Second Test

Discussion of some of the questions that caused most difficulty:

Q: Suppose the Fed purchases $100 million of U.S. securities from the public. The reserve requirement is 20 percent and all banks have zero excess reserves. The final total impact of this action on the money supply will be at most

If the reserve requirement is 20%, each $1 of reserves can support up to $5 of checkable deposits, which are money. When the Fed buys US securities from the public, it pays the public; if the public deposit the $100 million they get in commercial banks, the reserves of the commercial banks increase by $100 million. So the most the money supply can increase is $500 million, five [equals 1/.20, i.e. one divided by 20 percent] times the increase in reserves.

For some reason, this was the hardest question on the test. About a quarter of you answered that the money supply would decrease -- NO, when the Fed buys bonds the money supply expands. Over half of you got the direction right but the amount wrong -- remember that the money creation multiplier is one over the reserve requirement.

Q: In the Keynesian aggregate expenditure model, if the economy has plenty of spare capacity, which of the following would be the most likely final result of an autonomous $6 billion increase in investment?

In this model, output is determined by expenditure on output up to full employment output; and in addition, when autonomous expenditures [injections into the circular flow] change, they create multiplier effects because they change output, which changes income to households, which then change their consumption expenditure which changes output and income again, and so on. So the correct answer was

"an increase in the equilibrium level of income by more than $6 billion" [because of the multiplier effects]

which only about a quarter got right. The most popular answer was "an increase of $6 billion in the national income" -- that would be the IMMEDIATE effect, but not the "final result" -- the right answer was the last option, always read them all.

Q: Starting from a position of macroeconomic equilibrium at the full-employment level of real GDP, in the short run an unanticipated decrease in the money supply will

"raise real interest rates, lower prices, and reduce real GDP"

What does the decrease in money supply do? Immediately, it raises the nominal interest rate and thereby the real interest rate; that lowers borrowing and therefore investment spending; Aggregate Demand is therefore reduced [shifts in to the left]. SRAS has not changed; so we move down the unchanged SRAS in the short run, reducing real GDP and the price level. For some reason that escapes me, the most popular answer was the one that said the exact opposite -- that real interest rates would be lowered, prices raised, and real GDP increased. The question says "decrease in money supply" -- that is contractionary, it will reduce prices and output [both if unanticipated, only prices if fully anticipated]; and interest rates must go up if we have reduced the supply of money without doing anything to change the demand to hold money.

Q: Which of the following would count as investment in the national income accounts?

In the national income accounts, "investment" is the purchase of durable capital equipment by business firms [or additions to inventories by business firms, or purchase of new housing by households]. Nothing else counts as investment in the national income accounts of the US. So, the answer is

"a freight-hauling firm buying a new domestically-produced truck,"

which under a third of you got right; the most popular answer was buying a U.S. government bond, which is a purely financial transaction so cannot be investment in the national income accounts sense [although many households would think of it as such -- this is one of those JARGON questions, where you must remember the jargon].

Q: An increase in the nominal interest rate would

The nominal interest rate is the opportunity cost of holding money; in our simplified jargon, one of the characteristics of money is that it does not earn interest for its holders. So if the nominal interest rate increases, it has become more expensive to hold money, so people will hold less of it. The right answer was

"encourage people to hold smaller money balances"

which unfortunately attracted fewer responses than the reverse, which said "larger." A possible explanation is that you were forgetting the jargon and thinking 'balances,' if I am earning interest I will want more -- but the key characteristic here of 'money' is that in our jargon it does not earn interest, interest is the opportunity cost of holding it.

Q: Suppose the U.S. Treasury finances a budget deficit by selling securities to the public. The money supply will

If the Treasury sells securities to the public to finance the federal government budget deficit, that is the federal government borrowing from the public. The public got the securities, the federal government got the money, which it then spent -- that is why it borrowed it, to finance the excess of spending over revenue, the budget deficit. What has happened to change the money supply? Absolutely nothing -- the money supply is the IOU's of the Federal Reserve, and the balances in checking accounts supported by the commercial banks' reserves which are the Federal Reserve's IOU's. The Federal Reserve's holdings of government securities, and the commercial banks' reserves, have not changed, and neither has the money supply. Only a third of you got this right

Q: If both monetary and fiscal policy became much more expansionary, Keynesians and monetarists would agree that

