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Economics 112 Professor RaffertyPrinciples of Macroeconomics Fall 2011

Exam #3

Multiple Choice Questions (2 poin ts each)

1. Dollar bills in the modern economy serve as money because:a.they can be redeemed for gold by the central bank.

b.they have value as a commodity independent of their use as money.c.people have confidence that others will accept them as money.d.they are backed by the gold stored at Fort Knox.

2.Banks can continue to make loans until their:a.actual reserves equal their excess reserves.b.actual reserves equal their checking account balances.c.excess reserves equal their required reserves.d.actual reserves equal their required reserves.

3.Expansionary monetary policy refers to the ______ to increase real GDP.a.government increasing spending and lowering taxes.b.the Feds increasing the money supply and decreasing interest rates. c.governments decreasing spending and raising taxes.d.the Feds decreasing the money supply and increasing interest rates.

4.The supporters of a monetary growth rule believe that active monetary policy

a.destabilizes the economy, increasing the number of recessions and their severity.b.cannot change real GDP.c.stabilizes the economy, decreasing the number of recessions and their severity.d.cannot change the inflation rate.

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8.An increase in the interest ratea.increases the opportunity cost of holding money.

b.decreases the percentage yield of holding money.c.decreases the opportunity cost of holding money.d.increases the percentage yield of holding money.

9.Which of the following is nota consequence of hyperinflation?a.The price level grows in excess of hundreds of percentage points per year.b.It causes an economy to suffer low growth.c.Money loses value so rapidly that firms and individuals stop holding it.d. Moneys function as the medium of exchange is enhanced.

10.The Federal Reserves four goals of monetary policy are: a.low rate of bank failures, high reserve ratios, price stability, and economic growth.b.price stability, high employment, economic growth, and stability of financial markets andinstitutions.c.price stability, low government budget deficits, low current account deficits, and low rate ofbank failures.d.low government budget deficits, low current account deficits, high employment, and high

foreign exchange value of the dollar.

11.The Fed can increase the federal funds rate bya.selling Treasury bills, which increases bank reserves.b.selling Treasury bills, which decreases bank reserves.c.buying Treasury bills, which decreases bank reserves.d.buying Treasury bills, which increases bank reserves.

12.If the Federal Reserve targets the interest rate and the money demand curve shifts to the left,

then the Feda.can maintain the interest rate target, but at a higher quantity of the money supply.b.can maintain the interest rate target with no change in the money supply.c. can maintain the interest rate target, but at a lower quantity of the money supply.

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15.Which of the following is not a function of the Federal Reserve System?a.taking actions to control the money supply.

b.performing check clearing services.c.acting as a lender of last resort.d.insuring deposits in the banking system.

16.If the money supply grows by 10 percent and real GDP grows by 2%, then according to thequantity theory the inflation rate will bea.12%b.5%c.8%

d.20%.

17.Monetary policy refers to the actions thea.President and Congress take to manage government spending and taxes to pursue theireconomic objectives.b.Federal Reserve takes to manage the money supply and interest rates to pursue its economicobjectives.c.Federal Reserve takes to manage government spending and takes to pursue its economic

objectives.d.President and Congress take to manage the money supply and interest rates to pursue theireconomic objectives.

18.Suppose that you deposit $2,000 in your bank and the required reserve ratio is 10 percent.The maximum loan your bank can make as a direct result of your deposit is:a.$20,000.b.$200c.$1,800

d.$2,000.

19.As was demonstrated in 2007, firms in the shadow banking systema. were very vulnerable to bank runs.

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22.Suppose that the equilibrium real federal funds rate is 2 percent, the target inflation rate is 2percent, the current inflation rate is 4 percent, and real GDP is 2 percent above potential GDP. If

the weights on the inflation gap and the output gap are both , then according to the Taylor rulethe federal funds target rate equalsa.4 percent.b.10 percent.c.6 percent.d.8 percent.

23.An increase in interest ratesa.increases investment spending on machinery, equipment, and factories, consumption spending

on durable goods, and net exports.b.decreases investment spending on machinery, equipment, and factories, consumption spendingon durable goods, and net exports.c.decreases investment spending on machinery, equipment, and factories, but increasesconsumption spending on durable goods, and net exports.d.increases investment spending on machinery, equipment, and factories, but decreasesconsumption spending on durable goods, and net exports.

24.Suppose that Warren Buffet withdraws $1 million from his checking account at ChaseManhattan Bank. If the reserve requirement ratio is 0.2, what is the maximum change in depositsin the banking system?a.- $4 millionb.$5 millionc.- $5 milliond.- $200,000

25.In the Aggregate Demand/Aggregate Supply model, monetary policy initially affects:

a. the short-run aggregate supply curve.b. the long-run aggregate supply curve.c. the aggregate demand curve.d. the money demand curve.

