ECON 352 Problem Set 3

Spring 2022

Professor F. Ibrahimi-Nazarian

1) What is the relationship between the trade balance and the current account balance?

2) Explain how "net capital flows" are related to "net foreign investment," "net foreign direct investment," and "net
foreign portfolio investment."

3) Why is the balance of payments always zero?

4) Explain why economies with financial account surpluses usually have current account deficits.

5) What is the difference between net exports and the current account balance?

Table 18-1

Increase in foreign holdings of assets in the United States $2,560

Exports of goods 925
Imports of services -456
Statistical discrepancy ?
Net transfers -77
Exports of services 623
Imports of goods -1,211
Income payments on investments -444
Increase in U.S. holdings of assets in foreign countries -2,478
Income received on investments 502

6) Refer to Table 18-1. Use the information in the table to prepare a balance of payments account and find the
value of the statistical discrepancy. Assume that the balance on the capital account is zero.

Article Summary
In August 2019, China's central bank lowered the exchange rate for its currency, the yuan, to its lowest level in 11
years. The devaluation changed the exchange rate to more than 7 yuan per U.S. dollar, a move some analysts believe is
in retaliation to U.S. tariffs on Chinese goods. According to Andrew Collier, managing director of Orient Capital
Research in Hong Kong, "The drop suggests that the central bank of China is willing to weaponize the currency in
light of the trade war." The move could expand a growing U.S. trade deficit with China, which reached a 5-month
high in June according to the U.S. Commerce Department.
Source: Emily Feng "China's Currency Falls To Lowest Exchange Rate In 11 Years", npr.org, August 5, 2019.

7) Refer to the Article Summary. All else equal, a depreciation of the Chinese yuan relative to a currency such as
the U.S. dollar should ________ foreign investment into China and ________ exports from China.
A) increase; increase B) increase; decrease
C) decrease; increase D) decrease; decrease

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 8) Refer to the Article Summary. All else equal, a depreciation of the Chinese yuan relative to a currency such as
the U.S. dollar should ________ the current account balance in China and therefore ________ the financial
account balance in China.
A) increase; increase B) increase; decrease
C) decrease; increase D) decrease; decrease

9) What are the three main sets of factors that cause the supply and demand curves in the foreign exchange
market to shift?

10) If the exchange rate between the Mexican peso and the U.S. dollar expressed in terms of pesos per dollar is 13.5
pesos = 1 dollar, what is the exchange rate when expressed in terms of dollars per peso?

11) Explain and show graphically the effect of a decrease in U.S. budget deficits that decrease U.S. interest rates on
the demand and supply of U.S. dollars for euros.

12) If American demand for purchases of British goods has decreased, how would you expect the equilibrium
exchange rate in the market for dollars to respond? Support your answer graphically.

13) If American demand for purchases of Mexican goods has increased, how would you expect the equilibrium
exchange rate in the market for dollars to respond? Support your answer graphically.

14) What three real-world complications keep purchasing power parity from being a complete explanation of
exchange rate fluctuations in the long run? Explain.

15) The "Big Mac Theory of Exchange Rates" tests the accuracy of purchasing power parity theory. In January 2020,
The Economist reported that the average price of a Big Mac in the United States was $5.67. In South Korea, the
average price of a Big Mac at that time was 4,500 Korean won. If the exchange rate between the dollar and the
Korean won was 1,150 Korean won per dollar, how would purchasing power parity predict the exchange rate
will change in the long run?

16) What are the three main exchange rate systems, and how do they operate?

17) What is the difference between a fixed exchange rate system and a managed float exchange rate system?

18) Why might a developing country choose to peg the value of its currency to the dollar?

19) What does it mean when one currency is "pegged" against another currency?

20) Why do countries peg their currencies, and what problems can result from pegging?

21) Why does continued foreign investment in U.S. stocks and bonds and foreign companies continuing to build
factories in the United States result in a current account deficit in the United States?

22) What are the four functions of money? Can something be considered money if it does not fulfill all four
functions?

23) Suppose you withdraw $1,000 from your savings account and put it under your mattress. Briefly explain how
this will affect M1 and M2.

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24) Suppose you withdraw $1,000 from your savings account and put it in your checking account. Briefly explain
how this will affect M1 and M2.

25) Suppose you transfer $2,000 from your money market mutual fund account to your checking account. What is
the immediate impact of this transfer on M1 and M2?

26) Why do banks create money? Do they create money to help the Federal Reserve control the money supply or is
there a more basic reason?

27) Suppose that the required reserve ratio is 20 percent and you deposit $50,000 of currency into Comerica Bank.
What is the potential increase in deposits in the banking system brought about by your deposit? What is the
potential change in the money supply?

28) Describe the structure of the Fed's Open Market Committee (FOMC). What is this committee's primary
responsibility?

