Macro Paper 3 Workbook

IB Economics
Welker
2.1 The Level of Overall Economics Activity
Introduction to Macroeconomics

Welcome to Section 2 of the IB Economics course: For the next several months you will be
focusing on Macroeconomics . But what is “macro” and how is it different from “micro”? This
activity will define “macroeconomics”and introduce some of the major topics and themes of the
unit to you.

Activity 1 From Micro concept to its Macro equivalent1
Follow the link to the table comparing new macro concepts to their more familiar micro
equivalents. Answer the following questions after studying the table.+

1. How do “aggregate” demand and supply differ from plain old demand and supply?

2. What are “inflation” and “deflation”?

3. What are two things that can lead to inflation?

4. What is “economic growth”?

5. What are two things that can lead to economic growth?
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http://goo.gl/w7iJ8P

6. How is the “average price level” measured?

7. What is “GDP”?

Activity 2 Ways of measuring GDP, video lecture2
Watch the video lecture above. Study the circular flow diagram used in the video and listen to
the explanations of the various measurements of Gross Domestic Product.
1. What are two valid definitions of GDP?

2. What are the four types of income households earn that contribute to GDP?

3. What are the four types of spending (“expenditures”) that contribute to GDP?

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http://goo.gl/IxJ7nM
4. Why do the total incomes and total expenditures in a nation in a particular period of time
equal each other?

5. What are the three “sectors” identified in the macroeconomic circular flow that were not
included in the microeconomic circular flow learned earlier in the year?

6. What are “leakages” from the circular flow and what three things are considered
“leakages”?

7. What are “injections” into the circular flow and what three things are considered
injections?

Activity 3 Researching Macroeconomic Performance3
Complete the survey for two countries (one more developed and one less developed country).
CIA World Factbook4 . When each class
Use the data available in the “Economy” section of the
member has completed the survey twice, study the results and answer the questions below.
Responses can be viewed here 5.
1. What is a more valid indicator of a nation’s level of income, GDP or GDP per capita?
Explain.

2. Which countries tend to have higher inflation, more or less developed countries?
(Provide evidence to support your answer).

3. Which two countries have the highest unemployment rates? The lowest?

4. Which two countries have the highest real GDP growth rate? The lowest?

government sector
5. For which two countries is the the largest? The smallest?

net exports
6. For which two countries are the largest? The smallest?
3
http://goo.gl/EyofO6
4
http://goo.gl/kKQwnm
5
http://goo.gl/cHmjel

7. If you were hired today as an economic advisor to the government of one of these
nations, and the president or prime minister called you into his office and asked you the
following questions, how would you answer? Question: What should our primary
macroeconomic objectives be as a nation?

Welker’s Wikinomics
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2.1 The Level of Overall Economic Activity
Different Ways to Measure GDP

Instructions:
Before completing this activity, watch the video lesson
The Income and
Expenditure Approach to Measuring GDP

1. Of the various types of expenditures identified in the video, which one could possibly be
recorded as a negative figure in a nation's GDP measurement? How could it be
negative? (2 points)

2. Assume a government wishing to balance its budget does so by shutting down several
military bases in locations around the country. Explain the impact this policy will have on
GDP. (2 points)

3. Assume a government reduces the income tax rate on households and businesses.
Explain the impact this policy will most likely have on GDP. (2 points)

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4. Suppose that the central bank (which controls the interest rates in an economy) wishes
to stimulate GDP growth. Should the central bank raise or lower interest rates, and why?
(2 points)

5. When a nation's currency appreciates (becomes more valuable in terms of other
currencies), its GDP tends to fall. Why is this the case? (2 points)

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2.2 Aggregate Demand and Aggregate Supply
The Keynesian Spending Multiplier

Introduction: Country Y’s real GDP is currently $890 billion. Economists estimate that at full
employment the country would be producing $950 billion. In the last year the country has
experienced a collapse in home prices following a housing market bubble. Consumer and
business confidence is expected to decline in the next year. Use this information to help answer
the following questions.

1. Explain which “phase” of its business Country Y is most likely experiencing.

2. Draw an AD/AS diagram for Country Y showing its current level of output and its full
employment level of output. Below your graph, explain the major macroeconomic
problems Country Y is experiencing.

Explain:

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3. Define “recessionary gap” and indicate the size of Country Y’s recessionary gap.

