Fernanda Matos De Oliveira
Section 14
Gandalf wishes the economy of Middle Earth to operate smoothly after he sails from the Grey
Havens to the never-ending lands in the West. He gathers King Elessar of Gondor, King Eomer
of Rohan, Thain Pippin Took of the Shire, King Thorin III Stonehelm of the Lonely Mountain,
King Bard II of Dale, King Thranduil of Mirkwood, Gimli son of Gloin of Aglarond, Prince
Faramir of Ithilien, Prince Imrahil of Dol Amroth, Treebeard of Fangorn Forest and other
councilors and leaders of the various countries of Middle Earth to instruct them on fiscal
policies designed to smooth out the business cycle.
Even as the first shadows were felt in Mirkwood there
appeared in the west of Middle-earth the Istari, whom
Men called the Wizards....[A]terwards it was said among
the Elves that they were messengers sent by the Lords of
the West to contest the power of Sauron, if he should
rise again, and to move Elves and Men and all living things
of good will to valiant deeds. In the likeness of Men they
appeared, old but vigorous, and they changed little with
the years, and aged but slowly, though great cares lay on
them; great wisdom they had, and many powers of mind
and hand.
a) Describe a budget deficit, a budget surplus and a balanced budget. Include relationship of
tax revenues and government spending. What impact will each have on the market for
loanable funds?
A budget deficit occurs when total expenditures exceed total revenues. A budget surplus,
on the other hand, describes a situation where total revenues exceed total expenditures.
Finally, a balanced budget is one where total expenditures are equal to total revenues. A
budget deficit would imply that an economy would not be in a position to pay off its debts in
case it is given a loan. A budget supply, on the other hand, would increase the probability of
a country receiving loans. GO BACK TO HANDOUT #16 ON LOANABLE FUNDS TO STATE
THE ROLE OF GOVERNMENT IN LOANABLE FUNDS IN EACH SITUATION.
b) Describe and graph how an income tax affects potential
GDP and aggregate supply. Indicate the income tax
wedge. (2 graphs) How do taxes on expenditures affect
the income tax wedge?
LOOK IN HANDOUT #24. YOU NEED TO SHOW THE
WEDGE IN THE LABOR MARKET AND SHOW THE
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CONNECTION ON THE
PRODUCTION FUNCTION
(LIKE WE DID IN
ECONOMIC GROWTH
SECTION).
expenditures, which reduces aggregate supply and GDP.
Taxes on expenditures, on the other hand, reduce
INCREASE the income tax wedge
AS1
Price
AS
D
GDP
Income
Tax wedge
AS1
AS
D
GDP
An increase in income tax
reduces GDP and aggregate
supply.
This is because an income tax
translates to reduced
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c) Draw the Laffer curve. Show where the maximum tax
revenues would be. From this point does an increase in
tax rates increase or decrease tax revenues?
Tax
Rate
Maximum tax revenues
Tax Revenue
From the maximum tax revenues point, any further increase in the tax rates reduces the
tax revenues. OK
d) Describe the three multipliers for government fiscal policy and describe the differences in
size of impact. How does each affect the economy?
The three fiscal multipliers are impact multiplier, peak multiplier and cumulative multiplier. The
peak multiplier has the greatest impact, followed by the cumulative multiplier, then the impact
multiplier. Each affects the economy depending on time frame. WHERE ARE YOU GETTING
THIS STUFF? LOOK AT THE GUIDE –HANDOUT 24
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e) Draw expansionary fiscal policy that is applied when the economy is in a recessionary
gap using the AD/AS model. What are the two fiscal actions that the government
could take to implement this policy?YOU HAVE MOVED INTO AN INFLATIONARY
GAP ON YOUR GRAPH RATHER THAN CORRECTING THE ECONOMY.
Price
AS
AD1
AD
Q1
Qe
GDP
OKThe two fiscal actions that the government can undertake to close the recessionary
gap are;
a) reduction of taxes
ii)
increase of government expenditures.
