ECON 175 FINAL

1. Use only 1 or 2 sentences only to answer in terms of economic concepts. [10 points]
a. What are automatic stabilizers?
Automatic stabilizers are part of the fiscal policy and are built into the federal/state/local tax and transfer systems. They are put in place to stimulate aggregate demand in a recession without the need for action by policymakers. Corporate and personal income taxes are the best-known automatic stabilizers. For example: when the economy is in its growth stage, our progressive tax system automatically reduces money supply, as income rises. When the economy turns into a recession, payments of unemployment benefits and food stamps inject more money into the system to help stimulate demand.
b. How would currency depreciation affect aggregate demand?
When an increase in the supply of currency occurs, the currency loses value, or its price decreases. A decrease in currency price would cause the aggregate demand curve to shift to the downward right. A lower currency price means less demand for the currency. The book uses a great example with the country Zimbabwe. In 2002, the Zimbabwe government increased its supply of money drastically. This caused currency depreciation and very high inflation for the country’s people. The Zimbabwe Dollar was worth around 2 cents US Dollar. By 2006 the depreciation had grown and the new currency price was 0.00001 or one-thousandth of a US Dollar. This has made the Zimbabwe dollar very repealing compared to other world currencies. Therefore, the aggregate demand for Zimbabwe Dollar has decreased immensely.
c. Why would someone want currency from another nation?
The reason someone would favor say the British pound over the US Dollar is because the British pound holds more value. $1.61 equals about 1 British pound making the pound more desirable and attractive to investors. After the financial crisis of 2008, the US Dollar suffered and the government was forced to print a lot of money and this created depreciation in the dollar and made investors extremely worried. Many of them converted all their assets into Euros or Pounds in order to better protect their wealth.
d. What is the yield curve? Which part can the Fed control more easily?
The yield curve shows the relation between the level of interest and the time it matures. The most common yield curve illustrated is the US debt curve on its Treasury Notes. As the note or bond maturity lengthens, the yields will rise. The Fed can control the interest rates more easily than it can control inflation or employment. Through open market operations, the discount rate, and reserve requirements, the Fed can influence the supply and demand for reserve balances. When the Fed lowers the federal funds rate, it allows central banks to lower their

interest rates to their investors. This helps push the economy forward and motivates investors to spend their money.
e. Canada’s economy is heavily influence by the price of oil. If the price of oil rises, would you prefer to buy or sell the Canadian dollar?
If the price of oil rises I would prefer to buy the Canadian dollar because the first principle of demand for a currency states that as a country’s exports increase so does the value of its currency. Higher oil prices means higher returns. High oil prices would make Canada more desirable to foreign investment, thus raising its value of its currency and strengthening my personal portfolio. Therefore, transferring all of my assets into Canadian dollars would be the smart move.

2. When the Fed wants to increase the federal funds rate, what action to do they undertake? Clearly explain how the Fed’s action leads to an increase in the federal funds rate. What might cause the Fed’s policies to be ineffective? [5 points]
The Fed will sell bonds until the federal funds rate increases by a desired amount. When the Fed does this they are simply decreasing the money supply by removing cash from the economy in exchange for bonds. The transactions deduct the purchase amounts from the bank’s reserve. This reduces the amount the banks have to lend in the federal funds market, thus increasing the federal funds rate. The Fed does all of this in order to slow down the economy and tighten the flow of money supply and credit. Thus, all consumer and business spending will decrease and individuals will have less access to borrow, and eventually slow down the entire economy.
The loose monetary policies by the Fed in the recent years could be seen as a huge concern. The Fed believes that if they continue to print money and buy bonds that this will help push forward the economy. However, this is not the case. All this money that has been created just ends up as deposits back at the central bank in form of excess reserves. The Feds idea was to inject liquidity into the marketplace. What they failed to realize is that small banks and credit unions do a majority of lending to small business owners and consumers. These small banks rely heavily on borrowing due to their lack of reserves and deposits. But big banks don’t see the point in lending to small banks and taking on the risk with little to no payout (0-0.25%). If we look back to previous chapter when we learned the GDP function C+G+I+NX, C, was the biggest and most influential part. Consumption is made up mostly of individuals (consumers) and the Fed as still yet to realize, that we the individuals, are what move the economy forward, not big banks sitting behind their super computers. The abnormally low interest rates set by the Feds will backfire on them if they don’t find a better way of putting the liquidity into the hands of the consumers, not these big centralized banks.

