Test 3

Question 1

What is fiscal policy?

Answer 1

discretionary changes in government spending and taxation

Question 2

When does the government implement expansionary fiscal policy and when does it implement contractionary fiscal policy?

Answer 2

Expansionary - when a recession occurs in the economy
Contractionary - when the economy’s output is to the right of the full employment level of output

Question 3

How does the government implement expansionary and contractionary fiscal policies?

Answer 3

Expansionary = raise government spending and / or taxes so GDP will rise
Contractionary = lower government spending and / or raise taxes so GDP will lower

Question 4

How does the government decide to change (increase/decrease) government spending and change (increase/decrease) taxes?

Answer 4

They decide using if the government is using demand pull or cost push inflation

Question 5

What variables are needed to determine how much government spending needs to be changed (increased/decreased) and/or how much taxes need to be changed (increased/decreased)? (Figure 13.1, Figure 13.2)

Answer 5

Increases/decreases in government spending and taxes

Question 6

What is built-in stability?

Answer 6

Anything that increases the government’s budget (or reduce its budget surplus) during a recession and and increases its budget surplus (or reduce its budget deficit) during an expansion without requiring explicit action by policymakers

Question 7

What is the implication of progressive, proportional, and regressive tax systems on the size of budget deficits and surpluses?

Answer 7

Progressive - the more progressive the tax system is, the steeper the slope of the tax revenues
Proportional - the average tax rate remains constant with GDP. However, the impact of the proportional tax system on the size of the budget deficit and the budget surplus would be smaller then under the progressive tax system.
Regressive - the more regressive the tax system is, the less steeper the slope of the tax revenues would be
The larger (smaller) the size of deficits during recessions and larger (smaller) the size of the surpluses during expansions would be

The built in stability is greater with a progressive tax system than with a regressive tax system

Question 8

What did the American Recovery and Reinvestment Act of 2009 did?

Answer 8

Increases in government spending and decrease in taxes

Question 9

What are problems, criticisms, and complications of implementing Fiscal Policy?

Answer 9

Problems of timing – recognition, administrative, operational lags, political considerations, future policy reversals, offsetting state and local finances, crowding out effect

Question 10

What is political business cycle?

Answer 10

Swings in overall economic activity and real GDP resulting from election-motivated fiscal policy, rather than from inherent instability on the private sector

Question 11

What is crowding-out effect?

Answer 11

Suggests that increases in government spending would increasing the interest rate and therefore reduce investment spending businesses as well as interest-sensitive consumption spending by households

Question 12

What are the three problems of timing with implementing fiscal policy?

Answer 12

Recognition lag, administrative lag, operational lag

Question 13

What is recognition lag?

Answer 13

Time between the beginning of recession or inflation and the certain awareness that it is actually happening

Question 14

What is administrative lag?

Answer 14

Time between the need for fiscal action is recognized and the time action is taken

Question 15

What is operational lag?

Answer 15

Defined as the time between the fiscal action is taken and the time that action affects output, employment, or the price level

Question 16

What are political considerations with implementing fiscal policy?

Answer 16

Elected officials try to stimulate the economy to improve their reelection hopes and then after the election, they try to use contractionary fiscal policy to dampen the excessive aggregate demand that they caused with their pre-elections stimulus

Question 17

What are future policy reversal problems with implementing fiscal policy?

Answer 17

Fiscal policy may fail to achieve its intended objectives if households expect future policy reversals

Question 18

What are future policy reversal problems with offsetting state and local finances?

Answer 18

fiscal policies of state and local governments are frequently pro-cyclical, meaning that they worsen rather than correct recession or inflation b/c they face constitutional or other requirements to balance their budgets

Question 19

What are future policy reversal problems with the Crowding-out effect?

Answer 19

An expansionary fiscal policy may increase the interest rate and reduce investment spending, thereby weakening or canceling the stimulus of the expansionary policy

Question 20

What are functions of money?

Answer 20

Medium of exchange - money is usable for buying and selling goods & services
Unit of account - society uses monetary units as a yardstick for measuring the relative worth of a wide variety of goods, services, and resources
Store of value - money also enables people to transfer purchasing power from the present to the future

Question 21

What is liquidity?