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f) Draw contractionary fiscal policy that is applied when the economy is in an inflationary gap
using the AD/ AS model? What are the two fiscal actions that the government could take
to implement this policy? BETTER BUT NEED ALL LABELS. SHOULD ALSO SHOW
MULTIPLIER EFFECT ON GRAPH. SEE HANDOUT 24
Price
AS
AD
AD1
Qe
Q1
GDP
OK The two fiscal actions that the government can undertake to close the inflationary gap are;
Increase of taxes
Decrease of government expenditures.
g) List and briefly describe the five lags that cause problems in implementing fiscal policy.
1. Data lags-relate to changes that policy makers are not cognizant of.
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Fernanda Matos De Oliveira
2. Wait-and-see lags-Relate to the tendency of policy makers to relax even when they have
identified a problem in the economy???? WHERE DID THIS COME FROM?? SEE
HANDOUT 24
3. Legislative lags-relate to legal procedures that must be followed once a policy has been
proposed. POLLITICAL PROCESS
4. Transmission lags-relate to the time a policy takes before in is effected. BUREAUCRACY
5. Effectiveness lags-relate to the time a policy prescription takes before actual effect is
felt on the economy.
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Fernanda Matos De Oliveira
Section 15
Thorin III Stonehelm, son of Dain, became King of the Lonely Mountain after his father’s fall
in the War of the Ring. The dwarves of his kingdom were busy and prosperous producing the
weapons, armor and jewelry for which they were famous and which the inhabitants of Middle
Earth were demanding now that there was peace. But Thorin III Stonehelm began to notice
that prices were rising in his kingdom and he went to consult with King Bard II of Dale (son of
Brand) to see why this was happening.
The lands opened wide about him, filled with the waters
of the river which broke up and wandered in a hundred
winding courses, or halted in marshes and pools dotted
with isles on every side; but still a strong water flowed on
steadily through the mist. And far away, its dark head in a
torn cloud, there loomed the Mountain! Its nearest
neighbours to the North-East and the tumbled land that
joined it to them could not be seen. All alone it rose and
looked across the marshes to the forest. The Lonely
Mountain!
a) Draw (in the AD/AS model) and explain what happens to aggregate demand in the short
run. What happens to the price level, unemployment and real GDP in the short run? Is
there an inflationary or recessionary gap?
OK BUT LRAS IS ALWAYS LABELED Qn – CHECK ALL YOUR GRAHS In the short-run, the
aggregate demand increases, thereby causes a rightward shift of the demand curve from AD
to AD1. At the same time, the price level increases, while the unemployment level decreases.
Real GDP increases. The economy is facing an inflationary gap.
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Fernanda Matos De Oliveira
Price
LRAS
SRAS
p1
pe
AD1
AD
Qe
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Q1
Real GDP
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b) Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy on
its own in the long run as a result of a) if no policy response occurs. What happens to the
price level, unemployment and real GDP in the long run? Include all the dynamics. Is this
inflation? Explain why or why not. If so, what is it called?
In the long-run, the increase in aggregated demand will be offset by a decrease in aggregate
supply. As the aggregate demand curve shifts to the right, the aggregate supply curve will
shift to the left. This shift in the supply curve to the left will occur because laborers will
demand higher wages upon realizing that prices have increased, yet their incomes have not
increased. This will be costly to firms since they will incur higher business costs. This will
result in a decrease in supply. Also, in the long-run, the price level will increase, while
unemployment and real GDP will remain constant. The economy faces inflation because the
price level increases considerably. WHAT IS IT CALLED? ADD LABELS AND Qn
Price
LRAS
SRAS1
SRAS
AD1
AD
Qe
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Real GDP
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c) Draw (in the AD/AS model) and explain what happens to the
Lonely Mountain economy in the long run as a result of a) if
the Council (Fed) immediately applies monetary policy and
contracts the money supply rather than wait for the economy
to self-correct like in b). What happens to the price level,
unemployment and real GDP in the long run? What is the final
difference in the result of the monetary policy and the
results in b)?
