ECON 214 HW21 Monetary and Fiscal Policy Assignment solutions complete answers

ECON 214 HW21 Monetary and Fiscal Policy Assignment solutions complete answers

 

1. The opportunity cost of holding money

Suppose you've just inherited $5,000 from a relative. You're trying to decide whether to put the $5,000 in a non-interest-bearing account so that you can use it whenever you want (that is, hold it as money) or to use it to buy a U.S. Treasury bond.

The opportunity cost of holding the inheritance as money depends on the interest rate on the bond.

For each of the interest rates in the following table, compute the opportunity cost of holding the $5,000 as money.

Interest Rate on Government Bond

Opportunity Cost

(Percent)

(Dollars per year)

5            

7            

What does the previous analysis suggest about the market for money?

 

          The quantity of money demanded increases as the interest rate rises.

          The quantity of money demanded decreases as the interest rate rises.

          The supply of money is independent of the interest rate.

 

Suppose you've just inherited $5,000 from a relative. You're trying to decide whether to put the $5,000 in a non-interest-bearing account so that you can use it whenever you want (that is, hold it as money) or to use it to buy a U.S. Treasury bond.

The opportunity cost of holding the inheritance as money depends on the interest rate on the bond.

For each of the interest rates in the following table, compute the opportunity cost of holding the $5,000 as money.

Interest Rate on Government Bond
Opportunity Cost
(Percent)
(Dollars per year)
8
    
6
    
What does the previous analysis suggest about the market for money?

 The quantity of money demanded decreases as the interest rate falls.

 The supply of money is independent of the interest rate.

 The quantity of money demanded increases as the interest rate falls.

 

Suppose you've just inherited $5,000 from a relative. You're trying to decide whether to put the $5,000 in a non-interest-bearing account so that you can use it whenever you want (that is, hold it as money) or to use it to buy a U.S. Treasury bond.

The opportunity cost of holding the inheritance as money depends on the interest rate on the bond.

For each of the interest rates in the following table, compute the opportunity cost of holding the $5,000 as money.

Interest Rate on Government Bond
Opportunity Cost
(Percent)
(Dollars per year)
6
    
3
    
What does the previous analysis suggest about the market for money?

 The supply of money is independent of the interest rate.

 The quantity of money demanded decreases as the interest rate falls.

 The quantity of money demanded increases as the interest rate falls.

 

2. The theory of liquidity preference and the downward-sloping aggregate demand curve

Suppose the money market for some hypothetical economy is given by the following graph, which plots the money demand and money supply curves. Assume the central bank in this economy (the Fed) fixes the quantity of money supplied.

Suppose the price level decreases from 90 to 75.

Shift the appropriate curve on the graph to show the impact of a decrease in the overall price level on the market for money.

 

Following the price level decrease, the quantity of money demanded at the initial interest rate of 6% will be    than the quantity of money supplied by the Fed at this interest rate. As a result, individuals will attempt to    their money holdings. In order to do so, they will    bonds and other interest-bearing assets, and bond issuers will realize that they    interest rates until equilibrium is restored in the money market at an interest rate of

 

.

The following graph plots the aggregate demand curve for this economy.

Show the impact of the decrease in the price level by moving the point along the curve or shifting the curve.

 

The change in the interest rate found in the previous task will lead to a      in residential and business spending, which will cause      in the quantity of output demanded in the economy.

 

Suppose the money market for some hypothetical economy is given by the following graph, which plots the money demand and money supply curves. Assume the central bank in this economy (the Fed) fixes the quantity of money supplied.

Suppose the price level increases from 150 to 175.

Shift the appropriate curve on the graph to show the impact of an increase in the overall price level on the market for money.

 

Following the price level increase, the quantity of money demanded at the initial interest rate of 9% will be    than the quantity of money supplied by the Fed at this interest rate. As a result, individuals will attempt to    their money holdings. In order to do so, they will    bonds and other interest-bearing assets, and bond issuers will realize that they    interest rates until equilibrium is restored in the money market at an interest rate of

 

.

The following graph plots the aggregate demand curve for this economy.

Show the impact of the increase in the price level by moving the point along the curve or shifting the curve.

