Chapter 16

Questions
2. What are government’s fiscal policy options for ending severe demand-pull
inflation? Which of these fiscal policy options do you think might be favored by a person
who wants to preserve the size of government? A person who thinks the public sector is
too large? How does the ‘ratchet effect’ affect anti-inflationary policy?LO1
Answer: Options are to reduce government spending, increase taxes, or some
combination of both. See Figure 30.2. If the price level is flexible downward, it will fall.
In the real world, the goal is to reduce inflation—to keep prices from rising so rapidly—
not to reduce the price level. A person wanting to preserve the size of government might
favor a tax hike and would want to preserve government spending programs. Someone
who thinks that the public sector is too large might favor cuts in government spending
since this would reduce the size of government. The ratchet effect implies that prices are
rigid downward.

3. Use the aggregate expenditures model to show how government fiscal policy
could eliminate either a recessionary gap or an inflationary gap (Figure 10-8). Use the
concept of the balanced budget multiplier to explain how equal increases in G and T
could eliminate a recessionary gap and how equal decreases in G and T could eliminate
an inflationary gap.
Answer: A recessionary gap could be eliminated by increasing government
spending and/or decreasing personal taxes. Both of these policies have the effect of
raising aggregate demand and shifting the aggregate expenditures schedule upward
toward full-employment GDP. An inflationary gap could be eliminated by pursuing the
opposite policies: either decreasing government spending or raising taxes or both. This
would reduce aggregate expenditures and would shift actual spending downward toward
the full-employment level of real GDP. Because the balanced budget multiplier
essentially multiplies any change in government spending by a factor of 1, an increase in
government spending and taxes would still have a positive effect on aggregate
expenditures, increasing them by the amount of the initial increase in G. If G were large
enough, the recessionary gap could be eliminated. Likewise, a balanced decrease in G
and T could eliminate an inflationary gap, because the decline in aggregate expenditures
would be equal to G. If the decrease in G were large enough to bring aggregate
expenditures to the level of full-employment GDP, then the inflationary gap would be
eliminated.

5. Briefly state and evaluate the problem of time lags in enacting and applying
fiscal policy. How might “politics” complicate fiscal policy? How might expectations of
a near-term policy reversal weaken fiscal policy based on changes in tax rates? What is
the crowding-out effect and why might it be relevant to fiscal policy?
Answer: It takes time to ascertain the direction in which the economy is
moving (recognition lag), to get a fiscal policy enacted into law (administrative lag); and
for the policy to have its full effect on the economy (operational lag). Meanwhile, other
factors may change, rendering inappropriate a particular fiscal policy. Nevertheless,
discretionary fiscal policy is a valuable tool in preventing severe recession or severe
demand-pull inflation.
Politics might complicate fiscal policy through the political business cycle. A political
business cycle is the concept that politicians are more interested in reelection than in
stabilizing the economy. Before the election, they enact tax cuts and spending increases
to please voters even though this may fuel inflation. After the election, if they apply the
brakes to restrain inflation; the economy will slow and unemployment will rise. In this
view the political process creates economic instability.
A decrease in tax rates might be enacted to stimulate consumer spending. If households
receive the tax cut but expect it to be reversed in the near future, they may hesitate to
increase their spending. Believing that tax rates will rise again (and possibly concerned
that they will rise to rates higher than before the tax cut), households may instead save
their additional after-tax income in anticipation of needing to pay taxes in the future.
The crowding-out effect is the reduction in investment spending caused by the increase in
interest rates arising from an increase in government spending, financed by borrowing.
The increase in G was designed to increase AD but the resulting increase in interest rates
may decrease I. Thus the impact of the expansionary fiscal policy may be reduced.

8. How do economists distinguish between the absolute and relative sizes of the
public debt? Why is the distinction important? Distinguish between refinancing the debt
and retiring the debt. How does an internally held public debt differ from an externally
held public debt? Contrast the effects of retiring an internally held debt and retiring an
externally held debt.
Answer: There are two ways of measuring the public debt: (1) measure its
absolute dollar size; (2) measure its relative size as a percentage of GDP. The distinction
is important because the absolute size doesn’t tell you about an economy’s capacity to
repay the debt. The U.S. has the largest public debt of any country, but as a percentage of
GDP has a smaller debt than some other nations. This means that the U.S. has greater
ability (more income) to service that debt than those countries whose debt is a higher
percentage of GDP.
Refinancing the public debt simply means rolling over outstanding debt—selling
“new” bonds to retire maturing bonds. Retiring the debt means purchasing bonds back
from those who hold them or paying the bonds off at maturity.
An internally held debt is one in which the bondholders live in the nation having
the debt; an externally held debt is one in which the bondholders are citizens of other
nations. Paying off an internally held debt would involve buying back government
bonds. This could present a problem of income distribution because holders of the
government bonds generally have higher incomes than the average taxpayer. But paying
off an internally held debt would not burden the economy as a whole—the money used to
pay off the debt would stay within the domestic economy. In paying off an externally
held debt, people abroad could use the proceeds of the bonds sales to buy products or
other assets from the U.S. However, the dollars gained could be simply exchanged for
foreign currency and brought back to their home country. This reduces U.S. foreign
reserves holdings and may lower dollar exchange rate.
 Problems

