Questions



Chapter 13Macroeconomic PolicyQuestions1.What are the similarities and the differences between monetary and fiscal policies? Answer: Monetary policy is conducted by the central bank, whereas fiscal policy is undertaken by the legislative and executive branches of government. Monetary policy manipulates monetary aggregates (such as bank reserves and M2), credit access, and interest rates, while fiscal policy adjusts government spending and taxes. Though monetary and fiscal policies work differently in different situations, both sets of policies cause shifts in the labor demand curve.2.How do expansionary policies differ from contractionary policies?Answer: During a recession, expansionary policy aims to reduce the severity of the downturn by shifting labor demand to the right and “expanding” economic activity. Contractionary policy, on the other hand, shifts the labor demand curve to the left and sometimes is used to reduce the rate of inflation or slow down the economy when it grows too fast or “overheats.” 3.Briefly explain how expansionary monetary policy shifts the labor demand curve to the right. Answer: Expansionary monetary policy lowers short-run interest rates and increases access to credit in order to stimulate economic activity. The fall in short-run interest rates usually causes the long-term expected real interest rate to fall. A fall in the long-term expected real interest rate encourages households and firms to make more investments (such as building new homes and factories) because a lower real interest rate implies that the cost of a loan has fallen. Lower interest rates also stimulate consumption spending, especially on durable goods, because loans to finance those purchases cost consumers less. To satisfy an increase in demand for investment and consumption goods, firms seek to hire more workers, shifting the labor demand curve to the right. 4.What is quantitative easing? Why do central banks undertake quantitative easing programs?Answer: Quantitative easing involves primarily a change in the way that the Fed conducts open market operations. Rather than buying just short-term Treasury bonds, which is the usual way that the Fed increases bank reserves in a standard open market operation, the Fed buys other assets as well, including long-term bonds and mortgage-backed securities. This pushes up the price on the long-term bonds and thereby drives down long-term interest rates. Such purchases also increase the quantity of bank reserves, with the goal of increasing bank lending, and ultimately, stimulating the economy. Quantitative easing is one of the major factors behind the significant increase in bank reserves that occurred from 2008 to 2014. 5.Other than open market operations and quantitative easing, what tools does the Federal Reserve use to manipulate interest rates in the economy? Answer: The Federal Reserve has several tools in addition to open market operations to affect interest rates. First, it can change the reserve requirement, the percentage of checking deposits that banks are required to keep on reserve. If the requirement is increased, banks must keep more in reserves, and the demand for reserves curve shifts to the right, increasing the fed funds rate. Conversely, if the requirement is decreased, the reserves demand curve shifts to the left, decreasing the fed funds rate.Second, the Fed can change the interest rate it pays banks on the reserves banks hold at the Fed. A decrease in that rate lowers the demand for reserves and shifts the reserves demand curve to the left, thus lowering the fed funds rate. An increase in the rate paid would have the opposite effect.Third, the Federal Reserve can change interest rates by using the discount window through which it can provide short-term liquidity to banks. Banks use the discount window when they can’t find a lender in the federal funds market. Such lending occurs frequently during financial crises. 6.Does the effectiveness of monetary policy depend on inflation expectations? Explain. Answer: Yes, inflation expectations are linked closely with the long-term expected real interest rate. The federal funds rate, which is the annualized interest rate on overnight loans between banks, is a short-term nominal interest rate that the Fed directly controls using monetary policy. However, the interest rate that is relevant for consumers’ and firms’ investment decisions—for instance, the mortgage interest rate—is the long-term expected real interest rate. Long-term expected real interest rate = Long-term nominal interest rate – Long-term expected inflation rate. For the Fed to lower the long-term expected real interest rate, it has to either lower the long-term nominal interest rate or raise long-term expectations of the inflation rate (or both). To do this, the Fed can communicate that it will maintain an expansionary monetary policy, holding down the federal funds rate and increasing the money supply, for a long period of time. If the Fed promises to keep the federal funds rate low and households and firms believe