If the Fed applies contractionary monetary policy, the AD
curve will shift to the left. This will cause a decrease in the
price level. At the same time, unemployment will increase,
while real GDP will reduce. The difference that occurs when
the council chooses to let the economy to self-correct itself
and when it chooses to apply contractionary monetary policy
is that in the former, unemployment and real GDP will remain
unchanged, GOES BACK TOO while in the latter, these will
change. ONLY PRICE MISSING LRAS AND LABELS
c)
Price
SRAS
AD
AD1
Qe Q1
Output
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Fernanda Matos De Oliveira
d) The Federal Council of Elrond (Fed) gets on a roll and increases the money supply each
year for 3 years. Draw (in the AD/AS model) and explain the long-run effect of these
increases on the economy of the Lonely Mountain. What happens to the price level,
unemployment and real GDP in the short run and in the long run? What is the end result
of these continued increases? Is there inflation? Explain why or why not. If so, what is it
called?
In the long-run, a continued increase of money supply will be counterproductive because it
will not be met by a proportionate increase in production. The price level is likely to increase
significantly, both in the short-run and the long-run. Unemployment is likely to increase in
the short-run, but will tend to remain constant in the long-run. As for real GDP, it will reduce
in the short-run, but will remain unchanged in the long-run. As a result of the continued
increase in money supply, the situation experienced is one where a lot of money is chasing
few goods. This results in inflationary tendencies. ADD MORE LEVELS. ADD AND FIX
LABELS WHAT IS THIS SITUATION CALLED? SEE HANDOUT #25
Price
LRAS
SRAS
AD1
AD
Qe
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Q1
Real GDP
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The economy of the Lonely Mountain is dependent on iron for
its armor and weapon manufacturing. A pack of Orcs fleeing the
destruction before the gates of Barad-Dur make their way to
the Iron Hills where the dwarves mine ore and force battle.
The attack on the Dwarves’ mines causes a temporary supply
shock to the economy of Middle Earth due to the reduction of
raw materials.
e) Draw (in the AD/AS model) and explain the shortrun effect of the supply shock on economy of the
Lonely Mountain. What happens to the price level,
unemployment and real GDP in the short run? Is
there an inflationary or recessionary gap?
A supply shock is likely to cause a left-ward shift of
the demand curve to the left. As a result, the price
level will increase, while unemployment will increase.
Real GDP will reduce. The economy will face a
recessionary gap. MISSING LRAS, LABELS
Price
SRAS1
SRAS
LRAS
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Q1
Qe
Real GDP
AD
Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy on its own
in the long run as a result of e) if no policy response occurs. What happens to the price level,
unemployment and real GDP in the long run? Include all the dynamics. Is there inflation? Explain
why or why not. If so, what is it called?
In the long-run, the decrease in supply will be offset by an increase in demand. NOT UNLESS
SOMETHING ELSE STEPS IN. FIXING ITSELF MOVES YOU OUT OF A RECESSIONARY GAP
JUST LIKE USUAL—END UP BACK WHERE UYOU STARTED. Consequently, the price level will
increase, while unemployment and real GDP will remain constant. The situation witnessed of
sluggish economy and high inflation is called stagflation.
Price
LRAS
SRAS1
SRAS
AD1
AD
Q1
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Qe
Real GDP
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f) Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy in
the long run as a result of e) if the attacks continually re-occur and the Council (Fed)
applies expansionary monetary policy and increases the money supply one time rather than
wait for the economy to self-correct like in f). What happens to the price level,
unemployment and real GDP in the long run? Include all the dynamics. Is there inflation?
Explain why or why not. If so, what is it called? What is the final difference in the result
of the monetary policy and the results in f)?