4. Assume macroeconomic policymakers do nothing to try and fix Country Y’s economy.
Outline two possible longrun outcomes of the current economic crisis, one reflecting the
Keynesian neoclassical
view of Aggregate Supply and one reflecting the view of
Aggregate Supply.
a. The Keynesian view:

b. The neoclassical view:

5. In country Y, a typical household allocates an additional $1 of income in the following
way. $0.12 is paid as tax. $0.05 is saved. $0.13 is spent on imported goods and services
a. Define “Marginal Propensity to Consume” and calculate Country Y’s MPC.

b. Determine the size of the Keynesian spending multiplier in Country Y.

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c. Assume that instead of doing nothing, Country Y’s macroeconomic policy makers
decide to stimulate aggregate demand using government spending. Calculate the
amount of new government spending that would be needed to increase the
country’s income back to its full employment level.

6. Draw a new AD/AS diagram showing the impact of the multiplier following an increase in
government spending by Country Y.

7. Explain the multiplier process which causes the final increase in GDP to be different from
the initial increase in government spending.

8. Besides an increase in government spending, outline two additional policies the
government could take that could help reduce the recessionary gap in Country Y.

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Equilibrium in the AD/AS Model

Instructions: For each of the following, illustrate and explain the changes to AD and AS,
output, price levels and employment that will occur in the shortrun and in the longrun. Assume
that wages are “sticky” in the shortrun and “flexible” in the longrun.

1. An increase in stock prices makes households feel wealthier:

Explain the shortrun and longrun consequences of the change described above:

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2. A new trade deal with Mexico leads to lower tariffs on Mexican goods and more imports
to the United States.


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3. The government raises the minimum wage.


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4. Lower interest rates make borrowing money for capital investments more attractive to
businesses.


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5. A weakening of the value of the US dollar against other major currencies makes
American goods more attractive to foreign consumers.


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6. Education spending by state and federal government is reduced, which over time makes
it harder for firms to higher skilled, qualified workers.


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7. Looser immigration laws lead to an increase in the labor force, putting downward
pressure on wages.


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8. A hurricane destroys several offshore oil rigs, leading to higher transportation and
energy prices. Soon after, the government announces a multibillion dollar spending plan
to rebuild damaged coastal cities.


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9. Government spending on unemployment benefits and health care for out of work
Americans is slashed.


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The Determinants of Aggregate Demand

Introduction:
The graph below shows the aggregate demand in Switzerland at three different
levels. Assume the economy starts at AD1

Assuming the economy begins at AD1, indicate and explain which AD curve will result from
each of the changes described below.

1. An increase in labor productivity causes household incomes to rise.

2. Per capita incomes abroad grow more rapidly than incomes at home:

3. Lower energy costs cause the price level of domestically produced goods and services
to fall.
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4. Government cuts income tax rates on households.

5. A war in the Middle East makes oil more scarce and causes firm to raise the prices they
charge for their goods and services

6. A stock market bubble bursts and share prices tumble.

7. Unexpectedly high inflation reduces the real interest rate on savings and loans.

8. Government, in an effort to balance its budget, reduces spending on infrastructure
repairs.

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9. Speculation causes international investors to demand more of the nation’s currency,
causing it to appreciate against the currencies of trading partners.

10. By issuing new bonds to finance its budget deficit, the government is able to spend
more this year than it collected in taxes.

11. Due to the threat of rising unemployment, households begin saving a larger percentage
of their disposable income.

12. Real estate prices are rising at record annual rates.

13. Swiss households take a record number of vacations abroad, while tourism to
Switzerland declines.

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14. Firm in various industries expect prices of their output to fall in the near future.

15. The Swiss government raises the minimum wage in all Swiss cantons.

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IB Economics
Welker
2.3 the Macroeconomic Objectives
the Phillips Curve

Part 1 the Shortrun Phillips Curve: On the Phillips Curve diagram below, place values
ranging from 2% to 7% on the vertical axis and 0% to 10% on the horizontal axis. Label the
axes appropriately to show the shortrun tradeoff that a country faces between unemployment
and inflation.

● For each of the scenarios below, draw a point on your the diagram and label it with the
letter corresponding with the scenario it illustrates. Connect the points that together
make up a single shortrun Phillips Curve.
● If the scenario describes something that would shift the Phillips Curve, draw a new curve
and label it with the appropriate letter.
● Some scenarios will lead to the same outcome as others; in these cases put multiple
letters next to each point.
● Provide a brief explanation of why each scenario leads to the change you identified.

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Scenarios:
A. The economy is producing at its full employment level of output, with unemployment at
its natural rate of 4% and inflation at the target rate of 2%. (For the following scenarios,
assume the economy starts at this point)

B. A decrease in interests rates causes investment to increase.
Explain the location of the point you added to your graph.