that the federal funds rate will remain low for several years, then the long-term nominal interest rate will also be low. Inflation expectations are likely to be high when the Fed creates expectations of inflation by promising to conduct expansionary monetary policy for several years. High inflation expectations will then lower the long-term expected real interest rate. 7.Briefly explain how an increase in the quantity of reserves that commercial banks hold at the Federal Reserve could lead to inflation. Answer: The Federal Reserve buys government bonds from commercial banks and electronically increases the quantity of reserves held by these commercial banks. Because banks now have a higher quantity of reserves, they can create more loans. Those loans circulate through the economy and return to the banking system as deposits. Rising bank deposits enable banks to make even more loans. The resulting total increase in deposits generates an increase in monetary aggregates like M2. If the stock of money grows faster than the real level of GDP, the aggregate price level will rise, generating inflation.8.How does the zero lower bound on interest rates affect the working of monetary policy?Answer: The zero lower bound is a barrier that nominal interest rates cannot cross; when nominal interest rates have been lowered to zero, the central bank cannot lower rates any further. When the rate of inflation is low or negative, the zero lower bound is a problem for the working of monetary policy. When the nominal interest rate is stuck at or above zero and the inflation rate is negative, the real interest rate will be positive. If the inflation rate keeps falling, the real interest rate will rise, reducing investment and shifting the labor demand curve to the left.9.When nominal interest rates have hit the zero lower bound, can central banks use interest rates to stimulate the economy? Explain. Answer: Yes, the central bank can try to influence expectations of future nominal interest rates and future inflation. By promising to keep nominal interest rates low for many years and promising to keep inflation low in the long term, the central bank can influence the long-term expected real rate of interest, even if the current interest rate is at zero and can’t be lowered any further.10.What does the Taylor rule state? Answer: The Taylor rule shows that the federal funds rate should be set at the level where: Federal funds rate = Long-run federal funds rate target + 1.5[inflation rate –Inflation rate target] + 0.5[Output gap in percentage points]11.According to the Taylor rule, when should the Federal Reserve lower or raise the federal funds rate?Answer: The Taylor rule contains two relationships:The Fed should raise the federal funds rate as the inflation rate rises. A larger inflation rate leads the Fed to engage in less stimulus by raising the federal funds rate. Specifically, the formula says that every percentage point increase in the inflation rate should translate into a 1.5 percentage point increase in the federal funds rate. The Fed should set a higher federal funds rate the higher the output gap. A larger output gap leads the Fed to engage in more contractionary monetary policy by raising the federal funds rate. Specifically, the formula says that every percentage point increase in the output gap should translate into a 0.5 percentage point increase in the federal funds rate.12.What are the automatic and discretionary components of fiscal policy?Answer: Fiscal policy can be divided into automatic and discretionary components. Automatic components are aspects of fiscal policy that automatically partially offset fluctuations in economic activity. These automatic components do not require deliberate action on the part of the government. For example, tax collection falls automatically during a recession because unemployed workers don’t owe income tax. Discretionary components are aspects of fiscal policy that policymakers deliberately enact in response to economic fluctuations. In most cases, these new policies introduce a package of specific, temporary tax cuts or spending increases to reduce economic hardship and stimulate aggregate economic activity.13.Why do governments, in most cases, not follow countercyclical fiscal policy? How can the need for discretionary fiscal policies be decreased?Answer: The leaders in government typically have two goals: assist and lead their own countries and to stay in power. In most cases, it is possible to stay in power by providing funds for those voting groups who can be convinced to vote for you. This makes it difficult to follow prudent fiscal choices, as that would mean saving when the economy is booming and spending when the economy is in a downturn. Most governments do not save enough during boom years, and are therefore not able to spend enough during a crisis.14.What could explain why a decrease in taxes could lead to a less-than- proportionate increase in output? Answer: Expansionary fiscal policy is implemented by increasing government spending or by cutting taxes. A