29) How do open market operations work?

30) How effective is discount policy as compared to open market operations in managing the money supply?
Explain how The Federal Reserve uses discount policy today.

31) What is the principle monetary policy tool used by the Fed. Why?

32) Would the maximum loan that a bank can make be different when receiving a discount loan from the Federal
Reserve of $1 million versus receiving a checking account deposit of $1 million? Explain why or why not.

33) How will the purchase of $100 million of government securities by the Federal Reserve change bank reserves
and total checking account deposits in the banking system as a whole? Assume that banks do not hold any
excess reserves, that households and firms do not change the amount of currency they hold, and that the
required reserve ratio is 20 percent.

34) In countries that have experienced hyperinflation, what role have large government budget deficits played in
causing the very high inflation rates?

35) When a government has a budget deficit, it must issue (sell) government bonds to finance the deficit. Does it
matter for the rate of inflation if the government sells the government bonds to the public or sells the
government bonds to the central bank? Explain why it does or does not matter.

36) What are the implications of the quantity theory of money for monetary policy and price stability?

37) According to the quantity theory of money, if the money supply is growing at a rate of 5 percent, real GDP is
growing at a rate of 2 percent, and velocity is constant, what will the inflation rate be?

38) List the Fed's four main monetary policy goals.

39) What is a banking panic, and what role did banking panics play in the decision by Congress to establish the
Federal Reserve?

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40) When Congress established the Federal Reserve in 1913, what was its main responsibility? When did Congress
broaden the Fed's responsibilities?

41) What problems can high inflation rates cause for the economy?

42) Does the money demand curve have a positive slope or a negative slope? Why does it have this slope? Explain
why an increase in the variable on the vertical axis of the money demand curve causes either an increase or a
decrease in the variable on the horizontal axis of the money demand curve.

43) Give an example of a monetary policy target. Explain why the Fed uses policy targets.

44) Describe how the Fed would traditionally use open market operations to change short-term and long-term
interest rates.

45) Use the money demand and money supply model to show graphically and explain the effect on interest rates of
the Federal Reserve's open market purchase of Treasury securities.

46) Use the money demand and money supply model to show graphically and explain the effect on interest rates of
the Federal Reserve's open market sale of Treasury securities.

47) What actions should the Fed take if it believes the economy is about to fall into recession?

48) What actions should the Fed take if it believes the economy is about to experience a high rate of inflation?

49) If the Fed orders an expansionary monetary policy, describe what will happen to the following variables
relative to what would have happened without the policy:
a. The money supply
b. Interest rates
c. Investment
d. Consumption
e. Net Exports
f. The aggregate demand curve
g. Real GDP
h. The price level

50) Use a graph to show the effects of an expansionary monetary policy moving an economy out of recession and
to potential real GDP. Explain what happens to aggregate demand, real GDP, and the price level.

51) Would the Federal Reserve respond more aggressively with interest rate cuts in a recession caused by a
decrease in spending, as in the 2001 recession, than in a recession caused by an increase in oil prices, as in the
1974-75 recession?

52) Write out the expression for the Taylor rule. Use the Taylor rule to explain how a decline in real GDP below
potential GDP will affect the Federal Reserve's target for the federal funds rate.

53) Present two arguments as to why the Fed should adopt inflation targeting as a framework for monetary policy.

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54) The money supply is $12.5 million, currency held by the nonbank public is $2.5 million, and the
reserve-deposit ratio is 0.25.
(a) What is the quantity of bank deposits?
(b) What is the quantity of bank reserves?
(c) What is the quantity of the monetary base?
(d) What is the money multiplier (give a number)?

55) Suppose the following statistics are available for the economy:
CU = $60 billion
RES = $100 billion
DEP = $1000 billion

Calculate the size of the monetary base, the money supply, the reserve-deposit ratio, the currency-deposit
ratio, and the money multiplier.

56) Was the money multiplier stable during the Great Recession? Why would an unstable money multiplier pose a
problem for monetary policy?

57) Describe, in general terms, the lags in the effects of monetary policy on interest rates, output, and prices. Be
sure to note how long it takes each variable to respond to policy changes.

58) Describe the strategy of inflation targeting. Why have many countries begun to use this strategy instead of
targeting money growth? What are the advantages and disadvantages of inflation targeting?

59) Describe the Taylor rule. If the Fed were following the rule, what would the nominal Fed funds rate be if
inflation over the past year were 4% and output were 1% below its full-employment level?

60) What is the difference between fiscal policy and monetary policy?

61) List the five categories of federal government expenditures.

62) What is fiscal policy, and who is responsible for fiscal policy?

63) What is the difference between federal purchases and federal expenditures?

64) Give an example of an automatic stabilizer. Explain how automatic stabilizers work in the case of recession.