 

The change in the interest rate found in the previous task will lead to a      in residential and business spending, which will cause      in the quantity of output demanded in the economy.

 

3. Changes in the money supply

The following graph represents the money market for some hypothetical economy. This economy is similar to the United States in the sense that it has a central bank called the Fed, but a major difference is that this economy is closed (and therefore does not have any interaction with other world economies). The money market is currently in equilibrium at an interest rate of 6% and a quantity of money equal to $0.4 trillion, designated on the graph by the grey star symbol.

 

 Suppose the Fed announces that it is raising its target interest rate by 75 basis points, or 0.75 percentage points. To do this, the Fed will use open-market operations to    the    money by      the public.

Use the green line (triangle symbol) on the previous graph to illustrate the effects of this policy by placing the new money supply curve (MS) in the correct location. Place the black point (plus symbol) at the new equilibrium interest rate and quantity of money.

Suppose the following graph shows the aggregate demand curve for this economy. The Fed's policy of targeting a higher interest rate will    the cost of borrowing, causing residential and business investment spending to    and the quantity of output demanded to     at each price level.

Shift the curve on the graph to show the general impact of the Fed's new interest rate target on aggregate demand.

 

The following graph represents the money market for some hypothetical economy. This economy is similar to the United States in the sense that it has a central bank called the Fed, but a major difference is that this economy is closed (and therefore does not have any interaction with other world economies). The money market is currently in equilibrium at an interest rate of 5% and a quantity of money equal to $0.4 trillion, designated on the graph by the grey star symbol.

 

3. Changes in the money supply

The following graph represents the money market for some hypothetical economy. This economy is similar to the United States in the sense that it has a central bank called the Fed, but a major difference is that this economy is closed (and therefore does not have any interaction with other world economies). The money market is currently in equilibrium at an interest rate of 5% and a quantity of money equal to $0.4 trillion, designated on the graph by the grey star symbol.

New MS CurveNew Equilibrium00.10.20.30.40.50.60.70.87.06.56.05.55.04.54.03.53.0INTEREST RATE (Percent)MONEY (Trillions of dollars)Money SupplyMoney Demand

 Suppose the Fed announces that it is lowering its target interest rate by 25 basis points, or 0.25 percentage points. To do this, the Fed will use open-market operations to    the    money by      the public.

Use the green line (triangle symbol) on the previous graph to illustrate the effects of this policy by placing the new money supply curve (MS) in the correct location. Place the black point (plus symbol) at the new equilibrium interest rate and quantity of money.

Suppose the following graph shows the aggregate demand curve for this economy. The Fed's policy of targeting a lower interest rate will    the cost of borrowing, causing residential and business investment spending to    and the quantity of output demanded to     at each price level.

Shift the curve on the graph to show the general impact of the Fed's new interest rate target on aggregate demand.

 

The following graph represents the money market for some hypothetical economy. This economy is similar to the United States in the sense that it has a central bank called the Fed, but a major difference is that this economy is closed (and therefore does not have any interaction with other world economies). The money market is currently in equilibrium at an interest rate of 3.5% and a quantity of money equal to $0.4 trillion, designated on the graph by the grey star symbol.

 

 Suppose the Fed announces that it is raising its target interest rate by 50 basis points, or 0.5 percentage points. To do this, the Fed will use open-market operations to    the    money by      the public.

Use the green line (triangle symbol) on the previous graph to illustrate the effects of this policy by placing the new money supply curve (MS) in the correct location. Place the black point (plus symbol) at the new equilibrium interest rate and quantity of money.

Suppose the following graph shows the aggregate demand curve for this economy. The Fed's policy of targeting a higher interest rate will    the cost of borrowing, causing residential and business investment spending to    and the quantity of output demanded to     at each price level.

Shift the curve on the graph to show the general impact of the Fed's new interest rate target on aggregate demand.

 

4. The multiplier effect of a change in government purchases

Suppose there is some hypothetical closed economy in which households spend $0.80 of each additional dollar they earn and save the remaining $0.20.

The marginal propensity to consume (MPC) for this economy is    , and the spending multiplier for this economy is    .