decrease in taxes could lead to a less-than-proportionate increase in output for the following reasons. Tax cuts might generate crowding out effects. As consumers try to spend more, resources that would have previously gone to investment may now be redirected to consumption. The extra goods might be provided by an increase in imports, lowering net exports.Consumers may not actually spend much of their tax cut right away and may choose to save instead. Consumers may try to smooth their consumption by spreading the “extra” spending over the long term rather than consuming the proceeds of a tax cut all at once. They may also recognize that the government will eventually have to raise taxes in the future to pay for the current tax cut. This may lead them to save the tax cut now to pay for the tax raise later. 15.Why is the Troubled Asset Relief Program (TARP) considered an example of a countercyclical policy that represents a mix of fiscal and monetary effects? Answer: A program like TARP is an example of a policy that includes both fiscal and monetary effects. The TARP was developed jointly by the Federal Reserve and the Treasury Department. The TARP legislation required that the Fed Chairman be consulted during TARP’s implementation. The U.S. Congress passed the legislation authorizing the Treasury Department to spend $700 billion to stabilize the financial system. This money was used to infuse capital into the banking system. The increase in capital stabilized banks that were close to bankruptcy and prevented financial contagion. Therefore, the fiscal component of TARP involved the increase in government expenditure, while the monetary component was the fact that banks and the financial system were affected by this program. Problems1.The former chairman of the Federal Reserve, Alan Greenspan, used the term “irrational exuberance” in 1996 to describe the high levels of optimism among stock market investors at the time. Stock market indexes such as the S&P Composite Price Index were at an all-time high. Some commentators believed that the Fed should intervene to slow the expansion of the economy. Why would central banks want to clamp down when the economy is growing? What policies could the government and the central bank use to achieve the goal of slowing down the economic expansion? Answer: To quote Greenspan, “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?” Policymakers may want to limit growth because factors such as irrational optimism about the economy can result in unsustainable increases in asset values. Bubbles or irrational increases in asset prices are usually not supported by corresponding changes in fundamentals. Unsustainable expansions can subsequently lead to very severe downturns because irrational optimism can implode suddenly and severely (due to multiplier effects).The government and the central bank can use contractionary policies to slow or even reverse an economic expansion. Contractionary monetary policy can be implemented to raise interest rates, thereby increasing the cost of borrowing and reducing investment and consumer spending. Contractionary fiscal policy, such as tax increases or reductions in government spending, could also be employed to dampen aggregate economic activity. Either of these policies will serve to slow an economic expansion and avoid the dangers of unsustainable increases in asset pricesAlan Greenspan’s speech: 2.The following figures show the Federal Reserve’s balance sheet as well as the balance sheet of a commercial bank, BHZ Bank. Suppose the Federal Reserve wants to lower bank reserves by $1?billion. Assuming that BHZ Bank is willing to transact with the Federal Reserve, show how the Fed’s as well as BHZ’s balance sheet will change. THE FEDERAL RESERVEAssetsLiabilities and Shareholders' Equity Treasury Bonds?$1,500 billionReserves?$1,500 billionOther bonds ?$500 billionCurrency?$ 500 billionTotal assets?$2,000 billionTotal liabilities $2,000 billionBHZ BANKAssetsLiabilities and Shareholders' equity Reserves?$200 billion Deposits and other liabilities?$700 billionBonds and other investments ?$800 billionShareholders' equity ?$300 billionTotal assets?$1,000 billionLiabilities + shareholders' equity ?$1,000 billionAnswer: To lower bank reserves by $1 billion, the Fed engages in an open market operation with BHZ Bank. The Fed deducts $1 billion from the reserves that BHZ holds with the Fed and gives BHZ $1 billion in bonds instead. On the liability side of the Fed’s balance sheet, the reserves (held by BHZ) fall by $1 billion. On the asset side, the Fed has $1 billion less in bonds (sold to BHZ Bank).THE FEDERAL RESERVEAssetsLiabilities and Shareholders' Equity Treasury Bonds?$1,499 billionReserves?$1,499 billionOther bonds ?$500 billionCurrency?$ 500 billionTotal assets?$1,999 billionTotal liabilities $1,999 billionBHZ Bank buys $1 billion in bonds from the Fed, paying for them by a reduction of $1 billion in the bank’s reserve account at the Fed. Nothing changes on the liability (and shareholders’ equity) side of BHZ’s balance sheet. On the asset side, total assets don’t change, but the composition of assets does. After the trade, BHZ has another $1 billion in bonds and $1 billion less in reserves. BHZ BANKAssetsLiabilities and Shareholders' Equity Reserves?