65) What is expansionary fiscal policy? What is contractionary fiscal policy?

66) Does expansionary fiscal policy directly increase the money supply? Isn't it true that the president and
Congress fight recessions by spending more money?

67) The problem typically during a recession is not that there is too little money, but too little spending. If the
problem was too little money, what would be its cause? If the problem was too little spending, what could be its
cause?

68) How does expansionary monetary policy increase spending in the economy compared to how expansionary
fiscal policy increases spending in the economy?

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69) Consider the following statement, "The Federal Reserve fights recessions by increasing the money supply so
people will have more money to spend." What is wrong with the statement and how can it be corrected?

70) Identify each of the following as (i) part of an expansionary fiscal policy, (ii) part of a contractionary fiscal
policy, or (iii) not part of fiscal policy.

a. The personal income tax rate is lowered.

b. Congress cuts spending on defense.
c. College students are allowed to deduct tuition costs from their federal income taxes.
d. The corporate income tax rate is lowered.
e. The state of Nevada builds a new tollway in an attempt to expand employment and ease traffic in Las
Vegas.

71) You are given the following budget data for a country that has both a central government and local
governments.

Central purchases of goods 500

Local purchases of goods 250
Central transfer payments 200
Local transfer payments 100
Grants in aid (central to local) 150
Central tax receipts 800
Local tax receipts 150
Interest received from private sector by central government 25
Interest received from private sector by local governments 10
Total central government debt 1500
Total local government debt 0
Central government debt held by local governments 300
Nominal interest rate 10%

How much is the deficit for the central government, the local government, and the total of the central and local
governments?

72) Suppose that the federal income tax on individuals is set up as follows:
Income above Income below Taxes
0 $8000 0.10 × income
$8000 $35,000 $800 + [0.15 × (income - $8000)]
$35,000 & up $4850 + [0.25 × (income - $35,000)]

Calculate the average tax rate and marginal tax rate for workers with the following levels of income:
(a) $6500
(b) $27,000
(c) $72,000
(d) $250,000

73) Why is the Social Security system in crisis at a time when it's running large surpluses? What's the source of the
problem? What solutions have been proposed?

74) Who bears the burden of the government debt? Explain why. Under what circumstances is there no burden to
be borne?

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75) Why do bank panics normally lead to recessions?

76) What are the two most common reasons for a sovereign debt crisis?

77) In what ways did the stock market crash of 1929 increase the severity of the downturn?

78) Describe the debt-deflation process.

79) How does deflation affect those with debt?

80) What are the four explanations given as to why the Fed did not intervene to stabilize the banking system
during the Great Depression?

81) How does the relationship between housing prices and rental rates provide evidence for or against the
existence of a housing bubble?

82) What are the primary reasons for and against a policy of "too big to fail."

83) Which aspects of a bank's operations are evaluated as part of the CAMELS rating system?

84) Describe the four stages of the financial regulatory pattern.

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Answer Key
Testname: ECON 352 PROBLEM SET 3

1) The trade balance measures the difference between the value of the goods a country exports and the value of the
goods a country imports. If a country's exports of goods are greater than its imports of goods, there is a trade
surplus, which increases the current account balance. However, the trade balance is not the only component of the
current account balance. The balance of services (exports of services minus imports of services), net income on
investments, and net transfers are also included in the current account balance.
2) Net capital flows measure the difference between capital inflows and capital outflows. Capital inflows increase
when assets flow into the United States from other countries. Capital outflows increase when assets flow from the
United States into other countries. Net foreign investment is equal to net foreign direct investment (U.S. investment
in facilities in other countries minus foreign investment in U.S. facilities) plus net foreign portfolio investment (U.S.
investment in foreign stocks or bonds minus foreign investment in U.S. stocks or bonds). An increase in net foreign
direct investment or an increase in foreign portfolio investment will result in an equal decrease in net capital flows.
In other words, net capital flows will be equal to the negative of net foreign investment.
3) If a country spends more on goods and services and other items in the current account than it receives, it must have
received the income needed to buy those items from investments from foreigners. In other words, a current account
deficit must be offset by a surplus in the financial account. Apart from measurement errors, the sum of the current
account and the financial account must equal zero. Therefore, the balance of payments must also equal zero.
4) An economy will have a current account deficit if it is importing more than it is exporting in goods and services.
This deficit must be financed by foreign investment in the economy (capital inflows) that exceeds capital outflows.
As a result, the current account deficit must be accompanied by a financial account surplus.
5) The current account balance includes net exports plus net income on investments and net transfers.
6) CURRENT ACCOUNT
Exports of goods $925
Imports of goods -1,211
Balance of trade -286
Exports of services 623
Imports of services -456
Balance of services 167
Income received on investments 502
Income payments on investments -444
Net income on investments 58
Net transfers -77
Balance on current account -138
FINANCIAL ACCOUNT
Increase in foreign holdings of assets in the
United States 2,560
Increase in U.S. holdings of assets in foreign
countries -2,478
Balance on financial account 82
BALANCE ON CAPITAL ACCOUNT 0
Statistical discrepancy 56
Balance of payments 0

