Economics 100
Third Exam A
November 3, 2006
Name ________________________
Please fill in your name above and on the bubble sheet (write in the relevant spaces and fill
in the relevant bubbles). Please put your last name first. Each of the multiple-choice
questions is worth three points. There are a total of 94 points on the exam. Please make
sure that you have 7 pages.
“I pledge my honor that I have neither given nor received aid on this examination.”
_________________________________
1.
If the aggregate supply increases by more than the aggregate demand increases, what
will likely happen to the short-run equilibrium level of
inflation? ________ to output? ________
a.
b.
c.
d.
decrease; decrease
decrease; increase
increase; increase
increase; decrease
2. The natural level of real GDP is $12 trillion. The economy is currently in equilibrium at a
level of real GDP of $11 trillion. If the economy adjusts naturally, inflation will
________ and employment will _________.
a.
b.
c.
d.
e.
decrease; decrease
decrease; increase
increase; increase
increase; decrease
not change; not change
3. Given a concern with rising inflation, which of the following monetary policies should the
Federal Reserve undertake?
a.
b.
c.
d.
e.
buy bonds and increase the required reserve ratio
buy bonds and decrease the required reserve ratio
sell bonds and increase the required reserve ratio
sell bonds and decrease the required reserve ratio
neither buy nor sell bonds, but decrease the required reserve ratio
4. In one economy, the amount of currency held as a percentage of money is small, but
banks tend to make as many loans as they can. In a second, the amount of currency held
as a percentage of money is large, but banks tend to make fewer loans than they can. In
which economy will a sale of bonds have the largest effect on spending?
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a.
b.
c.
d.
in the first economy
in the second economy
one cannot tell as the effects counteract one another in each economy
one cannot tell as it depends upon the size of the spending multiplier
5. A _________ saving rate and a ________ required reserve ratio will mean that a
Federal Reserve purchase of bonds will have a greater effect on spending.
a.
b.
c.
d.
e.
higher; higher
lower; lower
higher; lower
lower; higher
the saving rate does not affect monetary policy; higher
6. How should the Federal Reserve react to a recession created by a slowdown in the
growth of spending?
a.
b.
c.
d.
buy bonds and raise the discount rate
sell bonds and raise the discount rate
buy bonds and lower the discount rate
sell bonds and lower the discount rate
7. Increases in interest rates and the length of time before a business earns a profit from
a new investment will change the present value of the profit in which of the following
ways?
a.
b.
c.
d.
decrease
increase
one cannot tell as the two changes have opposite effects
one cannot tell unless we know how long it will take to earn the profit
8. Suppose that the natural level of real GDP is growing. Spending is growing at a faster
pace. As a result, prices will likely __________ and output will likely be _________
the natural level.
a.
b.
c.
d.
e.
decrease; more than
decrease; less than
increase; more than
increase; less than
not change; equal to
9. A sale of bonds by the Federal Reserve will do which of the following to bond prices and
interest rates?
a.
b.
c.
d.
e.
decrease bond prices and lower interest rates
decrease bond prices and not change interest rates
increase bond prices and lower interest rates
decrease bond prices and raise interest rates
increase bond prices and raise interest rates
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10. Compare two situations. Suppose that Canada has extremely low unemployment and the
U.S. has very high unemployment. If everything else is the same, in which country will
an increase in the money supply have the smallest effect on real GDP?
a. The effects will be the same in both countries, as the multiplier does not depend
upon unemployment.
b. One cannot tell; it depends upon how much inflation the countries are currently
experiencing.
c. in Canada
d. in the U.S.
11. Suppose the FOMC increases the target for the federal funds rate. What will happen
to bond prices and interest rates?
a.
b.
c.
d.
increase; increase
increase; decrease
decrease; decrease
decrease; increase
12. The economy is growing. Investment has contributed to the steady expansion of
capacity. Decreases in spending by consumers have insured that growth in total
spending exists but is less than the expansion of capacity.
Inflation should _________ and output should be ________.
a.
b.
c.
d.
increase; more than full-employment GDP.
increase; less than full-employment GDP.
decrease; more than full-employment GDP.
decrease; less than full-employment GDP.
13. The economy is growing. If wages increase due to conditions in the labor market and
growth in consumption spending decreases, it is likely that overall price levels
_____________ and real GDP will be ___________ than the full-employment level of
real GDP.
a.
b.
c.
d.
e.
increase; less
increase; greater
one cannot tell; less
one cannot tell; greater
decrease; one cannot tell
14. A Federal Reserve purchase of bonds will have the greatest effect on real GDP if the
amount of currency normally held as a percentage of money is ________ and the tax
rate is ______.
a.
b.
c.
d.
small; small
small; large
large; large
large; small
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e.
A smaller or larger amount of currency will affect the result; the tax rate will
not.
(10 points)
15. Explain the roles of and the importance or lack of importance of the spending multiplier
and the money multiplier in monetary policy.
