ANSWERS to HOMEWORK 9 E202 Spring 2008 The following questions draw on the material in Chapter 16 and accompanying lectures.

This time of year its important to ask, Are we having fun yet? Try these problems and see what you think. 1. What is the theory of liquidity preference? How does it help explain the downward scope of the aggregate demand curve? The theory of liquidity preference is Keynes's theory of how the interest rate is determined. According to the theory, the aggregate-demand curve slopes downward because: (1) a higher price level raises money demand; (2) higher money demand leads to a higher interest rate; and (3) a higher interest rate reduces the quantity of goods and services demanded. Thus the price level has a negative relationship with the quantity of goods and services demanded. Draw a diagram of the money market in equilibrium at an interest rate of 6%. (Remember: the money market and the market for loanable funds are not the same.)
Interest rate 6% Ms

2.

Md Quantity of

a.

Explain why the equilibrium rate of interest is stable. At any other interest rate, the amount of money demanded does not equal the amount of money supplied. Holders of money would adjust money balances relative to bond holdings, and the interest rate would move toward equilibrium. List the factors that shift the money demand curve. Change in price level is the only factor discussed in Mankiw. Other factors can shift money demand too: changes in institutional arrangements, such as frequency of paydays, use of credit cards, etc. Average income level will shift money demand: higher income implies a larger volume of consumer purchases so more money will be demanded at each interest rate. What can shift the money supply curve in this model? Federal Reserve policy changes

b.

c.

3.

a.

Use words (or notation) to explain the effect of a decrease in the money supply on the interest rate, aggregate demand, aggregate output, the price level, and employment. A decrease in the money supply causes an increase in the interest rate, which leads to a decrease in consumption and (especially) investment spending, so AD decreases; output falls, the price level falls, and employment falls. These are short run effects. Use a graph of the money market to show the effect of a decrease in the money supply on the money market. Show the effect of the change in the money market on the AD-AS diagram.

b.

Interest rate

Ms2

Ms1

Md Quantity of Money

Price Level

AS1

AD1 AD2 Real GDP 4. Explain how each of the following developments would affect the supply of money, the demand for money, and the interest rate. Illustrate your answers with diagrams. a. The Feds bond traders buy bonds in open-market operations. When the Feds bond traders buy bonds in open-market operations, the money-supply curve shifts to the right from MS1 to MS2, as shown below.

The result is a decline in the interest rate.

b.

And increase in credit card availability reduces the cash people hold. When an increase in credit card availability reduces the cash people hold, the money-demand curve shifts to the left from MD1 to MD2, as shown below. The result is a decline in the interest rate.

c.

The Fed reduces banks reserve requirements. When the Federal Reserve reduces reserve requirements, the money supply increases, so the money-supply curve shifts to the right from MS1 to MS2, as shown below. The result is a decline in the interest rate.

5.

a.

Define fiscal policy. Changes in government spending (G) and taxes (T) to affect Aggregate Demand Explain the multiplier effect of a change in fiscal policy. Additional shifts in AD that result from some initial change in G or T. What is the MPC and how does it affect the multiplier? The MPC is the fraction of an additional dollar in income that is spent on consumption. Bigger MPC implies a bigger multiplier, i.e., more income is passed on in each round of spending. Define crowding out. The decrease in private spending, especially I, caused by an increase in G. Explain crowding out using the AD-AS model in combination with the money market. See Figure 4 on page 358. An increase in G implies an increase in AD, which leads to an increase in the price level and an increase in output. This increase in output and the price level causes an increase in MD, which raises r, decreases I and C, and decreases AD, partially offsetting the previous increase in AD.

b.

c.

6.

a.

b.

7.

Define automatic stabilizers and give two examples. Changes in G and T that occur without any change in policy and that tend to stabilize AD. Examples include the corporate income tax and unemployment insurance benefits. Suppose a wave of pessimism overtakes the U.S. Households become anxious about an increasingly uncertain future and decrease their consumption purchases. Firms similarly cut back on investment spending.

8.

a.

Use the AD-AS model to explain the short run effects on output, employment, and the price level. The decrease in C and I cause a decrease in AD, which decreases P, Y, and E. Price Level AS1

AD1 AD2 Real GDP b. What should the Fed do if it wants to stabilize aggregate demand? Why might this policy not be as effective as the Fed may want it to be? (Hint: Think back to the conditions necessary for the maximum expansion of deposits in Chapter 11.) The Fed should increase the Ms to decrease r and increase AD. Commercial banks may not increase their lending enough and HH may choose to hold larger money balances. If the Fed does nothing, what might Congress do to stabilize aggregate demand? Why might this policy not be as effective a Congress may want it to be? Congress could increase G and/or decrease T. Effectiveness of fiscal policy is limited by crowding out and long lags.

c.

9.

What are two factors that are likely to have contributed to the Great Depression? Use the AD-AS model to explain how each factor affected the economy. Hint: see page 338. Large decrease in AD caused by (1) decrease wealth that followed the decrease in stock prices caused a decline in Consumption spending, and (2) Fed policy did not offset the decrease in the money demand as prices fell, so the money stock declined. In 1939, with the U.S. economy not fully recovered from the Great Depression, President Roosevelt proclaimed that Thanksgiving Day would be a full week earlier than usual so that the shopping period before Christmas would be lengthened. Explain this decision, using the AD-AS model. At the margin, a longer shopping period would likely increase consumption spending, thereby increasing aggregate demand. Explain how monetary policy might affect the value of corporate stocks.

10.

11.

The Fed can influence interest rates, which in turn can affect the willingness to hold stocks. If, for example, the Fed raises interest rates by decreasing the money supply, stocks are a less attractive way to hold wealth for two reasons. First, the return bonds, a substitute for stocks, increases relative to the return on stocks. Second, the higher interest rates raise the cost of borrowing to firms and decrease profitability of firms.