Section 14
Fernanda Matos De Oliveira
Page 25 of 25 1/30/13
*Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the questions—it’s there just for Tolkien fun. Go forth and read!!!
Gandalf wishes the economy of Middle Earth to operate smoothly after he sails from the Grey Havens to the never-ending lands in the West. He gathers King Elessar of Gondor, King Eomer of Rohan, Thain Pippin Took of the Shire, King Thorin III Stonehelm of the Lonely Mountain, King Bard II of Dale, King Thranduil of Mirkwood, Gimli son of Gloin of Aglarond, Prince Faramir of Ithilien, Prince Imrahil of Dol Amroth, Treebeard of Fangorn Forest and other councilors and leaders of the various countries of Middle Earth to instruct them on fiscal policies designed to smooth out the business cycle.
Even as the first shadows were felt in Mirkwood there appeared in the west of Middle-earth the Istari, whom Men called the Wizards....[A]terwards it was said among the Elves that they were messengers sent by the Lords of the West to contest the power of Sauron, if he should rise again, and to move Elves and Men and all living things of good will to valiant deeds. In the likeness of Men they appeared, old but vigorous, and they changed little with the years, and aged but slowly, though great cares lay on them; great wisdom they had, and many powers of mind and hand.
a) Describe a budget deficit, a budget surplus and a balanced budget. Include relationship of tax revenues and government spending. What impact will each have on the market for loanable funds?
A budget deficit occurs when total expenditures exceed total revenues. A budget surplus, on the other hand, describes a situation where total revenues exceed total expenditures. Finally, a balanced budget is one where total expenditures are equal to total revenues. A budget deficit would imply that an economy would not be in a position to pay off its debts in case it is given a loan. A budget supply, on the other hand, would increase the probability of a country receiving loans. GO BACK TO HANDOUT #16 ON LOANABLE FUNDS TO STATE THE ROLE OF GOVERNMENT IN LOANABLE FUNDS IN EACH SITUATION.
b) Describe and graph how an income tax affects potential GDP and aggregate supply. Indicate the income tax wedge. (2 graphs) How do taxes on expenditures affect the income tax wedge?
LOOK IN HANDOUT #24. YOU NEED TO SHOW THE WEDGE IN THE LABOR MARKET AND SHOW THE CONNECTION ON THE PRODUCTION FUNCTION (LIKE WE DID IN ECONOMIC GROWTH SECTION).
( Price )
( AS 1 ) ( AS )
( D )
( GDP )
( Income Tax wedge )
( AS 1 ) ( AS )
( D )
( GDP )
An increase in income tax reduces GDP and aggregate supply.
This is because an income tax translates to reduced expenditures, which reduces aggregate supply and GDP.
Taxes on expenditures, on the other hand, reduce INCREASE the income tax wedge
c) Draw the Laffer curve. Show where the maximum tax revenues would be. From this point does an increase in tax rates increase or decrease tax revenues?
( Tax Rate )
( Maximum tax revenues )
( Tax Revenue )
From the maximum tax revenues point, any further increase in the tax rates reduces the tax revenues. OK
d) Describe the three multipliers for government fiscal policy and describe the differences in size of impact. How does each affect the economy?
The three fiscal multipliers are impact multiplier, peak multiplier and cumulative multiplier. The peak multiplier has the greatest impact, followed by the cumulative multiplier, then the impact multiplier. Each affects the economy depending on time frame. WHERE ARE YOU GETTING THIS STUFF? LOOK AT THE GUIDE –HANDOUT 24
e) Draw expansionary fiscal policy that is applied when the economy is in a recessionary gap using the AD/AS model. What are the two fiscal actions that the government could take to implement this policy?YOU HAVE MOVED INTO AN INFLATIONARY GAP ON YOUR GRAPH RATHER THAN CORRECTING THE ECONOMY.