Suppose the government in this economy decides to increase government purchases by $400 billion. The increase in government spending will lead to an increase in income, creating an initial change in consumption equal to    . This increases income yet again, leading to a second change in consumption equal to    . The total change in demand resulting from the initial change in government spending is    .

The following graph shows the aggregate demand curve (AD1AD1) for this economy before the change in government spending.

Use the green line (triangle symbol) to plot the new aggregate demand curve (AD2AD2) after the multiplier effect takes place. For simplicity, assume that there is no "crowding out."

Hint: Be sure that the new aggregate demand curve (AD2AD2) is parallel to the initial aggregate demand curve (AD1AD1). You can see the slope of AD1AD1 by selecting it on the graph.

 

Suppose there is some hypothetical closed economy in which households spend $0.85 of each additional dollar they earn and save the remaining $0.15.

The marginal propensity to consume (MPC) for this economy is    , and the spending multiplier for this economy is    .

Suppose the government in this economy decides to increase government purchases by $300 billion. The increase in government spending will lead to an increase in income, creating an initial change in consumption equal to    . This increases income yet again, leading to a second change in consumption equal to    . The total change in demand resulting from the initial change in government spending is    .

The following graph shows the aggregate demand curve (AD1AD1) for this economy before the change in government spending.

Use the green line (triangle symbol) to plot the new aggregate demand curve (AD2AD2) after the multiplier effect takes place. For simplicity, assume that there is no "crowding out."

Hint: Be sure that the new aggregate demand curve (AD2AD2) is parallel to the initial aggregate demand curve (AD1AD1). You can see the slope of AD1AD1 by selecting it on the graph.

 

Suppose there is some hypothetical closed economy in which households spend $0.80 of each additional dollar they earn and save the remaining $0.20.

The marginal propensity to consume (MPC) for this economy is    , and the spending multiplier for this economy is    .

Suppose the government in this economy decides to decrease government purchases by $300 billion. The decrease in government spending will lead to a decrease in income, creating an initial change in consumption equal to    . This decreases income yet again, leading to a second change in consumption equal to    . The total change in demand resulting from the initial change in government spending is    .

The following graph shows the aggregate demand curve (AD1AD1) for this economy before the change in government spending.

Use the green line (triangle symbol) to plot the new aggregate demand curve (AD2AD2) after the multiplier effect takes place. For simplicity, assume that there is no "crowding out."

Hint: Be sure that the new aggregate demand curve (AD2AD2) is parallel to the initial aggregate demand curve (AD1AD1). You can see the slope of AD1AD1 by selecting it on the graph.

 

5. Fiscal policy, the money market, and aggregate demand

Suppose there is some hypothetical economy in which households spend $0.50 of each additional dollar they earn and save the $0.50 they have left over. The following graph plots the economy's initial aggregate demand curve (AD1AD1).

Suppose now that the government increases its purchases by $2 billion.

Use the green line (triangle symbol) on the following graph to show the aggregate demand curve (AD2AD2) after the multiplier effect takes place.

Hint: Be sure the new aggregate demand curve (AD2AD2) is parallel to AD1AD1. You can see the slope of AD1AD1 by selecting it on the following graph.

 

The following graph plots equilibrium in the money market at an interest rate of 1.5% and a quantity of money equal to $45 billion.

Show the impact of the increase in government purchases on the interest rate by shifting one or both of the curves on the following graph.

 

Suppose that for every increase in the interest rate of one percentage point, the level of investment spending declines by $1 billion. Based on the changes made to the money market in the previous scenario, the new interest rate causes the level of investment spending to    by    .

Taking the multiplier effect into account, the change in investment spending will cause the quantity of output demanded to    by    at every price level. The impact of an increase in government purchases on the interest rate and the level of investment spending is known as the    effect.

Use the purple line (diamond symbol) on the graph at the beginning of this problem to show the aggregate demand curve (AD3AD3) after accounting for the impact of the increase in government purchases on the interest rate and the level of investment spending.

Hint: Be sure your final aggregate demand curve (AD3AD3) is parallel to AD1AD1 and AD2AD2. You can see the slopes of AD1AD1 and AD2AD2 by selecting them on the graph.

 

Suppose there is some hypothetical economy in which households spend $0.50 of each additional dollar they earn and save the $0.50 they have left over. The following graph plots the economy's initial aggregate demand curve (AD1AD1).