7) A
8) B

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Answer Key
Testname: ECON 352 PROBLEM SET 3

9) The three main sets of factors are changes in the demand for U.S.-produced goods and services and changes in the
demand for foreign-produced goods and services; changes in the desire to invest in the United States and changes
in the desire to invest in foreign countries; and changes in the expectations of currency traders about the likely
future value of the dollar and the likely future value of foreign currencies.
10) If 13.5 pesos = 1 dollar, then 1 peso = 1 / 13.5 = 0.074 dollars.
11) A decrease in U.S. interest rates would decrease the desire to invest in financial assets in the United States relative
to the rest of the world. The demand for dollars would fall, causing the exchange rate for the dollar to fall. The
lower exchange rate would increase net exports, leading to a smaller current account deficit.

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Answer Key
Testname: ECON 352 PROBLEM SET 3

12) If Americans are demanding fewer British goods, they will trade fewer dollars in the foreign exchange market for
British pounds. This decrease in the supply of dollars is represented by the shift to the left in the supply of dollars
below. As the supply of dollars decreases, the equilibrium exchange rate rises (the dollar appreciates).

13) If Americans are demanding more Mexican goods, they must trade their dollars in the foreign exchange market for
pesos. This increase in the supply of dollars is represented by the shift to the right of the supply curve for dollars
below. As the supply of dollars increases, the equilibrium exchange rate falls (the dollar depreciates).

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Testname: ECON 352 PROBLEM SET 3

14) First, not all products are traded internationally. As a result, there is no way to take advantage of profit
opportunities to buy in one country and sell in another country, so exchange rates will not reflect exactly the
relative purchasing powers of currencies. Secondly, products and consumer preferences for products vary across
countries. As a result, consumers in one country might be willing to pay different prices for products than
consumers in another country, and exchange rates might not adjust for that difference in the long run. Finally,
countries sometimes impose barriers to trade. If there are barriers to trade, it may not be possible to take advantage
of profit opportunities to buy in one country and sell in another country, so, again, exchange rates will not reflect
exactly the relative purchasing powers of currencies.
15) The dollar in this example is "overvalued" while the Korean won is "undervalued." The relative price ratio of 4,500
Korean won per Big Mac to $5.67 per Big Mac (794 Korean won per dollar) is less than the current exchange rate of
1,150 Korean won per dollar. In other words, the dollar cost of a Big Mac in South Korea is $3.91 (4,500/1,150). This
implies that the supply of dollars will rise as more Americans trade their dollars in for Korean won to buy Big Macs
in South Korea. This increase in the supply of dollars will lower the exchange rate (decrease the value of the dollar).
(Similarly, the demand for the Korean won is rising, indicating an increase in the value of the Korean won.)
Adjustments will continue until the exchange rate is equal to 794 Korean won per dollar.
16) The three main exchange rate systems are the floating exchange rate, the fixed exchange rate, and the managed
float. The floating exchange rate is determined solely by equilibrium of demand and supply in the foreign exchange
market. The fixed exchange rate exists when the government maintains one fixed rate at which currency can be
exchanged. Under a managed float, the exchange rate is mostly determined by demand and supply in the market
for foreign exchange, with occasional government intervention.
17) In a fixed exchange rate system, the value of the currencies of the participating countries is fixed, and in a managed
float exchange rate system, the value of currencies is determined by demand and supply, with occasional
government intervention.
18) The dollar is a relatively stable currency, so by pegging the value of a country's currency to the dollar, the country
provides reassurance that debts will be paid in a currency whose value doesn't fluctuate dramatically. This reduces
the risk foreigners face in collecting returns on investments in that country. In addition, if imports are a significant
fraction of the goods consumers buy, a decrease in the value of the country's currency can result in higher inflation.
By pegging the country's currency, these fluctuations in the exchange rate don't occur, so inflation may be lower.
19) One currency is pegged against another currency when a country decides to keep the exchange rate between its
currency and another currency fixed.
20) Countries peg their currencies to make planning easier for their firms with extensive trade with another country, to
aid their firms that have borrowed foreign investment funds denominated in other currencies, and to prevent
inflation that would result from a decline in the value of their currency. Countries that peg can find that their
currencies become either overvalued or undervalued relative to the equilibrium exchange rate.
21) The willingness of foreign investors and companies to purchase financial and physical assets in the United States
leads to a U.S. financial account surplus. If the United States runs a financial account surplus, it must run a current
account deficit.
22) The four functions are medium of exchange, unit of account, store of value, and standard of deferred payment. In
the long run, something will not serve as money if it does not fulfill all four functions.
23) M2 will not change and M1 will rise by $1,000. When under your mattress, the $1,000 would be counted as
currency. Going from a savings account to currency would raise M1, but both are part of M2, so M2 would not
change.
24) M2 will not change and M1 will rise by $1,000. Going from a savings account to checking account would raise M1,
but both are part of M2, so M2 would not change.
25) Money market mutual fund balances are part of M2, but are not part of M1. Checking account balances are
included in both money supply measures. Thus M1 will increase by $2,000 with the increase in checking account
balances. M2 will not change, as the $2,000 increase in checking account balances is offset by the $2,000 decrease in
mutual fund accounts.