3. The Taylor Rule can be expressed by the equation . [10 points total]
a. Explain the economic interpretation of the term . What does this term say the Fed should do during recessions? [2 points]
The term ay (Yt-Y*) describes the difference in real output versus potential output. In order to interpret this term we must look at real and nominal GDP. We must also factor in the GDP deflator, which measures prices of all domestic goods. Then we divide nominal GDP by real GDP and multiply by a 100 in order to find the real output rate. This term helps give us a real look at the GDP rate and what factors can influence it. The Fed should lower interest rates when inflation is below the target level or when GDP growth is too slow. Both of these usually occur during a recession (slow GDP, lower inflation rate).
b. If the following numbers reflect the current economy, what is the implied interest rate? Show your work. [2 points]
Πt=5% π*=2% r*=3% Yt=2% Y*=3% aπ=0.75 ay=0.25
5%+3%+0.75(5%-2%)+0.25(2%-3%) = 10% is the implied interest rate in this current economy.
c. What is an inflation hawk and an inflation dove? [1 point]
An inflation hawk is someone who fights inflation more aggressively than Taylor Rule implies (i-actual > iTR). An inflation dove fights less aggressively than Taylor Rule implies (i-actual < iTR). Inflation hawks favor high interest rates in order to keep inflation in check. Inflation doves favor lower interest rates and believe inflation and its negative effects will have minimal impact on society.
d. The president of the San Francisco Federal Reserve Bank suggests that interest rates should be set at 8% given the economic conditions in her district. Is this person an inflation hawk or an inflation dove? [1 point]
The president of the San Francisco Federal Reserve Bank is an inflation hawk because she favors high interest rates. 8% is considered a very high interest rate in a borrowing market. She may be making this decision in order to prevent high inflation and cause a potential recession.
e. As Chairman of the Board of Governors, you have ultimate decision about interest rates. What concerns would you have about an 8% interest rate policy in the economy described by part b? At the same time why might you be inclined to agree with an 8% interest rate policy? [4 points]

If I were Chairman of the Board I would have many concerns having an 8% interest rate because this would cause a problem with the flow of money coming into and out of the city. 8% interest rate means that the banks will borrow less, and charge higher interest rates to their customers. In turn consumers and business owners won’t have access to financial funds in order to conduct business and transactions. Fewer businesses mean fewer employees, who result in less spending, which in turn slows GDP and could cause massive unemployment. All of this can ultimately lead to a recession.
I could also see myself agreeing with this statement as well. It is possible that the inflation in the market is getting out of control. Setting the interest rate at 8% would help because it would make borrowing more difficult which would lower spending. Thus, inflation would decrease because the demand for goods and services is also on the decline. A good example of this is back in 1981-1982 when the country’s inflation rate was 14% a year. The Fed ended up raising interest rates to 20% and causing a recession but it did put an end to the crazy high inflation. Eventually in a few years the economy had turned around and the Fed and US government put less restrictions on banking regulations and the economy flourished for years to come.

4. Two economies are alike in all respects except one: • In Economy O, businesses import about half of their inputs. • In Economy C, businesses use only domestically-produced inputs.
In which economy does a given amount of Fed stimulus have a greater effect on GDP: Economy O or Economy C? Why? [5 points]
In this example I would have to say that Economy O would benefit more from a stimulus than Economy C because Economy O states that it imports goods therefore its total GDP output level will be less than Economy C’s. Imports have a negative effect on output levels and can lead to outsourcing. Outsourcing can seriously damage an economy, as it has in the United States. This leads to more unemployment and less people spending money, which in turn means less money for businesses. Also if a country is importing a lot of goods it means workers are not as productive as another country. Economy O is possibly suffering from structural unemployment and the stimulus would better serve them and it would improve the flow of money and credit going into Economy O. Economy O may also want to include tax incentives and tax cuts in its stimulus package in order to lift some burden of costs for business owners. The number one most important thing for Economy O is to produce good long-term jobs and put money into education and job training. Just initiating a stimulus isn’t enough to help recover from a recession. Workers must be educated and trained in order to deal with competition in the future. Lastly, Economy O must be careful to not spend too much money on the stimulus because they do not want to risk an inflation war. Too much printed money on the market will cause depreciation in their currency. This is a great example of what is happening currently in the United States.