( Price )
( AS )
( AD 1 )
( AD )
( Q e ) ( Q 1 )
( GDP )
OKThe two fiscal actions that the government can undertake to close the recessionary gap are;
a) reduction of taxes
ii) increase of government expenditures.
f)
g) Draw contractionary fiscal policy that is applied when the economy is in an inflationary gap using the AD/ AS model? What are the two fiscal actions that the government could take to implement this policy? BETTER BUT NEED ALL LABELS. SHOULD ALSO SHOW MULTIPLIER EFFECT ON GRAPH. SEE HANDOUT 24
( Price )
( AS )
( AD )
( AD 1 )
( Q 1 ) ( Q e )
( GDP )
OK The two fiscal actions that the government can undertake to close the inflationary gap are;
Increase of taxes
Decrease of government expenditures.
h) List and briefly describe the five lags that cause problems in implementing fiscal policy.
1. Data lags-relate to changes that policy makers are not cognizant of.
2. Wait-and-see lags-Relate to the tendency of policy makers to relax even when they have identified a problem in the economy???? WHERE DID THIS COME FROM?? SEE HANDOUT 24
3. Legislative lags-relate to legal procedures that must be followed once a policy has been proposed. POLLITICAL PROCESS
4. Transmission lags-relate to the time a policy takes before in is effected. BUREAUCRACY
5. Effectiveness lags-relate to the time a policy prescription takes before actual effect is felt on the economy.
Section 15
Thorin III Stonehelm, son of Dain, became King of the Lonely Mountain after his father’s fall in the War of the Ring. The dwarves of his kingdom were busy and prosperous producing the weapons, armor and jewelry for which they were famous and which the inhabitants of Middle Earth were demanding now that there was peace. But Thorin III Stonehelm began to notice that prices were rising in his kingdom and he went to consult with King Bard II of Dale (son of Brand) to see why this was happening.
T he lands opened wide about him, filled with the waters of the river which broke up and wandered in a hundred winding courses, or halted in marshes and pools dotted with isles on every side; but still a strong water flowed on steadily through the mist. And far away, its dark head in a torn cloud, there loomed the Mountain! Its nearest neighbours to the North-East and the tumbled land that joined it to them could not be seen. All alone it rose and looked across the marshes to the forest. The Lonely Mountain!
a)
b) Draw (in the AD/AS model) and explain what happens to aggregate demand in the short run. What happens to the price level, unemployment and real GDP in the short run? Is there an inflationary or recessionary gap?
OK BUT LRAS IS ALWAYS LABELED Qn – CHECK ALL YOUR GRAHS In the short-run, the aggregate demand increases, thereby causes a rightward shift of the demand curve from AD to AD1. At the same time, the price level increases, while the unemployment level decreases. Real GDP increases. The economy is facing an inflationary gap.
( LRAS ) ( Price )
( SRAS )
( p 1 )
( p e )
( AD 1 )
( AD )
( Real GDP ) ( Q e ) ( Q 1 )
c) Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy on its own in the long run as a result of a) if no policy response occurs. What happens to the price level, unemployment and real GDP in the long run? Include all the dynamics. Is this inflation? Explain why or why not. If so, what is it called?
In the long-run, the increase in aggregated demand will be offset by a decrease in aggregate supply. As the aggregate demand curve shifts to the right, the aggregate supply curve will shift to the left. This shift in the supply curve to the left will occur because laborers will demand higher wages upon realizing that prices have increased, yet their incomes have not increased. This will be costly to firms since they will incur higher business costs. This will result in a decrease in supply. Also, in the long-run, the price level will increase, while unemployment and real GDP will remain constant. The economy faces inflation because the price level increases considerably. WHAT IS IT CALLED? ADD LABELS AND Qn
( LRAS ) ( Price )
( SRAS 1 )
( SRAS )
( AD 1 )
( Q e ) ( Real GDP )
( AD )
d) Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy in the long run as a result of a) if the Council (Fed) immediately applies monetary policy and contracts the money supply rather than wait for the economy to self-correct like in b). What happens to the price level, unemployment and real GDP in the long run? What is the final difference in the result of the monetary policy and the results in b)?
