2009 B Macroeconomics FRQ #2

2009 B Macroeconomics FRQ #2

These questions must be evaluated from their starting places.  The FED's actions must be thought of as outside the system.

(A) Calculate each of the following:

(i) The total change in reserves in the banking system.

This is a contractionary policy as the money supply is being decreased.

If the FED sells government securities (bonds) on the open market. Then the supply of money will be reduced by $50 million in reserves. Individuals will exchange $50m for FED bonds.

Understand that Required reserves and excess reserves will be reduced.

(ii) The maximum possible change in the money supply.

So this withdrawal of $50 million out of the system would reduce the money supply by $500m.

Why?

The multiplier works in reverse for this question: Its a contractionary policy...

But first let us think about the expansionary policy, if the FED had bought bonds instead of sold them.

So if the FED had bought bonds there would normally be an increase in the money supply of $450m 

$50 million bonds bought by the FED and 10% must be held in reserves, 50 x 10% = 5 mil

So we are down to $50 - 5 = $45 million able to be loaned out and multiplied.

With a 10% RRR the $45 million would be multiplied by a factor of 10m which would increase the money supply by $450m but don't forget the original 50m which would need to be added into the multiplied amount. So, 450m + original 50m = 500m expansion of the money supply.

The FED withdrawals the whole $50m out of the money supply reducing the amount of money that the banks have in reserves or could have loaned out, thus decreasing the money supply by the entire $500m.

(B) Using a CLG of the money market, show the impact of the Central Bank's bond sale on the nominal interest rate.

If the money supply is reduced then the nominal interest rate will rise. 

(C) What is the impact of the Central Bank's bond sale on the equilibrium price level in the short-run?

If a contractionary policy is enacted (selling of bonds) then the nominal interest rate will rise. A rising interest rate will cause investment and consumption to fall. If consumption (C) and investment (I) fall then AD will fall and therefore the PL will fall.

Graph - 

(D) As a result of the price level change in (C), are people with fixed incomes better off, worse off, or unaffected. Explain.

Recognise that even if you don't have a clue that by guessing you have a 331/3% chance of getting a point. 

If the price level falls, then people with a fixed income will be better off. They can buy more stuff as prices have fallen. Their purchasing power has increased.

Crowding-Out

Crowding-Out

Reffonomics on Crowding Out Video

Definition: A situation when increased interest rates lead to a reduction in private investment spending such that it dampens the initial increase of total investment spending is called crowding out effect.

Simply put, The Federal Government spends more money than they have as revenue and to keep spending must borrow from the banks. How do they borrow? They sell Government Bonds. In selling these bonds cash is sucked out of the banks. Interest rates rise as there is less cash in the banks coupled with a larger demand for this cash. Rising interest rates slow the amount of investment in the economy.

The government has an expansionary policy and with its spending is trying to push AD aggregate demand higher, taking advantage of the multiplier. Spending raises interest rates that slows or even decreases (I) investment spending thus decreasing the effects of the multiplier.

Fiscal Policy Cheat Sheet here.

Lets look at examples of multiple choice questions:

2008 AP Multiple Choice

Answer - (decrease in private investment due to increased borrowing by the government)

2000 AP Multiple Choice

Answer - (C) higher interest rates decrease private sector investment

2005 AP Multiple Choice

Answer - (B) The decrease in consumption or private investment spending caused by an increase in government spending.

2010 AP Multiple Choice

Answer - (B) government borrowing to finance its spending decrease private sector investment.

1995 AP Multiple Choice

Answer - (A)

Tricky!

A tax cut is an expansionary fiscal policy. If the government decreases tax rates then it has less revenue. Less revenue means it must borrow to keep spending. The borrowing raises interest rates. Raising of interest rates will slow the amount of (I) investment which will keep GDP from increasing as much as expected, but it will increase. Just less than the government would have liked.

(Practice Question)

Answer - (B) Increasing the real interest rate

(Practise Question)

Answer - (C) Budget deficit increases

2010 FRQ#1

2010B FRQ#1

2008 FRQ#1

Blog post for 2008 FRQ#1 here.

Least-Cost Rule

Least-Cost Rule

The Resource Costs Cheat Sheet is here.

Least Cost Rule: production at least cost requires the ratio of labor’s marginal product to its price equals the ratio of capital’s marginal product to its price. The amounts of labor and capital employed must be adjusted, all the while keeping output constant, until this condition is achieved.

Simple, yes. (NO)  The least cost rule comes into affect when the college board asks us to evaluate two inputs for production. Labor and Capital,,, workers and machines. 

We are usually given two inputs, (labor and capital) and asked to evaluate which we need to buy more. 

First - Let's create our own simple problem. 

The price of labor is $10 and the price (rent) on capital is $20. The marginal product of labor is 40 and the marginal product of capital is 60. Should we hire more labor or more capital?

Remember the formula:

Set up the numbers:

What does this mean: 

The marginal product of the last input of labor was 40 units produced and that labourer was paid $10. So for each $1 spent we received 4 units produced. 40/10 = 4

&

The marginal product of the last input of capital was 60 units produced and the rent was $20. So for each $1 spent we received 3 units produced. 60/20 = 3

Answer - Obviously we would want to hire more labor as (per dollar spent) on labourers produce a higher level of output. We want the biggest bang for the buck.

This is the simplest most straight forward way of presenting these problems don't expect it.

The legend of John Henry stands strong in American Folklore. Legend has it that Henry’s prowess as a steel driver was measured in a race against the new steam powered hammers being used to drill into rock to make holes for explosives to blast tunnels for the railroad back in the late 1800’s. In a battle of man versus machine, Henry outdueled the steam powered technology, only to die in victory with his hammer in his hands as his heart gave out from the stress. Where it actually happened, or if it even happened at all, will always be in debate but the legend will always be a firm reminder of how technology finds itself taking over tasks previously done by hand.

(2012 AP Multiple Choice)

Answer - (A) The marginal product per dollar spent on labor is equal to the marginal product per dollar spent on capital.

2000 AP Multiple Choice Question

To answer this question you must understand that the Profit Max rule is about setting the ratios equal to one. There is a point where the right combination of labor and capital is maximised, this is always at the profit max (MR=MC) point on our graphs.  If we are at Profit Max then the least cost rule is attained/satisfied.

Lets plug in some numbers: for answer (A)

This combination of capital and labor we would want to hire more labor.

Lets plug in the numbers for (E)

Answer (E) Both sides (ratios) equal each other. We are at profit max = least cost combination.

2008 AP Multiple Choice Question

Formula:

or

OK, so we can see clearly that we would want to hire more (increase) labor as the output per dollar is greater for labor. But, the confusion is should we choose answer (D) or (E).

The marginal product of the last input of labor was 40 units produced and that labourer was paid $10. So for each $1 spent we received 4 units produced. 40/10 = 4

If we increase the amount of labor we hire the MP will fall due to diminishing marginal returns. 

&

The marginal product of the last input of capital was 60 units produced and the rent was $20. So for each $1 spent we received 3 units produced. 60/20 = 3

If we decrease the amount of capital we hire the MP will rise due to increasing marginal returns.

Remember, it is the least-cost rule, we want the least inputs we can hire(rent) to get to profit max. 

Answer - (E) Increase labor and decrease capital.

(Practise Problem)

Answer (A) make no changes as the mix of inputs (last dollar spent yield the same marginal product)

(Practise Problem)

Answer (D) less labor and more capital.

 (FRQ Practise)

then...

or

(10,000/1,000) = (50/w)

(W = 5)