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Answer Key
Testname: ECON 352 PROBLEM SET 3

26) Banks create money to make a profit. Banks create money when they make loans. The loans take the form of
checking account deposits. Asking why banks create money is the same as asking why they make loans.
27) The simple deposit multiplier is equal to (1/required reserve ratio). In this case it is 1/0.2 = 5. Since the deposit
multiplier is 5, then an increase in deposits in the banking system is equal to the multiplier times the initial deposit.
This is 5 × $50,000 = $250,000. To find the change in the money supply, we must then subtract the initial deposit
because cash held by the public declines by the size of the initial deposit. Thus the change in the money supply is
$250,000 - $50,000 = $200,000.
28) The FOMC is comprised of the seven members of the Board of Governors in Washington, D.C., the President of the
Federal Reserve Bank of New York, and four Presidents (serving one-year rotating terms) from the remaining
eleven district banks. This committee assumes primary responsibility for managing the U.S. money supply.
29) If the FOMC decides to increase the money supply, it will direct the trading desk at the Federal Reserve Bank of
New York to buy U.S. Treasury Securities from the public. When the sellers of these securities deposit the funds
from the sale into their banks, the reserves of the banking system will rise. This will start the process of expanding
the money supply as the increase in reserves expands loans and checking account deposits. If the FOMC wants to
reduce the money supply, it will direct the trading desk to sell U.S. Treasury securities. This will decrease reserves,
contract loans, contract checking accounts and shrink the money supply.
30) The effectiveness of discount policy in changing the money supply depends upon banks' willingness to borrow
reserves. The Fed may lower the discount rate of interest, encouraging bankers to borrow reserves and increase
loans. But bankers are not required to increase their borrowing. In contrast, an open market purchase of securities
will increase reserves in the banking system and encourage lending. The Fed prefers to limit the use of discount
policy to help banks that are temporarily in need of reserves. That is, the Fed uses the policy to serve as a lender of
last resort for banks. It did so after the stock market crash in 1987 and after the terrorist attacks on September 11,
2001.
31) The tool that the Fed primarily uses is open market operations. There are three reasons. First, because the Fed is the
party that initiates the open market operations, it completely controls the volume. Second it can make the volume
large or small, depending on how many U.S. Treasury securities it decides to buy or sell. Finally, it can implement
this policy tool quickly. It does not have to change regulations and the administrative machinery is in place for it to
make changes quickly.
32) They are different. Both increase the reserves at the bank by $1 million, but the bank does not have to hold required
reserves against the discount loan because it is not a deposit. The entire $1 million of the discount loan is excess
reserves, which the bank can loan out.
33) Bank reserves will increase by $100 million when the seller of the bond deposits the $100 million in its checking
account. Total checking account deposits in the banking system as a whole will increase by $500 millionthe $100
million increase in reserves times the simple deposit multiplier of 5.
34) The large government budget deficits lead to the massive increases in the money supply necessary to generate the
hyperinflation. The public, especially in the developing world, will not buy the government bonds necessary to
finance the large budget deficits. The central bank has had to purchase the government bonds, which has sent the
money supply through the roof, leading to hyperinflation.
35) It matters greatly. When the government sells the bonds to the public the money supply does not change, but when
they sell the bonds to the central bank the money supply increases. If there are large budget deficits, the money
supply will increase substantially when the central bank buys government bonds. Using the quantity theory of
money, the increase in money supply from the purchase of the bonds by the central bank will increase the inflation
rate.

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Answer Key
Testname: ECON 352 PROBLEM SET 3

36) If one assumes that the velocity of money is constant, there are clear implications on how to use monetary policy
for price stability. If we transform the quantity equation, MV = PY, into an equation about growth rate for these
variables, then the quantity equation becomes:
growth rate of money + growth rate of velocity = growth rate in prices (inflation rate) + growth rate of real output.