You are told that "policy became much more expansionary," i.e. AD shifted some way out to the right, but nothing about where we started from. If AD shifts out to the right, both monetarists and Keynesians agree that the short run effect will be to increase output [and therefore employment] temporarily, so long as people did not fully anticipate the consequences. Monetarists would emphasize that prices would also rise, and that the split between output increase and price increase would depend on how widely anticipated the change was; in the long run, monetarists would argue that the effect would only be on prices. Keynesians would say it would depend on where you started from; if initially below full employment output, there would be little effect on prices and long run effects on output and employment; if initially above full employment output, much of the effect would be on prices, but there would still be some short run real effects on output and employment. So the correct answer was

"the policy would temporarily stimulate output and employment if people did not anticipate the effects of the policy"

More of you gave the first answer, which alleged that the fiscal policy change would "control primarily unemployment" whereas the change in monetary policy would "primarily affect prices." Think about that a bit; it is a distractor, you are associating Keynes-fiscal-unemployment and monetarists-monetary-prices, but the response is ridiculous if you think about it -- how could you tell which was doing which, anyway?

Q: If consumption expenditures are $180, total planned investment is $50, government purchases are $40, exports are $20, imports are $40, and taxes are $25, then aggregate demand must be

AD = C + I + G + (X - M) That is the only equation/definition you really absolutely must know. Plug in the numbers:

[C = 180] + [I =50] + [G = 40] + [X = 20] - [M = 40] gives you 290 - 40 = $250. This was the most popular answer, I am pleased to report, but nearly as many said $275, presumably adding in $25 for taxes ---NO, this kind of question often gives you more information than you need as a distractor.

Q: Which of the following best expresses the central idea of countercyclical fiscal policy?

The idea of countercyclical fiscal policy is to use the government budget to counter the business cycle, i.e. to add to Aggregate Demand when output is less than the full employment level (i.e. in a recession), to take away from AD when output is more than the full employment level (i.e. in a boom, especially if there is inflation). Government purchases (G) are part of AD, so add to AD; net taxes (T, taxes less transfer payments) reduce disposable income (and therefore consumption), so reduce AD. A larger deficit [the deficit is (G - T); if T is bigger than G you have a surplus] (or smaller surplus) adds to AD, a smaller deficit (or larger surplus) takes away from AD. So the right answer was

"Deficits are planned during economic recessions [to add to AD], and surpluses [reducing AD] are utilized to restrain inflationary booms"

This was the most popular answer, but still a lot of people missed it -- and this is central, you should understand it. Disturbing is that the next most popular response was the one that exactly reversed this answer -- which would have fiscal policy making cycles larger, not smaller; the objective of countercyclical fiscal policy is to reduce the size of economic fluctuations (cycles), not enlarge them.

Q: If unemployment were 3 percent and prices were rising 12 percent annually, which of the following would be the most appropriate policy?

OK, this requires you to figure things through a little bit. 3 percent unemployment is less than the natural rate, 12 percent per year price rise is fairly rapid inflation. So the appropriate policy has to be a restrictionary one, something that will reduce AD and stop the inflation. Let's look at the alternatives offered:

  1. an increase in planned government expenditures. This would increase AD even more, so it can't be right -- it would make the inflation even worse, because there is no spare capacity here.
  2. A decrease in the Fed's reserve requirements. If the Fed decreases commercial banks' reserve requirements, each $1 of reserves can support MORE dollars of balances in checking accounts, so the money supply expands, which is expansionary monetary policy, which increases AD again, so again cannot be right.
  3. The sale of US securities by the Federal Reserve. If the Fed sells US securities, the reserves available to the commercial banks are reduced (when the buyers pay the Fed, bank reserves are reduced -- the Fed owes the banks less, i.e. the commercial banks' balances with the Fed are reduced). So the money supply tends to contract, the banks make fewer loans, and the interest rate goes up -- Investment and other loan-financed spending tends to fall, AD is reduced. This is an appropriate policy in these circumstances.
  4. A reduction in the discount rate. This will tend to lower interest rates and expand the money supply -- again, the exact reverse of what would be appropriate.
The right answer was the most popular, but less than half of you got it.

I think this is enough to read on the web. There were some other questions that only about half of you got right; they tended to be mostly similar to ones above, though, on fairly basic issues like what expands and what restricts AD, or what the Phillips Curve is. Review!