$199 billion Deposits and other liabilities?$700 billionBonds and other investments $801 billionShareholders' equity ?$300 billionTotal assets?$1,000 billionLiabilities + shareholders' equity ?$1,000 billion3. Indicate whether the following phenomena will lead to a shift in the reserves supply and demand curve for the Bank of England (BoE), where the horizontal axis indicates the quantity of reserves and the vertical axis the interest rate of the Bank of England. In your answer, use a graph of the money market to show how the Bank of England’s action translates into a higher interest rate. a.Economic contraction. b.Increasing deposit base. c.Selling government bonds. d. If the demand curve shifts to the left, how should the BoE respond to keep the interest rate constant? Answer:a.In case of an economic contraction, firms are less in need of loans. Therefore, we shall witness a shift to the left in the case of the demand curve.b.Banks are required to hold a certain amount of their customers’ bank accounts in reserve deposits at the Fed. If the deposit base is increased (the Fed might do this in order to increase the safety of banks during a potential crisis), then banks will have to increase their holdings at the Fed. Therefore, the demand curve will shift to the right. c.If the Fed decides on selling government bonds, then it is decreasing its reserves moving the supply curve to the left. d.If the demand curve shifts to the left, then the Fed should consider shifting its own supply curve to the left as well. As we have seen from the previous example, this can be done by selling government bonds, for instance.4.You and a friend are debating the merits of using monetary policy during a severe recession. Your friend says that the central bank needs to lower interest rates all the way down to zero. According to him, zero nominal interest rates will boost lending and investment; consumers and firms will surely borrow and spend when interest rates are zero. Would you agree with his reasoning? How does the level of inflation affect your answer? Explain your conclusions.Answer: Yes, zero nominal interest rates could boost spending and act as an economic stimulus. Households and firms make investment decisions based on the real interest rate. When the nominal interest rate is zero and the inflation rate is positive, the real interest rate will be negative. Suppose the inflation rate is 2 percent. The real interest rate would be equal to 0% – (2%) = –2%. This provides a significant incentive for consumers and firms to borrow, which stimulates consumption expenditure and investment expenditure.5. Why is observing the Taylor rule important in ensuring macroeconomic stability? What are the potential effects of not taking it into consideration? Visit and check the following pages. Can you see the Taylor effect in practice with the European Central Bank (ECB)? a.The ECB refi rate, European Central Bank’s interest rate b.Inflation Europe (HICP) Answer:The Taylor rule states that the federal funds rate should be increased if inflation increases. If the federal funds rate is higher, then the degree of stimulus being provided by inflation is lower. The Taylor rule even states that one percentage point of increase in the interest rate will have to lead to a 1.5 percentage increase in the federal funds rate. In addition, a stronger output gap (stronger economy) should also lead to a higher federal funds rate. If the Taylor rule is not observed, that is the federal funds rate does not increase in parallel with inflation or economic growth, the economy of the country can very easily overheat. This can be partially observed by looking at the following graph. The Fed started to increase its federal funds rate from only 2004 Q1 onwards, which probably was too late. This led to two years in which inflation and economic growth were uncontrolled for, and may have contributed to the financial crisis of 2008/2009. 6.The following graph shows actual and projected estimates of potential GDP and GDP. Potential GDP is also a measure of trend GDP. When is the output gap, defined as the percent difference between GDP and potential GDP, negative? According to the Taylor rule, how should a negative output gap affect the federal funds interest rate?Answer: The output gap is the percentage difference between trend GDP, or potential output, and the actual level of GDP. When the economy is producing less GDP than it can, or when actual GDP is lower than potential GDP, the output gap is negative. A negative output gap implies a weaker economy, and therefore the Fed should set a lower federal funds rate the more negative the output gap. The graph given above shows that the output gap was negative from the year 2008 onward and is projected to remain negative until after 2016. It follows that, according to the Taylor rule, other