GM545

Week 6 Suggested Answers to Questions and Problems

NOTE: Please pay particular attention to the way that answers are stated, because these are the kinds of statements that will be looked for in the quizzes and final exam. In general, all answers need to be supported with appropriate reasoning. CHAPTER 20 Chapter 20 Question 1 1. An annually balanced budget would eliminate the automatic stabilization aspect of the federal budget. When the economy enters a recession, the budget normally moves toward a deficit as transfer payments increase and tax collections decline. With a balanced budget amendment, spending would have to be cut back or taxes raised, causing the recession to be deeper. The benefit of such an amendment is that the growth (or size) of the federal government would be restricted. Chapter 20 Question 2 2. Dunn has it right. When the economy enters a recession, surpluses will fall and deficits will rise. Rising government spending and declining taxes (via automatic stabilizers) will help to dampen a recession. Chapter 20 Question 5 5. All government spending affects the economy. In contrast, some of the tax cuts are saved, so only a part of the tax cut is spent, cutting its impact on the economy. CHAPTER 21 Chapter 21 Question 15 15. Inflation depreciates the currencys value, and extreme inflation (hyperinflation) renders the currency worthless, creating a whole host of problems for society including stifling growth and forcing people to turn to barter. By keeping political pressure to continually expand the economy away from the Federal Reserve, its decisions will reflect a more balanced approach to the economy. Chapter 21 Question 16 16a. The reserve requirement is equal to 35% ($700,000/$2,000,000). 16b. The bank must keep 35% ($350,000) in reserves, so loans will rise by $650,000. 16c. Total deposits will equal $2,860,000, total loans will be $1,860,000, and total reserves will equal $1,000,000. 16d. The potential money multiplier is 1 reserve requirement = 1/.35 = 2.86. CHAPTER 22 Chapter 22 Question 8 8. The Fed either buys or sells government securities. When the government sells securities, individual buyers or banks use checks or cash to buy those bonds. As a result, the money supply immediately

shrinks, as do bank reserves. This leads to a further contraction in the money supply. To entice buyers to purchase the bonds, the Fed may receive a lower price (the supply of bonds has now increased), and these lower prices mean interest rates rise. The opposite is true when the Fed buys bonds. Chapter 22 Question 9 9. When interest rates are low, it can be difficult for the Fed to get any traction in the economy by lowering rates further. Either a business investment is worth-while, or it is not. By keeping rates low, the Fed kept the housing-construction sector strong, and this investment somewhat offset the declines in investment following the dot-com bust and the downturn in 2001. This was a tough choice for the Fed; it seems to have worked, but may have resulted in the subprime lending binge that led to a housing bubble that showed signs of collapsing in 2007. Chapter 22 Question 15 15. Information and recognition lags. Supply shocks (oil price increases) may take a while to work themselves through the economy. But, once they get a head of steam, and more importantly, as consumers and businesses begin to build this inflation into their expectations about the future, they can become a difficult problem. Looking in the rearview mirror might be what the Fed would be doing if it let inflation expectations into economy-wide decision making.