Unit 06: Open-Economy - International Trade and Finances

Question 1

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06.01

Modern Theories

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Question 2

Why do experts disagree in economics (4) ?

Answer 2

1. Different Time Period
   
   • one might be discussion one month and the other a year
2. Different Assumptions
3. Different Theories
   
   • might be Keynesian or Classicalist
4. Different Values
   
   • some belief inflation more important

Question 3

What is the Monetarism Theory?

Answer 3

• associated withh Milton Friedman (same as Classical theory)
• argued Keynesian policy ineffective → because of crowding out and crowding in

What:

Economy is stable in the long run

• Follow MONETARY RULE (increase money supply by 3-5% per year to spur matching increase in GDP)
• Not enough money flowing through economy to sustain inflation
• (Recession) injection of money increase output causing unemployment to decrease

Question 4

What is the Supply Side Economics Theory?

Answer 4

Ronald Reagan, “Government is not the answer to your problems; Government is the problem”

• what mean: decades taxation and regulations cause reduced nation’s ability to produce maximum levels of efficiency
• Result: reduced aggregate supply of nation
  
  • permanent state of reduced output
• Resolve: Shifting AS curve back to the right

Question 5

How can supply side economics be implemented?

Answer 5

(Theory) all the government has to do is tax and regulate businesses less

• question “who gets the tax?”
  
  • Supply answer: “businesses”
  • why: based on AS/AD model: businesses are the producers → their tax burden increases the AS curve → shift line to right

Question 6

What are the advantages to Supply Side economics?

Answer 6

1. Reducing Tax Rate: businesses stimulates production and increases output
2. Reduce tax rate for the wealthier → more likely to purchase goods that will stimulate GDP
3. If government needs to borrow money to pay budget deficit → issue bonds
4. Reducing government regulations on business community: stimulate national economy

Question 7

What are the disadvantages of the Supplied Side Economy?

Answer 7

1. If the government reduces tax: cut back the amount of services will provide
2. Lowering taxes for the wealthy: cause a growing divergence between upper and lower classes → jeopardizing middle class
3. Issuance bonds: increase national debt
4. Without adequate government regulatiosn: businesses more likely pollute environment, take advantge workers

Question 8

What is the Rational Expectations Theory?

Answer 8

• John Muth: others ineffective because people will make their decisions based on all the avaliable information
  
  • People expect economic changes as price level increase
  • If inflation and Fed increased discount rate: not be effective because people were expecting change
• Only effecitive is citizens are surprised by the change

Other economists believe that Muth’s findings were overstated and that is why rational expectations theory is not popular among economic decision makers.

Question 9

06.02 Fiscal Policy Review

♣ 06.02 Fiscal Policy ♣

Question 10

06.02 Fiscal Policy Review

What is the purpose of Fiscal policy? What is the difference between expansionary and contractionary?

Answer 10

Government’s effort to manage economy

1. Expansionary Fiscal Policy: increasing spending or decrease income tax
2. Contractionary Fiscal Policy: decrease spending or increase income tax

Question 11

06.02 Fiscal Policy Review

What is the cause and effect of “increased aggregate demand”?

Answer 11

why: stimulate economy

what:

1. Government Expenditures:
   
   • increase spending programes
   • increase AD → more jobs, more income, more spending
   • Ouput and price levels increase when AD increases
   • Employment increases when output increases
2. Personal Income Tax:
   
   • Decrease personal income taxes → more disposable income taxes
   • Consumer spending increases → increase AD
   • Output and price levels increase when AD increases
   • Employment increases when output increases

Question 12

06.02 Fiscal Policy Review

What can the government do to increase aggregate demand?

Answer 12

why: slow down economy

1. Government Expenditures:
   
   • Decreaes
   • Decrease AD → cutbacks in pay, less income, less spending
   • Output & price levels decrease when AD decreases
   • Employment decreases when ouput decreases
2. Personal Income Taxes:
   
   • Increase (raise)
   • Less disposable income
   • Output & price levels decrease when AD decreases
   • Employment decreases when ouput decreases

Question 13

06.02 Fiscal Policy Review

How do congress and state government limit the effect of fiscal policy?

