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1. The opportunity cost of holding money

Suppose you’ve just inherited $10,000 from a relative. You’re trying to decide whether to put the $10,000 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 $10,000 as money.

Interest Rate on Government Bond (Percent)

Opportunity Cost

(Dollars per year)

6

8

 

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

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

The supply of money is independent of the interest rate.

The quantity of money demanded increases as the interest rate rises

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

The following graph shows the money market in a hypothetical economy. The central bank in this economy is called the Fed. Assume that the Fed fixes the quantity of money supplied.

Suppose the price level increases from 90 to 105.

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

After the increase in the price level, 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. People will try to _____ their money holdings. In order to do so, people will _____ bonds and other interest-bearing assets, and bond issuers will find that they ______ interest rates until the money market reaches its new equilibrium at an interest rate of ______.

The following graph shows the economy’s aggregate demand curve.

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 that you found previously will cause residential and business investment spending to ______, leading to _______ in the quantity of output demanded in the economy

3. Changes in the money supply

The following graph represents the money market in a hypothetical economy. As in the United States, this economy has a central bank called the Fed, but unlike in the United States, the economy is closed (that is, the economy does not interact with other economies in the world). The money market is currently in equilibrium at an interest rate of 4% and a quantity of money equal to $0.4 trillion, as indicated by the grey star.

Suppose the Fed announces that it is lowering its target interest rate by 75 basis points, or 0.75 percentage point. 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.

 

4. The multiplier effect of a change in government purchases

Consider a hypothetical closed economy in which households spend $0.70 of each additional dollar they earn and save the remaining $0.30.

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 purchases will lead to an increase in income, generating an initial change in consumption equal to _____. This increases income yet again, causing 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

Consider a hypothetical economy in which households spend $0.50 of each additional dollar they earn and save the remaining $0.50. The following graph shows the economy’s initial aggregate demand curve (AD1AD1).

Suppose 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 shows the money market in equilibrium 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 each one-percentage-point increase in the interest rate, the level of investment spending declines by $1 billion. The change in the interest rate (according to the change you made to the money market in the previous scenario) therefore causes the level of investment spending to _____ by ______.

After the multiplier effect is accounted for, the change in investment spending will cause the quantity of output demanded to _____ by _____ at each 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.

6. Changes in taxes

The following graph shows the aggregate demand curve.

Shift the aggregate demand curve on the graph to show the impact of a tax hike.

Suppose the governments of two different economies, economy X and economy Y, implement a permanent tax cut of the same size. The marginal propensity to consume (MPC) in economy X is 0.85 and the MPC in economy Y is 0.8. The economies are identical in all other respects.

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, and the pros and cons of using these tools to combat economic fluctuations.

The following graph shows a hypothetical aggregate demand curve (AD), short-run aggregate supply curve (AS), and long-run aggregate supply curve (LRAS) for the U.S. economy in May 2023.

Suppose the government decides to intervene to bring the economy back 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 the government undertakes the type of policy that is necessary to bring the economy back to the natural level of output in the preceding scenario. In September 2023, U.S. imports increase because the United States has eliminated trade restrictions on French goods. Because of 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 has the ability to influence the level of output in the short run using monetary and fiscal policy. There is some disagreement as to 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.

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

Businesses make investment plans many months in advance.

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.

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

The discount rate

Unemployment insurance benefits

Personal income taxes

 

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