things remaining unchanged, the Fed should keep the federal funds rate below its long-term target level. Graphs and data from: 7.Two economists estimate the government expenditure multiplier and come up with different results. One estimates the multiplier at 0.75, while the other comes up with an estimate of 1.25.a.What do these different estimates imply about the consequences of government expenditure? b. If the current value of GDP is $13.28 trillion and the government is planning to increase spending by $800 billion, what is the percentage increase in GDP for each of the two estimates for the multiplier? Assume the increase in spending occurs all in one year.Answer: a.The economist who estimates the multiplier at 1.25 is likely to be assuming that the increased government spending will lead to an increase in consumption. The increase in government spending can stimulate business activity, which will increase the income of workers and hence consumption spending in the economy. The other economist is likely to be assuming that the increase in government spending will lead to more government borrowing, which will divert resources away from consumption and investment. The resulting higher interest rates dampen consumption and investment spending. According to the economist who estimates the multiplier at 0.75, a $1 increase in government spending will not even generate a $1 increase in equilibrium GDP.b.4.52 percent, 7.53 percentIf the multiplier is 0.75, an $800 billion increase in government spending will result in an increase in GDP of 0.75 × $800 billion = $600 billion. GDP would increase from $13.28?trillion to $13.88 trillion, an increase of 4.52 percent.If the multiplier is 1.25, then an $800 billion increase in government spending will result in a 1.25 × $800 billion = $1,000 billion increase in GDP. GDP would increase from $13.28?trillion to $14.28 trillion, which is an increase of 7.53 percent.8.According to the article Politics and investment: Examining the territorial allocation of public investment in Greece, in the 34 years before the 2008 financial crisis, public expenditure in various constituencies in Greece was closely correlated with electoral results. The regions that voted a party back to office were rewarded, whereas contested and opposition areas were not supported. a.What is this type of attitude or spending called? Explain your answer. b.What are the problems with heavy government investment in pork barrel type spending?Answer: a.Rewarding your loyal supporters and spending for popularity purposes is called pork barrel spending. This is an inefficient use of funds as the benefits will be provided to a small group of people, whereas the costs will be paid by many.ernment expenditure in healthcare, education, and infrastructural investment can be quite important in order to maintain the competitiveness of the given country. However, resources should be allocated in a way as to support those regions of a country where there is a real need. Otherwise, the investment will not be sustainable and have a government expenditure multiplier close to zero. Furthermore, if a government decides to spend during the peak of the boom period, the positive impact will be close to zero. In fact, it might crowd out perfectly good investment, increasing the economy’s dependence on government investments as opposed to market-based investments. 9.Milton Friedman, the renowned monetary economist, gave the following analogy about the Fed: “Imagine your house is being heated by a heater. The heater is controlled by a thermostat. The way it’s set up, when the house gets a little too warm, the thermostat turns off the heater; if it gets too cold, the thermostat turns the heater back on. If everything works as planned, the room temperature in the house should roughly be the targeted temperature all the time.Now suppose the thermostat is not in the same room as the heater. In fact, it’s in the last room that is affected by the heater. Say, the attic. And the radiators through which the heater works are really old, and it takes them at least twenty minutes to react. Then, instead of making the temperature more stable, the thermostat would make the temperature swing wildly. For example, if the house is cold, then the thermostat will turn the heater on. But it will turn the heater off only when the attic is warm. By then, the entire house will be scorching hot. When it turns the heater off, it will not turn it back on until the attic is cooler. By then, the house will be freezing.” (In this analogy, the thermostat is the Fed; the house is the entire economy.)a.What do you think Milton Friedman was trying to say about monetary policy? (Hint: you do not need to draw any graphs for this question.) b.As in the thermostat analogy, what might be some possible unintended consequences of monetary policy? Might there be a similar effect for fiscal policy? If yes, how does it differ from monetary policy?Answers:a.Milton Friedman is referring to lags in monetary policy, more specifically, what are called impact