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1 Using an appropriately labeled money market graph, show the effects of an open market purchase of government securities by the FED on : The money supply Interest rates Nominal Interest rates i1 i2 Sm1 Sm2 Dm Qm1 Qm2 Q of Money

2 Use ½ of your board for each bullet below: Assume the economy is currently at full employment. Using an appropriately labeled AD-AS model show the short-run effects of an open-market sale of government securities by the FED on the following: Price level Real output On an appropriately labeled graph of the Phillips Curve, show how the open-market operation will affect the following in the short run. Use an arrow to show direction of change. Unemployment rate Inflation rate Identify a fiscal policy action that would offset the impact on real output and price level identified on the AD-AS model.

3 AD-AS Model The Phillips Curve PL LRAS SRAS Inflation rate % 1 PL 1 PL 2 AD2 AD1 % 2 SRPC Y 2 Y F GDP R U 1 U 2 Unemployment rate The initial open market operation sale of government securities decreased the money supply and increased interest rates. The increase in interest rates decreased C and I causing AE and AD to decline. The decrease in AD reduced the PL and output. The Phillips curve shows the trade-off between inflation and unemployment in the long-run as the rate of inflation dropped, unemployment increased. A fiscal policy action to address the recession caused by the OMO is increase G or decrease T or both.

4 The Spending Multiplier What effect does a change in spending (AE) have on income and output in the economy? small changes in spending greater changes in income/output

5 Key Ideas and Concepts APC Average Propensity to Consume = APS Average Propensity to Save = MPC Marginal Propensity to Consume = MPS Marginal Propensity to Save C/Yd M = 1/MPS or 1/1-MPC or ΔGDP/ ΔAE ΔGDPe = Δ AE x Multiplier S/Yd ΔC/ ΔYd =ΔS/ ΔYd

6 Δ G vs. ΔT: impact? Assume MPC of.75, what is the impact on GDPe of a $100 billion increase in G? ΔGDPe = ΔAE x M = 100 x 4 = 400 M = 1/1-.75 = 1/.25 = 4 What is the impact if government lowers T by $100 billion instead of increasing G? T YD of $100 B ΔC =.75(100) = 75B 75 x 4 = 300B

7 What happens to the federal budget (ceteris paribus) in each of the following situations: G by $50B T by $100B taxes by $100 billion G by $40B Taxes by $50B Deficit of 150B Deficit of 100B Surplus of 90B G by $25B taxes by $25B G by $30B taxes by $30B NC balanced Budg. NC balanced Budg.

8 Balanced Budget Multiplier = 1 1 x ΔG = 1 x 100 = 100B What is the impact of equal increases in G and T of $100 if the MPS =.20? ΔAE x M = 100 x 5 = 500 B M = 1/.20 = 5 T 100 B 100 B in YD C =.80(100)=80 B ΔAE x M =80 x 5 = 400 B Therefore, net effect on the economy is 100B.

9 AP Questions The Multiplier

10 If $500 billion in AE $1000 billion in GDPe, then how much would G have to to reach a YF of $2000 billion? $2000B $1000B $500B $200B $100B If $500 B in spending gives rise to $1000 B in GDP, the multiplier is 2; therefore, $500B increase in G would increase GDP by another $1000 to reach Y F of $2000.

11 The value of the spending multiplier decreases when? A. Tax rates are decreased B. Exports decrease C. Imports decrease D. Government expenditures decrease E. The MPS increases If the amount of saving as a fraction of a change in Y increases, less is spent; therefore, the multiplier is lessened.

12 Which of the following best explains why equilibrium income will rise by more than $100 in response to a $100 increase in G? A. Incomes will taxes B. Incomes will C C. AE PL D. AE MS I E. budget deficit AE

13 In a closed economy with no taxes in which the APC is 0.75, which of the following is true? A. If income is $100, then saving is $75 B. If income is $100, then C is $50 C. If income is $200, then saving is $50 D. If income is 200, then C is $75 E. If income is $500, then S is $100 If income is $200, then consumption is $150 and saving is $50. APC (Yd) = C =.75(200) = 150. S = Yd C = $ = 50.