If Fed applies expansionary monetary policy and increases money supply, the price level is
likely to reduce????, while unemployment will reduce. Real GDP will increase. The
difference when the council chooses to let the economy to self-correct itself and when it
chooses to apply expansionary monetary policy is that in the former, the economy will
face a mild-recession, while in the latter, it will face inflation. BACKWARDS
Price
SRAS1
SRAS
AD
Q1
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Qe
Real GDP
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Fernanda Matos De Oliveira
Section 16
After the War of the Rings, Legolas returns to Mirkwood, where his father rules the
Woodland Elves. Due to new ideas gained in his wide travels, Legolas convinces King Thranduil
to implement continuing expansionary monetary and fiscal policy to reduce unemployment in
Mirkwood. (Actually, a reduction in the consumption of barrels of wine would work better.)
There was also a strange Elf,
clad in green and brown, Legolas,
a messenger from his father,
Thranduil, the King of the Elves
of Northern Mirkwood.
a) Draw and explain the short-run Phillips curve for the economy of Mirkwood on which
Legolas is basing his ideas. What is held constant along the short-run Phillips curve?
In the short-run Phillips curve expected inflation and actual inflation are held constant.
SHOULD CURVE
Inflation
rate
Short-run Phillips
curve
Unemployment rate
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b) Draw the short-run and long-run Phillips curve for the Mirkwood economy. Explain what
happens to the price level and unemployment in the long run?
In the long-run, the price level increases, while unemployment remains at its natural rate.
This occurs because laborers revise their wages upon realizing that the price level has
increased. Others even choose to renounce their job positions. This combination of some
laborers renouncing their positions and others revising their expectation of inflation
causes wages to increase and consequently, prices. This shift the supply curve to the left,
taking the economy back to its full potential point.
NO TRADEOFF IN LR—ADD LABELS SEE HANDOUT #26
Long-run Phillips
curve
Inflation
rate
Short-run Phillips
curve
Unemployment rate
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c) Explain and show by graph the
connection through unemployment
and changes in the price level
between the business cycle as
shown by the AD/AS model and the
long run Phillips curve (show 3
points on the graph). NEED 2
GRAPHS JUST LIKE HANDOUT
#26. BE SURE TO INCLUDE U
AND Un—THAT IS HOW THEY
CONNECT
Inflation
Rate
3
2
1
U1
Un
Point 1: Shows an increase in output
following a shift of the aggregate
demand curve to the right.
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Point 2: Shows the decrease in
unemployment that is brought
about by an increase in aggregate
demand.
Point 3: Shows how the economy
moves back to its full potential
point when laborers revise their
inflation expectations. This
causes the short-run aggregate
supply curve to shift to the left.
Unemployment Rate
d) Suppose job search time in
Mirkwood suddenly becomes easier.
Draw and explain what happens to
the Phillips curve in Mirkwood.
Inflation
Rate
U1
2
1
Page 18 of 25
Un
If job search time in Mirkwood
becomes easier, this means that
the economy will move point 1 to
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2. That is, the rate of
unemployment will reduce.
NEED TO MOVE BOTH LRPC
AND SRPC TO LEFT SO THAT
ACTUAL INFLATION REMAINS
THE SAME
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Section 17
Elrond, Chairman of the Council, is a monetarist and believes that prices and wages are flexible
so that the economy is self-regulating. But unlike Denethor, he feels that money is the key to
the economy.
The face of Elrond was ageless, neither
old nor young, though in it was written the
memory of many things both glad and
sorrowful. His hair was dark as the
shadows of twilight, and upon it was set a
circlet of silver; his eyes were grey as a
clear evening, and in them was a light like
the light of stars. Venerable he seemed as
a king crowned with many winters, and yet
hale as a tried warrior in the fulness of
his strength. --
a) What are the monetary policy objectives and goals of the Federal Council of Elrond (Fed)?
What tradeoff does the council face for its goals? Explain.
The main objective of monetary policy is to keep prices stable by changing money supply in
the economy. In doing this, the Fed faces tradeoffs. Because of the tendency of the
economy to self-correct itself following a recession or an inflation period, the Fed faces the
tradeoff of allowing the economy to self-correct itself or implementing policy to correct the
imbalance. Either way, there is a cost of each decision.