C. An appreciation of the nation’s currency leads foreigners to demand less of the country’s
exports.

D. The discovery of large reserves of natural gas causes energy prices to decline.

E. An earthquake strikes, destroying much of the nation’s transportation infrastructure.

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F. Home prices decline, harming consumer and investor confidence.

G. The government reduces payroll taxes by 2% for all households.

H. Fear over the national debt forces government to reduce its budget deficit.

I. The Environmental Protection Agency requires all the nation’s producers to adhere to
strict new greenhouse gas emissions standards.

J. Looser immigration laws increase the available supply of labor in the country (assume
wages are flexible)

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K. Rapid economic growth abroad boosts demand for the nation’s output.

Part 2 The Longrun Phillips Curve: On the diagrams below you will illustrate and explain the
process by which a nation will return to its natural rate of unemployment in the longrun
following a shortrun shock to AD.

1. On the AD/AS diagram on the left, illustrate a country producing at its full employment
level of output. On the diagram on the right, show the same country’s shortrun Phillips
Curve, and identify its equilibrium level of unemployment and inflation. Answer the
questions that follow.

a. In both diagrams, illustrate the shortrun effect of a fall in AD on output, price
level, unemployment and inflation. Explain why the changes you illustrate occur
in the shortrun.

b. Assume that following the decrease in AD, government does nothing to bring the
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economy back to full employment. Illustrate on your diagrams the changes that
will occur in the longrun in both graphs. Explain why the changes you illustrate
occur in the longrun.

2. Redraw the graphs showing the economy above at full employment.

a. In both diagrams, illustrate the effect of a rise in AD on output, price level,
unemployment and inflation. Explain why the changes you illustrate occur in the
shortrun.

b. Assume that following the rise in AD, government does nothing to bring the
economy back to full employment. Illustrate on your diagrams the changes that
will occur in the longrun in both graphs. Explain why the changes you illustrate
occur in the longrun.

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3. Finally, on the graph below, show this nation’s Longrun Phillips Curve. Write a brief
explanation for the shape and location of the LRPC.

Explain the shape and location of the LRPC:

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2.3 the Macroeconomic Objectives
Reduced Income Inequality

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Part 1 the Lorenz Curve:
Follow this link and use the data available to answer the following
questions.

1. Using the dropdown menu on the left, determine the percentage of total income in
Germany earned in 2010 by the:
a. highest 20%:

b. fourth 20%:

c. third 20%:

d. second 20%:

e. lowest 20%:

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http://goo.gl/Ogx0Bg
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2. Use this information to construct a carefully drawn and labelled Lorenz Curve diagram
for Germany.

3. Next choose two “high income: OECD” countries from dropdown menu on the left of the
screen: One for which income is distributed MORE evenly than in Germany and one for
which income is distributed LESS evenly than in Germany. Identify the percentages of
income earned by each quintile for the two countries you chose below:
a. More equal country
i. highest 20%:

ii. fourth 20%:

iii. third 20%:

iv. second 20%:

v. lowest 20%
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b. Less equal country
i. highest 20%

ii. fourth 20%

iii. third 20%

iv. second 20%

v. lowest 20%

4. Add Lorenz curves for the two countries you researched to the diagram you drew for
Germany.

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Part 2 Gini Index: this link2 to answer the following questions.

Next, use

5. Indicate the Gini Index value for each of the three countries you researched above.
a. Germany:

b. Country 2:

c. Country 3:

6. Redraw Lorenz curve for Germany below.

a. Watch this video (starting at 2:14)
b. Referring to your diagram, explain how Germany’s Gini Index is calculated.

2
http://goo.gl/1U3GHw
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c. Referring to their Lorenz curves, explain why the Gini coefficients of the two other
countries you researched are greater or less than Germany’s
i. Country 2

ii. Country 3

7. Using the dropdown menu on the left, change the “income level” to “all”, then select the
following countries and describe the trends in inequality of each country between 1985
and 2010 (zoom in on the horizontal axis to narrow the dates)
a. Brazil

b. Russia

c. India

d. China

e. South Africa

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Bonus video How to calculate the Gini Index3 (for HL Math students who are interested!)

Part 3 Taxation: this link4 to answer the following questions.
Finally, use

7. Identify the tax revenue as a percentage of total GDP for Germany and the two other
countries you created Lorenz curves for above.
a. Germany:

b. Country 2:

c. Country 3:

8. Is there a correlation between the percentage of total GDP taxed in the three countries
and the and their Gini indexes? Explain why there might be.

9. In addition to the tax system, what other tools are at a government’s disposal to affect
the level of income distribution in a country.

3
http://goo.gl/5Atjgb
4
http://goo.gl/hvW8v3
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10. Analyze one argument for and one argument against a government’s decision to
prioritize relative equality in the distribution of income.