Answer 13

1. Congress takes time recognize problems in economy & to respond
   
   • politicians also have adgendas & different ideas how to fix it
   • months of negotiations take place
2. Implimentation also takes time to complete
   
   • might correct self before congress
   • (then) Congressional action worsen situation
3. State local governments take actions undermine Congressional action
   
   • might increase taxes enlarge budget

If Congress is lowering taxes to spur recovery and the state government increases taxes to balance its budget, aggregate demand will not shift as expected by the expansionary fiscal policy.

Question 14

06.02 Fiscal Policy Review

How doe state and local governments try to undermine Congressional action

Question 15

06.02 Fiscal Policy Review

What happens to expansionary fiscal policy if the government begins deficit spending?

Answer 15

• demand loanable funds increase
  
  • why: government not collect as much tax or begins spending mone
• Result: real interets rates increase
  
  • (then) private investment spending is “crowded out” (less private investment)
  • (then) AD shift right less than expected because of crowding out

Question 16

06.02 Fiscal Policy Review

How do the different economic theories view “crowding out?”

Answer 16

• Keynesian: minimal and should not be considered
• But other economic theorists have their own ideas about the extent to which crowding out occurs.

Question 17

06.02 Fiscal Policy Review

how does contractionary policy affect the demand for loanable funds and what are the effects?

Answer 17

More taxes / less spending

1. Demand loanable funds decrease & interest rates decrease
2. Private investment increases & “crowded in”

Result: AD shift left less than expected

Question 18

06.02 Fiscal Policy Review

how can congress try to combat changes in interest rates when fiscal policy changes?

Answer 18

Attempt to balance the change in spending with euqal change in taxes

Question 19

06.02 Fiscal Policy Review

What are the limiations of Fiscal Policy?

Answer 19

1. Congressional and state action
2. Net Export Effect
3. Shocks (exogenous stocks) from abroad
4. Sloped and vertical sections in SRAS

Question 20

06.02 Fiscal Policy Review

What is the Net Export Effect?

Answer 20

Change in depand for money = affects exchange rate market

• If demand dollar changes: interest rates change
• Interest rate changes: individual other nations change amount of financial capital invest in country
• Then: international value of dollar to change
• Change dollar value: change in QD of exports and imports

For example, if the U.S. Congress decreased taxes, the demand for loanable funds would increase to fund the expansionary fiscal policy causing interest rates to increase. When interest rates in the United States increase, individuals from other nations will invest financial capital in U.S. banks in order to receive a higher rate of return on their money than they would if they placed the money in their own country. The appreciation of the dollar as a result of the expansionary fiscal policy would cause American goods to become more expensive. In addition, foreign goods appear less expensive, so imports increase, making net exports more negative. As a result, GDP shifts to the right less than expected, countering the expansionary fiscal policy enacted by Congress.

Question 21

06.02 Fiscal Policy Review

How do price level changes and interest rate changes compare when government spending increases?

Answer 21

Price level changes slower than interest rates

Question 22

06.02 Fiscal Policy Review

How do economic, exogenous stocks affect fiscal policy?

Answer 22

• shock reverberates through economy → drives up prices of everythings
• government cannot plan for stocks that shift AD or SRAS & not react fast enough

Question 23

06.02 Fiscal Policy Review

How does slopes and vertical sections of the SRAS affect the multiplier?

Answer 23

When the SRAS is vertical, there is no multiplier effect.

If analysts who gather data and make recommendations don’t account for the steepness of the SRAS curve, then the impact of the change in government spending will not have the desired effect and the problem in the economy will not be solved.

Question 24

06.03 Automatic Stabilizers

♣ 06.03: Automatic Stabilizers ♣

Question 25

06.03 Automatic Stabilizers

What are discretionary policies?

Answer 25

• Congress changes taxes or fiscal policies

Discretionary Policies: policymakers take action, economics term change in taxes or spending

Question 26

06.03 Automatic Stabilizers

What are automatic or nondiscretionary fiscal policies?

