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Questions and Answers of Economics

In the model of the open economy just developed, two markets determine two relative prices. What are the markets? What are the two relative prices?
Suppose that Americans decided to spend a smaller fraction of their incomes. What would be the effect on saving, investment, interest rates, the real exchange rate, and the trade balance?
Describe supply and demand in the market for loanable funds and the market for foreign currency exchange. How are these markets linked?
Why are budget deficits and trade deficits sometimes called the twin deficits?
Suppose that a textile workers’ union encourages people to buy only American-made clothes. What would this policy do to the trade balance and the real exchange rate? What is the impact on the
What is capital flight? When a country experiences capital flight, what is the effect on its interest rate and exchange rate?
Japan generally runs a significant trade surplus. Do you think this is most related to high foreign demand for Japanese goods, low Japanese demand for foreign goods, a high Japanese saving rate
Suppose that Congress is considering an investment tax credit, which subsidizes domestic investment.a. How does this policy affect national saving, domestic investment, net capital outflow, the
The chapter notes that the rise in the U.S. trade deficit during the 1980s was due largely to the rise in the U.S. budget deficit. On the other hand, the popular press sometimes claims that the
An economist discussing trade policy in The New Republic wrote: “One of the benefits of the United States removing its trade restrictions [is] the gain to U.S. industries that produce goods for
Suppose the French suddenly develop a strong taste for California wines. Answer the following questions in words and with a diagram.a. What happens to the demand for dollars in the market for
A senator renounces her past support for protectionism: “The U.S. trade deficit must be reduced, but import quotas only annoy our trading partners. If we subsidize U.S. exports instead, we can
Suppose the United States decides to subsidize the export of U.S. agricultural products, but it does not increase taxes or decrease any other government spending to offset this expenditure. Using a
Suppose that real interest rates increase across Europe. Explain how this development will affect U.S. net capital outflow. Then explain how it will affect U.S. net exports by using a formula from
Suppose that Americans decide to increase their saving.a. If the elasticity of U.S. net capital outflow with respect to the real interest rate is very high, will this increase in private saving have
Over the past decade, some of Chinese saving has been used to finance American investment. That is, the Chinese have been buying American capital assets.a. If the Chinese decided they no longer
Suppose that U.S. mutual funds suddenly decide to invest more in Canada.a. What happens to Canadian net capital outflow, Canadian saving, and Canadian domestic investment?b. What is the long-run
List and discuss three key facts about economic fluctuations.
How does the economy’s behavior in the short run differ from its behavior in the long run? Draw the model of aggregate demand and aggregate supply. What variables are on the two axes?
Explain the three reasons the aggregate-demand curve slopes downward give an example of an event that would shift the aggregate-demand curve. Which way would this event shift the curve?
Explain why the long-run aggregate-supply curve is vertical. Explain three theories for why the short-run aggregate-supply curve is upward sloping. What variables shift both the long-run and
Suppose that the election of a popular presidential candidate suddenly increases people’s confidence in the future. Use the model of aggregate demand and aggregate supply to analyze the effect on
Name two macroeconomic variables that decline when the economy goes into a recession. Name one macroeconomic variable that rises during a recession.
Draw a diagram with aggregate demand, short-run aggregate supply, and long-run aggregate supply. Be careful to label the axes correctly.
List and explain the three reasons the aggregate demand curve is downward sloping.
Explain why the long-run aggregate-supply curve is vertical.
List and explain the three theories for why the short-run aggregate-supply curve is upward sloping.
