Macroeconomics Keynesians Sample Questions

MACRO FINAL EXAM SAMPLE QUESTIONS Answers wont be given but I am more than happy to help make sure you are going in the right direction. 1. How do the Keynesians differ from the monetarists / classical economists? Please give specific examples. Keynesians - - Excessive unemployment can be reduced by increases in government spending (Y=CIG) Government intervention is needed (fiscal policy) - Money in your pocket doesn’t grow: the idea of the money multiplier - Low interest rates affect the multiplier which causes a liquidity trap (money can’t be accessed) Monetary policy can only be used to stabilize prices and not things like unemployment Unemployment was solved because of the world war. - - Monetarists/Classical economists - Free market – the economy is not circular, but will be able to sort itself out naturally - Interest rates have a large impact on investment spending (monetary policy) - Fed sets rates low, which expands credit and higher investment spending; money is just the cause of inflation and will cause a bust in the future - Credit crunch was a cause of banks without enough money - World War caused a multiplier because consumption decreased. (1/1-MPE) - Of course there was full employment because people were drafted into the war. (Unemployed – not working/but looking) 2. a. Briefly describe the four types of unemployment and the potential solutions to each one. Structural – people are unemployed because their jobs are becoming outdated due to a mismatch of skillsets – SOLUTION: Incentives for retraining to make employees more marketable for other jobs Seasonal – people are unemployed because they work in seasonal employment (e.g. agricultural/construction) – SOLUTION: Diversify the employment economy; i.e. create jobs in the off-season; pay workers through the year. Frictional – people are unemployed because they are switching jobs or looking for jobs for the first time – SOLUTION: information outlets that connect people with jobs; cutting unemployment benefits to increase the opportunity costs of remaining idle Cyclical – people are unemployed as a result of the poor economy (no demand for workers – recession) – SOLUTION: Keynesian in nature – increase government spending & reduce taxes to jump start economy. Hopefully multiplier will create a double boost to aggregate demand. b. Why does the employment rate and the unemployment rate not equal one. The employment rate is calculated by dividing the # of employed individuals by the working age population. The unemployment rate is calculated by dividing the # of unemployed people by the labour force. The labour force number does not include discouraged workers. Because they are calculated differently, they will not equal one. c. Describe a situation where a job creation program could lead to an increase in the unemployment rate. Job creation program meant to decrease unemployment rate could lead to an increase in the rate because discouraged workers may want to re-enter the workforce. *Aside: criticisms of unemployment rate: - understated b/c they exclude discouraged workers - overstated b/c of false information - overstated b/c of underground economy 3. a. On a fully labelled AD/AS diagram, which shows that the economy is experiencing a recessionary gap, demonstrate what would happen if the government increases its’ spending. Was the policy successful? Increased government spending affects demand. Good – right. Therefore, prices and GDP increase. Depending on the size of the gap and the amount of the increase, the policy may successfully pull an economy from a recessionary gap to full employment. b. On a fully labelled AD/AS diagram, which shows that the economy is experiencing an inflationary gap, demonstrate what would happen if there is an increase in the post secondary graduation rates? Increase in the post secondary graduation rates would affect supply. More graduates – Good for Supply – shift right of both aggregate supply and long run supply. Price goes down, GDP increases; possibly still an inflationary gap because LAS shifts right as well. 4. a. Explain the multiplier. What are three things that what would make a multiplier smaller? An increase in the three leakages would make the multiplier smaller as the denominator of the equation is 1-MPC or MPS. Therefore higher amounts of savings, taxes, and imports would cause more leakages from the initial injection into the economy. b. If the MPC is .2 and there are no leakages to the economy, what will the multiplier be? If there is a recessionary gap of $20m, how much money would the government have to inject into the economy to bring it back to long run equilibrium? 1/(1-MPC) = 1/0.8 = 1.25 Government would have to inject $16m into the economy in order to bring it back to long run equilibrium. c. Would the tax multiplier be higher, lower, or the same as what you got in part b? Why? Tax multiply is smaller than the expenditure multiplier because the first round of spending is not included in the tax multiplier. (Expenditure – government gives $100, then consumer spends $80, then $64, etc. = $244) (Tax – government gives tax break of $100, consumer spends $80, then $64, etc. = $144) 5. a. According to Keynes, what three things would decrease people’s demand for money and why? The Transaction Motive – Funds to cover the lack of sync between income and spending. Tre precautionary motive – fund to cover unexpected costs or opportunities. The asset motive – a safe asset in a mixed portfolio of financial assets b. How does a decrease in money demanded affect the real GDP and price level? Use either three graphs or a flow chart to demonstrate this. c. What is the neutrality of money / the crude theory of money? Why is this concept important? Velocity of money – the number of times a currency changes hands. Money Supply * Velocity = Price * Quantity Changes in the money supply cause proportional changes in the price level. We can’t simply print more money because prices will increase proportionately, and you won’t be any better off than you were before. 6. a. Briefly describe the history of money. First banks were chartered in the early 19th century (banking legislation). Before this, banks operated under their own charters. The early banks produced their own notes and the amount of money in circulation depended solely on the public’s demand for loans. Politicians decided that the country needed a more stable money supply with the government issuing the currency. The chartered banks didn’t like this because this was a source of income for them. In 1866 The Provincial Note Act – The issue of government notes for circulation became a permanent feature in the Canadian monetary system. Bank Back 1871 – established governmental regulatory control over the banks. Chartered Banks then incorporated and regulated under the Bank Act. System now is dominated by a few large banks. History of money - movie b. How can a new deposit of $5,000 create other new deposits at other banks? Suppose the desired reserve ratio is 20 percent and people do not keep currency outside of the banking system, what will be the ultimate effect of this new deposit? A new deposit would increase the amount of money in the reserves. If the bank has excess reserves, it will want to loan them out to increase the money supply by way of the money multiplier. Therefore, $5000 deposit with a 20% target reserve would mean that the bank is free to loan out $4000 to other consumers. If people do not keep currency outside of the banking system then this money will be recycled back into the system as these new consumers deposit their money in the chequing accounts. The process repeats. The ultimate effect of this new deposit would be $4000 (the amount of the first loan) times the money multiplier. 