If the Fed applies contractionary monetary policy, the AD curve will shift to the left. This will cause a decrease in the price level. At the same time, unemployment will increase, while real GDP will reduce. The difference that occurs when the council chooses to let the economy to self-correct itself and when it chooses to apply contractionary monetary policy is that in the former, unemployment and real GDP will remain unchanged, GOES BACK TOO while in the latter, these will change. ONLY PRICE MISSING LRAS AND LABELS
( Price )
( Output ) ( SRAS )
( AD )
( AD 1 )
( Q e ) ( Q 1 )
c)
a)
e) The Federal Council of Elrond (Fed) gets on a roll and increases the money supply each year for 3 years. Draw (in the AD/AS model) and explain the long-run effect of these increases on the economy of the Lonely Mountain. What happens to the price level, unemployment and real GDP in the short run and in the long run? What is the end result of these continued increases? Is there inflation? Explain why or why not. If so, what is it called?
In the long-run, a continued increase of money supply will be counterproductive because it will not be met by a proportionate increase in production. The price level is likely to increase significantly, both in the short-run and the long-run. Unemployment is likely to increase in the short-run, but will tend to remain constant in the long-run. As for real GDP, it will reduce in the short-run, but will remain unchanged in the long-run. As a result of the continued increase in money supply, the situation experienced is one where a lot of money is chasing few goods. This results in inflationary tendencies. ADD MORE LEVELS. ADD AND FIX LABELS WHAT IS THIS SITUATION CALLED? SEE HANDOUT #25
( LRAS ) ( Price )
( SRAS )
( AD 1 )
( AD )
( Real GDP ) ( Q 1 ) ( Q e )
The economy of the Lonely Mountain is dependent on iron for its armor and weapon manufacturing. A pack of Orcs fleeing the destruction before the gates of Barad-Dur make their way to the Iron Hills where the dwarves mine ore and force battle. The attack on the Dwarves’ mines causes a temporary supply shock to the economy of Middle Earth due to the reduction of raw materials.
f) Draw (in the AD/AS model) and explain the short-run effect of the supply shock on economy of the Lonely Mountain. What happens to the price level, unemployment and real GDP in the short run? Is there an inflationary or recessionary gap?
A supply shock is likely to cause a left-ward shift of the demand curve to the left. As a result, the price level will increase, while unemployment will increase. Real GDP will reduce. The economy will face a recessionary gap. MISSING LRAS, LABELS
( Price )
( SRAS 1 )
( SRAS )
( LRAS )
( Q e ) ( Q 1 )
( AD )
( Real GDP )
Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy on its own in the long run as a result of e) if no policy response occurs. What happens to the price level, unemployment and real GDP in the long run? Include all the dynamics. Is there inflation? Explain why or why not. If so, what is it called?
In the long-run, the decrease in supply will be offset by an increase in demand. NOT UNLESS SOMETHING ELSE STEPS IN. FIXING ITSELF MOVES YOU OUT OF A RECESSIONARY GAP JUST LIKE USUAL—END UP BACK WHERE UYOU STARTED. Consequently, the price level will increase, while unemployment and real GDP will remain constant. The situation witnessed of sluggish economy and high inflation is called stagflation.
( Price ) ( LRAS )
( SRAS 1 )
( SRAS )
( AD 1 )
( Q e ) ( Q 1 )
( AD )
( Real GDP )
g) Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy in the long run as a result of e) if the attacks continually re-occur and the Council (Fed) applies expansionary monetary policy and increases the money supply one time rather than wait for the economy to self-correct like in f). What happens to the price level, unemployment and real GDP in the long run? Include all the dynamics. Is there inflation? Explain why or why not. If so, what is it called? What is the final difference in the result of the monetary policy and the results in f)?