Rearranging, we get:
inflation rate = growth rate of money + growth rate of velocity - growth rate of real output. If velocity does not
change, then the growth rate of velocity is zero. Then, inflation is determined by:
growth rate of money - growth rate of output. As long as money does not grow faster than real output, inflation
will not occur. If the supply of money grows faster than the growth of real output, the result will be inflation.
37) Using the growth rate version of the quantity equation, we have:
growth rate of the price level (or inflation rate) = growth rate of money + growth rate of velocity - growth rate of
real output.

If velocity does not change, then the growth rate of velocity is zero. Then:
growth rate of the price level (or inflation rate) = growth rate of money - growth rate of output.
Substituting in our values:
growth rate of the price level (or inflation rate) = 5 percent - 2 percent = 3 percent.
38) 1. Price stability
2. High employment
3. Stability of financial markets and institutions
4. Economic growth
39) When the Fed was founded, its primary responsibility was to make discount loans to banks in order to deal with
the bank panics, which occurred when many banks suffered from large withdrawals by depositors.
40) When Congress established the Fed in 1913, the main responsibility of the Fed was to prevent bank panics by
making discount loans to banks. Congress broadened the Fed's responsibilities in the aftermath of the Great
Depression.
41) The problems that inflation causes for the economy include the loss of purchasing power of money, menu costs,
and an unintended redistribution of income.
42) The money demand curve has a negative slope. An increase in the interest rate, the variable on the vertical axis,
causes a decrease in the quantity of money demanded, the variable on the horizontal axis, because an increase in
the interest rate increases the opportunity cost of holding money. Money earns little or no interest, so an increase in
the interest rate induces people to reduce their holdings of money and switch into interest-bearing financial assets.
43) One possible monetary target is the money supply. Another possible target is the interest rate. (Either answer is
correct). A monetary policy target is an economic variable that the Fed can affect directly. The Fed uses monetary
targets because it cannot directly manipulate and change monetary policy goals such as high employment,
economic growth, and price stability. The Fed can affect the targets directly and they in turn affect the variables
such as real GDP and the price level, which are closely related to the Fed's policy goals.
44) The Fed would try to achieve a target level for the federal funds rate by using open market operations. If it wants to
lower the federal funds rate, it would buy Treasury bills using open market operations. This purchase would inject
the banking system with reserves. The increased supply of reserves would lower the overnight loan rate on these
reserves, which is called the federal funds rate. Changes in the federal funds rate will usually result in changes in
the interest rates on other short-term financial assets such as Treasury bills, and eventually affect longer-term rates
such as the rate of corporate bonds and mortgages. However, the effect on these longer-term rates is usually
smaller than the impact on short-term rates and occurs with a lag.

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Answer Key
Testname: ECON 352 PROBLEM SET 3

45) An open market purchase of Treasury securities by the Federal Reserve increases the money supply from MS1 to
MS2, lowering the interest rate from 3% to 2%.

46) An open market sale of Treasury securities by the Federal Reserve decreases the money supply from MS1 to MS2,
raising the interest rate from 3% to 4%.

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Answer Key
Testname: ECON 352 PROBLEM SET 3

47) If the Fed believes the economy is about to fall into recession, it should conduct expansionary monetary policy,
increasing the money supply and reducing interest rates. In implementing expansionary monetary policy, the Fed
could lower the discount rate, lower the reserve requirement, and/or have the trading desk purchase U.S. Treasury
securities.
48) If the Fed believes the economy is about to experience a high rate of inflation, it should conduct contractionary
monetary policy, decreasing the money supply and raising interest rates. In implementing contractionary monetary
policy, the Fed could raise the discount rate, raise the reserve requirement, and/or have the trading desk sell U.S.
Treasury securities.
49) a. The money supply increases
b. Interest rates fall
c. Investment increases
d. Consumption increases
e. Net exports increase
f. The aggregate demand curve shifts to the right
g. Real GDP rises
h. The price level rises
50) If the economy is in recession, it is currently at point A, below potential real GDP. An expansionary monetary policy
will shift the aggregate demand curve to the right from AD1 to AD2, increasing real GDP and the price level until it
reaches potential real GDP at point B.

51) The inflation rate responds differently in the two recessions. A large increase in oil prices decreases real GDP, but
increases inflation. The large decrease in spending decreases real GDP and decreases inflation. The Fed wants to
increase real GDP, but they also want to prevent an increase in inflation. Cutting interest rates increases aggregate
demand which increases real GDP and increases inflation. With a recession caused by a drop in spending, the rate
of inflation declines, which allows the Fed to more aggressively cut interest rates.