What might shift the aggregate-demand curve to the left? Use the model of aggregate demand and aggregate supply to trace through the short-run and long-run effects of such a shift on output and the
What might shift the aggregate-supply curve to the left? Use the model of aggregate demand and aggregate supply to trace through the short-run and long-run effects of such a shift on output and the
Suppose the economy is in a long-run equilibrium.a. Draw a diagram to illustrate the state of the economy. Be sure to show aggregate demand, short-run aggregate supply, and long-run aggregate
Explain whether each of the following events will increase, decrease, or have no effect on long-run aggregate supply.a. The United States experiences a wave of immigration.b. Congress raises the
Suppose an economy is in long-run equilibrium.a. Use the model of aggregate demand and aggregate supply to illustrate the initial equilibrium (call it point A). Be sure to include both short-run and
In 1939, with the U.S. economy not yet fully recovered from the Great Depression, President Roosevelt proclaimed that Thanksgiving would fall a week earlier than usual so that the shopping period
a. “The aggregate-demand curve slopes downward because it is the horizontal sum of the demand curves for individual goods.”b. “The long-run aggregate-supply curve is vertical because economic
For each of the three theories for the upward slope of the short-run aggregate-supply curve, carefully explain the following:a. How the economy recovers from a recession and returns to its long-run
Suppose the Fed expands the money supply, but because the public expects this Fed action, it simultaneously raises its expectation of the price level. What will happen to output and the price level
The economy begins in long-run equilibrium. Then one day, the president appoints a new chairman of the Federal Reserve. This new chairman is well-known for his view that inflation is not a major
Explain whether each of the following events shifts the short-run aggregate-supply curve, the aggregate-demand curve, both, or neither. For each event that does shift a curve, draw a diagram to
For each of the following events, explain the short-run and long-run effects on output and the price level, assuming policymakers take no action.a. The stock market declines sharply, reducing
Suppose firms become very optimistic about future business conditions and invest heavily in new capital equipment.a. Draw an aggregate-demand/aggregate supply diagram to show the short-run effect of
In economy A, all workers agree in advance on the nominal wages that their employers will pay them. In economy B, half of all workers have these nominal wage contracts, while the other half have
Use the theory of liquidity preference to explain how a decrease in the money supply affects the equilibrium interest rate. How does this change in monetary policy affect the aggregate-demand curve?
Suppose that the government reduces spending on highway construction by $10 billion. Which way does the aggregate-demand curve shift? Explain why the shift might be larger than $10 billion. Explain
Suppose a wave of negative “animal spirits” overruns the economy, and people become pessimistic about the future. What happens to aggregate demand? If the Fed wants to stabilize aggregate demand,
What is the theory of liquidity preference? How does it help explain the downward slope of the aggregate-demand curve?
Use the theory of liquidity preference to explain how a decrease in the money supply affects the aggregate-demand curve.
The government spends $3 billion to buy police cars. Explain why aggregate demand might increase by more than $3 billion. Explain why aggregate demand might increase by less than $3 billion.
Suppose that survey measures of consumer confidence indicate a wave of pessimism is sweeping the country. If policymakers do nothing, what will happen to aggregate demand? What should the Fed do if
Give an example of a government policy that acts as an automatic stabilizer. Explain why the policy has this effect.
Explain how each of the following developments would affect the supply of money, the demand for money, and the interest rate. Illustrate your answers with diagrams.a. The Fed’s bond traders buy
The Federal Reserve expands the money supply by 5 percent.a. Use the theory of liquidity preference to illustrate in a graph the impact of this policy on the interest rate.b. Use the model of
Suppose a computer virus disables the nation’s automatic teller machines, making withdrawals from bank accounts less convenient. As a result, people want to keep more cash on hand, increasing the
Consider two policies—a tax cut that will last for only one year and a tax cut that is expected to be permanent. Which policy will stimulate greater spending by consumers? Which policy will have
The economy is in a recession with high unemployment and low output.a. Draw a graph of aggregate demand and aggregate supply to illustrate the current situation. Be sure to include the
In the early 1980s, new legislation allowed banks to pay interest on checking deposits, which they could not do previously.a. If we define money to include checking deposits, what effect did this
Suppose economists observe that an increase in government spending of $10 billion raises the total demand for goods and services by $30 billion.a. If these economists ignore the possibility of
Suppose the government reduces taxes by $20 billion, that there is no crowding out, and that the marginal propensity to consume is ¾.a. What is the initial effect of the tax reduction on aggregate
An economy is operating with output $400 billion below its natural rate, and fiscal policymakers want to close this recessionary gap. The central bank agrees to adjust the money supply to hold the
Suppose government spending increases. Would the effect on aggregate demand be larger if the Federal Reserve held the money supply constant in response or if the Fed were committed to maintaining a
In which of the following circumstances is expansionary fiscal policy more likely to lead to a short-run increase in investment? Explain.a. When the investment accelerator is large or when it is
For various reasons, fiscal policy changes automatically when output and employment fluctuate.a. Explain why tax revenue changes when the economy goes into a recession.b. Explain why government
Some members of Congress have proposed a law that would make price stability the sole goal of monetary policy. Suppose such a law were passed.a. How would the Fed respond to an event that contracted
Draw the Phillips curve. Use the model of aggregate demand and aggregate supply to show how policy can move the economy from a point on this curve with high inflation to a point with low inflation.