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2.4 Macroeconomic Policies
Expansionary Fiscal Policy

Part 1 the Government Spending Multiplier:

1. Assume the economy of Switzerland is experiencing a slump in aggregate demand, and
output in the economy is thought to be $10 billion what would be produced at full
employment. On the graph below, illustrate the Swiss economy at its current level of
output.

2. On the graph you drew above, identify the recessionary gap.

3. Assume that the Swiss government wishes to enact a fiscal policy that would return the
economy’s output to its full employment level. Identify the options available to the Swiss
government.

4. The Swiss government is considering increasing government expenditures by $2 billion.
The government has determined that at present, a $2 billion increase in household
income will have the following effects:
○ $1.2 billion would be spent on domestically produced goods and services
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○ $800 million would be saved or otherwise leaked from the nation’s economy

Calculate the following for Switzerland:
a. The Marginal Propensity to Consume (MPC)

b. The Marginal Rate of Leakage (MRL)

5. Using the results from your calculations in #4, determine the size of the government
spending multiplier in Switzerland. Explain the relationship between the “marginal
propensities” you found above and the government spending multiplier.

6. Calculate the effects of the proposed $2 billion spending package. Will it be large
enough to achieve the $10 billion increase in output and national income that the
government wishes to achieve? Why or why not?

7. Calculate the minimum increase in government spending that could bring about full
employment assuming the marginal propensities remain at the level you calculated in
#4?

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8. Assume that several economists have determined that the MPC among Swiss
households is actually much higher, at 0.8. How large an increase in government
spending would be needed to fill the recessionary gap if this estimate were correct?
Show your calculations.

Part 2 the Tax Multiplier
9. The conservative members of the Swiss government are concerned about the increase
in the size of the government that may result from the proposed expansionary fiscal
policy. Instead of increasing government expenditures, they argue, a tax cut is needed.
Assuming the marginal propensity figures you calculated in #4 are correct, determine the
tax multiplier
size of the in Switzerland.

10. Explain the process by which a change in taxes could bring about an increase in national
output.

11. How large a tax cut would be needed to bring about the desired increase in national
output of $10 billion? Show your calculations.
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12. Explain why the size of a tax cut required to bring the Swiss economy is larger than the
size of an increase in government spending.

13. On the graph below, illustrate the effects of the fiscal policies you identified above on
aggregate demand, output, and the price level in Switzerland.

13. Assume Switzerland’s MPC is 0.8. How large a tax cut would be needed now to achieve
the desired $10 billion increase in GDP? How does this compare to the needed tax cut
you identified in #11? What accounts for this difference?

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14. Explain the impact the two fiscal policies identified in this activity would have on Swiss
government’s budget.

15. Discuss the strengths and weaknesses of fiscal policy as a tool for reducing a
recessionary gap in a nation’s output.

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2.4 Fiscal Policy
Automatic Stabilizer

Instructions:
Study the graph below and answer the questions that follow. Assume Canada’s
target Economic growth rate over the longrun is 2.5% per annum.

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Data source: World Bank via Google’s public data explorer

1. For the periods highlighted in the chart, explain one demand factor and one supply factor
that may account for the fluctuations from the country’s longrun average growth rate.
a. Yellow and Purple:
Demand factor:

Supply factor:

b. Blue and Green:
Demand factor:

Supply factor:

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https://goo.gl/DX6eJu

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The table below shows Canada’s income tax rates for different income levels:
● 15% on the first $44,701 of taxable income
● 22% on the next $44,702 of taxable income (on the portion of taxable income
between$44,702 and $89,401)
● 26%on the next $89,402 of taxable income (on the portion of taxable income
between$89,402 and $138,586)
● 29% of taxable income over $138,586

2. Referencing the table above, explain how Canada’s tax receipts would have changed
during the highlighted periods.

b. Blue and Green:

3. Explain how government expenditures on unemployment compensation would have
been affected during the highlighted periods.

b. Blue and Green:

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4. How do progressive income taxes and unemployment compensation programs act as
automatic stabilizers
during periods of economic growth that vary from a nation’s
longrun trend growth rates?
a. During slowdowns or recession:

b. During expansions:

5. Outline the advantages of having builtin fiscal stabilizers like progressive taxes and
unemployment compensation when compared to depending solely on discretionary fiscal
policies to promote stable growth.

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Contractionary Fiscal Policy

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Instructions:
Study the chart below and answer the questions that follow.

1. Describe the level of inflation experienced in Argenta between 2010 and 2015 compared
to that experienced by the United States. Which country is achieving an inflation rate
closer to the “target” rate?