Answer 26

Requires no action by government but still stabilizes the economy

• economic changes: because of ebb and flow of business cycle
  
  • more poeple working → more taxes → more government spending
  • more people working, fewer people collecting unemployment and welfare
  • Government spending less in transfer payments

Result: government surplus money used to offset any budget deficits

Question 27

06.03 Automatic Stabilizers

How can normal economic changes result in a surplus in governmental funds?

Answer 27

• economic changes: because of ebb and flow of business cycle
  
  • more poeple working → more taxes → more government spending
  • more people working, fewer people collecting unemployment and welfare
  • Government spending less in transfer payments

Result: government surplus money

used to:

1. offset any budget deficits
2. pay down public debt
3. saved time in recession

Question 28

06.03 Automatic Stabilizers

How do automatic stabilizers come into play during a recession?

Answer 28

• More poeple collect welfare & unemployment
• Government: usually deficit spending
  
  • borrow money on loanable funds

Because automatic stabilizers affect disposable income and government revenue, they help make inflation and recession less severe on the overall economy.

Question 29

06.04 Economic Impact of Deficits and Debt

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06.04

Economic Impact of Deficits and Debt

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Question 30

06.04 Economic Impact of Deficits and Debt

What is the federal budget?

Answer 30

• US budget proposed every year by President and passed by Congress as a bill
• law
• divided into 15 spending bills: $40 trillion
  
  • may borrow money in loanable funds market - pay bills
  • sell treasury bonds, bills, and notes on the open market
  • Surplus: more taxes than expenditures

Question 31

06.04 Economic Impact of Deficits and Debt

What is the national debt? Whhat are the proponents and opponents of high debt?

Answer 31

cumulative amount of deficit that was not paid off in the year it was incurred

• Opponents:
  
  • lowers standard of living
  • crowds out private investment
  • stunting research and development
• Proponents:
  
  • only a small portion of GDP
  • government’s responsibility to fund education, national defense, infrastructure
  • only 1/4 owned foreign nation

Question 32

06.05 The Federal Reserve System

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06.05

The Federal Reserve System

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Question 33

06.05 The Federal Reserve System

What is the purpose of the board of governors in the federal reserve system?

Answer 33

• 17 members (14-year term)
• Appointed by president (confirmed Senate)
• Analyze economic data
• Supervises Federal Banks
• Administers financial reguations
• Participates Federal Open market committee
• Communicates with leaders in other parts of government

Question 34

06.05 The Federal Reserve System

What are the 5 parts of the federal reserve system?

Answer 34

1. board of governors
2. federal open market committee
3. federal reserve banks
4. member banks
5. other depository institutions

Question 35

06.05 The Federal Reserve System

What is the federal open market committee?

Answer 35

• Board of governors, President NY Reserve, and 4 other reserve bank presidents
• Gathers 8 meetings per year in Washington
• Discusses economic outlook and potential adjustments

Question 36

06.05 The Federal Reserve System

What are Federal Reserve Banks?

Answer 36

• Comprised of 12 Federal Reserve Banks, each serving its own region of the United States
• 25 branch banks throughout the 12 districts
• Provide service to banks and the U.S. Treasury, also known as “the bankers’ bank”
• Supervise bank operations within their region
• Handle check collection, electronic funds transfer, distribution of currency and coin to banks
• Provide service as banks for U.S. Treasury accounts–issue and redemption of U.S. government securities

Question 37

06.05 The Federal Reserve System

What are the Member Banks?

Answer 37

• Consist of 38% of commercial banks (like Bank of America®)
• Are stockholders in regional Federal Reserve Bank, receive dividends
• Receive services from regional Federal Reserve Bank

Question 38

06.05 The Federal Reserve System

What are Other Depository institutions?

Answer 38

• Not technically considered part of the Federal Reserve System, yet subject to regulations
• Include credit unions, savings and loan associations, commercial banks, and savings banks
• Receive services from regional Federal Reserve Bank

Question 39

06.06 Introduction to Monetary Policy

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06.06

Introduction to Monetary Policy

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Question 40

06.06 Introduction to Monetary Policy

What is the Money Market Graph? How does it interact with the Investment demand graph?

