $1 billion worth of bonds from commercial banks. This action will increase the money supply by: a. $1 billion. b. $2 billion. c. $3 billion. d. $4 billion. 2. Suppose there is a banking crisis. The money supply would shrink by the greatest amount if the public _______ their currency holding ratio and the commercial banks _______ their excess reserve ratio. a. Decreased; decreased. b. Decreased; increased. c. Increased; decreased. d. Increased; increased. 3. In the Keynesian model, suppose the Federal Reserve sets a target for the money supply. If the IS curve shifts to the left, and the Fed wants to keep output unchanged, then the Fed should: a. Reduce taxes. b. Reduce the money supply. c. Increase taxes. d. Increase the money supply. 4. Which of the following statements would a monetarist DISAGREE with? a. Monetary policy has few short-run effects on the real economy. b. In the long run, changes in the money supply primarily affect the price level. c. In practice, there is little scope for using monetary policy actively to smooth out business cycles. d. The Federal Reserve cannot be relied on to effectively smooth out business cycles. 5. According to the Taylor rule, if inflation in the past year was 6% and output was 2% below its full-employment level, the nominal federal funds rate should be: a. 3%. b. 5%. c. 7%. d. 9%.Problem Set #6 (Spring 2008) 3/106. There is _______ relationship between inflation and central bank independence and _______ relationship between long-run rates of unemployment and central bank independence. a. A negative; no. b. A negative; a negative. c. A positive; no. d. A positive; a negative. 7. The primary current deficit is: a. Current expenditures – tax revenues. b. Current expenditures + transfers + net interest – tax revenues. c. Current expenditures – net interest – tax revenues. d. Current expenditures + transfers – tax revenues. 8. Because of automatic stabilizers, in recessions the government budget balance _______ while in expansions the balance _______. a. Falls; rises. b. Falls; falls. c. Rises; falls. d. Rises; rises. 9. Increases in the debt-to-GDP ratio are primarily caused by: a. A higher growth rate of GDP. b. A high government deficit relative to GDP. c. Increases in government borrowing through bonds. d. Increases in interest rates. 10. Suppose that the unemployment rate is below the natural rate of unemployment. Then we know that for sure that: a. The actual budget balance is below the structural budget balance. b. The actual budget balance is above the structural budget balance. c. The actual budget is in surplus. d. The cyclical budget is in deficit.Problem Set #6 (Spring 2008) 4/10B. Answer BOTH of the following questions. In both questions, assume a Keynesian short-term situation. (10 points each.) 1. IS – LM Model with Monetary Policy. Suppose that the economy is initially above its full-employment output level. The government then uses fiscal policy to move the economy to its potential output level. Once the economy reaches potential output, consumer and business confidence suddenly collapses. Use 3 separate IS-LM diagrams to accurately and clearly show and briefly explain what happens to economic output and the real interest rate when these events happen and the Fed’s response to them is to:Problem Set #6 (Spring 2008) 5/10a. Keep the money supply unchanged at its initial level. Because the economy starts above its full-employment output level at Y0, the government needs to use a contractionary fiscal policy, i.e., lower G and/or higher t, in order to move the economy back to full-employment output. This shifts the IS curve to the left to IS1 and decreases economic output. Because of the decrease in economic output/income, the demand for money falls. With a fixed supply of money, interest rates decline to R1, which stimulates some interest-sensitive spending, and limits the decrease in equilibrium income to Y1, which equals Y*. Once full-employment output is reached both consumer and business confidence collapse. This decreases autonomous consumption and investment and shifts the IS curve to the left to IS2 and decreases economic output. Because of the decrease in economic output/income, the demand for money falls. With a fixed supply of money, interest rates decline to R2, which stimulates some interest-sensitive spending, and limits the decrease in equilibrium income to Y2. Net Result: Lower income, lower interest rates. R R0 R1 R2 Y2 Y*=Y1 Y0 Y LM0 IS2IS1 IS0Problem Set #6 (Spring 2008) 6/10b. Keep the real interest rate unchanged at its initial level. Same as in part a except that now the Federal Reserve reduces the money supply in order to keep interest rates unchanged at R0. This shifts the LM curve to the left to LM3. With the supply of money now less than the demand for money, interest rates rise back to R3 = R0. Higher interest rates restrain some interest-sensitive spending and decreases economic output further to Y3. Net Result: Even lower income and much higher interest rates than in scenario #1. R R0 = R3 R1 R2 Y3 Y2 Y*=Y1