2. Outline two possible causes of the higher than desired rate of inflation experienced by
Argentina.

3. Study the chart2 below and answer the questions that follow
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Source: International Monetary Fund data on Google Public Data Explorer.
http://goo.gl/TjSxJK
2
Source: International Monetary Fund data on Google Public Data Explorer:
http://goo.gl/ocalaL
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a. What has been the relationship between Argentina’s inflation rate and its real
GDP growth rate between 2010 and 2015?

b. Explain why low and stable inflation can contribute to a higher rate of real GDP
growth in a nation.

c. Based on the data in this chart, what is the most likely cause of Argentina’s
inflation, demandpull or costpush? Explain.

4. Using an AD/AS diagram, illustrate the cause of Argentina’s inflation you described in #3
c). Identify Argentina’s “inflationary gap”.
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5. Assume the government of Argentina wished to use fiscal policies to reduce its inflation
rate. Outline the options available to the government.

6. Describe the mechanism through which a contractionary fiscal policy could help
Argentina close its inflationary gap.

7. Show the effects of the contractionary fiscal policy on the diagram you drew in #4.

8. Explain why the use of contractionary fiscal policy may be unpopular among the citizens
and voters in Argentina.

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9. Explain the impact the contractionary fiscal policy will have on unemployment and
nominal GDP in Argentina.

10. Assuming the contractionary fiscal policy succeeds at bringing down Argentina’s inflation
rate, how could this benefit Argentina’s real GDP growth rate in the longrun?

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Fiscal Policy and the Crowdingout Effect

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Instructions:
Study the chart below and answer the questions that follow.

1. Knowing that Europe experienced a recession in 2008 and 2009, explain below how the
decrease in national income during recessions impacted the size of the national debts of
the EU and the countries represented on the chart above.

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Source: Eurostat data on Google Public Data Explorer
http://goo.gl/Qq22V8
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2. Referring to the chart above, explain the relationship between a country’s budget
balance and the level of national debt (shown in the first chart).

3. Explain how the use of expansionary fiscal policy affects a government’s budget
balance.

Introduction to theory: When a government engages in deficitfinanced fiscal policy,
it has to
borrow money from the public to make up the difference between tax revenues and government
expenditures (the deficit).
● Government borrowing occurs in the bond market . Assume the Italian government
issues bonds that have a face value of 1,000 euros and will be repaid in 1 year’s time.
● The price a lender has to pay for the bond today determines the “yield” (or the interest
rates) the bond will pay over the year it is held. For instance, if a one year, 1,000 euro
government bond can be bought for 950 euros today, the return on the bond is 50 euros
on a 950 euro investment. The is therefore 1,000 −950
yield 950 × 100 = 5.26%
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When a government’s budget deficit increases, it must supply more of its bonds to the bond
market in order to borrow money to cover its deficit. This leads to an
increase in the supply of
government bonds .
● Just like any asset or good or service, when supply increases, the price decreases.
● In the case of government bonds, as the price increases, the yields

(or interest rates)
they offer investors increase.
● For example, if the Italian government’s deficit increased, it would have to supply more
1,000 euro bonds to the market. Assume the price to an investor today of a 1,000 euro
bond that matures in one year falls from 950 euros to 925 euros. The yield
on the Italian
1,000−925
government bond is now 925 × 100 = 8.11% .
● The increase in Italy’s budget deficit required the government to issues new
governments bonds, increasing their supply on the bond market, driving down their price
and increasing their yields.

Practice:
Answer the questions below to show your understanding of how bond markets
determine yields (interest rates) on government bonds.

4. Referring to the chart on the 2nd page, describe what happened to Italy’s budget
balance as a percentage of its GDP between 2006 and 2009.

5. Referring to the chart on the 1st page, describe what happened to Italy’s national debt
as a percentage of its GDP between 2006 and 2009.

6. Using a market diagram for Italian government bonds (1year, 1,000 euro bonds), show
the effect the increase in Italy’s national debt may have had on interest rates on Italian
bonds between 2007 and 2009. (Assume a 1,000 euro bond could be bought for 970
euros at the beginning of 2006 but had fallen to 950 euros by 2009).
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7. Calculate the yields on 1year, 1,000 euro Italian government bonds in
a. 2006

b. 2009

8. Referring to your graph above, explain why the quantity demanded for Italian
government bonds increases as the supply of government bonds increases.

Introduction to theory: The total supply of funds available for savings and investment in Italy is
limited by the amount of disposable income that households wish to save. The market for
loanable funds shows the supply of savings and the demand for investment in a country, relative
real interest rate
to the .
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In the market for loanable funds…
● Supply is directly related to the real interest rate: Households will save more money in
the private sector when the return on savings in banks is higher, and less when the
return is lower
● Demand is inversely related to the real interest rates: Businesses and households will
demand more funds for investment when the cost of borrowing is lower, and less when
the cost of borrowing is higher.