Answer 40

Reflects nominal interest rates (as opposed to real interest rates) that are shown in the loanable funds graph.

• Supply: Vertical (finite amount of money in the money system)
• drawn alongside investment demand graph (no supply curve)

Line connects 2: shows quantity of investment demanded at specific interest rate

Question 41

06.06 Introduction to Monetary Policy

What is the investment demand graph?

Answer 41

• no supply curve (amount of investments is determined by interst rates in money supply market)

Question 42

06.06 Introduction to Monetary Policy

How is the Money Market Graph used by the Fed?

Answer 42

• Fed uses monetary policy → increase or decrease money supply in order to maintain stability
  
  • stabalize Aggregate Output, employment, and price level
• How:
  
  1. change investment spending
  2. interest sensitive components of consumer spending
  3. net exports
• Autonomous and non-discretionary government spending would change as interest rates do not directly affect government spending and borrowing

Question 43

06.06 Introduction to Monetary Policy

What are the 3 tools the Federal Reserve can use to accomplish full employment, stable prices, and economic growth?

Answer 43

1. Open Market Operations (OMO)
2. Discount Rate
3. Required Reserve Ratio

Question 44

06.06 Introduction to Monetary Policy

How does the Federal Reserve use Open Market Operations to accomplish full employment, stable prices, and economic growth?

Answer 44

Involves the buying and selling of government bonds

most effective & most used

Purchases Bonds:

• takes it from banks or individual owners gives money in return
• increases excess reserves of bank
  
  • loaned out → increases money supply

Selling Bonds:

• Bank/Individuals buy bonds from Fed
• Money is removed from economy and held in vaults → give bonds in return
  
  • Decresaes money supply

Question 45

06.06 Introduction to Monetary Policy

How does Open Market Operations affect the Federal Funds Rate?

Answer 45

Interest rate at which one bank lends to another bank

• OMO manipulates it
• Fed sets target fund rate → changes money supply
  
  • Lower: increase money supply by buying bonds
  • Increase: decrease money supply by selling bonds

Question 46

06.06 Introduction to Monetary Policy

How does the Federal Reserve use the Discount Rate to accomplish full employment, stable prices, and economic growth?

Answer 46

Interest rate that the Fed charges member banks to borrow money so they can meet reserve requirement

One of the most common reasons that banks borrow money from each other is to meet their reserve requirements.

• Borrowed Mone y = charged interest
  
  • Decreased discount rate: borrow more money & money supply increase
  • Increased discount rate: less borrowing and decreased money supply
• Purpose:
  
  • signal to markets
  • no impact if bank do not borrow money
    
    • could go to federal funds market
    • Fed prefer banks borrow from each other

Changes in the both the federal funds rate and the discount rate affect the interest rates that banks and other lenders charge borrowers. This rate in turn affects the prime interest rate, which is the rate banks charge their best customers to borrow money.

Question 47

06.06 Introduction to Monetary Policy

How does the Federal Reserve use the Required Reserve Ratio to accomplish full employment, stable prices, and economic growth?

Answer 47

is the least used of all monetary policy → very difficult to constantly estimate reserves

cause radical or strong changes in money supply

Question 48

06.06 Introduction to Monetary Policy

What is the Taylor Rule?

Answer 48

• John Taylor (1993) → formula help guide Fed correction of inflationary or recessionary gap
• this rule aids in fostering price stability and full employment, two goals of monetary policy.

Federal Funds Rate = 1 + (1.5 * inflation gap) + (0.5 output gap)

Question 49

06.06 Introduction to Monetary Policy

What is the relationship between bond prices and interest rates?

Answer 49

• Bonds: laon to federal, state, local government
  
  • fixed interest rate over period of time
• Interest rates: impact price people and businesses pay for bonds
• invest relationship

When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise

Question 50

06.06 Introduction to Monetary Policy

What is the effect if the Fed institutes “Easy Money” policy?

Answer 50

1. Supply of money increases
2. Increase in money supply → decrease interest rates
3. Result: more investment spending
   
   • shift AD right
   • output and price levels increase
   • employment increases

Question 51

06.06 Introduction to Monetary Policy

What is the effect of “Tight Money” policy?