Answer 21

The ease with which an asset can be converted quickly into the most widely accepted and easily spent form of money, cash, with little or no loss of purchasing power

Question 22

What is included in the M1 and M2 definitions of money?

Answer 22

M1 is very liquid
M1 = currency [coins + paper $] + checkable deposit accounts
M2= M1 + saving deposits + small denominated time deposits (certificate of deposits) + money market mutual funds held by individuals

Question 23

What is token money?

Answer 23

Bills or coins for which the amount printed on currency bears no relationship to the value of the paper or metal embodied within it

Question 24

Which institution issues the paper money in the United States and which institution issues coins in the United States?

Answer 24

Paper money - Department of Treasury (primarily) and Federal Reserve (helps them)
Coins - US mint

Question 25

What is money supply backed by?

Answer 25

The government’s ability to control the supply of money and therefore to keep its value relatively stable; It’s acceptability as a medium of exchange

Question 26

What does legal tender mean?

Answer 26

Coins or paper money that must be accepted to pay off debt

Question 27

How do we measure the value of money?

Answer 27

1 / price level = value $

Question 28

Is there a positive or negative relationship between the price- level and the value of money?

Answer 28

Inverse relationship - inflation erodes the value of $; negative

Question 29

Which institution controls the money supply in the U.S.?

Answer 29

The Federal Reserve

Question 30

What is the organizational structure of the Federal Reserve System?

Answer 30

12 regional Federal Reserve Banks; Board of Governors of the Federal Reserve has 7 members (appointed by president and Senate); the reserve banks blend private ownership and public control - quasi public banks; The federal Reserve Acts as the lender of last resort to commercials and for this they are known as bankers’ bank

Question 31

How many members are there on the Board of Governors of the Federal Reserve System?

Answer 31

12; however all of the banks act as a single central bank with a goal to control $ supply and interest rates to promote general economic well-being

Question 32

Who appoints and confirms the Board of Governors?

Answer 32

Appointed by the president of the US and confirmed by the Senate

Question 33

How many Federal Reserve Banks are there in the U.S.?

Answer 33

7

Question 34

What is a quasi-public institution?

Answer 34

They blend private ownership and public control; Each bank is privately owner (by member banks) and publicly controlled central banks whose goal is to control money supply and interest rates in promoting the general economic well-being

Question 35

What is meant by banker’s banks and lender of last resort?

Answer 35

Commercial banks may go to federal reserve banks in times of liquidity crisis to get a loan from the federal reserve bank

Question 36

Which group aids the Board of Governors in conducting monetary policy?

Answer 36

Federal Open Market Committee (FOMC)

Question 37

What is the structure of FOMC?

Answer 37

Made up of the seven members of the Federal Reserve System along with the president of New York Federal Reserve Bank and four other Federal Reserve Bank presidents on a rotating basis

Question 38

What are the responsibilities of the Federal Reserve Banks?

Answer 38

Issuing currency, setting reserve requirements and holding reserves, lending to financial institutions and serving as an emergency lender of last resort, providing for check collection, acting as fiscal agent, supervising banks, controlling the money supply

Question 39

What is FDIC?

Answer 39

Insures deposits up to $250,000 at commercial banks and thrifts

Question 40

In which sector of the U.S, economy did the financial crisis of 2007-2008 begin?

Answer 40

Real estate and housing

Question 41

New York Life, Prudential, and Harford are all primarily what?

Answer 41

Insurance companies

Question 42

Wells Fargo, J.P. Morgan Chase, and, Citibank are all primarily what?

Answer 42

Commercial banks

Question 43

What is the moral hazard problem?

Answer 43

The tendency for financial investors and financial services firms to take on greater risk because they assume they are at least partially insured against losses

Question 44

What are assets and what are liabilities of commercial banks?

Answer 44

Assets - loans, securities, property, cash and reserves Liabilities - checkable deposits and stock shares

Question 45

What is the relationship among assets, liabilities, and net worth?

Answer 45

Assets = liabilities + net worth

Question 46

What is the primary purpose of reserve requirements?