If Fed applies expansionary monetary policy and increases money supply, the price level is likely to reduce????, while unemployment will reduce. Real GDP will increase. The difference when the council chooses to let the economy to self-correct itself and when it chooses to apply expansionary monetary policy is that in the former, the economy will face a mild-recession, while in the latter, it will face inflation. BACKWARDS
( Price )
( SRAS 1 )
( SRAS )
( Q e ) ( Q 1 )
( AD )
( Real GDP )
Section 16
After the War of the Rings, Legolas returns to Mirkwood, where his father rules the Woodland Elves. Due to new ideas gained in his wide travels, Legolas convinces King Thranduil to implement continuing expansionary monetary and fiscal policy to reduce unemployment in Mirkwood. (Actually, a reduction in the consumption of barrels of wine would work better.)
There was also a strange Elf, clad in green and brown, Legolas, a messenger from his father, Thranduil, the King of the Elves of Northern Mirkwood.
a)
b) Draw and explain the short-run Phillips curve for the economy of Mirkwood on which Legolas is basing his ideas. What is held constant along the short-run Phillips curve?
In the short-run Phillips curve expected inflation and actual inflation are held constant.
SHOULD CURVE
( Inflation rate )
( Short-run Phillips curve )
( Unemployment rate )
c) Draw the short-run and long-run Phillips curve for the Mirkwood economy. Explain what happens to the price level and unemployment in the long run?
In the long-run, the price level increases, while unemployment remains at its natural rate. This occurs because laborers revise their wages upon realizing that the price level has increased. Others even choose to renounce their job positions. This combination of some laborers renouncing their positions and others revising their expectation of inflation causes wages to increase and consequently, prices. This shift the supply curve to the left, taking the economy back to its full potential point.
NO TRADEOFF IN LR—ADD LABELS SEE HANDOUT #26
( Long-run Phillips curve )
( Inflation rate )
( Unemployment rate )
( Short-run Phillips curve )
d) Explain and show by graph the connection through unemployment and changes in the price level between the business cycle as shown by the AD/AS model and the long run Phillips curve (show 3 points on the graph). NEED 2 GRAPHS JUST LIKE HANDOUT #26. BE SURE TO INCLUDE U AND Un—THAT IS HOW THEY CONNECT
( Inflation Rate )
( 3 )
( 2 )
( 1 )
( U n ) ( U 1 )
Point 1: Shows an increase in output following a shift of the aggregate demand curve to the right.
Point 2: Shows the decrease in unemployment that is brought about by an increase in aggregate demand.
Point 3: Shows how the economy moves back to its full potential point when laborers revise their inflation expectations. This causes the short-run aggregate supply curve to shift to the left.
( Unemployment Rate )
e) Suppose job search time in Mirkwood suddenly becomes easier. Draw and explain what happens to the Phillips curve in Mirkwood.
( Inflation Rate )
( 2 )
( 1 )
( U n ) ( U 1 )
If job search time in Mirkwood becomes easier, this means that the economy will move point 1 to 2. That is, the rate of unemployment will reduce.
NEED TO MOVE BOTH LRPC AND SRPC TO LEFT SO THAT ACTUAL INFLATION REMAINS THE SAME
Section 17
Elrond, Chairman of the Council, is a monetarist and believes that prices and wages are flexible so that the economy is self-regulating. But unlike Denethor, he feels that money is the key to the economy.
The face of Elrond was ageless, neither old nor young, though in it was written the memory of many things both glad and sorrowful. His hair was dark as the shadows of twilight, and upon it was set a circlet of silver; his eyes were grey as a clear evening, and in them was a light like the light of stars. Venerable he seemed as a king crowned with many winters, and yet hale as a tried warrior in the fulness of his strength. --
a) What are the monetary policy objectives and goals of the Federal Council of Elrond (Fed)? What tradeoff does the council face for its goals? Explain.
The main objective of monetary policy is to keep prices stable by changing money supply in the economy. In doing this, the Fed faces tradeoffs. Because of the tendency of the economy to self-correct itself following a recession or an inflation period, the Fed faces the tradeoff of allowing the economy to self-correct itself or implementing policy to correct the imbalance. Either way, there is a cost of each decision.
