Exam #2

Question 1

What is a Fractional Banking System ?

Answer 1

A system in which banks hold a fraction of their deposits as reserves. Fractional reserve banking systems create money but doesn’t create wealth: Bank loans give borowers some neew money and an equal amount of debt.

Question 2

Money Multiplier

Answer 2

the increase in the money supply resulting from one-dollar increase in the monetary base

Question 3

What is the Velocity of Money?

Answer 3

the rate at which money circulates

the number of times the average dollar bill changes hands in a given time period

Question 4

Velocity of Money Equation

Answer 4

V= (P*Y)/M

where V=velcoity, T=value of all transactions(Nominal GDP P*Y), M=Money supply,P=Price of output(GDP deflator), Y=Quanity of output(real GDP)

Question 5

Fisher Equation

Answer 5

i=r+(pi); therefore an increase in pi (inflation) causes an equal increase in i. one for one effect

Question 6

The oppourunity cost of holding money

Answer 6

the oppournity cost of holding money is the nomial interst rate,i.

Question 7

Benefits of Inflation

Answer 7

Inflation allows the real wages to reach equilibrium levels without nomail wage cuts. Therefore moderate inflation improves the functioning of labor markets.

Nominal wages are rarely reduced even when the equilibrium wage falls. This hinders labor market clearing.

Question 8

Costs of Inflation

Answer 8

1. the shoeleather cost:the costs and inconveniences of reducing money balances to avoid the inflation tax. If inflation ^ then i^ which causes real money balances to decrease
2. Menu Costs:the costs of changing prices-the higher the inflation the more frequently firms must change their prices and incur these costs
3. Relative price distortions:
4. Unfair Tax Treatment: some taxes are not adjusted to account for inflation such as the capital gains tax.
5. General inconvenience: Inflation make it harder to compare nominal values from different time periods.
6. Arbitrary redistribution of purchasing power
7. Increased Uncertainty: when inflation is high, its more variable and unpredictable.

Question 9

Quantity of Money Theory

Answer 9

Quantity of Money Equation= M*V=P*Y, pi=inflation=(DeltaM/M)-(DeltaY/Y);

Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions. Money growth in excess of this amount leads to inflation. DeltaY/Y depends on the growth in the factors of production and technological process.

Question 10

IS Curve

Answer 10

The IS curve represents equilibrium in the goods market.

Y= C(Y-_T)_ + I (r) + G underline indicates constant

Question 11

Okun’s Law

Answer 11

Okun’s law: the negative relationship between GDP and unemployment.

Question 12

Three Types of Unemployment

Answer 12

Natural Rate of Unemployment;Fricitonal Unemployement; Structural Unemployment

Question 13

Money

Answer 13

is the stock of assets that can be realiy used to make transactions

Question 14

Functions of Money

Answer 14

Medium of exchange: we use it to buy things;Store of Value:transfers perchasing pwer from the present to the future; Unit of Account:the common unit by which everyone measures prices and values.

Question 15

Types of Money

Answer 15

1. Fiat Money: has no intrinisic value(paper currency)
2. Commodity Money: has intrinsic value(gold coins)

Question 16

Monetary Control

Answer 16

Monetary policy is conducted by the central bank(Federal Reserve). To control the money supply the fed uses open market operations, the puracase and sale of government bonds

Question 17

Reserves (R)

Answer 17

the portion of deposits that banks have not lent

Question 18

Implications of the Quantity theory of money

Answer 18

the quantity theory of money predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate. Implies two things: (1) counties with higher money growth rates should have higher inflation rates. (2) The long-run trend in a country’s inflation rate should be similar to the long-run trend in the country’s money growth rate.

