5 AGGREGATE DEMAND AND INFLATION. Part Review. Reading Between the Lines WHERE WILL INTEREST RATES GO IN 2002?

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1 Part Review 5 AGGREGATE DEMAND AND INFLATION Reading Between the Lines WHERE WILL INTEREST RATES GO IN 2002? On May 6, 2002 the FOMC met in Washington D.C. To combat the recession that started in 2001, the Federal Reserve had cut the interest rate eleven times in 2001 so that the federal funds interest rate was 1.75 percent. Because the unemployment rate had not turned down (indeed, in the month before the meeting, it had risen to 6.0 percent) and because inflation had not heated up, analysts predicted that the Federal Reserve would not change the interest rate at its meeting. Most of the economists surveyed predicted that the Fed would begin to raise the interest in late summer or early fall of One economist predicted that GDP growth would average 4.5 percent over For details, go to The Economics Place web site, the Economics in the News archive, Analyze It The FOMC meets every six weeks to determine the course of the nation s monetary policy. The article reports about its meeting in May, At this meeting, as predicted, the Federal Reserve did not change the interest rate. But the Fed indicated that if the interest rate was changed in the future, it likely would be increased. 1. Using an aggregate demand/aggregate supply diagram, illustrate what the Fed feared might occur in 2003 if it does not raise the interest rate in a timely fashion. 2. Do you think the Fed s policy in 2001 and 2002 was the correct policy the Fed should have been pursuing? 221

2 222 PART REVIEW 5 Mid-Term Examination Chapter On the 45 diagram, consumption expenditure is measured as a. a horizontal distance. b. a vertical distance. c. the area of a triangle. d. the area of a rectangle. 12. When the consumption function lies above the 45 line, households a. spend all of any increase in income on consumption. b. consume more than their disposable income. c. save some portion of their disposable income. d. save all of any increase in income. 13. Expenditure that depends on the level of income is a. spurious expenditure. b. equilibrium expenditure. c. induced expenditure. d. autonomous expenditure. 14. Suppose the MPC = 0.90, taxes do not depend on income, and there are no imports. Then a $100 increase in autonomous spending causes equilibrium expenditure to a. decrease by $100. b. increase by $100. c. increase by $900. d. increase by $1,000. Chapter The largest source of expenditure for the Federal government is a. government purchases of goods and services. b. transfer payments. c. corporate income taxes. d. interest on the debt. 16. In an economy with no international sector and no income taxes, if the MPC = 0.90, the lump-sum tax multiplier is a b c d Which of the following are expansionary fiscal policy? a. A cut in taxes and an increase in government purchases. b. An increase in taxes and a decrease in government purchases. c. An increase in taxes and an increase in government purchases. d. A cut in taxes and a decrease in government purchases.

3 AGGREGATE DEMAND AND INFLATION Crowding out is a decrease in investment which is the result of a. contractionary monetary policy. b. expansionary monetary policy. c. expansionary fiscal policy. d. contractionary fiscal policy. Chapter If Daniel transfers $1,000 out of his checking account and places it in his savings account, instantly a. M1 and M2 fall. b. M1 falls and M2 rises. c. M1 and M2 rise. d. M1 falls and M2 does not change. 10. Your loan from a bank is a. an asset to you and a liability to your bank. b. a liability to you and asset to your bank. c. an asset to both you and your bank. d. a liability to both you and your bank. 11. A bank s reserves include a. the cash in its vault plus the value of its depositors accounts. b. the cash in its vault plus any gold held for the bank at Fort Knox. c. the cash in its vault plus any deposits held at the Federal Reserve. d. its common stock holdings, the cash in its vault, and any deposits held at the Federal Reserve. 12. Banks are able to create money whenever they have excess a. reserves. b. deposits. c. loans. d. personnel. Chapter Which of the following is one of the Fed s policy tools? a. Open market operations. b. The tax rate on interest income. c. Transfer payments. d. The government s deficit or surplus. 14. If the Fed buys government securities, a. banks reserves and the money supply increase. b. banks reserves decrease and the money supply increases. c. banks reserves increase and the money supply decreases. d. banks reserves and the money supply decrease.

4 224 PART REVIEW If the money multiplier is 4 and the Fed sells $1 million in securities, the money supply will a. increase by $4 million. b. increase by $250,000. c. decrease by $2 million. d. decrease by $4 million. 16. If interest rates fall, then a. bond prices fall. b. bond prices rise. c. banks reserves increase. d. households decrease their cash holdings. Chapter A cost-push inflation is NOT characterized by a. continuing increases in the money supply. b. continuing increases in money wage rates. c. a one-time increase in government purchases. d. All of the above are characteristics of cost-push inflation. 18. A demand-pull inflation requires persistent increases in a. tax rates. b. real wages. c. the money supply. d. government purchases. 19. If lenders and borrowers base their lending on an inflation forecast that turns out to be too low, with regard to income redistribution, borrowers a. are hurt and lenders are helped. b. are helped and lenders are hurt. c. and lenders are both hurt. d. and lenders are both helped. 20. The short-run Phillips curve ; the long-run Phillips curve. a. slopes downward; slopes downward b. slopes upward; slopes upward c. is horizontal; is vertical d. slopes downward; is vertical

5 AGGREGATE DEMAND AND INFLATION 225 Answers Reading Between the Lines 1. The Fed s fear is that even though real GDP is less than potential GDP, the low interest rates will lead aggregate demand to increase so much that the price level rises substantially and inflation jumps higher. Figure 1 for illustrates this fear. In the figure, the equilibrium in 2002 is where the aggregate demand curve AD02 intersects the shortrun aggregate supply curve, SAS. Real GDP, $10.0 trillion, is less than potential GDP of $10.25 trillion, as indicated by the long-run aggregate supply curve LAS 02. Between 2002 and 2003, long-run aggregate supply will increase, in the figure from LAS02 to LAS 03. Short-run aggregate supply will increase because of the increase in potential GDP but will decrease because the money wage rate will rise. For simplicity, these two effects are assumed to be the same magnitude so that the short-run aggregate supply remains constant at SAS. The Fed is unsure by how much aggregate demand will increase. In the Fed s ideal world, aggregate demand will increases by the right amount, from AD02 to AD03A. In this case, real GDP in 2003 will equal potential GDP and the price level will rise only from 110 to 115, for an inflation rate of 4.4 percent. However the Fed fears that if it keeps the interest rate too low for too long, aggregate demand will increase by too much, from AD02 to AD 03B. In this case, real GDP in 2003 will exceed potential GDP. The price level will rise to 120 and the inflation rate will soar to approximately 8.7 percent. FIGURE 1 The Fed s Fear Price level (GDP deflator) LAS 02 LAS 03 AD 02 SAS AD 03A AD 03B Real GDP (trillions of 1996 dollars) 2. In 2001, the Federal Reserve slashed the interest rate to its lowest level in decades. Because the economy was heading into a recession, most observers thought the Fed s policy was appropriate, though some criticized the Fed for waiting too long to cut the interest rate. Through the first half of 2002 (when this section is being written) the Fed had not changed the interest rate in Once again, most observers thought this policy was correct. It is currently predicted that the Fed will raise the interest rate later in As you read these lines, you are in a position to know what the Fed actually did: Did the Fed raise the interest rate? And was this policy appropriate? The Economics Place web site will contain information to help you answer these two important questions! Mid-Term Exam Answers 11. b; 12. b; 13. c; 14. d; 15. b; 16. b; 17. a; 18. c; 19. d; 10. b; 11. c; 12. a; 13. a; 14. a; 15. d; 16. b; 17. c; 18. c; 19. b; 20. d.

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