Relationship between the bond market and the loanable funds market: When a
government issues new bonds to finance a budget deficit, the yields
on government bonds
increase, and the quantity demanded among investors increases correspondingly.
● The higher yields on government bonds that accompanies expansionary fiscal policies
may incentivize households to save less in the private sector and lend more money to
the government .
● The reduction of supply of funds available to the private sector may cause the real
interest rate to increase and the quantity of funds demanded for private sector
investment to decrease.
● This decrease in private sector investment arising from an increase in the government’s
debt is known as the crowdingout effect.

Practice: Answer the questions below to demonstrate your understanding of how
deficitfinanced fiscal policies can lead to
the crowdingout of private sector spending.

9. Referring to your answer to #8 above, explain how an increase in Italy’s budget deficit
between 2006 and 2009 may have affected the supply of loanable funds in Italy’s private
sector.
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10. On the loanable funds graph below, illustrate and explain the effect of the increase in
Italy’s budget deficits on the real interest rate and the amount of private sector
investment in Italy between 2006 and 2009.

Explain your graph:

11. Based on your answer to #9, explain why the effectiveness of deficitfinanced
the crowdingout effect.
expansionary fiscal policies might be reduced due to

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Further considerations when evaluating expansionary fiscal policies: The conclusion you
reached in #11 may seem to provide a major argument against the use of expansionary fiscal
policies to combat recessions. However, there are a couple of factors that should be considered
which may mean that crowdingout is unlikely to occur when a government borrows to finance a
fiscal stimulus. The main reason crowdingout may not occur arises from what Keynes referred
to as a liquidity trap.
● During recessions, households tend to increase their savings and decrease consumption
(in anticipation of deflation or job loss), thus the supply of funds available for investment
tends to increase.
● At the same time, firms tend to demand less funds for investment (for the same reasons
households save more).
● If the supply of loanable funds (savings) is very high and the demand for loanable funds
(investment) is very low, it is possible that the equilibrium real interest rate i
s below zero
(meaning the supply and demand curves intersect in the negative range of the vertical
axis), as seen on the graph below.

● In the graph above, there is a liquidity trap: Interest rates cannot fall below 0%, so the
“zerobound” acts like a price ceiling in the market for loanable funds. Households are
willing to save more than firms are willing to borrow at zero percent interest.
● In this scenario, the crowdingout effect will not happen, even when households choose
to lend money to the government rather than save in the private sector.

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Practice: Demonstrate your ability to judge the likeliness that crowdingout will occur by
answering following questions.

12. Assume that in 2008 Italy was in a deep recession and was experiencing a liquidity trap.

On the loanable funds market diagram below, show the effect of the government’s
budget deficit on the real interest rate and the amount of private sector investment in
Italy between in 2008.

Explain your graph:

13. While crowdingout may be unlikely to occur when a nation is in a liquidity trap, the
effectiveness of expansionary fiscal policies may also be limited by the size of the
spending multiplier. Explain why, during a liquidity trap, the size of the
Keynesian
spending multiplier may be smaller than it would be when an economy is in a mild
recession and still producing close to its full employment level.
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The Tools of Monetary Policy

Introduction:
For each of the questions below, assume the following:
● The Fed’s target inflation rate is 2%
● America’s natural rate of unemployment is 5%

The economy is currently experiencing inflation of 3%. The nominal interest rate is currently 5%.
1. Calculate the real interest rate.

2. Explain why an inflation rate higher than the target rate poses a concern to
macroeconomic policymakers (refer to the inflationary spiral
in your answer).

3. Define and explain how a change in the following could help reduce inflation to its target
rate of 2%:
a. The Discount Rate:

b. The Reserve Requirement:

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Introduction to theory Open Market Operations: The third tool of monetary policy requires a
central bank to increase or decrease the supply of liquid money in the economy by buying or
nonliquid
selling assets from from within the banking system. “Openmarket operations” refers
to the buying and selling of government bonds by a nation’s central bank to increase or
decrease the supply of money.

As you learned in the fiscal policy unit, there is an inverse relationship between the price of
government bonds and their yields (the interest rates on government bonds).
● Therefore, when a central bank intervenes in the market for government bonds by
buying bonds , this decreases their supply and raises the price, decreasing the yields on
government bonds. This is knowns as a expansionary monetary policy.
● If the central bank sells government bonds on the open market, their supply increases,
decreasing their prices and increasing their yields. This is known as a contractionary
monetary policy.

