EC 132 Discussion Note PS7
CHIU
P.1
Disclaimer:
All questions are adapted directly from the textbook and problem sets.
Suggestions from Professor Tresch are used in preparation of this note.
All solutions are just suggestive and tentative comments, not marking criteria actually adopted,
subject to further changes and interpretations.
Question 1 (Q3 Ch.16 P. 460)
Why does a money rain eventually cause an increase in the demand for money that
matches the new, higher supply of money?
With new supply of money, demand for real assets goes up. Hence, consumption and
investment goes up. When income goes up, demand for money goes up as transaction requires
money.
Definition: (Money rain) An abstract device used by economists to represent an
increase in the money supply that imagines the new money is falling from the sky.
Question 2 (Q5 Ch.16 P. 460)
a) Suppose that you buy a share of stock whose price is currently $50. You plan to sell
the stock one year from now, and you expect the price of the stock to be $60 when you
sell it. The stock pays an annual dividend of $3. Calculate your expected rate of return on
the stock.
Expected rate of return: [(60 – 50) + 3]/50 = 26%
b) Given the other saving options available to you today, would you actually be
interested in buying this stock?
Yes.
c) How would your answers to part (a) and (b) change if the current price of the stock is
$60?
Expected rate of return: 3/60 = 5%. It is lower so you may change your answer here.
Question 3 (Q6 Ch.16 P. 460)
The demand for money in the economy is closely related to three economic variables:
real national income, the overall level of prices, and interest rates on financial assets.
Why is the demand for money related to each of these variables? Name on other factor
besides these three that might affect the demand for money, and indicate why it would
do so.
Real national income: money as medium of exchange, Keynesian consumption function
Overall level of prices: quantity theory of money
Interest rate of financial assets: opportunity cost of holding money
Other factors include:
1) Use of credit cards
2) Rise of online transactions
3) how frequently people get paid in their jobs
Definition: (Transaction demand for money) The fundamental motive for holding
money that derives from money’s role as the medium of exchange; it says that the
aggregate demand for money is directly related to real national income, directly
related to the overall price level, and inversely related to interest rates, and rates
return of other assets.
EC 132 Discussion Note PS7
CHIU
P.2
Question 4 (Q7 Ch.16 P. 460)
Most economists believe that expansionary and contractionary monetary policies in the
United States first affect interest rates and then affect the equilibrium level of national
income? Why is this?
It is because Fed conducts monetary policies through open market operation, which is the
market for bank loans. The adjustment of interest rate is then channeled to consumption and
investment which ultimately reflected in national income.
Question 5 (Q3 Ch.17 P. 486)
a) Explain what is meant by the crowding out of consumer durables and investment and
by the crowding out of net exports.
When interest rate goes up, consumption and investment reduced because certain parts of
consumption and investment are from credit.
Furthermore, when interest rate goes up, the currency would appreciate which reduce net
export.
Definition: (Crowding-out effect) Changes in the demands for consumer durable,
investment, and net exports that are induced by the change in interest rates
following a change (shift) in aggregate demand, and that lower the value of the
spending multipler. (P.472)
b) Discuss the role of interest rates in the crowding-out phenomenon.
Interest rate is the channel. (without it, crowding-out would not happen!)
c) What effect does crowding out have on the value of spending multiplier?
Reduce the size of multiplier. (because crowding out acts in opposite way of spending)
Question 6 (Q6 Ch.17 P. 486)
Discuss the directional effects on the equilibrium level of national income and the level
of interest rates in the short run when the government engages in the following policies:
a) Congress passes a 6 percent increase in all personal income tax rates.
Contractionary fiscal policy (decrease Y, decrease R)
b) The Fed buys $200 million of Treasury debt on the Open Market.
Expansionary monetary policy (increase Y, decrease R)
c) The Fed increases the reserve requirement on checking account deposits by one
percentage point.
Contractionary monetary policy (decrease Y, increase R)
d) The federal government increases government spending on goods and services by
$5billion, financed by increasing the debt.
Expansionary fiscal policy (increase Y, increase R)
e) Both (a) and (b) occur simultaneously.
Contractionary fiscal and expansionary monetary policies (uncertain Y, decrease R)
f) Both (c) and (d) occur simultaneously.
Expansionary and contractionary monetary policies (uncertain Y, increase R)
EC 132 Discussion Note PS7
CHIU
P.3
Question 7 (Q8 Ch.17 P. 486)
Suppose that the federal government undertakes the following combination of fiscal and
monetary policies. Congress cuts all personal income tax rates by 5 percentage points,
and the Fed buys $100 million of Treasury securities on the Open Market. Discuss what
qualitative effects this combination of policies has on each of the four macroeconomic
policy goals in the short run.
(From Concept Summary in P.474)
Income tax rate reduction: expansionary fiscal policy (increase Y, increase R)
Buying Treasury securities: expansionary monetary policy (increase Y, decrease R)
(From Concept Summary in P.479)
Four macroeconomic policy goals:
1) Long-run economic growth
2) Full employment
3) Price stability
4) Balance of trade, stable dollar
Increase Y: increase investment, reduce unemployment, increase inflation, increase imports
which worsens balance of trade
Increase R: decrease investment, inflow of foreign currencies, dollar appreciate in value.
Question 8 (Q9 Ch.17 P. 486)
Suppose that the federal government wants to increase output growth without worsening
the balance of trade. What fiscal and monetary policies should the government
undertake?
Expansionary fiscal policy: boost income which increase import demand
Expansionary monetary policy: lower interest rate would depreciate the dollar which increase
export demand and decrease export demand
Hence, expansionary monetary policy is better.