(15 points)
16. Assume the Federal Reserve sells bonds. Explain each step in the process of how that
change affects the money supply in the economy and exactly why the changes occur.
(You do not need to go beyond the discussion of the changes in the money supply.)
(15 points)
17. Explain each step in how a contraction in the money supply affects interest rates and
how that affects real GDP in the economy. Explain each step in the process and
exactly why each occurs. (You do not need to explain how or why the money supply
changes or go beyond a short-run equilibrium.)
(12 points)
18. Summarize the short-run changes resulting from a negative supply shock. Then outline
the steps from the new short-run equilibrium to the long-run equilibrium, including
observations about the time it will take to adjust to the new equilibrium.
Economics 100
Sample Answers - Third Exam
November 3, 2006
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(10 points)
15. Explain the roles of and the importance or lack of importance of the spending multiplier
and the money multiplier in monetary policy.
If the Federal Reserve were to buy bonds, it would expand bank reserves and deposits. The
ultimate increase in money supply depends upon size of money multiplier as banks make
additional loans and create additional money. Once the money supply increases and interest
rates decrease, spending increases. A larger increase in the money supply will cause a
greater decrease in interest rates which in turn will cause a greater increase in spending.
The initial effect on spending is multiplied as the spending increases production and income
and that causes spending to increase even further. The final effect on total spending then
also depends upon the size of the spending multiplier.
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(15 points)
16. Assume the Federal Reserve sells bonds. Explain each step in the process of how that
change affects the money supply in the economy and exactly why the changes occur.
(You do not need to go beyond the discussion of the changes in the money supply.)
Buyers of those bonds write checks to Federal Reserve. The Federal Reserve removes
reserves from banks. The bank removes deposits from buyers’ accounts. Bank now do not
have sufficient reserves to meet their reserve requirements. Bank reserves fall by the
amount of the check and required reserves fall by a portion of that. Since actual reserves
have contracted by a larger amount, banks have insufficient reserves and they will have to
reduce the number of loans they can make.
As that happens, deposits disappear and the amount of required reserves decline. Total
reserves do not decline. How far banks will have to reduce their loans and deposits depends
upon the size of the reserve requirement, whether banks are fully loaned out, and how much
currency is deposited to repay loans. The greater the reserve requirement, the less the
necessary reduction in loans will be. If banks are not fully loaned out, they will not have to
reduce loans and deposits by as much. If some currency is used to pay off the loans, the
reduction in the money supply will be less.
This process of reduction in loans and reduction in required reserves will continue until the
money supply has decreased enough so that the banks have sufficient reserves to meet
their requirements.
(15 points)
17. Explain each step in how a contraction in the money supply affects interest rates and
how that affects real GDP in the economy. Explain each step in the process and
exactly why each occurs. (You do not need to explain how or why the money supply
changes or go beyond a short-run equilibrium.)
A reduction in the money supply means that banks can make fewer loans than borrowers
wish. Thus incentives exist for banks to raise interest rates and still make all of the loans
they wish to make. Increases in interest rates will reduce the amount of loans customers
want and the upward pressure on interest rates will continue until banks can no longer raise
interest rates without losing business.
Higher interest rates mean that investment is more costly and thus businesses cut
investment spending. Some consumers may reduce spending to the extent that they are
using savings or loans to finance purchases.
As a result spending is less than output and inventories rise. If nothing else happened,
businesses will cut back on production. Income falls, and individuals cut back on
consumption. Total spending would decrease by a multiple of the initial cutback in spending.
However, prices will fall as actual production is greater than the spending levels. Business
will decrease production as they can no longer cover all of their costs. Because prices fall,
spending rises from the level it would reach without the decrease in prices. That happens
as the lower inflation means lower interest rates, increasing investment; higher real wealth,
increasing consumption; and higher exports and lower imports.
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This entire process continues until aggregate quantity demanded equals the aggregate
quantity supplied. There is less real GDP than before the reduction in the money supply and
the price level (or inflation) is less.
(12 points)
18. Summarize the short-run changes resulting from a negative supply shock. Then outline
the steps from the new short-run equilibrium to the long-run equilibrium, including
observations about the time it will take to adjust to the new equilibrium.
The short-run changes resulting from a negative supply shock are rising inflation or prices
and falling output and employment and rising unemployment.
The long –run changes occur because at the short-run equilibrium there is significant
unemployment. That creates downward pressure on wages. Wages eventually fall, but this
process is not fast. They are slow to fall as businesses are slow to lower wages and are
often restricted by contracts. This is particularly true as prices just increased.
After the decrease in wages, business costs fall. As a result, the amount businesses want
to produce at current price levels is now greater than spending. As a result, prices
decrease. Spending increases in response to the lower prices. The amount that businesses
want to produce decreases as prices fall. This process continues until we return to full
employment
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