The effect of a central bank’s intervention in the bond market can be seen in the diagrams on
the next two pages.

practice activity
EXPANSIONARY MONETARY POLICY
CB buys bonds on the open market...

which leads to an increase in the money supply

practice activity
CONTRACTIONARY MONETARY POLICY
CB sells bonds on the open market...

which leads to a decrease in the supply of liquid money.

practice activity
Practice:
Answer the questions below to demonstrate your understanding of open market
operations.

4. The United States is experiencing 3% inflation. Outline the appropriate openmarket
operation
the Federal Reserve should enact to bring inflation down to its target rate of
2%.

5. On the graphs below, show the effect of the Fed’s openmarket operations in
a. The US Money Market
b. The broader US economy in an AD/AS diagram

Explain the changes you showed in your diagrams:
● Money Market:

● AD/AS:

practice activity

For the following questions, refer to the Phillips Curve diagram below.

6. Outline the likely causes and consequences of the macroeconomic problems faced by
the US economy as conveyed by the Shortrun Phillips Curve above.

7. Assume the Fed takes no action and the government does not engage in any fiscal
policies. Explain the the process by which the economy will adjust to the macroeconomic
conditions conveyed by the Shortrun Phillips Curve above.

8. Using a correctly labelled graph, show the changes in AD and/or AS that will occur in the
longrun assuming no policy actions are taken.
practice activity

9. Now assume that the Fed decides to engage in open market operations to help the
economy recover return to the target inflation rate. Outline the appropriate
openmarket
operation
the Federal Reserve should enact.

10. Explain the process by which the Fed’s openmarket operation will help the economy
return to its target rate of inflation.

11. Using correctly labelled graphs, show the effect of the Fed’s openmarket operation on
the US Money Market and on the Shortrun Phillips Curve

practice activity

12. Besides the openmarket operation you described above, outline and explain how
changes to the other policy tools the Fed has at its disposal would help to bring inflation
back to its target rate.
a. The Discount Rate:

b. The Reserve Requirement:

The Money Multiplier (APonly concept): The concept of the money multiplier allows us to
calculate the total increase in the money supply that will result from a Central Bank action such
as a purchase of government bonds. If the Central Bank wishes, for example, to increase the
amount of liquid money in circulation by amount X, it does not need to inject X dollars into the
economy through bond purchases, since a proportion of every dollar the central bank injects will
be lent out by a bank, deposited at another bank, and a proportion of it will be lend out again.

The proportion of commercial banks’ deposits that they are allowed legally to loan out is
determined by their excess reserves , the level of which are determined by the Reserve
Requirement. If, for instance, there is a Reserve Requirement of 20%, then a bank with $1
million in total deposits is required to keep $200,000 of its total deposits in reserve, and has
practice activity
excess reserves of $800,000. The bank will try to loan out as much of its excess reserves as
possible in order to earn interest on these deposits.

Continuing with the example above, if the central bank engages in an openmarket purchase of
government bonds (expansionary monetary policy), and buys $100,000 worth of bonds off of
this bank, the bank’s excess reserves increase by $100,000 and the bank will loan out as much
of this as possible. Assume the bank loans out all $100,000. To determine how much this new
lending will increase the overall money supply, we must multiply the bank’s new loans by the
money multiplier .

1
T he Money Multiplier (m) = Reserve Requirement 1 = 5
= 0.2

In this example, the central bank’s purchase of $100,000 of government bonds from our bank
will increase the total money supply by $100,000*5 = $500,000.

When a central bank engages in an openmarket purchase of government bonds by X dollars,
the total increase in the money supply will equal X*m, where 1
m = RR

When an individual deposits X dollars into a commercial bank, the total change in the money
supply will be smaller than when the central bank purchases X dollars of government bonds,
already part of the money supply.
since the individual’s dollars were When an individual
deposits X dollars, the total change in the money supply will be (
X*m) X.

Example: For a graduation present Suzie received a $1,000 check from her grandparents,
which she deposits in her bank account. The reserve requirement is 0.2. Calculate the total
change in the money supply that will result from Suzie’s deposit.
● Suzie’s $1,000 deposit increases her bank’s excess reserves by $800 and its required
reserves by $200.
● The bank will loan out the $800 of excess reserves, which can the by multiplied by m,
1
which is 0.2 = 5
● $800*5 = $4,000. The total money supply will increase by $4,000 as a result of Suzie
depositing her graduation check in the bank.
● The total change in the money supply was therefore ($1,000*5) $1,000 = $4,000.

Practice: Answer the questions below to demonstrate your understanding of the money
multiplier.