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Testname: ECON 352 PROBLEM SET 3

52) The Taylor rule states that the Fed should set the federal funds target so that it is equal to: the real equilibrium
federal funds rate + the current inflation rate + (w1) × inflation gap + (w2) × output gap. The inflation gap is the
difference between the current inflation rate and the target rate. The output gap is the percentage difference
between real GDP and potential GDP. The values w1 and w2 are weights determined by the Fed. If the growth rate
in real GDP is below potential GDP, then the output gap will be negative. This will lower the federal funds target.
53) Any two of the following three reasons are correct. First, an explicit inflation target will draw the public's attention
to the fact that the Fed can only have an impact on inflation and not real GDP in the long run. Second, the public
announcement of the target makes it easier for households and firms to form accurate expectations about future
inflation. This will increase efficiency in the economy. Third,,an inflation target would promote accountability by
the Fed. The target would offer a yardstick to measure the performance of the Fed.
54) (a) Since M = C + D, D = $10 million.
(b) Since R = 0.25 × D, R = $2.5 million.
(c) BASE = C + R = $5 million.
(d) multiplier = M/BASE = 2.5.
55) BASE = CU + RES = 60 + 100 = 160; M = CU + DEP = 60 + 1000 = 1060; cu = 60/1000 = .06;
res = 100/1000 = .10; mm = (cu + 1)/(cu + res) = (0.06 + 1)/(0.06 + 0.10) = 1.06/0.16 = 6.625.
56) The money multiplier was not stable during the Great Recession. The money multiplier declined sharply, because
the currency-deposit ratio and especially the reserve-deposit ratio both rose dramatically, as people increased their
demand for currency, and banks increased their demand for excess reserves. Instability in the money multiplier
creates instability in the money supply for a given monetary base.
57) Interest rates respond quickly to changes in monetary policy, reacting within the first month. But the effect is
transitory, and after 6 to 12 months, the interest rate has returned most of the way to its original value. Output and
prices barely respond to a change in monetary policy at first. Output begins to change after about 4 months, with
the full effect being felt about 16 to 20 months after the initial policy change. The price level doesn't change much
until about a year after the change in policy.
58) Under inflation targeting, the central bank announces the inflation rate that it will try to achieve over the next 1 to 4
years. Countries have moved to inflation targeting because money-growth targeting had problems in the 1980s as
money demand became unstable. Inflation targeting has the advantage of sidestepping the problem of instability in
money demand, of being easier to explain to the public, and of increasing the central bank's accountability to the
public. But the major disadvantage of inflation targeting is that the long lags through which inflation responds to
monetary policy make it difficult for the central bank to judge what policy actions are needed.
59) The Taylor rule is a rule for monetary policy that allows the Fed to respond to the state of the economy. The rule
sets the nominal Fed funds rate as the sum of the inflation rate over the past year plus 2% plus one-half times the
percentage deviation of output from its full-employment level plus one-half times the amount by which inflation
over the past year exceeds 2%. If inflation were 4% and output were 1% below its full-employment level, the
nominal Fed funds rate would be 0.04 + 0.02 + (0.5 × -0.01) + [0.5 × (0.04 - 0.02)] = 0.065 = 6.5%.
60) Fiscal policy involves changes in federal taxes and purchases and is implemented by Congress and the President.
Monetary policy involves changes in the money supply and interest rates and is implemented by the Federal
Reserve. Both are intended to achieve macroeconomic objectives.
61) 1. Defense spending
2. Transfer payments
3. Grants to state and local governments
4. Interest payments
5. Other expenditures
62) Fiscal policy refers to changes in federal taxes and purchases that are intended to achieve macroeconomic policy
objectives. Congress and the president are responsible for fiscal policy.

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Testname: ECON 352 PROBLEM SET 3