5. An economy can be characterized by the following equations:
C = 300 + 0.60(Y-T) I = 500 + 0.15Y G = 500 T= 200 IM = 100 + 0.25Y EX = 420
a. Solve for the equilibrium level of output. Show your work. [2 points]
Y*= 300+0.60(Y-200)+500+0.15Y+500+(420-(100+0.25Y))
Y*=300+0.60Y-120+500+0.15Y+500+320-0.25Y
Y*=0.50Y+1500
0.5Y=1500 Y*=3000
b. If government spending increases to 520, what is the new level of output? What is the expenditure multiplier? [2 point]
Y*=300+0.60Y-120+500+0.15Y+520+320-0.25Y
Y*=0.50Y+1520
0.50Y=1520 Y*=3040
Multiplier= Change in Y/Change in G = (3040-3000)/(520-500)=2 Exp. Multiplier is 2
c. Instead of taxes being exogenous, suppose taxes were described by the equation T = . Using the original values, what would the equilibrium level of output be in this case? [1 point]
Y*=300+0.60(1Y-0.15Y)+500+0.15Y+500+(420-(100+0.25Y))
Y*=300+0.60(0.85Y)+500+0.15Y+500+320-0.25Y
Y*=0.41Y+1620 0.59Y=1620 Y*=2,745.763
d. Would the expenditure multiplier be greater or smaller than in the previous model? Explain intuitively. [1 point]
The expenditure multiplier would be smaller than the previous model because this new model adds in 15% taxes that would hurt the overall equilibrium output level as stated above. Adding taxes would create a disruption with business owners who would have to find ways of coming up with covering these extra costs. They would either have to raise prices or cut labor. Either way the overall GDP will be affected proportionately to the tax percent increase. The multiplier is as follows= Change in Y/Change in Taxes = (2745.763-3000) / (0.15(2745.763)-200)=(-254.237/211.86445)= -1.20 = Exp. Multiplier

e. A senator suggests that the Congress enact a fiscal policy bill immediately. What is fiscal policy. Give a few examples. [1 point]
Fiscal policy is federal government policy on taxes, spending and borrowing that is designed to influence business fluctuations. Some examples are the 2009 federal stimulus package Obama put into place to help fund roads, bridges, and education, Medicare etc. Another example is when Bush cut taxes in 2001 to help consumers and investors have more income to spend to help restart the economy. He cut taxes on the top marginal rate from 39.6% to 35%. In 2010, Obama renewed the Bush Tax Cuts for 2 more years, as well as adding billons of dollars into unemployment insurance and job creation. Probably the most well known fiscal policies were through Franklin D. Roosevelt and his New Deal Programs which included FDIC, Social Security, Workers Progress Act, Federal Housing Administration and much more. These programs impacted the economy dramatically, and many of them are still around to this day.
f. Using the model in part c, suppose potential output is Y=2500. How much would the fiscal stimulus package need to total to close the recessionary gap? [1 point]
Y=300+0.60(0.15(2500))+500+0.15(2500)+500+(420-(100+0.25(2500))) = Y*=2645. The federal stimulus package would need to add 100 more in order to close the recessionary gap. Model c Y*=2745.763 and with Y=2500 the new Y*=2645 therefore Y*=2745-2645=100
g. Another senator says he will not vote for the bill because he does not believe fiscal stimulus will work. Why might the stimulus package not work as the model suggests? [2 points]
The stimulus package may not work because injecting federal dollars into the economy doesn’t necessarily fix the problems the economy is in. For example: building roads and bridges give many workers a short-term job, but as soon as the job is complete, the contractor can no longer keep the workers on payroll. So these temp workers go back on unemployment and begin spending less as their income has dropped significantly. The drop in incomes lowers the overall output level, thus there is still a recessionary gap. In order to print all this money and put it into the economy, the government must take money out by either raising taxes or cutting programs in order to keep inflation in line. Raising taxes on business is never a good thing especially during a recession, when businesses are barely scraping by. Most of them will have to reduce workers hours in order to cut back their benefits such as health and 401ks or just lay them off altogether. Otherwise the business would have to raise its prices, which is also a terrible idea considering the rest of the economy is in a recession with less disposable income. My assumption is this “other” senator is a Republican and before he will vote on this there has to be some compromise. A good solution would be to go back and rewrite the bill and add tax incentives for small businesses or cut unnecessary programs to help reduce the chance of inflation and keep citizens employed.