Answer 46

They control the lending ability of commercial banks It is determined by the Federal Reserve

Question 47

What is reserve ratio equal to?

Answer 47

Reserve Ratio = commercial bank required reserves / commercial bank’s checkable deposit liabilities

Question 48

What is the relationship among excess reserves, actual reserves, and required reserves?

Answer 48

Excess reserves = actual reserves - required reserves

Question 49

How do banks use excess reserves?

Answer 49

Purchase government securities and making loans

Question 50

How do commercial banks create money?

Answer 50

By purchasing government securities and making loans

Question 51

In which market do commercial banks lend excess reserves?

Answer 51

Federal Funds market

Question 52

What is the interest rate in this particular market called?

Answer 52

Federal funds rate

Question 53

How does multiple-deposit expansion work in a multi-banking environment?

Answer 53

As the checks of one bank are deposited into another, new money is created which leads to even more new money being created and so on and so forth

Question 54

What is the formula for monetary multiplier?

Answer 54

Monetary multiplier = 1 / required reserve ratio = 1/ R = m

Question 55

How do we calculate maximum checkable-deposit creation in a multiple banking environment?

Answer 55

Maximum deposit creation = excess reserves (money multiplier)

Question 56

How is interest defined?

Answer 56

the price paid for the use of money. It is also the price that borrowers need to pay lenders for transferring purchasing power to the future.

Question 57

What is transactions demand for money? How is it graphed?

Answer 57

The demand for money as a medium of exchange, independent of the interest rate in the economy. The level of nominal GDP is the main determinant of the amount of money demanded for transactions. (Straight line)

Question 58

What is asset demand for money? How is it graphed? (Figure 16.1)

Answer 58

The demand for money as a store of value. The amount of money demanded as an asset varies inversely with the rate of interest, the opportunity cost of holding money as an asset. (Diagonal line)

Question 59

How is total demand for money measured? How is it graphed? (Figure 16.1)

Answer 59

The total demand for money is the horizontal sum of the asset demand and the transactions demand for money. A change in nominal GDP will shift the total money demand curve.

Question 60

How do we find the equilibrium interest rate? (Figure 16.1)

Answer 60

Find the intersection of the money supply and total demand for money

Question 61

What would happen to the equilibrium interest rate when money supply increases and when it decreases?

Answer 61

The equilibrium interest rate would increase (decrease) when the money supply decreases (increases). The money supply would shift to the right when there is an increase in it and shift to the left when there is a decrease in it.

Question 62

What is the relationship between interest rates and bond prices?

Answer 62

There is an inverse relationship between interest rates and bond prices. That is, interest rates increase (decrease) when bond prices go down (up).

Question 63

What accounts are listed under the assets and liabilities side of the consolidated balance sheet of the Federal Reserve Banks? (Table 16.1)

Answer 63

Assets - securities, loans to commercial banks Liabilities - reserves of commercial banks, treasury deposits and Federal reserve notes

Question 64

What kind of securities are being held by the Federal Reserve Banks?

Answer 64

Treasury bills, treasury notes and treasury bonds

Question 65

What are the tools of monetary policy and how each tool is used to change the supply of money?

Answer 65

Open market operations Reserve ratio Discount rate Interest on reserves

Question 66

What are open market operations?

Answer 66

bond market transactions in which the Fed either buys or sells government bonds.

Question 67

What is the reserve ratio?

Answer 67

The Fed can also manipulate the reserve ratio in order to influence the ability of commercial banks to lend. Raising (lowering) the reserve ratio increases (lowers) the amount of required reserves banks must keep. This would lower (raise) excess reserves and therefore diminish (increase) the money creating ability of commercial banks by lending.

Question 68

What is the discount rate?

Answer 68

The Fed can change the interest rate it charges, known as the discount rate, to commercial banks when they lend money to commercial banks. A lower (higher) discount rate would encourage commercial banks to borrow more (less), raise (lower) their reserves and enhance (diminish) their ability to extend credit and therefore increase (decrease) the money supply.

Question 69

What is the interest on reserves?

Answer 69

Interest on reserves is a relatively new tool of monetary policy. If the Fed wishes to reduce (increase) the amount of bank lending and so the amount of money circulating in the economy, then they could increase (decrease) the rate of interest on excess reserves held at the Fed.

