Money and banking
Part I – Short Answer Questions:
1. Below is a graph of the Phillips curve for the United States in the 1960s.
1) Assuming that the natural rate of unemployment during the 1960s was about 5.5 percent:
1.1) use an AS/AD diagram to depict the economy in 1961. Was there a recessionary gap or an expansionary gap present?
1.2) use a separate AS/AD diagram to depict the economy in 1969. Was there a recessionary gap or an expansionary gap present?
2) Name two policies that could have caused this movement along the Phillips curve from 1961 to 1969.
3) Is the unemployment rate of 1969 sustainable in the long run? Why or why not? Explain in words and with reference to your diagram in part 1.2)
2. Up to the 1960s, many Keynesian economics believed that high unemployment was typically associated with low inflation, and the vice versa. However, from 1973 to 1974, both unemployment and prices rose sharply. It became obvious that the relationship between inflation and employment was not necessarily stable.
1) What word does economists use to describe a situation in which the inflation rate is high and unemployment is also high? What type of shock could have caused this?
2) Assuming that the economy was in long-run equilibrium before the shock hit. Show on an AD/AS diagram both the pre-shock and post-shock short-run equilibrium.
3) If the Fed’s main priority is keeping prices from rising quickly in the short run, what policy should the Fed pursue in response to the shock? Explain your proposal in words and with reference to your diagram.
4) What is the main drawback of the policy suggested in part 3)? Explain.
3. Some economics view the short-run aggregate supply curve as relatively flat, and think that it moves up slowly in response to an increase in aggregate demand. Other economics believe that the short-run aggregate supply curve is relatively steep, and that it adjusts quickly to changes in aggregate demand.
Explain why economists in the first group will argue more strongly for stabilization policies to fight unemployment, while economists in the second group will argue more strongly for stabilization policies to fight inflation.
4. Comment on the following statement: “Inflationary and recessionary gap are nothing to worry about because the economy has a built-in mechanism that cures either type of gap automatically”.
5. Suppose the American economy is in long-run equilibrium. Now assume that the Fed decides to sell government bonds to the public.
1) What is the effect on the money supply? Use the diagram of market for money to show how the Fed’s action affects the federal funds rate (or the nominal interest rate). Also explain the intuition behind the change in the change of fed funds rate/nominal interest rate.
2) Assume there is no change in expected inflation in the short run, what happens to consumption, investment? Explain. (we assumed closed economy)
3) Using your conclusions from part 2), explain and show graphically how the Fed’s action affects aggregate demand. What happens to the price level and to aggregate output in the short run?
4) Explain why the economy in part 3) is not in a long-run equilibrium. Explain the transition to the long run. Illustrate your answers using a diagram.
Part II – Multiple Choice Questions:
1. Which of the following statements is correct about price levels and SRAS?
A) SRAS is always a vertical line
B) SRAS curve would become flatter if prices become more “sticky”
C) SRAS curve would become steeper if prices become more “sticky”
D) SRAS curve would approach a horizontal position if almost all prices become completely flexible
2. The existence of lags prevents the monetary policy or fiscal policy to take immediate effect. Among all different types of lags, the time it takes for the policy actually to have an impact on the economy is referred to as _______, and it is often a year or longer.
A) implementation lag
B) effectiveness lag
C) recognition lag
D) legislative lag
3. Prices are “sticky” is due to the reason that______
A) it is expensive to change prices for goods and services
B) frequently changing prices of goods and services would probably annoy customers who purchase very often .
C) not all the firm managers monitor the price level thus adjust prices quickly, and it takes time to recognize changes in the economy
D) some firms may be locked into certain prices because of long-term contracts
E) all of the above are correct
4. Which of the following statements is true about the role that the stabilization policy plays in stabilizing inflation and economic activity.
A) policy that targets at stabilizing inflation will not stabilize output at the same time
B) there is no tradeoff between the pursuit of price stability and economic activity stability
C) when a permanent supply shock occurs, there is no tradeoff between the dual objectives
D) when a temporary supply shock occurs, there is no tradeoff between the dual objectives
5. Phillips curve describes _______.
A) the relationship of natural unemployment and potential output
B) the relationship of natural unemployment and inflation
C) the relationship of natural unemployment and expected inflation
D) the relationship of inflation and unemployment
E) none of the above
6. The modern expectations-augmented Phillips curve takes the following form:
A) π = πe – 2ω(U-Un) + ρ
B) π = πe – ω(U-Un) + ρ
C) πe = π – ω(U-Un) + ρ
D) π = πe + ω(U-Un) + ρ
7. Monetary policy that stabilizes inflation will also stabilize economic activity if
A) temporary supply shocks are more common
B) most shocks to the economy are aggregate demand shocks
C) permanent aggregate supply shocks are more common
D) both A and B of the above are correct
E) both B and C of the above are correct
F) both A and C of the above are correct
8. If the current output is two percentage points below the potential output level, according to Okun’s Law, unemployment rate should be ______ its natural rate by ______.
A) above; one percentage point
B) above; two percentage points
C) above; four percentage points
D) below; two percentage points
E) below; four percentage points
9. Which of the following statements is correct regarding Taylor rule:
A) it provides a guidance for the central bank to set a target for long-term interest rate
B) it indicates that the Fed should set the federal funds rate equal to the inflation rate plus an “equilibrium” fed funds rate plus a weighted average of inflation gap and output gap.
C) the Taylor rule also predicts that when inflation is at target and output is at potential (the output gap is zero), the FOMC will set the real federal funds rate at 2 percent—about its historical average.
D) all of the above are correct
E) only A and B of the above are correct
F) only B and C of the above are correct
G) only A of the above is correct
10. Which of the following factors can be considered as positive supply shocks that would increase potential output and shift the long-run aggregate supply curve to the right?
A) an increased proliferation of computer technology which leads to rapid increases in productivity
B) favorable demographic factors that lead to an increase in the average age of the workforce, which helps to reduce the natural rate of unemployment
C) a tax cut on the sales tax, and consumers have more disposable income thereby consume more goods and services
D) all of the above
E) only A and B of the above
11. Which of the following policy will shift the AD curve rightward?
A) The Federal Reserve lowers the discount rate
B) Congress decides to “rebuild America” through a massive program of highways and transit construction
C) Banks increase their holdings of excess reserves
D) Only A and B of the above
E) Only A of the above
F) All of the above
12. The advantage of making a “commitment” when conducting monetary policy – adopt rules, include_____
A) Committed policy generates lower long-run inflation without any adverse effects on economic activity
B) a credible commitment will help to anchor inflation expectations, which leads to smaller fluctuations in inflation
C) however it doesn’t help when there is a negative aggregate supply shock
D) all of the above
E) only A and B of the above
13. Government policies that aim to stimulate the economy would cause the unemployment rate to _____ the natural rate of unemployment, and this leads to movement along the _________, and thus ______ the inflation rate.
A) raise above; long-run Phillips Curve; raise
B) fall below; long-run Phillips Curve; raise
C) fall below; short-run Phillips Curve; raise
D) fall below; expectation-augmented Phillips Curve; lower
14. When unemployment rate is at its natural level, _____
A) there is inflationary output gap in the economy
B) there is inflation gap in the economy
C) there is only frictional unemployment in the economy
D) only A and C of the above are correct
E) only B and C of the above are correct
F) none of the above is correct
G) all of the above are correct
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