Macroeconomics – Unit 5 – Practice Short Answer
Essay Questions
a. Using monetary and fiscal policies outline an
expansionary policy that would encourage long-run
growth and explain why the policies will encourage
this growth.
To encourage long-run growth, an
expansionary policy should stimulate
investment as much as possible.
An
expansionary monetary policy (lower
discount rate), lower reserve requirement,
buy bonds on the open market) will lower
the interest rate and thus encourage
investment. To stimulate investment, an
expansionary fiscal policy should be
directed toward business tax deductions.
For these business tax deductions to have
their full effect on investment, monetary
policy would be needed to keep interest
rates low.
A combination of cutting
business taxes and expanding money
supply will be good for economic growth.
b. Some economists want to decrease government
spending to reduce government budget deficits. Other
economists want to reduce the size of the deficit by
raising taxes. Compare these two points of view using
aggregate supply and aggregate demand analysis.
Illustrate the effects of each program using a correctly
labeled aggregate demand (AD) and short-run
aggregate supply (SRAS) graph.
c. Why is there a conflict between the Fed’s attempt to
control both the money supply and the interest rate?
What is the implication of the Fed’s attempt to control
the money supply?
The interest rate is determined by the
interaction between the supply of and
demand for money in the money market.
The supply of money is primarily controlled
be the Fed; the demand for money is a
function of the liquidity preferences of the
private sector (households and businesses)
and the public sector (governments). Thus,
the Fed can either expand (or contract) the
money supply to control the interest rate, or
it can control the growth in the money
supply and let the interest rate be
established by the interaction of the money
supply and money demand. When the Fed
controls the money supply, the interest rate
is allowed to fluctuate depending on the
demand for money. If the interest rate
fluctuates too much, this can lead either to
fluctuations in investment or to a reduced
level of business investment because of the
uncertainty associated with interest rates.
Fluctuations in investment can cause
business cycles.
d. Discuss the trade-off between unemployment and
inflation in the short run. Why does this trade-off
pose a dilemma for policy makers? What trade-off
exists between inflation and unemployment in the long
run?