Question 19

Real interest rate,r, adjusted for inflations

Answer 19

r=i-(pi); S=I which determines r

Question 20

Quanity Theory of Money Summary

Answer 20

Quantity theory of money -assumes velocity is constant - concludes that the money growth rate determines the inflation rate - applies in the long run -consistent with cross-country and time-series data

Question 21

Costs of Inflation

Answer 21

Costs of inflation Expected inflation shoeleather costs, menu costs, tax & relative price distortions, inconvenience of correcting figures for inflation Unexpected inflation all of the above plus arbitrary redistributions of wealth between debtors and creditors

Question 22

Fricitonal Unemployment

Answer 22

frictional unemployment: caused by the time it takes workers to search for a job

• occurs even when wages are flexible and there are enough jobs to go around
• occurs because
• >workers have different abilities, preferences
• >jobs have different skill requirements
• >geographic mobility of workers not instantaneous
• >flow of information about vacancies and job candidates is imperfect

Question 23

Reasons for wage rigidity

Answer 23

Reasons for wage rigidity 1. Minimum wage laws 2. Labor unions 3. Efficiency wages

Question 24

Natural Unemployement

Answer 24

the long-run average or “steady state” rate of unemployment; depends on the rates of job separation and job finding

Question 25

Structural Unemployment

Answer 25

results from wage rigidity: the real wage remains above the equilibrium level caused by: minimum wage, unions, efficiency wages

Question 26

The Keynsian Cross

Answer 26

A simple closed economy model in whihc income is determined by expenditure.

I= planned investment

PE= C +I + G = planned expenditure

Y= real GDP= actual expenditure

The difference between actual and planned expenditure = unplanned inventory investment

Question 27

Government Purchases Multiplier

Answer 27

The increase in income resulting from a $1 increase in G. The mulitplier is generally greater than 1.

∆Y/∆G = 1/ (1-MPC)

MPC - marginal propensity to consume

Question 28

Implciations of Flexibile/Sticky Prices long/short run

Answer 28

In the long run prices are flexible, outut and employment are at their natural rates and the classical theory applies

In the Short run prices are sticky, shocks can pus output and employment away from their natura lrates.

Question 29

When Prices are sticky

Answer 29

When prices are sticky output and employement depend on demand, which is effected by Fiscal Policy ( G and T), Monetary Policy (M), and exogenous changes ( C or I).

Question 30

Tax Multiplier

Answer 30

The tax multiplier is negative: A tax reduces C which reduces income.

The tax mulitplier is greater than 1 because a change in tax has a multiplier effect on income

The tax mulitplier is smaller than government the government spending multiplier: Comumers save the fraction of a tax cut so the intital boost in spending from a tax cut is smaller than from an equal increase in G.

Question 31

LM Curve

Answer 31

the LM curve represents the money market equilibrium

M/P= L(r, Y)

the intersection determines the unique combination of Y and r that satisfies equilibrium in both markets

Question 32

The Phillips Curve

Answer 32

Phillips curve is derived from the SRAS curve

• states that inflation depends on expected inflation, cyclical unemployment, and supply shocks
• presents policymakers with a short-run tradeoff between inflation and unemployment

Question 33

What shifts the IS curve?

Answer 33

Changes in Government Purchases or Taxes- increase/decrease in taxes or government spending

IS Curve Shocks:

• Stock market boom or crash -> change in wealth will change consumption
• Change in consumer confidence or business confidence will cause a change in I or change in C

Question 34

What shifts the LM curve?

Answer 34

Changes in Monetary Policy- an increase/decrease in money supply

LM Shocks: a wave of credit card fraud may increase the demand for money.

More ATMs or the internet reduce the money demand

Question 35

What is a supply shock & give examples?

Answer 35

A supply shock alters production costs and affects the prices that firms charge.

Examples of Supply Shocks are:

• Bad weather reducing crop yeilds, increasing food prices
• Works unionize increasing wages
• New environmental regualations that require emission reductions. Firms must increase prices to cover compliance costs.

Favorable Supply Shocks LOWER costs and prices

Question 36

IS-LM Model

Answer 36

Can be used to analyze the effects of fiscal policy ( G and/or T) and Monetary Policy (M).

Question 37

In the Long Run

Answer 37

In the long run prices are flexible, output is determined by factors of production & techonology, unemployment equals its natural rate.

Question 38

In the Short Run

Answer 38

Prices are fixed, output is determined by aggregate demand, unemployment is negatively related to output