AGAIN, WHERE ARE YOU GETTING THIS STUFF? IF SOMEONE IS HELPING YOU THEY
ARE NOT DOING YOU A LOT OF GOOD. SEE THE GUIDE AND HANDOUT 27. THERE ARE
3 GOALS SET BY LAW.
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b) Graph the implementation of expansionary monetary policy on the economy of Middle Earth
when there is a recessionary gap (in both money market and AD/AS model). What happens
to the price level, unemployment and real GDP? Specify 3 different actions the Council (Fed)
could do to accomplish this policy.
AS
AD1
AD
Q1
Qe
GDP
Following the implementation of expansionary monetary policy, the price level increases, while
unemployment reduces. BACK TO Un Real GDP increases BACK TO Qn
GRAPH IS MISSING LRAS, LABELS. WHERE IS THE MONEY MARKET?
The three actions that the Fed can undertake to close a recessionary gap are;
 Purchase of bonds and securities
 Decrease of interest DISCOUNT rates
 Reduction of reserve requirements.
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c) Graph the implementation of contractionary monetary policy on the economy of Middle Earth
when there is an inflationary gap (in both money market and AD/AS model). What happens
to the price level, unemployment and real GDP? Specify 3 different actions the Council (Fed)
could do to accomplish this policy.
Price
AS
AD
AD1
Qe
Q1
GDP
Following the implementation of contractionary monetary policy, the price level will reduce,
while unemployment will increase BACK TO Un. Real GDP will reduce BACK TO Qn. GRAPH IS
MISSING LRAS, LABELS. WHERE IS THE MONEY MARKET?
The three actions that the Fed can undertake to close an inflationary gap are;
 Sell of bonds and securities
 Increase of interest DISCOUNT rates
 Increase of reserve requirements.
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d) Draw the effect on the federal funds rate if the Council (Fed) performs an open market
purchase. Describe in detail or graphs the ripple effects of this action. Be sure to include
the end result in each market and how those results affect the components of aggregate
demand. THERE ARE 5 GRAPHS YOU NEED TO DRAW AND EXPLAIN. SEE HANDOUT #27
An open market purchase is likely to increase aggregate demand, thereby causing a shift of the
aggregate demand curve to the right. In the money market, an open market purchase will lead to
more money in the economy. The component of aggregate demand that will be affected is
consumption. Individuals will consume more because the purchase will increase the money they
hold
AS
AD1
AD
Q1
Qe
GDP
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e) Draw the effect on the federal funds rate if the Council (Fed) performs an open market
sale. Describe in detail or graphs the ripple effects of this action. Be sure to include the end
result in each market and how those results affect the components of aggregate demand.
THERE ARE 5 GRAPHS YOU NEED TO DRAW AND EXPLAIN. SEE HANDOUT #27
An open market sale is likely to reduce aggregate demand, thereby causing a shift of the
aggregate demand curve to the left. In the money market, an open market purchase will lead to
less money in the economy. The component of aggregate demand that will be affected is
consumption. Individuals will consume less because the sale will reduce the money they hold.
Price
AS
AD
AD1
Qe
Q1
Real GDP
Then Círdan led them to the Havens, and there was a white ship lying, and upon the quay
beside a great grey horse stood a figure robed all in white awaiting them. As he turned and
came towards them Frodo saw that Gandalf now wore openly on his hand the Third Ring, Narya
the Great, and the stone upon it was red as fire. Then those who were to go were glad, for
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they knew that Gandalf would also take ship with them....
Then Frodo kissed Merry and Pippin, and last of all Sam, and went aboard; and the sails
were drawn up, and the wind blew, and slowly the ship slipped away down the long grey firth;
and the light of the glass of Galadriel that Frodo bore glimmered and was lost. And the ship
went out into the High Sea and passed on into the West, until at last on a night of rain Frodo
smelled a sweet fragrance on the air and heard the sound of singing that came over the water.
And then it seemed to him that as in his dream in the house of Bombadil, the grey rain-curtain
turned all to silver glass and was rolled back, and he beheld white shores and beyond them a
far green country under a swift sunrise.
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