Third Exam

Economics 100
November 5, 2010
Sample Answers

Question Form A Form B Question Form A Form B Question Form A Form B

1 D A, D, or E 6 E A 11 A A
2 B E 7 A A 12 D D
3 C A 8 A D 13 D B
4 B A 9 C D 14 C C
5 A, D, or E C 10 A C 15 A B

(10 points)
16. Suppose the Federal Reserve purchases bonds. Describe how that purchase will affect
spending in the economy. You do not need to explain exactly why, but do explain the
sequence of events. You do not need to go beyond the initial change in spending.

The Federal Reserve writes checks to sellers. Sellers deposit the checks. Banks present
checks to the Fed and the Fed will add reserves to that banks reserves. Since the increase in
reserves is equal to the increase in deposits, banks have excess reserves. Thus banks can
and will normally make additional loans to increase profits. As they do, more new deposits
are created. This expansion in the money supply continues until there are no excess reserves.

Determinants of size of changes in the money supply include: the size of original purchase,
the larger purchase will result in a larger increase in the money supply; the money supply
will increase by more if banks make as many loans as they legally can; the greater the
level of the required reserve ratio, the smaller the increase in the money supply; and the less
the amount of currency withdrawn will result in a greater increase in the money supply.

As banks increase loans, they will have to lower the interest rates they charge to attract new
customers. The ease and availability of loans and the lower interest rates will ultimately
cause more investment spending. Investment spending is less expensive and easier to
finance. Consumption spending that depends upon the borrowing of money may also
increase.

(12 points)
17. Explain the natural process of adjustment from a short-run equilibrium that was created by a
decline in spending in the economy. What causes the natural adjustment? What happens as a
result? What determines how long it takes?

The natural adjustment process is one based on labor market conditions. At a level of
production less than the full employment level, labor markets have large amounts of
unemployment and there will be a significant downward pressure on wages.

As wages decrease, costs of production decrease. And businesses will increase production at
existing price levels (or lower prices at current levels of production) Prices of goods and
services will begin to fall. As prices fall, spending in the economy begins to rise due to
increases in wealth causing increased consumption, falling interest rates increasing
investment spending, and rising exports and falling imports due less expensive exports and
more expensive imports.

1
 This process continues until the economy returns to the full employment level of output where
there is no longer downward pressure on wages and therefore prices. We will end the process
when prices are lower than when we started and real gross domestic product is greater and
equal to the full-employment level of real GDP.

The length of adjustment time depends upon how flexible wages and prices are. Wages
particularly tend to be not very flexible in a downward direction. It is not customary that
wages decrease and there are contracts and in some cases union agreements that prevent
wage decreases over a relatively brief time period.

(15 points)
18. Describe how an increase in consumer spending will cause a short-run change in real GDP
and price levels. Explain each step in the process and exactly why the changes occur.

Consumption spending increases resulting in spending greater than output. Inventories

decrease. Businesses begin to increase output and therefore income increases. As income
increases, consumption spending again expands by a portion of the initial change in income.
This process (of rising spending, increases in incomes, and another round of spending
increasing by a portion of the increase in income) continues until there are no longer
increases in consumption.

The amount of saving and the amount of taxes influence the sizes of the subsequent amounts
of spending. The greater the amount of saving and taxes, the less left over to be spent. The
amount of imports is also a leakage and reduces the amount of consumption spending
domestically following increases in income. A possible increase in investment associated
with the increases in income and spending will add to the increases in the the amount of
spending.

As this is happening, businesses will begin to increase prices. Costs of production increase
as output increases. The degree of price increases depends how close the economy is to full
employment output or beyond that level of output. If most labor and other resources are
employed, the increased production can only be accomplished at increased costs. The new
resources will likely not be as productive as resources already in use.

As price levels rise, spending on investment will fall (due to interest rate increases);
consumption will decrease as real wealth falls; and exports will come down and imports rise
as our prices rise relatively to prices abroad. That is the aggregate quantity demanded will
begin to decrease.

The ultimate effect on real GDP depends how much prices rise. The larger the increase in
prices the less the effects of real GDP will be. The closer to full employment, the greater the
rise in prices and the less the rise in real GDP will be. If the economy were far below full
employment level of real GDP, the less the upward pressure on prices and the greater the
effect on real GDP.