Exam 2 Sample Questions Identify and explain the significance of Inventory adjustment mechanism GDP gap Excess Reserves Three types of unemployment inventory adjustment mechanism Quantity theory of money Frictional unemployment effects of unanticipated inflation on creditors Three functions of money Default risk Consumer Wealth how inflation affects creditors 1 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 Using a 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 8 9a Using your knowledge of the government spending and tax multipliers calculate the change in Y caused by the decrease in 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 the policy 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 these policies 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 suppose that 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 exchange MS x V P x Q Y is true by definition at a point in time Now suppose that the money S supply is initially M 0 100 while V is constant at 5 and initial nominal GDP Y0 500 Finally suppose that Y 600 and the Fed s required reserve ratio RRR 20 18a Under the conditions described