Suppose now that the government increases its purchases by $2.5 billion.

Use the green line (triangle symbol) on the following graph to show the aggregate demand curve (AD2AD2) after the multiplier effect takes place.

Hint: Be sure the new aggregate demand curve (AD2AD2) is parallel to AD1AD1. You can see the slope of AD1AD1 by selecting it on the following graph.

 

The following graph plots equilibrium in the money market at an interest rate of 1.5% and a quantity of money equal to $15 billion.

Show the impact of the increase in government purchases on the interest rate by shifting one or both of the curves on the following graph

 

Suppose that for every increase in the interest rate of one percentage point, the level of investment spending declines by $1 billion. Based on the changes made to the money market in the previous scenario, the new interest rate causes the level of investment spending to    by    .

Taking the multiplier effect into account, the change in investment spending will cause the quantity of output demanded to    by    at every price level. The impact of an increase in government purchases on the interest rate and the level of investment spending is known as the    effect.

Use the purple line (diamond symbol) on the graph at the beginning of this problem to show the aggregate demand curve (AD3AD3) after accounting for the impact of the increase in government purchases on the interest rate and the level of investment spending.

Hint: Be sure your final aggregate demand curve (AD3AD3) is parallel to AD1AD1 and AD2AD2. You can see the slopes of AD1AD1 and AD2AD2 by selecting them on the graph.

 

Suppose there is some hypothetical economy in which households spend $0.50 of each additional dollar they earn and save the $0.50 they have left over. The following graph plots the economy's initial aggregate demand curve (AD1AD1).

Suppose now that the government increases its purchases by $3 billion.

Use the green line (triangle symbol) on the following graph to show the aggregate demand curve (AD2AD2) after the multiplier effect takes place.

Hint: Be sure the new aggregate demand curve (AD2AD2) is parallel to AD1AD1. You can see the slope of AD1AD1 by selecting it on the following graph.

 

6. Changes in taxes

The following graph plots an aggregate demand curve.

Using the graph, shift the aggregate demand curve to depict the impact that a tax hike has on the economy.

 

Suppose the governments of two very similar economies, economy N and economy M, implement a permanent tax cut of equal size. The marginal propensity to consume (MPC) in economy N is 0.85 and the MPC in economy M is 0.8. The economies are otherwise completely identical.

The tax cut will have a larger impact on aggregate demand in the economy with the    .

 

The following graph plots an aggregate demand curve.

Using the graph, shift the aggregate demand curve to depict the impact that a tax cut has on the economy.

Suppose the governments of two very similar economies, economy B and economy A, implement a permanent tax cut of equal size. Investment spending in economy B is more sensitive to changes in the interest rate than investment spending in economy A. The economies are otherwise completely identical.

The tax cut will have a smaller impact on aggregate demand in the economy with the

 

The following graph plots an aggregate demand curve.

Using the graph, shift the aggregate demand curve to depict the impact that a tax hike has on the economy.

 

Suppose the governments of two very similar economies, economy Y and economy Z, implement a tax cut of equal size. The tax cut in economy Y is permanent, while the tax cut in economy Z is temporary. The economies are otherwise completely identical.

The tax cut will have a larger impact on aggregate demand in the economy with the    .

 

7. Use of discretionary policy to stabilize the economy

Should the government use monetary and fiscal policy in an effort to stabilize the economy? The following questions address the issue of how monetary and fiscal policies affect the economy, as well as the pros and cons of using these tools to combat economic fluctuations.

The following graph plots hypothetical aggregate demand (AD), short-run aggregate supply (AS), and long-run aggregate supply (LRAS) curves for the U.S. economy in February 2026.

Suppose the government chooses to intervene in order to return the economy to the natural level of output by using    policy.

Depending on which curve is affected by the government policy, shift either the AS curve or the AD curve to reflect the change that would successfully restore the natural level of output.

 

Suppose that in February 2026 the government successfully carries out the type of policy necessary to restore the natural level of output described in the previous question. In July 2026, U.S. imports decrease because the United States has implemented trade restrictions on Mexican goods. Due to the    associated with implementing monetary and fiscal policy, the impact of the government's new policy will likely    once the effects of the policy are fully realized.

