Exam 2 Sample QuestionsIdentify and explain the significance of:Inventory adjustment mechanism GDP gap Excess ReservesThree types of unemploymentinventory adjustment mechanismQuantity theory of moneyFrictional unemploymenteffects of unanticipated inflation on creditorsThree functions of moneyDefault riskConsumer Wealthhow inflation affects creditors1. Use the Quantity Theory of Money to explain inflation.2. If you were a member of the Federal Reserve Board of Governors, what three policies would you suggest to combat inflation? Why? Explain carefully.3. Using money and bond market diagrams, illustrate and briefly explain effects the effects of your suggested open market operation.4. Assume: (a) the economy is initially in equilibrium at noninflationary full-employment GDP (*Y) (b) due to terrorist attacks, the consumption function shifts downward by $100 billion and (c) the marginal propensity to consume is 0.8. Usinga Keynesian total expenditure (TE)/aggregate supply (ASK) diagram, illustrate and explain the probable macroeconomic effects of the decline in consumer spending.5. How big a tax cut would be needed to restore full-employment under the circumstances outline above? Show your calculations.6. First, use the Quantity Theory of Money and the standard assumption of constant velocity to explain the hyper inflation experienced by the Confederate states during the American Civil War. Now, suppose that velocity is not necessarily constant. How do you think velocity may have changed due to the extremely high wartime inflation? Why? Would the change in velocity tend to reduce or intensify the inflationary pressure in the economy? Why?7. Suppose that the Fed’s policy objective is to keep the nominal interest rate (i) constant. How would a Fed with this policy objective respond to an increase in money demand? Why? Illustrate your answer with diagrams of the money and bond markets.8. Suppose that there is an initial GDP gap of $20 billion. Now suppose that MPC = .8 and government spending (G) is increased by $2 billion and at the same time taxes (T) are decreased by $2 billion. Will this combination of policies restore noninflationary full-employment GDP (Y*)? Why or why not? Show your calculations and illustrate your answer graphically.9. Assume: (a) the economy is initially in equilibrium at noninflationary full-employment GDP (Y*) (b) government spending (G) is cut by $8 billion (c) taxes (T) are cut by $10 billion and (d) the marginal propensity to consume (MPC) = 0.89a Using your knowledge of the government spending and tax multipliers, calculate the change in Y caused by the decreasein government spending then calculate the change in Y caused by the decrease in taxes.9b Using a Keynesian Total Expenditure (TE)/aggregate supply (ASK) and aggregate injections (J)/aggregate withdrawals diagram (W), illustrate and briefly explain the combined effects of the spending and tax cuts. What, if any, problem would the economy be experiencing after these fiscal policy changes?10. Use a consumption function diagram and brief verbal descriptions to explain: “From 1927 to 1929, the Federal Reserve fueled the prosperity of the “Roaring Twenties” by repeatedly lowering interest rates. When the market crash wiped out consumer wealth in 1929, however, the Fed reacted by raising interest rates. Many economists believe this credit “tightening” made the decline in overall economic activity even worse.”11. Suppose initially that: velocity (V) is constant and there is no inflation. Now suppose that velocity (V) increases. If thepolicy objective is to prevent inflation, how would the Fed respond to this exogenous change in velocity? Use the Quantity theory of Money to explain your answer.12. What are the three major economic effects of inflation? Be sure to carefully explain the effects of inflation on debtors and creditors.13. Congressional Republicans recently proposed a $25 billion tax cut. Congressional Democrats recently proposed a $50 billion increase in government spending.13a Assuming MPC = .8, calculate the combined effects of these actions on nominal GDP (Y). Show your calculations.13b Assuming that the economy is currently operating at full-employment (= Y*), what macroeconomic problem will these policies create? Why?13c Using a Keynesian aggregate injections (J)/aggregate withdrawals (W) diagram, illustrate the combined effects of thesepolicies.14. Consider the following: “Some Clinton Administration officials have urged the Federal Reserve (Fed) to lower interest rates in an attempt to increase the growth rate of real output. These officials claim that real growth will accelerate while inflation remains at its current rate (about 3% per year). Fed Chairman Alan Greenspan has rejected the Administration’s proposals arguing that such expansionary monetary policy would simply result in higher inflation while real output growth remains the same.”14a Use the Quantity Theory of Money to analyze the Administration’s and Chairman Greenspan’s contentions. 14b If the Fed decides to lower interest rates, what open market operations would they use? Illustrate these “expansionary”open market operations using supply/demand diagrams of the money and bond markets.15. First, suppose the economy is operating at non-inflationary full-employment Y*. Now, suppose that government spending (G) and taxes (T) are increased by the same amount. Show your knowledge of the government spending (mG) and tax (mTAX) multipliers in predicting the effects of this equal increase in G and T on nominal gross domestic product (Y). What, if any, macroeconomic problem would result from these policy changes? Why?16. What are the three types of unemployment? What are the economic and noneconomic costs of unemployment?17. Suppose that equilibrium GDP (Ye) exceeds noninflationary full-employment GDP (Y*) by $100 billion. Now supposethat MPC = .8 and taxes (T) are decreased by $100 billion while at the same time government spending (G) is decreased by $100 billion. Will this combination of policies restore noninflationary GDP at Y*? Show all of your calculations and illustrate your answer with a Keynesian TE/aggregate supply (ASK) diagram which also shows injection (J) and withdrawals(W). (Hint: calculate the effects of the government spending cut and the tax cut on nominal GDP separately then add the effects together).18. The equation of