Chapter 34. The Influence of Monetary and Fiscal Policy on Aggregate Demand. Exercises 1-6

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Principles of Economics. Chapter 34. The Influence of Monetary and Fiscal Policy on Aggregate Demand. Exercises 1-6 Gregory Mankiw. 8th edition.
1. Explain how each of the following developmentswould affect the supply of money, the demand formoney, and the interest rate. Illustrate your answers with diagrams.
a. The Fed’s bond traders buy bonds in open-market operations.
b. An increase in credit-card availability reduces the amount of cash people want to hold.
c. The Federal Reserve reduces banks’ reserve requirements.
d. Households decide to hold more money to use for holiday shopping.
e. A wave of optimism boosts business investment and expands aggregate demand.
2. The Federal Reserve expands the money supply by 5 percent
a. Use the theory of liquidity preference to illustrate in a graph the impact of this policy on the interest rate.
b. Use the model of aggregate demand and aggregate supply to illustrate the impact of this change in the interest rate on output and the price level in the short run.
c. When the economy makes the transition from its short-run equilibrium to its new long-run equilibrium, what will happen to the price level?
d. How will this change in the price level affect the demand for money and the equilibrium interest rate?
3. Suppose a computer virus disables the nation’s automatic teller machines, making withdrawals from bank accounts less convenient. As a result, people want to keep more cash on hand, increasing the demand for money.
a. Assume the Fed does not change the money supply. According to the theory of liquidity preference, what happens to the interest rate? What happens to aggregate demand?
b. If instead the Fed wants to stabilize aggregate demand, how should it change the money supply?
c. If it wants to accomplish this change in the money supply using open-market operations, what should it do?
4. Consider two policies—a tax cut that will last for only one year and a tax cut that is expected to be permanent. Which policy will stimulate greater spending by consumers? Which policy will havethe greater impact on aggregate demand? Explain.
5. The economy is in a recession with high unemployment and low output.
a. Draw a graph of aggregate demand and aggregate supply to illustrate the current situation. Be sure to include the aggregate-demand curve, the shortrun aggregate-supply curve, and the long-run aggregate-supply curve.
b. Identify an open-market operation that would restore the economy to its natural rate.
c. Draw a graph of the money market to illustrate the effect of this open-market operation. Show the resulting change in the interest rate..
d. Draw a graph similar to the one in part a to show the effect of the open-market operation on output and the price level. Explain in words why the policy has the effect that you have shown in the graph.
6. In the early 1980s, new legislation allowed banks to pay interest on checking deposits, which they could not do previously.
a. If we define money to include checking deposits, what effect did this legislation have on money demand? Explain.
b. If the Federal Reserve had maintained a constant money supply in the face of this change, what would have happened to the interest rate? What would have happened to aggregate demand and aggregate output?
c. If the Federal Reserve had maintained a constant market interest rate (the interest rate on nonmonetary assets) in the face of this change, what change in the money supply would have been necessary? What would have happened to aggregate demand and aggregate output?