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Economics 112 Professor Rafferty

Principles of Macroeconomics Fall 2011


Exam #3

Multiple Choice Questions (2 points 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.

5. Which of the following is one of the most important benefits of money in an economy?
a. money allows for the accumulation of wealth.
b. money allows for the exchange of goods and services.
c. money encourages people to produce all of their own goods (self-sufficiency) and therefore
increases economic stability.
d. money makes exchange easier, leading to more specialization and higher productivity.

6. The M1 measure of the money supply equals
a. paper money plus coins in circulation.
b. currency plus checking account balances plus travelers checks.
c. currency plus checking account balances.
d. currency plus checking account balances plus travelers checks plus savings account balances.

7. The main tool the Federal Reserve uses to conduct monetary policy is
a. discount policy.
b. check clearing.
c. open market operations.
d. setting reserve requirements.
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8. An increase in the interest rate
a. 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 not a 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 and
institutions.
c. price stability, low government budget deficits, low current account deficits, and low rate of
bank 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 by
a. 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 Fed
a. 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.
d. cannot maintain the interest rate target.

13. Inflation targeting refers to conducting _______ policy so as to commit the central bank to
achieving a _______.
a. monetary; zero inflation rate.
b. monetary; publicly announced level of inflation.
c. fiscal; zero inflation rate.
d. fiscal; publicly announced level of inflation.

14. While many analysts defended the actions taken by the Fed and the Treasury to respond to the
financial crisis in 2008, others were critical of these actions. The critics were concerned that by
not allowing large firms to fail,
a. there will be less competition in the U.S. economy, which could lead to higher prices for
consumers.
b. there is an increased likelihood that other firms will engage in risky behavior in the future with
the expectation that they will also not be allowed to fail.
c. smaller firms will resent not receiving similar assistance.
d. stockholders and bondholders of these firms were not allowed to receive the proceeds from the
sale of assets that would have occurred if the firms had declared bankruptcy.
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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 the
quantity theory the inflation rate will be
a. 12%
b. 5%
c. 8%
d. 20%.

17. Monetary policy refers to the actions the
a. President and Congress take to manage government spending and taxes to pursue their
economic objectives.
b. Federal Reserve takes to manage the money supply and interest rates to pursue its economic
objectives.
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 their
economic 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. $200
c. $1,800
d. $2,000.

19. As was demonstrated in 2007, firms in the shadow banking system
a. were very vulnerable to bank runs.
b. were more insulated from the financial crisis than were commercial banks.
c. were protected from financial ruin by federal deposit insurance.
d. were insulated from bank runs.

20. Contractionary monetary policy on the part of the Fed results in
a. a decrease in the money supply, an increase in real interest rates, and a decrease in GDP.
b. a decrease in the money supply, a decrease in interest rates, and a decrease in GDP.
c. an increase in the money supply, an increase in interest rates, and an increase in GDP.
d. an increase in the money supply, a decrease in interest rates, and an increase in GDP.

21. The Federal Reserve responded to the 2008 financial crisis in several ways. Which of the
following is not one of the ways the Fed responded?
a. The Fed made investment banks eligible for discount loans.
b. The Fed lowered the required reserve ration on demand deposit accounts in order to increase
the amount of bank reserves.
c. The Fed helped JP Morgan to acquire Bear Stearns, a nearly bankrupt investment bank.
d. The Fed loaned investment banks Treasury securities in exchange for mortgage backed
securities.

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22. Suppose that the equilibrium real federal funds rate is 2 percent, the target inflation rate is 2
percent, 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 rule
the federal funds target rate equals
a. 4 percent.
b. 10 percent.
c. 6 percent.
d. 8 percent.

23. An increase in interest rates
a. 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 spending
on durable goods, and net exports.
c. decreases investment spending on machinery, equipment, and factories, but increases
consumption spending on durable goods, and net exports.
d. increases investment spending on machinery, equipment, and factories, but decreases
consumption spending on durable goods, and net exports.