13. The reserve requirement is currently set at 0.15.
a. Calculate the maximum effect that a $200 deposit by an individual into her bank
account can have on the total supply of money in the banking system.

practice activity

b. Calculate the maximum effect that a $200 purchase of government bonds will
have on the total supply of money in the banking system.

c. Explain why the two scenarios above will result in different increases in the total
money supply.

14. The central bank lowers the reserve requirement from 0.15 to 0.10.
a. What is the immediate effect of the lowered reserve requirement on the level
commercial banks’ excess reserves?

b. What is the impact of the lowered reserve requirement on the money multiplier?

c. Calculate the effect of the two scenarios described in #1 after the decrease in the
reserve requirement.
i. $200 deposit by an individual

ii. $200 bond purchase by the central bank.
practice activity

practice activities
Supplyside Policies

Introduction to Theory: The macroeconomic problems a nation may face, including high
unemployment, high inflation and stagnant economic growth, can be addressed with a wide
range of policies. The macroeconomic impact of a particular government or central bank policy
can be analyzed according to the effect it has on either aggregate demand,
aggregate supply,
or both AD and AS.
● Policies that primarily affect AD are known as demandside policies: These include
most fiscal policies, such as changes in tax rates or the level of government spending.
They also include monetary policies, which either raise or lower interest rates to
stimulate or reduce the level of consumption or investment (both components of AD).
● Policies that primarily affect AS are known as supplyside policies: Supplyside policies
can fall into one of two subcategories:
○ “Interventionist” policies : These include governmentled programs such as the
provision of infrastructure, subsidies for research and development and the
provision of jobtraining programs or support for public or private education aimed
at increasing the skills of the nation’s workforce.
○ “Marketbased” policies : These are measures aimed at reducing the role of
government in the economy, which should allow the market to function more
efficiently and for output to return more quickly to its full employment level
following shocks to AD or AS. They include reductions in government benefits for
the unemployed or poor, reduction or elimination of a minimum wage, reduction
of trade union power, deregulation of industries, reduction in business tax rates,
liberalized trade and any other policies that make producing goods cheaper and
more efficient for businesses.

The goal of supplyside policies is to increase the level of aggregate supply in a nation and
promote longrun economic growth. Some of the policies described above will have
demandside effects as well (any of those that require government to spend money), but the key
difference between them and other demandside policies is that their primary purpose is to
increase the potential longrun output actual shortrun output
(Yfe) rather than just the (Ye) of a
nation.

practice activities
Study the chart1 below then answer the questions that follow to demonstrate your
Practice:
understanding of interventionist and marketbased supplyside policies.

1. Describe the change in unemployment in France between 2008 and 2014.

2. Outline the possible causes for the change in France’s unemployment rate.

3. Assuming the rise in unemployment is because of weak aggregate demand, outline two
demandside policies that France could have employed over this time period to reduce
unemployment.

4. Outline two problems that might arise from the use of demandside policies aimed at
reducing unemployment.
1
Source: Eurostat from Google’s Public Data Explorer.
http://goo.gl/esYzpR
practice activities

5. Using an AD/AS diagram, illustrate the rise in unemployment in France between 2008
and 2014.

increasing aggregate supply i
6. Explain why policies aimed at n France could help avoid
the problems you described with expansionary demandside policies in number 4.

interventionist supplyside policies
7. Briefly explain how the following may have helped
France reduce its rate of unemployment.
a. Increased government spending on education and jobtraining programs

b. Increased government subsidies to firms researching and developing new
technologies
practice activities

c. Increased government spending on communication and transportation
infrastructure

d. Taxcuts to or subsidies to manufacturing firms that invest in new capital
equipment

8. On the graph below, illustrate the desired effects of the policies mentioned in #7 on AD,
SRAS and LRAS.

Explain your graph:

practice activities

marketbased supplyside policies
9. Briefly explain how the following may have helped
France reduce its rate of unemployment.
a. Reduced regulations relating to environmental impacts, workplace safety, product
quality, etc…

b. Elimination of the minimum wage

c. Reduction in unemployment benefits

d. Reduction of business taxes

e. Trade liberalization (reduce or eliminate taxes on imported goods and resources)

f. Antimonopoly legislation

practice activities

10. How will the pursuit of economic growth and reduced unemployment through the use of
marketbased supplyside policies affect the France’s distribution of income in the
shortterm? Explain.

11. Contrast the impact that interventionist supplyside policies would have on France’s
government budget budget with the impact that marketbased policies would have on the
budget.

12. Which type of policy is likely to have a more immediate impact on employment in France,
demandside policies or supplyside policies. Explain.

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