Answer 51

1. Reduces amount of money in circulation
2. Lending institution/ banks raising interest rates
3. Less investment spending
   
   • shifting AD to left
   • output decrease and prive level decreases
   • employment decreeases

Question 52

06.06 Introduction to Monetary Policy

Monetary Policy vs. Monetarism

Answer 52

• Monetary Policy: altering supply of money in order to change interst rates which influences amount of economic investment and credit sensitive consumption
• Monetarism:
  
  • Milton Friedman (1970s)
  • Amount of money in economic is single most important factor
  • Equation of Exchange: MV = PQ
  • Economy always tends towards full employment and required steady increase in money supply to support growth
  • attempts to “fine tune” economy - doom to failure

Question 53

06.06 Introduction to Monetary Policy

How do Kenysian Monetary Policy and Monetarist Policy compare when fighting recessions?

Answer 53

• Keynesian: OMO increase money supply
  
  • reduce interest rates
  • stimulate investment and possibly some forms of consumptions
  • AD shifts right and RGDP grow
• Monetarist: none
  
  • continue expand money supply 3% yearly
  • stimulus for economic growth

Question 54

06.06 Introduction to Monetary Policy

How do Kenysian Monetary Policy and Monetarist Policy compare when fighting inflation?

Answer 54

• Keynesian: OMO decrease money supply and increase interest rates
  
  • reduce investment and consumption
  • AD left & RGDP fall
• Monetarist: non
  
  • Continue to expand the money supply at 3%/year

Question 55

06.06 Introduction to Monetary Policy

What is the prime interest rate?

Answer 55

is the rate banks charge their best customers to borrow money

Question 56

06.06 Introduction to Monetary Policy

The federal funds rate is

1. the rate the Fed charges member banks to borrow money.
2. set directly by the Fed through monetary policy.
3. the rate banks charge each other to borrow money.
4. set directly by the Fed through fiscal policy.
5. the rate banks charge their best customers to borrow money.

Answer 56

3. the rate banks charge each other to borrow money

Question 57

06.06 Introduction to Monetary Policy

The prime interest rate is

1. the rate the Fed charges member banks to borrow money.
2. set directly by the Fed through monetary policy.
3. the rate banks charge each other to borrow money.
4. set directly by the Fed through fiscal policy.
5. the rate banks charge their best customers to borrow money.

Answer 57

5. the rate banks charge their best customers to borrow money

Question 58

06.06 Introduction to Monetary Policy

If the government decreases tax rates for all Americans, we would expect to see

1. an increase in the demand for money.
2. a decrease in the demand for money.
3. an increase in the quantity of money demanded.
4. a decrease in the quantity demanded of money.
5. no change in the demand for money.

Answer 58

1. an increase in the demand for money

Question 59

06.06 Introduction to Monetary Policy

Which of the following would be a monetary policy option for solving the problem in this economy (inflationary gap)?

I. Sell securities bonds.
II. Buy securities bonds.
III. Increase the discount rate.
IV. Decrease the discount rate.

1. I only.
2. I and III only.
3. II and IV only.
4. I and IV only.
5. II and III only.

Answer 59

2. I and III only

Question 60

06.06 Introduction to Monetary Policy

If the Fed enacts the proper policy to solve the problem in the economy illustrated in the graph above (inflationary gap), then the money supply would

1. increase, interest rates would increase, investment spending would decrease, and AD curve would shift left.
2. increase, interest rates would decrease, investment spending would increase, and AD curve would shift left.
3. decrease, interest rates would increase, investment spending would decrease, and AD curve would shift right.
4. decrease, interest rates would decrease, investment spending would increase, and AD curve would shift left.
5. decrease, interest rates would increase, investment spending would decrease, and AD curve would shift left.