AGAIN, WHERE ARE YOU GETTING THIS STUFF? IF SOMEONE IS HELPING YOU THEY ARE NOT DOING YOU A LOT OF GOOD. SEE THE GUIDE AND HANDOUT 27. THERE ARE 3 GOALS SET BY LAW.
b)
c) Graph the implementation of expansionary monetary policy on the economy of Middle Earth when there is a recessionary gap (in both money market and AD/AS model). What happens to the price level, unemployment and real GDP? Specify 3 different actions the Council (Fed) could do to accomplish this policy.
( AS )
( AD 1 )
( AD )
( Q e ) ( Q 1 )
( GDP )
Following the implementation of expansionary monetary policy, the price level increases, while unemployment reduces. BACK TO Un Real GDP increases BACK TO Qn
GRAPH IS MISSING LRAS, LABELS. WHERE IS THE MONEY MARKET?
The three actions that the Fed can undertake to close a recessionary gap are;
· Purchase of bonds and securities
· Decrease of interest DISCOUNT rates
· Reduction of reserve requirements.
d) Graph the implementation of contractionary monetary policy on the economy of Middle Earth when there is an inflationary gap (in both money market and AD/AS model). What happens to the price level, unemployment and real GDP? Specify 3 different actions the Council (Fed) could do to accomplish this policy.
( Price )
( AS )
( AD )
( AD 1 )
( GDP ) ( Q e ) ( Q 1 )
Following the implementation of contractionary monetary policy, the price level will reduce, while unemployment will increase BACK TO Un. Real GDP will reduce BACK TO Qn. GRAPH IS MISSING LRAS, LABELS. WHERE IS THE MONEY MARKET?
The three actions that the Fed can undertake to close an inflationary gap are;
· Sell of bonds and securities
· Increase of interest DISCOUNT rates
· Increase of reserve requirements.
e)
f) Draw the effect on the federal funds rate if the Council (Fed) performs an open market purchase. Describe in detail or graphs the ripple effects of this action. Be sure to include the end result in each market and how those results affect the components of aggregate demand. THERE ARE 5 GRAPHS YOU NEED TO DRAW AND EXPLAIN. SEE HANDOUT #27
An open market purchase is likely to increase aggregate demand, thereby causing a shift of the aggregate demand curve to the right. In the money market, an open market purchase will lead to more money in the economy. The component of aggregate demand that will be affected is consumption. Individuals will consume more because the purchase will increase the money they hold
( AS )
( AD 1 )
( AD )
( Q e ) ( Q 1 )
( GDP )
An open market sale is likely to reduce aggregate demand, thereby causing a shift of the aggregate demand curve to the left. In the money market, an open market purchase will lead to less money in the economy. The component of aggregate demand that will be affected is consumption. Individuals will consume less because the sale will reduce the money they hold.
( Price )
( AS )
( AD )
( AD 1 )
( Real GDP ) ( Q e ) ( Q 1 )
Then Círdan led them to the Havens, and there was a white ship lying, and upon the quay beside a great grey horse stood a figure robed all in white awaiting them. As he turned and came towards them Frodo saw that Gandalf now wore openly on his hand the Third Ring, Narya the Great, and the stone upon it was red as fire. Then those who were to go were glad, for they knew that Gandalf would also take ship with them.... Then Frodo kissed Merry and Pippin, and last of all Sam, and went aboard; and the sails were drawn up, and the wind blew, and slowly the ship slipped away down the long grey firth; and the light of the glass of Galadriel that Frodo bore glimmered and was lost. And the ship went out into the High Sea and passed on into the West, until at last on a night of rain Frodo smelled a sweet fragrance on the air and heard the sound of singing that came over the water. And then it seemed to him that as in his dream in the house of Bombadil, the grey rain-curtain turned all to silver glass and was rolled back, and he beheld white shores and beyond them a far green country under a swift sunrise.
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