24. Suppose that Warren Buffet withdraws $1 million from his checking account at Chase
Manhattan Bank. If the reserve requirement ratio is 0.2, what is the maximum change in deposits
in the banking system?
a. - $4 million
b. $5 million
c. - $5 million
d. - $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 how
the Fed can do this. This means explain the change in policy the Fed would have to
implement and explain how that change in policy affect the price level. Use all relevant
models. (25 points)

2.
a. Explain what economists mean by the terms bank run and banking panic. Explain
why financial institutions are vulnerable to them. (10 points)
b. Explain how a bank run can turn an otherwise solvent financial institution into an
insolvent 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 Aggregate
Demand/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 the
long-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 the AD/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 investment
expenditures, 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 means
the Fed needs to sell U.S. Treasury securities:


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



















The Fed Banks
Securities
Reserves
MD
MS
2

MS
1

B
A
M
2
M
1
Money
Nominal interest rate
i
2

i
1

7

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 the
expected inflation rate is constant then the cost of borrowing funds has decreased so
consumption and investment expenditures increase. As a result, the AD curve will shift
to the right from AD
1
to AD
2
and the price level will increase:



















2.
a. A bank run occurs when depositors lose confidence in a bank and become
concerned that their checking account deposits, savings account deposits etc. are
not safe. As a result, depositors simultaneously withdraw the funds from the bank
which can exhaust the banks liquid assets. A banking panic occurs when many
bank runs occur at exactly the same time.
Financial institutions are vulnerable to bank runs for three reasons. First, banks
operate under a fractional reserve system where the banks keep less than 100% of
their deposits on hand as cash. Therefore, there is never enough cash or other
liquid assets in a bank to pay out all depositors simultaneously. Second, banks
have short-term liabilities (deposits), but long-term assets (mortgages, car loans,
etc.). These assets can be converted into cash to pay out depositors, but it takes
time which banks may not have during a bank run. Third, there is asymmetric
information between the bank and the depositors. The bank has far better
information than the depositors about the quality of the banks loans and the bank
has far better information about how many liquid assets the bank owns.
SRAS
LRAS
AD
1

AD
2

Price Level
Real GDP

P
1

P
2

Y
2

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Therefore, if a depositor even thinks that a bank is running out of liquid assets or
thinks 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 to
sell a large amount of their long-term assets which can cause the price of those
assets to decrease. Therefore, a bank run can reduce the value of a financial
institutions assets and may turn an otherwise solvent financial institution into an
insolvent financial institution.
c. Central banks can prevent bank runs by lending freely to solvent financial
institutions that do not have enough liquid assets to meet the surge in withdraws
by depositors. The financial institution can use its illiquid assets such as
mortgages and other loans as collateral for the loans. Therefore, the financial
institution will not be forced to sell assets at low prices so it should remain
solvent and depositors should have confidence that they will get their funds if
they want them. This later effect should reduce or eliminate the bank run.

3.
a.


















b. See above figure. At point A, the unemployment rate is less than the natural
rate of unemployment. As a result, workers have the bargaining strength so
nominal wages begin to rise. Nominal wages are a cost of production so the
SRAS
1

LRAS
AD
1

Price Level
Real GDP

A P
1

Y
1

P
2
B
SRAS
2

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SRAS curve shifts to the left from SRAS
1
to SRAS
2
. The price level rises so the
inflation 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 increasing
then 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 and
the monetary base. If the money multiplier is constant then the money supply will
decrease. The decrease in the money supply will increase short-term nominal
interest rates and eventually long-term nominal interest rates will also increase. If
expected inflation is constant, then long-term real interest rates will increase
making it more expensive to borrow funds to finance consumption and investment
expenditures. As a result, the AD curve will shift to the left from AD
1
to AD
2
.
The economy is now at point C.


















At point C, real GDP equals potential so the unemployment rate equals the natural
rate of unemployment. As a result, there is no more upward pressure on nominal
wages which means there is no tendency for the price level and the inflation rate
to increase.
d. One risk the Fed faces is that it may decrease the money supply by more than is
necessary to eliminate the upward pressure on the price level and the inflation
rate. In that case, the AD curve still shifts to the left, but it shifts to AD
3
and the
economy is now at point D.


SRAS
1

LRAS
AD
1

Price Level
Real GDP

A P
1

Y
1

AD
2

C P
3

10



















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 the
price level and the inflation rate, this came at the cost of causing a recession. The
Fed has a goal of price stability and high employment so the Fed has failed to
achieve both goals.












SRAS
1

LRAS
AD
1

Price Level
Real GDP

A P
1

Y
1

AD
3

D P
4

Y
4

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