1/target reserve = 5 Therefore, $20000. c. What two things could be done to make the multiplier larger? Reduce the target reserve ratio. Encourage people to deposit more money into the banks More credit worthy applicants for loans Increased demand for loans 7. a. Who sets fiscal policy? What is meant by cyclically balanced budget fiscal policy? What problems exist with this type of policy? Fiscal policy (spending and taxes – use of the federal budget to influence employment and production) is set by the Federal government. Cyclically Balanced-budget: use of counter cyclical fiscal policy to balance budget over the life of the business cycle. Counter cyclical – deliberate adjustments to level of government spending and taxation in order to close the recessionary or inflationary gap (hot economy – decrease taxes to increase spending). Problems: - - No guarantee that the size and length of the recessionary gap, when the government is running a deficit, will be exactly offset by the size and length of an inflationary gap when the government is running a surplus. (business cycle does not correspond to a government cycle) Most governments find it easier to increase spending in bad times than to decrease it in good times One government might leave the problem of balancing to the next government b. Who sets monetary policy? What is the inflation target? Bank of Canada sets monetary policy. Inflation target: 2% They can either set the bank rate and then adjust the money supply via buying/selling government securities or transferring to government accounts. OR They can adjust the money supply and then accept the interest rate that comes from that. c. The economy is currently in an inflationary gap, clearly describe five (5) things that can be done in terms of fiscal policy and / or monetary policy to bring the economy back to full employment. - Decrease expenditures (decrease consumption, investment spending) Increase taxes - Increase interest rates (monetary policy) Higher imports (stronger Canadian dollar), Lower exports 8. Inside the meltdown: • Asset bubbles (price of asset going up, but nothing substantial reason) Housing bubble crashed – risky mortgages; people benefited from the housing bubble because the brokers go more money, real estate benefitted, right to wall street. • Unintended consequences (intentions are good, but backfires) Alan (Bear’s CEO) wanted to downplay the stock crash. He downplayed that he was not aware that GoldmanSachs was pulling out. He appeared to be incompetent. Federal Reserves decision to loan to Bear Stearns via JP Morgan backfired as people believed that Bear Stearns must be even more in the weeds and thus stocks dropped further faster. • Moral hazard (act recklessly without threat of consequences) Mortgage lenders lent to people without the intent that they would be paid out. They lent to more risky consumers. Then they sold the rights to collect to other investment banks. Credit Default Agreements made by Bear Sterns to pay off bonds if they were to go belly up. If you bail someone out of a crisis that they had themselves caused then what consequences are there to prevent them from doing it again. Aggressive investing by Fuld (CEO of Lehman Brothers) by offering risky mortgage options (30 yr. mortgages, interest only mortgages for 10 years). Moral hazard led to the Federal Reserve and Treasury decision to let Lehman Brothers fail. • Financial contagion (domino effect) Stocks started dropping at Bear Stearns, People wanted their money out and it continued from there. If Bear Sterns was allowed to go under, then there would be a cascade of other failures across Wall Street. Lehman Brothers was very closely connected to other companies and thus caused a credit crunch with lending. Also caused AIG insurance company to have a huge deficit as they had insured against Lehman going bankrupt. Financial contagion of the US spread on a global scale. • Financial panic (if you think something, people think its true even without facts) People believed that Bear Stearns was in trouble so bailed out on their stocks. Many others followed. Freddie Mac and Fannie Mae – Mortgage companies lost 60% of stocks. People believed that if 2 of the largest companies could fail than any large business was a risk of failing because of the Mortgage crash. • Credit crunch 700 billion to unstop the credit markets After the Lehman Brothers went under, no bank wanted to trade with other banks. This made it extremely difficult for anyone to get any sort of loan (even short-term loans; car loans, etc.) • Fiscal austerity v fiscal stimulus (austerity – let them fail/stimulus – add to system) Federal Reserve Bank originally believed that they should let Bear go under. Federal Reserve Bank, after discovering Financial Contagion, then decided the risk to the system was too great if Bear Stearns went Bankrupt. And thus decided to loan money to Bear Stearns through JP Morgan. If you don’t let someone go belly up, then you run the risk of losing the market. Parliament does not back the bill to provide $700 billion to provide a full system bailout of the financial system. Government was becoming a stakeholder in each of the major banks. Types of Questions: AS/AD diagram Keynes vs. Hayek Monetary/Fiscal policy Fiscal: - Surplus or deficit = receipts – payments National debt = amount of debt outstanding that arises from past deficits Discretionary – initiated by parliament Automatic – triggered by state of economy such as increase in payments to unemployed and a decrease in tax receipts because of recession. Using discretionary fiscal stabilization, a government might increase expenditure on Goods and Services, cut taxes, or some of both – if timed correctly they could increase AD and might restore full employment Discretionary affected by law making lag time, errors in estimating potential GDP, uncertainty of forecasting economic future 2 of GDP, Economic Growth, Unemployment, Inflation Multiplier Money/Banking: - M1/M2/M3 - Fractional reserve banking: a banking system whereby banks keep only a small fraction of their deposits on reserve in the form of cash - Target reserve ratio: portion of deposits that a bank wants to hold in cash - Spread: the difference between the rate of interest a bank charges borrowers and it pay its savers. - Buying securities increases reserves of the banking system leading to an increase in money supply