Problem Set 6

1.	a.	Draw an AD/SRAS/LRAS diagram which shows the economy experiencing a recession.
	b.	Illustrate in your diagram where the economy will end up if the self-correction mechanism cures the recession.
	Suppose instead that the government uses its policy tools to cure the recession.
	c.	What is meant by countercyclical macroeconomic policy?
	d.	What are the tools of fiscal policy, who controls them, and how would they be adjusted to cure the recession?
	e.	What are the tools of monetary policy, who controls them, and how would they be adjusted to cure the recession?
	f.	Illustrate in your diagram where the economy will end up if expansionary macroeconomic policies are used to cure the recession.

Suppose the required reserve ratio is .15 (15% of deposits received), and that the public always redeposits into some bank all the currency it receives. However, banks also maintain an idle excess reserve ratio of 10% of deposits received. Complete the following table to track the results if the Fed buys $24,000 of government securities (T-bills) from the public:

Round	Bank deposits received	Change in required reserves	Change in idle excess reserves	Change in loans
1	$24,000	$3,600	$2,400	$18,000
2
3

3.	Use a credit-market diagram and an AD/SRAS/LRAS diagram to illustrate the short-run effects of each of the following (assume the economy begins at full employment, consider each case separately, and draw separate diagrams for each case):
	a.	The Fed sells government securities on the open market.
	b.	The Fed lowers the discount rate.

4.	In a news report a few years ago, a Clinton administration official expressed worries that the deficit cuts that would be required by a balanced budget amendment might harm the economy too much. The same official estimated that each dollar of government spending financed by borrowing crowds out 30 to 70 cents worth of investment.
	a.	Explain how "deficit cuts" could "harm the economy."
	b.	Diagram and explain how deficit spending can "crowd out private spending."

5.	During the first Clinton administration, policies were adopted to reduce the federal budget deficit. Fed Chair Alan Greenspan expressed support for the deficit reductions, and the Fed cushioned the impact on the macroeconomy with some expansionary monetary policy. Indicate whether the combined impact of both policies would tend to make each of the following rise, fall, remain the same, or change in an uncertain direction compared to what would have happened without the policy combination: (1) real GDP, (2) the price level, (3) interest rates, (4) investment, and (5) the national debt.

Complete the table below to indicate whether the listed policy makes real GDP, the price level (GDP deflator), the real interest rate and investment rise (+), fall (-), remain the same (0), or change in an uncertain direction (?); consider both output-market and credit-market effects in each case:

		Real GDP	Price level	Interest rate	Investment
a.	The Fed buys T-bills on the open market
b.	The government cuts welfare payments
c.	The Fed raises its discount rate
d.	Highway spending rises AND the Fed raises the required reserve ratio

7.	Indicate whether each of the following statements is most likely to made by a Keynesian economist (K), a monetarist concerned with crowding out (M), a new classical economist (NC) or a supply-side economist (SS):
	a.	"Discretionary macroeconomic policy plays a useful role in reducing the loss of output due to resources left idle during a recession."
	b.	"The large budget deficits of the 1980s were accompanied by historically high real interest rates."
	c.	"Most research indicates that there is no link between budget deficits and interest rates; higher deficits may simply be matched by higher savings."
	d.	"Contractionary fiscal policy is not likely to be a very effective weapon against inflation, because the impact will be offset by the effects of lower interest rates."
	e.	"Lower marginal tax rates stimulate people to work, save and invest, resulting in more output and a larger tax base."
	f.	"Since taxpayers are concerned about the welfare of succeeding generations, they consider debt financing of government spending to be equivalent to tax financing."
	g.	"The self-correcting mechanism is too slow and unreliable to be relied on to cure recessions."
	h.	"The best combination of policies is to rely on automatic stabilizers and to keep the money supply growing at a constant rate."
	i.	"Tax cuts can reduce inflation by increasing aggregate supply."
	j.	"Because of policy lags, discretionary stabilization policy often ends up being procyclical rather than countercyclical."

8.	Suppose that the current equilibrium exchange rate between dollars and the Japanese yen is 100 yen per dollar. Suppose also that at this exchange rate, exports equal imports.
	a.	Now suppose that the Japanese interest rate rises. Will individuals tend to transfer savings to Japan or vice versa? Explain briefly.
	b.	What term describes the resulting change in the foreign exchange market value of the dollar?
	c.	Will the net exports of the U.S. (X-M) tend to rise or fall? Why?

9.	Indicate how each event below would affect each of the following: (1) real output, (2) the price level, and (3) net exports (exports minus imports). Consider each event separately.
	a.	The Fed raises the discount rate.
	b.	Congress, seeking to reduce the budget deficit, increases taxes.