63) Federal purchases refer to federal spending where the federal government receives a good or service in return, like
an aircraft carrier. Federal expenditures include federal purchases plus interest on the national debt, grants to state
and local governments, and transfer payments.
64) Examples of automatic stabilizers are unemployment insurance payments and income taxes. (The student only
needs to present one example.) Automatic stabilizers change tax receipts and government spending automatically
as a result of fluctuations in the business cycle. This occurs without discretionary actions on the part of government.
In the case of recession, they would change automatically to stimulate spending in the economy. During a
recession, employment declines and government spending on unemployment insurance payments increases. This
should raise disposable income and consumer spending above what they would otherwise be. During a recession,
income tax receipts decline as incomes decline. This automatic decline in income tax revenues keeps disposable
income and consumer spending from falling as much as they would without automatic stabilizers.
65) An expansionary fiscal policy is a decrease in taxes or an increase in government purchases intended to increase
aggregate demand. A contractionary fiscal policy is an increase in taxes or a decrease in government purchases
intended to decrease aggregate demand.
66) No, expansionary fiscal policy does not directly increase the money supply. The president and the Congress fight
recessions by increasing spending, not the money supply, by either increasing government spending or cutting
taxes to increase household disposable income and, therefore, consumption spending.
67) Too little money would be caused by too small of a money supply by the Federal Reserve. Too little spending could
be caused by a variety of reasons such as a decrease in consumption spending by households because they become
pessimistic about the future, a decrease in investment spending by firms because they lower their estimates of the
future profitability of new factories and machinery, or a decrease in U.S. exports because a major trading partner is
in a recession.
68) Expansionary monetary policy increases spending by decreasing interest rates which induces households and firms
to increase spending on consumer durables and plant and equipment. Expansionary fiscal policy increases
spending by directly increasing government spending or by cutting taxes to increase household disposable income
which increases consumption spending.
69) The Federal Reserve fights recessions by increasing the money supply to lower interest rates, which in turn
increases spending. It is not that people will have more money to spend, but that interest rates will be lower, which
stimulates spending.
70) a. This is expansionary fiscal policy.
b. Although a decrease in defense spending will lead to a decrease in aggregate demand, it is not part of fiscal
policy because it is not intended to achieve a macroeconomic policy goal.
c. Although reducing taxes in this way will lead to an increase in aggregate demand, it is not part of fiscal policy
because it is not intended to achieve a macroeconomic policy goal.
d. This is expansionary fiscal policy.
e. This is not part of fiscal policy because the action is not intended to affect the national economy.
71) 175, 10, 185
72) (a) MTR = .10.
(b) T = 800 + [(27,000 - 8000) × .15] = 3650. ATR = 3650/27,000 = .135. MTR = .15.
(c) T = 4850 + [(72,000 - 35,000) × .25] = 14,100. ATR = 14,100/72,000 = .196. MTR = .25.
(d) T = 4850 + [(250,000 - 35,000) × .25] = 58,600. ATR = 58,600/250,000 = .2344. MTR = .25.
73) The Social Security system is in a crisis even though it's running large surpluses because its surpluses will turn to
large deficits within the next 20 years. The source of the problem is that the baby-boom generation will begin to
retire, greatly increasing the Social Security benefits that will be paid out. Potential solutions include reducing
benefits, increasing taxes, or getting a higher return for the Social Security trust fund by investing in the stock
market.

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Testname: ECON 352 PROBLEM SET 3

74) If taxes must be raised in the future to pay off the debt, the distortions from higher tax rates are a burden on future
generations. Also, if bondholders are on average wealthier than taxpayers, there will be a redistribution of wealth
as the debt is repaid. Finally, if the debt reduces national saving, then investment will be lower, which reduces the
capital stock, which means a lower standard of living for future generations. But if taxes are lump-sum and
Ricardian equivalence holds, there is no burden, since then private saving rises to prevent the debt from having any
effects on national saving.
75) Bank failures can directly affect the ability of households and firms to spend by wiping out some of the wealth they
hold as deposits. Shareholders of banks also suffer losses to their wealth when banks fail. Households and firms
that relied on failed banks for credit will no longer have access to the loans they need to fund some of their
spending. Finally, by destroying checking account deposits, bank failures can result in a decline in the money
supply.
76) Chronic government budget deficits that eventually result in the interest payments required on government bonds
taking up an unsustainably large fraction of government spending, or a severe recession that increases government
spending and reduces tax revenues, resulting in soaring budget deficits.
77) It reduced household wealth. It made it more difficult for corporations to raise funds. It increased uncertainty
among both households and businesses.
78) As banks are forced to sell assets, the price of the assets decline, causing others who hold these assets to suffer a
decline in net worth, which may result in other banks and investors going bankrupt. The process repeats itself. This
worsens the economic downturn, resulting in deflation.
79) A decline in the price level means that the fixed payments of loans and bonds are made with dollars of greater
purchasing power, increasing the burden on borrowers.
80) First, no one was in charge. Second, the Fed was reluctant to rescue insolvent banks. Third, the Fed failed to
recognize the difference between nominal and real interest rates. Fourth, the Fed wanted to purge speculative
excess.
81) The fundamental value of a house should equal the present value of housing services that homeowners expect to
receive. As a result, we would expect housing prices and rental rates to increase at close to the same rate over time.
If housing prices increase much more rapidly than rental rates for a considerable period of time, there may be
evidence of a bubble.
82) The major argument in favor of such a policy is that the failure of some large financial institutions can pose a
systemic risk to the financial system. Arguments against such a policy include that it favors large banks over small
banks and that it may promote moral hazard.
83) The CAMELS rating system considers capital adequacy, asset quality, management, earnings, liquidity, and
sensitivity to market risk.
84) The first stage is a crisis in the financial system. The second stage is when the government steps in to end the crisis
through regulation. The third stage is the response of the financial system, typically in the form of changes and
innovation in the activities of financial institutions. The fourth is the regulatory response as regulators adapt
policies to efforts to circumvent regulatory restrictions.

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