Fiscal Policy Cheat Sheet This is a tentative cheat sheet,, I will be working my way over the next week through the FRQ's and Multiple choice questions to check my thinking. Questions, comments, corrections - firstname.lastname@example.org
If the Government is spending then the Real Interest rate is increasing.
FRQ's that ask about government spending always want to know the real interest rate. The loanable funds graph tell you whether the real interest rate is rising or falling.
Hint, if the government is spending the RIR is increasing.
Remember that Keynesian view spending is a short-term fix for a recession. When the RIR increases, investment is reduced and growth is sacrificed and there will be less capital investment.
As for the decrease in taxes being expansionary. Take the view that with a balanced budget when the government reduces taxes it must make up the difference with Government spending.
The reasoning is a bit circular because the idea of a reduction in government is not entertained along with the reduction in taxes.
So lately I've been trying to increase my understanding of how fiscal and monetary policies work in tandem. I've been a bit dismayed as many students can't understand the Real interest Rate questions on the AP exam and I haven't found any resources that string it all together.
So I've spent a few days working through the past FRQ's and Multiple choice sections of exams in hopes of clarifying exactly what the college board is testing.
1st Monetary Policy
On the left is an explanation of the causal chain of events. On the right is a graphical illustration of the left side. Sometimes seeing what happens in graphs makes the left side a bit more clear. Hope this helps,,, any mistakes, corrections, comments,, email@example.com
Some students have a conceptual problem with understanding this section (to many things to think about at this point in the course I think.
Anything that makes money flow into the commercial banks is an increase in the supply of loanable funds and therefore the real interest rate will fall, (more of a supply of something the price falls, ) more money supplied and the price (interest rate) will fall.
Notice that each question is in two places.
2014 is in the Supply decreasing (interest rates rise) and in demand increasing (interest rates rise)
2013 is in the supply increasing (interest rates fall) and the Demand decreasing section (interest rates fall).
Both answers would be correct unless on the AP exam they ask you specifically what happens to supply. 2014 would then be a supply increasing explanation with a correct graph.
Lower business taxes mean lower costs for business. AS curve shifts right (input costs decrease, PL decreases) & MC curve shifts right, and to produce at profit max, (produce more) a business must higher more labor. In an imperfectly competitive firm price will decrease.
Answer (B) gov't borrowing to finance its spending decreases private sector investment.
Answer (D) the automatic stabilizing effect of fiscal policy will be eliminated
Answer (C) decrease income taxes and increase gov't spending by equal amounts.
Let's go through a few and see if we can understand what the college board is testing.
Money Multiplier (Creation) Money Supply Increase
1995 AP Macro Exam
Answer (D) $500
(money already in excess reserves)
So, The Reserve Requirement is 20% (they must keep on reserve 20% of the checkable deposited amount), there is $100 dollars worth of excess reserves, how much money creation can happen within the money supply. (Think: money multiplier)
If the RR is 20% or .2 and the multiplier is (1/RRR) = 1/.2 = 5 ,, so the multiplier is 5
If there is $100 in excess reserves we simply take the 100 x 5 = $500 increase in the Money Supply.
Don't get confused,, you need the 20% RR to figure out the multiple (1/.2 = 5)
Not to subtract the 20% from the $100.
As the $100 dollars is already in excess reserves.
If the $100 dollars had been a checking deposit (deposited by someone) then you would have subtracted the $20 from the $100 and multiplied $80 x 5 and the money supply would have increased by $400.
AS the amount was already in excess reserves, the whole amount in excess reserves is multiplied by the 5.
2008 AP Macro Exam
Answer (C) $900
(money deposited in checking account)
So, the RR is 10%,, and the multiplier is (1/RRR) = 1/.1 = 10 is the multiplier.
There is a checkable deposit of $100 - (the RRR = 10% of $100 = $10 dollars) = $100 - $10 = $90
So, now we have $90 in excess reserves, & the money supply is expanded by the multiplier x the change in the excess reserves.
$90 x 10 = $900
You needed the RR 10% to have the multiple
Since it was a deposit you have to subtract out the RR
The difference is it goes into excess reserves and can be re-loaned out again.
This is the essence of fractional reserve banking.
What if the RR had been 20%
If the RR was 20% the multiple would be 5 not 10 like above.
This makes sense as the higher the RR the less money creation (loans) can take place.
20% would be subtracted from the $100 checkable deposit to leave $80
The $80 dollars would be placed in excess reserves to be re-loaned.
2010 Multiple Choice Questions (FED, Banking, Monetary Policy & Money Creation) This section, along with AD/AS is the second most tested. Here are the multiple choice questions for the 2010, AP Macroeconomics exam. Notice, topics questioned include: T-accounts, Velocity of Money, Bond Prices, Res. Requirements, Rational Expectations *(the FRQ's for this section are quite easy compared to the wealth of knowledge you need to be able to answer the Multiple choice)
Answer (A) Reduce Inflation
Answer (A) increase in the nominal output
Answer (C) Interest rates will decline
Answer (C) increasing the reserve requirements
Answer (C) selling bonds on the open market
Answer (B) Rational Expectations
Answer (B) demand deposits
Answer (D) Engage in Open Market Purchases
Answer (B) It falls when interest rates rise, because the opportunity cost of holding money increases.
Answer (B) Increase - Decrease
Answer (D) Decrease - Decrease
Answer (E) Buying Bonds increases the MS, which lowers the interest rate