Draw the short-run Phillips curve and the long-run Phillips curve. Explain why they are different.
Give an example of a favorable shock to aggregate supply. Use the model of aggregate demand and aggregate supply to explain the effects of such a shock. How does it affect the Phillips curve?
What is the sacrifice ratio? How might the credibility of the Fed’s commitment to reduce inflation affect the sacrifice ratio?
Draw the short-run trade-off between inflation and unemployment. How might the Fed move the economy from one point on this curve to another?
Draw the long-run trade-off between inflation and unemployment. Explain how the short-run and long-run trade-offs are related.
What is “natural” about the natural rate of unemployment? Why might the natural rate of unemployment differ across countries?
Suppose a drought destroys farm crops and drives up the price of food. What is the effect on the short-run trade-off between inflation and unemployment?
The Fed decides to reduce inflation. Use the Phillips curve to show the short-run and long-run effects of this policy. How might the short-run costs be reduced?
Suppose the natural rate of unemployment is 6 percent. On one graph, draw two Phillips curves that describe the four situations listed here. Label the point that shows the position of the economy in
Illustrate the effects of the following developments on both the short-run and long-run Phillips curves. Give the economic reasoning underlying your answers.a. A rise in the natural rate of
Suppose that a fall in consumer spending causes a recession.a. Illustrate the immediate change in the economy using both an aggregate-supply/ aggregate-demand diagram and a Phillips-curve diagram. On
Suppose the economy is in a long-run equilibrium.a. Draw the economy’s short-run and long-run Phillips curves.b. Suppose a wave of business pessimism reduces aggregate demand. Show the effect of
The inflation rate is 10 percent, and the central bank is considering slowing the rate of money growth to reduce inflation to 5 percent. Economist Milton believes that expectations of inflation
Suppose the Federal Reserve’s policy is to maintain low and stable inflation by keeping unemployment at its natural rate. However, the Fed believes that the natural rate of unemployment is 4
Suppose the Federal Reserve announced that it would pursue contractionary monetary policy to reduce the inflation rate. Would the following conditions make the ensuing recession more or less severe?
Given the unpopularity of inflation, why don’t elected leaders always support efforts to reduce inflation? Many economists believe that countries can reduce the cost of disinflation by letting
As described in the chapter, the Federal Reserve in 2008 faced a decrease in aggregate demand caused by the housing and financial crises and a decrease in short-run aggregate supply caused by rising
Suppose Federal Reserve policymakers accept the theory of the short-run Phillips curve and the natural-rate hypothesis and want to keep unemployment close to its natural rate. Unfortunately, because
Explain why monetary and fiscal policy work with a lag. Why do these lags matter in the choice between active and passive policy?
Give an example of a monetary policy rule. Why might your rule be better than discretionary policy? Why might it be worse?
Explain the costs and benefits of reducing inflation to zero. Which are temporary and which are permanent?
Explain how reducing a government budget deficit makes future generations better off. What fiscal policy might improve the lives of future generations more than reducing a government budget deficit?
Give three examples of how our society discourages saving. What are the drawbacks of eliminating these disincentives?
What causes the lags in the effect of monetary and fiscal policy on aggregate demand? What are the implications of these lags for the debate over active versus passive policy?
According to traditional Keynesian analysis, why does a tax cut have a smaller effect on GDP than a similarly sized increase in government spending? Why might the opposite be the case?
What might motivate a central banker to cause a political business cycle? What does the political business cycle imply for the debate over policy rules?
Explain how credibility might affect the cost of reducing inflation.
Why are some economists against a target of zero inflation?
Explain two ways in which a government budget deficit hurts a future worker.
What are two situations in which most economists view a budget deficit as justifiable?
Give an example of how the government might hurt young generations, even while reducing the government debt they inherit.
Some economists say that the government can continue running a budget deficit forever. How is that possible?
Some income from capital is taxed twice. Explain.
Give an example, other than tax policy, of how our society discourages saving.
What adverse effect might be caused by tax incentives to raise saving?
The chapter suggests that the economy, like the human body, has “natural restorative powers.”a. Illustrate the short-run effect of a fall in aggregate demand using an aggregate-demand/
Policymakers who want to stabilize the economy must decide how much to change the money supply, government spending, or taxes. Why is it difficult for policymakers to choose the appropriate strength

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