HW09_Policy.doc Foundations of Economic Analysis Stratton

Homework #9 Name ______

Objective: to provide practice and assessment of your understanding of the interaction of the “real” and “money” markets and fiscal and monetary policy in the U.S. Your ability to demonstrate understanding, insight and/or the ability to use the material is the primary purpose of the assessment. Thus full credit will only be earned if you follow the directions carefully and provide the explanation, description, and thought process as directed. Each numbered question is worth 2 points – total 46 points.

Instructions: In your own words compare and contrast or distinguish between the members of each pair of terms in the space provided or attach additional sheets if necessary.

Terms:

1.  Aggregate demand and Aggregate supply –

2.  Leading economic indicators and lagging economic indicators –

3.  Automatic stabilizers and Discretionary fiscal policy –

4.  IS-LM equilibrium and AD-AS equilibrium –

5.  Monetary Policy and Fiscal Policy –


Short Answer Questions: Describe how each of the following quotes from the article that opens chapter 14 of your textbook relates to the IS_LM and AD-AS models.

6.  “Commercial construction slumped 14% in the second quarter and state and local spending shrank 1.1%....”

7.  “The growth was so anemic that the economy would have contracted had businesses not restocked inventories after months of depleting them in anticipation of slower sales.”

8.  “The beige book … found retailers had ‘general sense of optimism about the near-term outlook, though a number of districts expressed concern [that falling stock prices] could affect the real economy’.”

9.  Mr. Guynn warned that “the Fed’s current low interest rates aren’t consistent with low inflation in the long run,” adding “but that’s a problem for another time, and another day.”

10.  “Previously, optimists argued that technological advances would allow productivity and profits to grow much more quickly without fueling inflation than in earlier decades.”


Short Answer Questions: Answer each question, indicating any assumptions you make, explaining your thinking, and showing all work where appropriate.

11.  Briefly explain the process by which an increase in the government spending (without offsetting tax increases) by the federal government will shift the IS curve. [Hint: the use of words and graphs would be helpful.]

12.  Briefly explain the process by which a shift to the left of the IS curve (caused by fiscal policy) will shift the AD curve. [Hint: the use of words and graphs would be helpful.]

13.  Briefly explain the process by which an increase in the nominal money supply by the Federal Reserve Open Market Committee (FMOC) will shift the LM curve. [Hint: the use of words and graphs would be helpful.]

14.  Briefly explain the process by which shifting the LM curve upward (caused by a change in monetary policy) will shift the AD curve. [Hint: the use of words and graphs would be helpful.]

15.  Briefly explain the process by which a shift to the right of the IS curve (caused by a change in fiscal policy) will shift the AS curve. [Hint: the use of words and graphs would be helpful.]


Scenario 1: Over the last year the Federal Reserve Open Market Committee (FOMC) has successfully increased the Effective Federal Funds Rate to about 4% as of November 2, 2005. Assume this has been in response to their concern that inflationary pressures are increasing due to AD growing faster than AS. In our static AD-AS analysis, this might be depicted as the current price level being below the equilibrium price level. Their goal is to reduce inflationary pressure.

http://research.stlouisfed.org/fred2/series/DFF/

16.  Depict the current AD-AS situation as seen by the FOMC, as stated above. And explain why this depiction is consistent with that statement. [Hint: the use of words and graphs would be helpful.]

Explain the process by which the FOMC actions will impact the economy to achieve its goal. Be sure to include the impact on the money market (2 points), IS-LM curves (2 points), and AD-AS (2 points). [Hint: the use of words and graphs would be helpful.]

17.  Explain the impact on the money market.

18.  Explain the impact on the IS-LM curves.

19.  Explain the impact on the AD-AS curves.


Scenario 2: With the damage caused by the hurricanes to the gulf coast, the federal government is considering how to budget the relief aid. One option being considered is to off-set any additional governmental spending (over the non-aid relief budget) with equivalent decreases in other spending. The intent of this option is to keep the total non-defense spending the same as what was acceptable prior to the storms.

A second option is to budget the needed relief aid and borrow additional funds. The intent of this option is to increase the total non-defense spending by the amount of the aid.

The current political debate seems to be focused on the first option and identifying those programs for which current spending would be reduced to pay for the aid. However, I want to focus on the second option.

Explain the process by which the increase in federal government non-defense spending would impact the economy. Be sure to include the impact on the money market (2 points), IS-LM curves (2 points), and AD-AS (2 points). [Hint: the use of words and graphs would be helpful.]

20.  Explain the impact on the money market.

21.  Explain the impact on the IS-LM curves.

22.  Explain the impact on the AD-AS curves.

23.  Explain how this action by the federal government would likely affect the actions of the Federal Reserve Systems monetary policy?

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