lags. This is the time that elapses between when a policy is decided, when it is implemented, and when it has an impact. The impact may occur when the economy has already begun to move by itself in the desired direction. Thus, monetary policy can exaggerate a swing in the business cycle instead of dampening it.b.Due to lags in monetary policy, the danger is that any action, such as expansionary monetary policy, will have an effect when the economy is already climbing out of recession. The effect of monetary policy will then overheat the economy. Conversely, if the Fed moves to raise interest rates and “tighten” the availability of credit, the policy may have its greatest effect when the economy is already cooling and thus cause a more pronounced recession than had been planned.The impact of fiscal policy tends to be more immediate than that of monetary policy. However, fiscal policy often involves a considerable delay in its formulation and implementation. This is sometimes called a “decision lag.” As is the case with monetary policy, the effect on the economy might occur when it is no longer needed.10. The European Central Bank (ECB) manages monetary policy for the eurozone. Following the financial crisis of 2007-2008, the ECB, like the Fed, lowered interest rates to around zero. a. Using the concept of the zero lower bound, explain how low interest rates could constrain countercyclical monetary policy. b. Though fiscal policies are controlled by individual governments in the eurozone, the European Union’s Stability and Growth Pact places strict limits on country-level deficit spending. Explain how the confluence of the zero lower bound and restrictions on the fiscal deficit might be problematic for countercyclical macroeconomic policy. Answer: a. As interest rates approach the zero lower bound, central banks become limited in their options. If the economy is in a recession, the bank would, ideally, want to lower the interest rate more to mitigate unemployment and deflation during the recession. However, because of the zero lower bound, that policy has a limit—at some point, the central bank will be unable to further lower the federal funds rate equivalent. b. As we saw in part a, the zero lower bound limits countercyclical monetary policy during a recession. The alternative, generally, might be countercyclical fiscal policy—during a recession, that might include tax cuts or increased government spending. However, both of these policies increase spending without a compensating increase in government income. Deficit restrictions, then, could prevent central governments from enacting the appropriate countercyclical policies. Combined, then, deficit restrictions and interest rates close to the ZLB could severely limit a country’s options during a recession. 11. Challenge Problem. The chapter mentions that an open market operation by the Fed can increase or decrease the quantity of deposits in banks, and therefore the money supply. (See, for example, Exhibit 27.8.)The expansion in the money supply from a Fed open market operation is given by the following equation (under the simplifying assumption that households don’t hold cash so the money supply is equal to demand deposits):Change in money supply = (Change in reserves) × (1 / (RR + ER’))where RR = the percentage of deposits that banks are required to keep as reserves (expressed as a decimal), and ER = the percentage of deposits that banks voluntarily hold as excess reserves (expressed as a decimal). 1/(RR + ER) is called the “money multiplier.”Suppose the Fed decides to sell $14 billion in Treasury bonds. Assume that the reserve requirement is 8 percent and banks hold 4 percent in excess reserves, so RR = 0.08 and ER = 0.04.What is the total increase or decrease in the money supply that would result from the Fed’s action? Explain your answer and show your calculations. Verify that the quantity of new deposits (which is the change in the money supply in this example) is backed up by an adequate quantity of new reserves: (RR + ER) × (Change in deposits) = (Change in reserves). Answer: Since RR = 0.08, and ER = 0.04: .The Fed's bond sale decreases the reserves in the banking system by $14B. With a reserve requirement of 8 percent, and banks holding 4 percent of their deposits as excess reserves, the money supply will fall by as much as $116.2 billion because of the “reverse money multiplier” process. The initial bond sale by the Fed takes reserves out of the banking system. This, in turn, reduces bank reserves, which sets the reverse money multiplier in motion. The resulting cycle of withdrawal then loan reduction then withdrawal Then loan reduction will decrease total deposits in the banking system by the amount shown below:Change in money supply= Change in deposits = (Change in reserves) × (Money multiplier)= ?$14B × 8.33333….. = ?$116.6666….. BVerifying:(RR + ER) × (Change in deposits)= (0.08 + 0.04) × (–$116.6666…. B) = (0.12) × (–$116.6666…… B) = –$14B= Change in reserves12. ................
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