14 Suppose that disposable income is $1000, consumption is $700, and the MPC is 0.6. If disposable income increases by $100, consumption and saving will equal which of the following? Consumption Saving A B C D E S = $ $700 = $300 ΔC = MPC (YD) = $60 ΔS = = $40 Therefore, C changes from $700 to $760 and saving changes from $300 to $340.

15 If the MPC increases, the equilibrium levels of income and consumption will change in which of the following ways? An increase in the amount of consumption that results from a change in Yd results in a greater impact on income and consumption through the multiplier. Level of Income Level of Consumption A. No change No change B. No change increase C. Increase No change D. Increase Increase E. Decrease Decrease

16 If private investment of 100 is added to the economy, the equilibrium level of income and consumption will change in which of the following ways? Level of Income Level of Consumption A. increase decrease B. increase increase C. increase no change D. No change increase E. No change no change A small change in spending will result in additional increases in Yd and C through the multiplier.

17 If at full employment, government wants to increase its spending by $100 billion without inflation in the short run, it must do which of the following? A. Taxes by greater than $100 B B. Taxes by $100B C. Taxes by less than $100 B D. Taxes by $100 B E. Taxes by less than $100 B A change in G has a greater effect on GDP than an equal change in taxes; therefore, taxes must be increased by greater than the amount of increase in G to offset the effect of G on the economy.

18 If AE from 200 to 300 solely due to a change in G and results in a change in GDPe of 1000 to 1500, which of the following is true? A. G is 300 and the multiplier is 5 B. G is 100 and the multiplier is 5 C. G is 100 and C increases by 500 D. G and GDP increase by 500 each E. C and GDP increase by 500 each If a ΔAE of 100 results in a Δ in GDP of $500, the multiplier is 5.

19 Suppose that disposable income is $1000, consumption is $700, and the MPC is 0.6. If disposable income increases by $100, consumption and saving will equal which of the following? A. G is 300 and the multiplier is 5 B. G is 100 and the multiplier is 5 C. G is 100 and C increases by 500 D. G and GDP increase by 500 each E. C and GDP increase by 500 each omit

20 Suppose that disposable income is $1000, consumption is $700, and the MPC is 0.6. If disposable income increases by $100, consumption and saving will equal which of the following? A. G is 300 and the multiplier is 5 B. G is 100 and the multiplier is 5 C. G is 100 and C increases by 500 D. G and GDP increase by 500 each E. C and GDP increase by 500 each omit

21 Current equilibrium output is equal to $2,500,000, potential output is equal to $2,600,000 and the MPC is equal to Under these conditions a Keynesian economist is most likely to recommend? A. Decrease taxes by $25,000 B. Decrease taxes by $100,000 C. Increase gov. expenditures by $25,000 D. Increase gov expenditures by $33,333 E. Increase gov expenditures by $100,000 The GDP gap = 2,600,000 2,500,000 = 100,000. The multiplier = 1/1-MPC = 4. ΔGDP = M x Δ AE = 100,000= 4 x?. Therefore, Δ AE = 25,000.

22 According to Keynesian theory, the most important determinant of saving and consumption is the: A. Interest rate B. Price level C. Level of income D. Level of employment E. Flexibility of wages and prices

23 An increase in the money supply will have the greatest effect on real GDP if: A. The MPC is low B. Unemployment is very low C. Investment spending is not sensitive to interest rates D. The quantity of money demanded is not very sensitive to interest rates E. The required reserve ratio is low.

24 Inflationary and Recessionary Gaps Recessionary Gap: The amount by which aggregate expenditures fall short of the amount of spending needed to purchase the full employment level of output (potential output). Inflationary Gap Inflationary Gap: The amount by which aggregate expenditures exceed the amount of spending needed to purchase the full employment level of output (potential output).

25 Inflationary and Recessionary Gaps PL LRAS SRAS PL LRAS SRAS AD AD Y F GDP R Y F GDP R Indicates a recessionary gap exists. Not enough spending to purchase the Y F output. Indicates an inflationary gap exists. Spending exceeds the amount needed to purchase the Y F output.

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