Answer 60

5. decrease, interest rates would increase, investment spending would decrease, and AD curve would shift left

Question 61

06.06 Introduction to Monetary Policy

If the Federal Reserve conducts easy money policy to expand the money supply, then

1. nominal interest rates will decrease and investment spending will increase.
2. nominal interest rates will decrease and investment spending will decrease.
3. nominal interest rates will decrease and price level spending will decrease.
4. nominal interest rates will increase and price level spending will increase.
5. nominal interest rates will increase and investment spending will decrease.

Answer 61

1. nominal interest rates will decrease and investment spending will increase

Question 62

06.06 Introduction to Monetary Policy

Which of the following would necessarily result in a decrease in the value of the dollar and a decrease in real interest rates?

1. Open market purchase of U.S. government bonds by the Fed.
2. Open market sale of U.S. government bonds by the Fed.
3. Taxes increase.
4. Discount rate decreases.
5. Government spending decreases.

Answer 62

1. Open market purchase of U.S. government bonds by the Fed

Question 63

06.06 Introduction to Monetary Policy

If the Federal Reserve conducts tight monetary policy to contract the money supply, it is most likely to change investment spending, aggregate demand, and net exports (based on changing value of the dollar) in the following ways:

Investment Spending / AD / Net Exports

1. Increase / Increase / Increase
2. Decrease / Increase / Decrease
3. Decrease / Decrease / Increase
4. Increase / Decrease / Decrease
5. Decrease / Decrease / Decrease

Answer 63

5. Decrease / Decrease / Decrease

Question 64

In response to an upturn in the economy, entrepreneurs seek to expand their businesses. What will happen to nominal interest rates and what will happen to aggregate demand based on the new interest rates? What policy could the Fed use to reverse the trend? (4 points)

Nominal Interest Rates / AD / New Fed Policy

1. Increase / Increase / Buy Bonds
2. Decrease / Increase / Sell Bonds
3. Increase / Decrease / Buy Bonds
4. Increase / Decrease / Sell Bonds
5. Decrease / Decrease / Buy Bonds

Answer 64

2. Decrease / Increase / Sell Bonds

Question 65

♣ 06.08 The Philips Curve ♣

Question 66

What is the purpose of Philips curve?

Answer 66

Inverse relationship between inflation and unemployment

• why: people have jobs they have more money
  
  • more money: more spending
  • more spending: prices rise - inflation

Question 67

What is Philips Curve?

Answer 67

• Short-Run: down-sloping
• Impacted: AD and SRAS
• Change in AD result movement along short-run Philips Curve
  
  • AD right: inflation increases but unemployment decreases
  • AD left: inflation decreases but unemployment increases
• Change in AS shift PC
  
  • AS left: both unemployment and inflation increases = stagflation
    
    • PC → left
• Long Run: inflation and unemployment are stable
  
  • vertical

Question 68

What factors shifts the Philips Curve to the right and left?

Answer 68

Factors that will cause unemployed people to invest more time in the job search process and therefore decrease the natural rate of unemployment will cause the long-run Phillips Curve to decrease or shift to the left.

Factors such as an increase in unemployment insurance benefits that increase the natural rate of unemployment will cause the Phillips Curve to increase or shift to the right.

Question 69

What factors cuases a shift in long-run Philips Curve?

Answer 69

Factors change the natural rate of unemployment

(CHIPP)

1. Labor Force Characterstics: Changes in the education level, age or gender of workers, the number of two income families or the number of new workers entering the workforce can impact the natural rate of unemployment
2. Labor Market Institutions:

Changes in the ability to find jobs using the Internet or through temporary employment agencies or the ability of labor unions to negotiate wages above equilibrium level can impact the natural rate of unemployment.

3. Government Policies: hanges in the minimum wages, job training programs, or unemployment compensation can impact the natural rate of unemployment.
4. Productivity: Changes in productivity without changes in wages can impact the natural rate of unemployment.

Question 70

How does expectations influence the Philips curve?

Answer 70

Shifts short-run

• Believe inflation occur: negotiate for a raise
  
  • raised wages → increased spending → inflation
  • rightwards shift

Question 71

How do fiscal and monetary policies influence the unemployment in the long run?

Answer 71

• not impact → Philips curve vertical at full employment
• policies change consumer and producer expectations
  
  • changes short-run Philips curve