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Long Answer Questions (answer 2 questions)

1.Suppose that the Fed wanted to increase the price level. Explain in great detail howthe Fed can do this. This means explain the change in policy the Fed would have toimplement and explain how that change in policy affect the price level. Use all relevantmodels. (25 points)

2.

a.Explain what economists mean by the terms bank run and banking panic. Explainwhy financial institutions are vulnerable to them. (10 points)

b.Explain how a bank run can turn an otherwise solvent financial institution into aninsolvent financial institution. (5 points)

c.Explain how central banks can prevent bank runs and banking panics. (10 points)

3.

a.Suppose that real GDP is currently greater than potential. Use the AggregateDemand/Aggregate Supply model to graph this situation. (5 points)

b.What is likely to happen to the price level and inflation as the economy returns to thelong-run equilibrium? Explain using the AD/AS model. (5 points)

c.Suppose the Fed does not want this change in the price level and inflation to occur.What should it do? Explain using the AD/AS model. (10 points)

d.What are the risks of the Feds policy? Explain using theAD/AS model. (5 points)

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Answers to Multiple Choice Questions

1. C 6. B 11. B 16. C 21. B

2. D 7. C 12. C 17. B 22. D

3. B 8. A 13. A or B 18. C 23.B

4. A 9. D 14. B 19. A 24.C

5. D 10. B 15. D 20. A 25. C

Answers to Long Answer Questions

1.If the Fed wants to increase the price level then it should buy U.S. Treasury securities.This would increase the money supply, decrease interest rates, increase investmentexpenditures, and cause an increase in equilibrium output and the equilibrium price level.

To increase the interest rate, the Fed needs to decrease the supply of money which meansthe Fed needs to sell U.S. Treasury securities:

At the end of this transaction, banks have more reserves so the monetary base willincrease. If the money multiplier is constant then the money supply will increase:

The Fed Banks

Securities

Reserves

N i l i t t t

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The money supply curve will shift to the right so the equilibrium short-term nominal

interest rate will decrease. Long-term nominal interest rates also decrease. If theexpected inflation rate is constant then the cost of borrowing funds has decreased soconsumption and investment expenditures increase. As a result, the AD curve will shiftto the right from AD1to AD2and the price level will increase:

SRAS

LRAS

AD1

AD2

Price Level

Real GDP

P1

P2

Y2

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Therefore, if a depositor even thinks that a bank is running out of liquid assets orthinks that other depositor might think that then the depositor has an incentive to

withdraw his or her funds immediately.b. One way for a financial institution to deal with a bank run is to sell its long-term assets. However, to raise enough cash the financial institution may have tosell a large amount of their long-term assets which can cause the price of thoseassets to decrease. Therefore, a bank run can reduce the value of a financialinstitutions assets and may turn an otherwise solvent financial institution into aninsolvent financial institution.

c.Central banks can prevent bank runs by lending freely to solvent financialinstitutions that do not have enough liquid assets to meet the surge in withdrawsby depositors. The financial institution can use its illiquid assets such asmortgages and other loans as collateral for the loans. Therefore, the financialinstitution will not be forced to sell assets at low prices so it should remainsolvent and depositors should have confidence that they will get their funds ifthey want them. This later effect should reduce or eliminate the bank run.

3.

a.

SRAS1LRAS

Price Level

P2 B

SRAS2

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SRAS curve shifts to the left from SRAS1to SRAS2. The price level rises so theinflation rate is positive as the economy moves from point A to point B.

c. See figure below.If the Fed wants to prevent the inflation rate from increasingthen it should decrease the money supply. This would require the Fed to sell U.S.Treasury securities to banks which will reduce the amount of bank reserves andthe monetary base. If the money multiplier is constant then the money supply willdecrease. The decrease in the money supply will increase short-term nominalinterest rates and eventually long-term nominal interest rates will also increase. Ifexpected inflation is constant, then long-term real interest rates will increasemaking it more expensive to borrow funds to finance consumption and investmentexpenditures. As a result, the AD curve will shift to the left from AD1to AD2.The economy is now at point C.

SRAS1LRAS

AD1

Price Level

AP1

AD2

CP3

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At point D, real GDP is less than potential so the unemployment rate has

increased above the natural rate. While the Fed has succeeded in reducing theprice level and the inflation rate, this came at the cost of causing a recession. TheFed has a goal of price stability and high employment so the Fed has failed toachieve both goals.

SRAS1LRAS

AD1

Price Level

Real GDP

AP1

Y1

AD3

DP4

Y4

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