Question 70

Which tool is the most used one by the FOMC?

Answer 70

Open market operations

Question 71

What happens to the supply of money when the Fed buys securities and when it sells securities?

Answer 71

When the Fed buys (sells) government securities from the public, the money supply expands (shrinks) and commercial bank reserves increase (decrease). The sale (purchase) of government bonds by the Fed to (from) commercial banks would decrease (increase) aggregate demand. Such Open Market Operations would change the commercial bank reserves but not the size of the monetary multiplier.

Question 72

What is repo and reverse repo transactions?

Answer 72

Repo - the government makes a loan of money in exchange for government bonds being posted as collateral. The Fed holds the bonds posted as collateral until the loan is either paid or goes into default. Reverse repo - repos in reverse. Instead of the Fed lending money against bond collateral, it is the Fed that posts government bonds as collateral when borrowing money from financial institutions. Thus, repos involve the Fed lending money into the financial system whereas reverse repos involve the Fed borrowing money out of the financial system.

Question 73

What happens to the supply of money when the Fed raises the reserve ratio and when it lowers it?

Answer 73

When the reserve requirement is increased (decreased), the excess reserves of member banks are reduced (increased), and the multiplier by which the commercial banking system can lend is reduced (raised). Thus, changes in the reserve ratio, one of the monetary tools of the Fed, can alter both the level of excess reserves and the money multiplier in the economy.

Question 74

What is the interest rate that the Federal Reserve charges to commercial banks when it lends money to commercial banks?

Answer 74

Discount rate

Question 75

Which monetary policy tool was introduced in 2008?

Answer 75

Paying interest on excess reserves

Question 76

What is the federal funds rate?

Answer 76

The interest rate that banks charge to other banks for overnight loans

Question 77

What is the prime interest rate and how is it related to the federal funds rate?

Answer 77

the benchmark interest rate used by banks as a reference point for a wide range of interest rates charged on loans to businesses and individuals alike, is positively (move in the same direction) correlated with the federal funds rate. when the federal funds rate is decreased (increased), the prime rate is also decreased (increased). However, the prime interest rate is higher than the federal funds rate b/c the prime rate involves longer, riskier loans than the overnight loans extended between banks in the federal funds market.

Question 78

How did the Fed initiate an expansionary monetary policy before and after the mortgage debt crisis?

Answer 78

Before - initiate an expansionary monetary policy by setting a lower target for the federal funds rate After - announce a higher target rate using the federal funds rate

Question 79

What is zero lower bound problem?

Answer 79

the Fed’s inability to stimulate the economy by reducing interest rates. The Fed’s response to that problem was quantitative easing which involved buying bonds solely with the intention of increasing the quantity of reserves in the banking system.

Question 80

What is quantitative easing?

Answer 80

buying bonds solely with the intention of increasing the quantity of reserves in the banking system

Question 81

How did the Fed initiate a restrictive monetary policy before and after the mortgage debt crisis?

Answer 81

When the Fed initiates a restrictive monetary policy, it sells bonds to the banks and the public with the expectation that the supply of federal funds will fall, the federal funds rate would rise, and a contraction of the money supply would occur.

Question 82

What is the federal government’s dual mandate?

Answer 82

Full employment and stable prices

Question 83

What is the cause-and-effect chain of expansionary and restrictive monetary policy? (Table 16.3 and Figure 16.4)

Answer 83

An increase in the money supply will lower the interest rate, increase investment spending, and increase aggregate demand and GDP.

Question 84

What are problems and complications of monetary policy? (lags, cyclical asymmetry, the liquidity trap)

Answer 84

Monetary policy can be implemented more quickly relative to fiscal policy b/c monetary policy lack the administrative lag. However, monetary policy seems to be more effective in controlling demand-pull inflation than in moving the economy out of a recession. This is known as cyclical asymmetry. The Fed cannot be certain of achieving its goal when it adds reserves to the banking system b/c of the so-called liquidity trap, in which adding more liquidity to banks has little or no additional positive effect on lending, borrowing, investment, or aggregate demand.