 

Should the government use monetary and fiscal policy in an effort to stabilize the economy? The following questions address the issue of how monetary and fiscal policies affect the economy, as well as the pros and cons of using these tools to combat economic fluctuations.

The following graph plots hypothetical aggregate demand (AD), short-run aggregate supply (AS), and long-run aggregate supply (LRAS) curves for the U.S. economy in May 2026.

Suppose the government chooses to intervene in order to return the economy to the natural level of output by using    policy.

Depending on which curve is affected by the government policy, shift either the AS curve or the AD curve to reflect the change that would successfully restore the natural level of output.

 

Suppose that in May 2026 the government successfully carries out the type of policy necessary to restore the natural level of output described in the previous question. In November 2026, U.S. exports decrease because India implements trade restrictions on U.S. goods. Due to the    associated with implementing monetary and fiscal policy, the impact of the government's new policy will likely    once the effects of the policy are fully realized.

 

Should the government use monetary and fiscal policy in an effort to stabilize the economy? The following questions address the issue of how monetary and fiscal policies affect the economy, as well as the pros and cons of using these tools to combat economic fluctuations.

The following graph plots hypothetical aggregate demand (AD), short-run aggregate supply (AS), and long-run aggregate supply (LRAS) curves for the U.S. economy in January 2026.

Suppose the government chooses to intervene in order to return the economy to the natural level of output by using    policy.

Depending on which curve is affected by the government policy, shift either the AS curve or the AD curve to reflect the change that would successfully restore the natural level of output.

 

Suppose that in January 2026 the government successfully carries out the type of policy necessary to restore the natural level of output described in the previous question. In March 2026, consumer confidence increases, leading to an increase in consumer spending. Due to the    associated with implementing monetary and fiscal policy, the impact of the government's new policy will likely    once the effects of the policy are fully realized.

 

8. Using policy to stabilize the economy

The government possesses the tools necessary to influence the output level in the short run through use of monetary and fiscal policy. However, there is some debate regarding whether the government should attempt to stabilize the economy.

Which of the following are arguments in favor of active stabilization policy by the government? Check all that apply.

 Businesses make investment plans many months in advance.

 Shifts in aggregate demand are often the result of waves of pessimism or optimism among consumers and businesses.

 Changes in government purchases and taxation must be passed by both houses of Congress and signed by the president.

 The current tax system acts as an automatic stabilizer.

Which of the following policies are examples of automatic stabilizers? Check all that apply.

 Corporate income taxes

 Personal income taxes

 The discount rate

 

The government possesses the tools necessary to influence the output level in the short run through use of monetary and fiscal policy. However, there is some debate regarding whether the government should attempt to stabilize the economy.

Which of the following statements regarding the debate over stabilization policy are correct? Check all that apply.

 Opponents of active stabilization policy believe that significant time lags in both fiscal and monetary policy often exacerbate economic fluctuations.

 Advocates of active stabilization policy believe that the government can adjust monetary and fiscal policy to counteract waves of excessive optimism and pessimism among consumers and businesses.

 Opponents of active stabilization believe that active fiscal and monetary policies have no effect on aggregate demand.

 Advocates of active stabilization believe that implementation lags for fiscal and monetary policy do not exist.

Which of the following policies are examples of automatic stabilizers? Check all that apply.

 Unemployment insurance benefits

 Corporate income taxes

 The federal funds rate

 

The government possesses the tools necessary to influence the output level in the short run through use of monetary and fiscal policy. However, there is some debate regarding whether the government should attempt to stabilize the economy.

Which of the following are arguments in favor of active stabilization policy by the government? Check all that apply.

 The Fed can effectively respond to excessive pessimism by expanding the money supply and lowering interest rates.

 The current tax system acts as an automatic stabilizer.

 Changes in government purchases and taxation must be passed by both houses of Congress and signed by the president.

 Shifts in aggregate demand are often the result of waves of pessimism or optimism among consumers and businesses.

Which of the following policies are examples of automatic stabilizers? Check all that apply.

 Corporate income taxes

 Unemployment insurance benefits

 Personal income taxes