1. Assume that a hypothetical economy with an MPC of .8 is experiencing

severe recession. By how much would government spending have to increase to shift the
aggregate demand curve rightward by $25 billion? How large a tax cut would be needed
to achieve this same increase in aggregate demand? Why the difference? Determine one
possible combination of government spending increases and tax decreases that would
accomplish this same goal.
Answer: In this problem, the multiplier is 1/.2 or 5 so, the required increase in
government spending = $5 billion.
For the tax cut question, initial spending of $5 billion is still required, but only
.8 (= MPC) of a tax cut will be spent. So .8 x tax cut = $5 billion or tax cut = $6.25
billion. Part of the tax reduction ($1.25 billion) is saved, not spent.

Chapter 17
Questions
1. What are the three basic functions of money? Describe how rapid inflation can
undermine money’s ability to perform each of the three functions.

Answer: Money is used as a medium of exchange for goods and services, as a

unit of account for expressing price, and as a store of value. People will only accept
money in exchange for goods and services and for the work they perform if they can be
reasonably certain that the medium of exchange—money—will retain its value until they
are ready to spend it. In runaway inflations of the thousands or tens of thousands of
percent a year, people revert to barter. Drastic inflation greatly reduces money’s use as a
measure of value, for it is impossible to adjust instantaneously all prices strictly in line
with their relative values. Thus, opportunities are afforded to speculators to profit at the
expense of the less sophisticated who, eventually, will learn to distrust money’s
usefulness as a measure of value. Finally, and most obviously, money’s usefulness as a
store of value is destroyed in a drastic inflation. The “rule of 70” is instructive here. By
dividing the absolute inflation rate into 70, one can estimate how long it takes one’s
dollar savings to lose half their purchasing power. At 7 percent inflation, the dollar will
be worth half as much in ten years.

2. What are the components of the M1 money supply? What is the largest
component? Which of the components is legal tender? Why is the face value of a coin
greater than its intrinsic value? What near-monies are included in M2 money supply?
Answer: M1 = currency (in circulation) + checkable deposits. The largest
component of M1 is currency (51 percent), and it is the only part that is legal tender. If
the face value of a coin were not greater than its intrinsic (metallic) value, people would
remove coins from circulation and sell them for their metallic content. M2 = M1 +
noncheckable savings deposits + money market deposit accounts + small time deposits +
money market mutual fund balances.

Chapter 18
Questions
1. What is he diifrenace between an asset and a liability on a bank’s balance sheet?
How does net worth relate to each? Why must a balance sheet always balance? What are
the makor assets and claims on a commercial bank’s balance sheet?
Answer: An asset of a commercial bank is something owned by the bank or owed to
the bank (cash, securities, loans) A liability of the bank is a claim against the bank by
non-owners (checkable deposit) and the owners of the bank. This last liability is the net
worth of the bank. The balance sheet must balance by definition. That is, the sum of
assets must equal the sum of liabilities plus net worth for the bank to ensure appropriate
accounting of transactions.
The major assets of a bank are reserves, securities, loans, and vault cash (this last one is
relatively small when compared to the others). The major claim on the bank is checkable
deposits.

Chapter 19
Questions
1. What is the basic determinant of (a) the transactions demand and (b) the
asset demand for money? Explain how these two demands can be combined graphically
to determine total money demand. How is the equilibrium interest rate in the money
market determined? Use a graph to show the impact of an increase in the total demand
for money on the equilibrium interest rate (no change in money supply). Use you general
knowledge of equilibrium prices to explain why the previous interest rate is no longer
sustainable.
Answer: (a) The level of nominal GDP. The higher this level, the greater the
amount of money demanded for transactions. (b) The interest rate. The higher the
interest rate, the smaller the amount of money demanded as an asset.
On a graph measuring the interest rate vertically and the amount of money demanded
horizontally, the two demands for the money curves can be summed horizontally to get
the total demand for money. This total demand shows the total amount of money
demanded at each interest rate. The equilibrium interest rate is determined at the
intersection of the total demand for money curve and the supply of money curve.
 Sm

i1
Rate of interest, i
(p ercent)

i0

Dm 0 Dm1
Qm
Amount of money demanded and supplied

With an increase in total money demand, the previous interest rate (i0) is unsustainable
because with the new demand for money (Dm1), the quantity of money demanded will
exceed the quantity of money supplied. There would be a shortage of funds and upward
pressure on the interest rate.

2. What is the basic objective of monetary policy? State the cause-effect chain
through which monetary policy is made effective. What are the major strengths of
monetary policy?
Answer: The basic objective of monetary policy is to assist the economy in
achieving a full-employment, non-inflationary level of total output.
Cause-effect chain: Changes in the money supply affect interest rates, which
affect investment spending and therefore aggregate demand. Changes in aggregate
demand affect output, employment, and the price level.
The major strengths of monetary policy are its speed and flexibility compared to
fiscal policy, the Board of Governors is somewhat removed from political pressure, and
its successful record in preventing inflation and keeping prices stable. The Fed is given
some credit for prosperity in the 1990s.