HOMEWORK 5 (post your answers in your Assignment Folder under HW5) 1. Explain what we expect to happen to the Money Supply, interest rates, AD, GDP, unemployment, and inflation in the following situations. Example: The Fed announces it is raising the Discount Rate. The discount rate (DR) is the interest rate the Fed charges member banks who need access to fed funds. If the DR goes up this means it’s more expensive to borrow from the Fed which means banks will be more cautious with their lending or keep more funds on hand. In this case the Money Supply (Ms) would tend to fall. When the supply of something falls, we know its price goes up, in this case the price going up would be the interest rate. When the interest rate goes up, Investment tends to fall which means AD falls. When AD falls, GDP falls, unemployment rises and there is pressure on the price level to fall. This would be Contractionary (or tight) Monetary Policy. a) The Fed decides to enter the open market and buy government bonds. b) The Fed decides to raise the required reserve ratio. 2. Explain and show what will happen to the money supply in the following situations: Example: The fed buys $100 in government bonds; the required reserve ratio (rrr) = 0.10. Answer: This is asking about the money multiplier process. The money multiplier = 1/rrr. Thus if the rrr is .10, the multiplier = 10. This means that a $100 billion purchase og government bonds will increase the money supply by $1000 billion (10 x $100 billion). a) What will happen to the money supply if the Fed decides to sell 0 billion worth of government bonds; assume the rrr = 0.25. 3. Now let’s incorporate Fiscal and Monetary Policy into our analysis. Let’s use work similar to what we already did in Homework 3 & 4 and then figure out what the appropriate policy response should be (Note: let’s assume we are Activists). I’ll get started by answering the first question. Again use the AD/AS model to explain what will happen to GDP, unemployment, and the price level as a result of the policy response in the following situations Assume that we are operating at our full employment, price stability equilibrium when the shocks described below move us away from this desirable equilibrium., and price stability. So in each example below provide the appropriate Fiscal and Monetary policy that would help get us back to full our full employment, price stability equilibrium. Stock market rises by 20 percent Sample Answer: We know from earlier discussions that an increase in the prices of stocks increases wealth which in turn increases Consumption. Since AD = C + I + G + NX, if C increases then AD increases. According to the AD/AS model, if AD increases (shifts to the right) then GDP increases and there is pressure on the price level to also rise. This is likely to create an Inflationary Gap. The appropriate Fiscal Policy to combat inflation is to engage in Contractionary Fiscal Policy. This means either a decrease in Government spending and/or an increase in Taxes. Both would cause AD to fall, reducing inflation and also decreasing GDP and increasing unemployment. Since neither cutting spending nor raising taxes is politically very easy, we may look to Monetary Policy. The appropriate monetary policy to follow when there is inflationary pressure is to reduce the money supply (by selling bonds) which causes interest rates to go up. When interest rates go up, Investment falls as does Consumption and thus AD falls. The reduction in AD which help us lower the price level, of course at the cost, as with fiscal policy, of lower GDP and higher unemployment. a) The value of real estate falls by 40 percent and thus household wealth has fallen. b) Concerns about the government defaulting on the debt abate and thus causing interest rates to fall. c) People expect the economy to get worse. d) Oil prices decrease. 4. What are the main differences between the Classical (Non-activist) and Keynesian (Activist) views of the way the economy works and what the government response should be?