ECON 203 Lecture Notes - Lecture 13: Monetary Transmission Mechanism, Potential Output, Aggregate Supply

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2 Feb 2017

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The central bank conducts monetary policy, using its control and setting of the nominal money supply as the policy instrument. (11. 1) Changes in the general price level change the real money supply and real expenditure through the monetary transmission mechanism. (11. 1) The slope and position of the aggregate demand curve describe economic conditions in the economy and the setting of economic policy. Money market conditions, the response of expenditure to changes in interest rates, and the expenditure multiplier determine the slope of ad. Autonomous expenditures and the expenditure multiplier and the nominal money supply determine the position of ad. Changes in autonomous expenditures cause business cycles by shifting the ad curve. (11. 2) Short-run aggregate supply (as) defines the relationship between the economy"s output (gdp) and the price level when factor prices, particularly wage rates, are constant but output prices are flexible.

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MBA502, Economics for Business

Apply and Discover 7.2

You are responsible for economic policymaking in your country. Your desire is to eliminate inflation, keeping prices absolutely stable at P = 100, no matter what happens to output. Currently, the economy is in equilibrium at Q = 3200 (where Q = potential GDP) and P = 100. You can use monetary and fiscal policies to affect aggregate demand but you cannot affect aggregate supply in the short run. How would you respond to the following scenarios?

Explain and illustrate how each of these events would affect aggregate demand, aggregate supply, and prices, then explain how you would respond with economic policies.

1. A surprise increase in investment spending

In the short run, when investment spending increases, it results in an increase in Aggregate Demand (AD), which in turn pushes up both GPD and the price index.

To counterbalance this development, government might pursue contractionary fiscal policy by increasing taxes (to reduce consumption) or decreasing its own investment and spending so that the AD curve shifts back to its original position. Alternatively, the government can pursue contractionary monetary policy by reducing money supply and increasing interest rate to discourage economic activity.

2. Catastrophic floods that cause a sharp food price increase

In this case, sharp food shortages and consequent price increases cause a shock-type adjustment of the aggregate supply curve (it shift up and to the left). The result is a lower GDP and a higher price level.

The government cannot do anything to adjust AS in the short run. However, if the goal is to maintain the price level constant, the government can decide to do something to decrease the aggregate demand to force prices to come down, though it will be accompanies by another contraction in GDP and so it would not be a smart thing to do.

To cause AD to decrease, the government, similar to example above, can pursue fiscal policy (increase taxes, decrease spending) or monetary policy (reduce supply of money to the economy and thus increase interest rates).

3. A productivity decline that reduces potential output

In this case, AS shifts to the left, as was the case in example 2. As a result, price levels go up, as the same amount of money is chasing the reduced amount of goods and services, and GDP declines.

Government remedies here would be centered about causing AD to decrease through contractionary fiscal (higher taxes, lower spending) or monetary (reduce money supply and increase interest rates) policy. Again, this decision reduces inflation but at expense of GDP, as real output shrinks further.

4. A deep depression in East Asia that causes a sharp decrease in net exports to the United States

A decrease in exports of goods to from the United States to Asia will mean that the aggregate demand (which includes net exports

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10. The monetarist program undertaken during the 1979-1982 period resulted in:

A. a reduction in the inertial rate of inflation.

B. a dramatic rise in unemployment.

C. very high-interest rates.

D. all of the above.

E. none of the above.

11. Some economists have suggested replacing the emphasis on controlled money supply as found in monetarism with controlled growth in nominal GDP. Money supply targets, then:

A. would be determined so as to attain the desired nominal GDP level.

B. would be eliminated.

C. could be set arbitrarily.

D. would be settled on following the discovery of an acceptable level of unemployment.

E. all of the above are true.

12. Which of the following is NOT a keystone of monetarism?

A, The money supply is the determinant of nominal GDP growth.

B. Fiscal policy can raise interest rates and thereby raise velocity.

C. Prices and wages are relatively stable.

D.The private sector is relatively stable.

E. All of the above are keystones.

13. It follows from the assumptions of the rational-expectations macroeconomics that:

A. most unemployment is voluntary.

B. monetary policy can work in the short run but not in the long run.

C. fiscal policy is hamstrung because of delays in the legislative process in Congress.

D. all policy that is predictable will be undone by clever citizens.

E. all are true.

14. Which of the following is true according to monetarist theory?

A. The IS curve is quite steep while the LM Curve is relatively flat.

B. Changes in the money supply have their greatest effect on prices.

C. Fiscal policy can do little to improve economic conditions, but much to worsen them.

D. Real GDP stays at or near potential output most of the time.

E. All of the above are true.

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True or False

1. The loanable fund market demand is the demand for consumption.

( ) 2. An increase in the bond price increases the bond yield.

( ) 3. An increase in the stock price increases the stock rate of return.

( ) 4. Monopoly increases unemployment, but monopsony does not.

( ) 5. The open market operation is the changes in interest rate in open market.

( ) 6. The high reserve requirement has the direct relationship with money creation.

( ) 7. The money value and price level have inverse relationship.

( ) 8. The nominal interest rate is related to inflation.

( ) 9. An inflation tax is the tax put on inflation.

( ) 10. Government expenditure belongs to the aggregate supply.

( ) 11. 1973-1975 recession is due to aggregate demand shift.

( ) 12. 2001 recession is due to aggregate demand shift.

( ) 13. As potential GDP is smaller than actual GDP, recession occurs.

( ) 14. A money supply results in shift of aggregate supply GDP.

( ) 15. The multiplier effect is bigger as marginal propensity to consume is smaller.

( ) 16. The multiplier effect comes together with crowding effect.

( ) 17. A recession results in decrease of welfare program.

( ) 18. A recession results in decrease of tax revenue.

( ) 19. The unemployment and inflation are in inverse relation.

( ) 20. The unemployment and inflation relation does not related to aggregate demand.

( ) 21. A quota deceases export

( ) 22. A tariff decreases import.

( ) 23. A real exchange rate is not related to nominal exchange rate.

( ) 24. A purchasing power parity exchange rate is not related to nominal exchange rate.

( ) 25. A flexible exchange rate is not related to nominal exchange rate.

( ) 26. The export increases consumer surplus.

( ) 27. The trade deficit results in capital inflow.

2. Summarize

(1) loanable fund market

(2) monetary policy tools

(3) quantity equation

(4) Okun's law

(5) mutiplier effect and crowding effect

(6) automatic stabilizers

(7) risk aversion and risk taking

(8) Fisher effect

(9) aggregate model

(10) aggregate demand shift

(11) Phillips curve

(12) protectionist policies

(13) capital inflow and capital outflow

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ECON 203 Lecture Notes - Lecture 13: Monetary Transmission Mechanism, Potential Output, Aggregate Supply

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