Macroeconomic Equation of Exchange - Essay Example

?Multiple Choice questions B – increase in savings 2. D – increase taxes by $28 Bn 3. B – increase equilibrium GDP 4. A – deficits in recession and surplus in inflation 5. B - $8 Bn downshift in consumption 6. C – equal to 1 7. D 8. B – destabilize economy 9. A 10. B – store of value 11. A – medium of exchange 12. C – money in circulation 13. C – downward sloping line 14. D – wealth or real balance effect 15. B – stock determined by fed 16. B – I2 17. D – NY Fed 18. B – control lending of banks 19. D – fractional reserve 20. A – 450 21. D – 1/R 22. C (E – 1/m) 23. D – increase GDP with low interest (inc money supply) 24. A – sell sec, reduce rates and inc reserve req 25. B– money supply 100 26. D – increase money supply to 100 27. C – 4 28. D 29. B – prime intt rate 30. D – decrease exports and appreciate $ 31. B - monetarism 32. C –Keynesian economics 33. A – rational expectation 34. C – Philips curve 35. C – Speed of adjustment 36. C –Laffer curve 37. B – below ob 38. D – done all 39. A – 3.6 trillion 40. B – Canada 41. D – all of the above 42. A – excise on imports 43. B – less resources and more needs 44. D – rent, wages, intt, profits 45. A – increase one at another’s expense 46. A – direct, inverse 47. C – price (price changes the demand curve not movement on same demand curve) 48. C – increase in demand 49. D – both statements are ok unless it is some sort of trick question! 50. D – high marginal cost of production 51. B – 1 and 200 52. B – 1.60 53. D – 0.50 54. D – corporate profits 55. B – functional 56. A – personal 57. D – top 1/5th get 8 times the lowest 1/5th 58. A – no claim on proprietor personal assets 59. C – GDP 60. B – PI 61. A – all final goods and services in a year 62. C – 25% 63. C – supply shock 64. B – 180 Bn 65. C – 40 at all levels 66. D - $2 for every +$3 in GDP 67. B – 3 Short Answers Question 1 The macroeconomic equation of exchange is the relationship between Money supply that is the total nominal amount of money in circulation (M), Velocity of money meaning the average frequency with which money is spent (V), Price level (P) and index of real expenditures (Q). It is expressed as M x V = P x Q From the equation of exchange, we see that money together with velocity is the source of funding for economic activities. Furthermore, it shows that for a given stock of money, an increase in velocity helps finance a greater value of transactions than money could have done by itself. Thus, the velocity of money describes the amount of economic activity with a given money supply. If all other things remain constant, changes in velocity of money can greatly affect the prices. A very high V at same M and Q would result in an increase in P (price level), that is inflation, and vice versa. If the velocity of money is stable, economists are able to predict the GDP levels and take action accordingly. Money supply can be effectively used to implement the economic policies with the desired result. If, however, V is unstable, it leads to fluctuations in price levels, and the economic policy changes in M can bring negative result. For example, if V decreases suddenly, inflation will also drop. In order to control this, the government might decide to increase the money supply. Now, if the V also increases after the increase in money supply, this would lead to sudden high inflation with combined effect of increased M and V. So, the stability of V is very important for governments to be able to decide and implement effective economic policies. Question 2 The structure of Federal reserve system is shown below in figure 1. Figure 1 Structure of Federal reserve system The components of the federal reserve system and their functions are described below: 1. Board of governors: they are appointed by the US president and confirmed by the US senate. The primary responsibility of the Board members is the formulation of monetary policy. The Board sets reserve requirements and shares the responsibility with the Reserve Banks for discount rate policy. 2. Federal Reserve banks: The 12 Federal Reserve banks operate under supervision of the board of governors. Each bank has 9 directors who appoint the bank presidents who form part of the Federal Open Market Comittee. The main role of the reserve banks is to influence the flow of money and credit in the economy. The Federal Reserve Banks hold, in their vaults, collateral for government agencies to secure public funds that are on deposit with private depository institutions. The Federal Reserve Banks also issue and redeem instruments of the public debt, such as savings bonds and Treasury securities. They have certain responsibilities for allotment and delivery of government securities and for wire transfer of securities. In addition, the Reserve Banks make periodic payments of interest on outstanding obligations of the U.S. Treasury, federal agencies, and government-sponsored corporations. 3. Federal Open Market Committee: The Federal Open Market Committee (FOMC) consists of twelve members - the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis. The FOMC holds eight regularly scheduled meetings per year. At these meetings, the Committee reviews economic and financial conditions, determines the appropriate stance of monetary policy, and assesses the risks to its long-run goals of price stability and sustainable economic growth 4. Member banks: Each member bank is a private bank that holds stock in one of the 12 regional Federal Reserve banks. The amount of stock each member bank must buy is set to be equal to 3% of its combined capital and surplus of stock in the Reserve Bank within its region of the Federal Reserve System. Holding stock in a Federal Reserve Bank is not, however, like owning publicly traded stock. The stock cannot be sold or traded. Member banks receive a fixed, 6% dividend annually on their stock, and they do not directly control the applicable Federal Reserve Bank as a result of owning this stock. They do, however, elect six of the nine members of Reserve banks' boards of directors. The advantage of the member bank status is that it gives one the right to receive loans from Federal Reserve Banks, use their services and get useful information. Question 3 1 franc = 18 cents 1 cent = 1/18 francs $1 = 100/18 = 5.55 francs Price of Levi shirt = $ 20 Price of Levi shirt in francs = 20 x 100/18 = 111.11 francs Price of Peugeot = 83250 francs Dollar price of Peugeot = 83250 * 18/100 = $ 14985 If the $ appreciates to twice the current value against the franc, the new conversion rate would be 1 franc = 9 cents 1 cent = 1/9 francs $1 = 100/9 = 11.11 francs New price of Levis shirt in francs = 20 x 100/9 = 222.22 francs New price of Peugeot in dollars = 83250 * 9/100 = $ 7492.5 This also shows that as the currency appreciates, the exports become less price competitive and imports become more cheap thus hurting the domestic producers. Question 4 Full employment GDP = $4 trillion Equilibrium GDP = $3.6 trillion mpc = 0.8 Recessionary gap = dy = 4 – 3.6 = $0.4 trillion To cover this gap with government spending only, the government must spend dG, where dG = dY * (1-mpc) = $ 0.4 trillion x 0.2 = $80 billion To close the gap by taxes only, the government must change taxes by dT where dT = dY * (1 – mpc)/(-mpc) = $0.4 trillion x 0.2 / -0.8 = - $100 billion Thus, the government must reduce taxes by $100 billion in order to solve the problem. References Ireland, Peter N.Money, Banking and Financial Markets. Accessed 9 June 2011. https://www2.bc.edu/~irelandp/ec261/chapter14.pdf Federal Reserve Board. The Structure of the Federal Reserve System. Accessed 9 June 2011. http://www.federalreserve.gov/pubs/frseries/frseri.htm Read More