Deck 15: Financial Crises, Stabilization, and Deficits

Question 1

What were the political and social costs of the bailout of the U.S. financial industry?

Answer 1

Most of the people who benefited from the bailout were wealthy- certainly wealthier than average. The wealth that didn't fall because of the bailout was mostly wealth of high-income people-people holding the bonds of the financial institutions. Also, the jobs in the financial institutions that were saved were mostly jobs of high-income earners. People who will pay for the bailout in the long run are the U.S. taxpayers, who are on average less wealthy than those who benefited from the bailout. The bailout thus likely had, or at least was perceived by many to have had, bad income distribution consequences, which put a strain on the body politic.

Question 2

Using the graph above, suppose it takes policy makers from time t2 to time t4 to take an action to stimulate the economy. What kind of policy lag is this and why does it happen?

Answer 2

This is an example of an implementation lag. It take Congress time to react. After all, it's a 535 member body with the House and the Senate having to pass legislation for eventual signing by the president.

Question 3

What is the Standard and Poor's 500?

Answer 3

It is an index based on the stock prices of 500 of the largest firms by market value.

Question 4

How might an increase in stock prices lead to increases in investment?

Question 5

When is the Fed more likely to decrease the money supply and why?

Question 6

Use the Economics in Practice titled "Financial Reform Bill" to answer the following question. What were the primary provisions of the Financial Reform Bill as described in the article as it applied to consumers and borrowers?

Question 7

How is the Fed likely to respond during periods of excessive expansionary growth that is characterized by strong inflationary pressures? Make sure to include in your answer the change in the money supply and interest rates.

Question 8

Suppose that there is a stock market crash in which the market loses twenty percent of its value in one day. Furthermore, assume that the crash leads to further pessimism that the market will crash again. What likely impact will this have on GDP and why?

Question 9

How and why does the stock market and housing market affect consumption?

Question 10

Using the graph above, if policy makers decide on a policy at point t3 but it does not affect the economy until period t6, then how might this be a problem?

Question 11

Use the Economics in Practice titled "Financial Reform Bill" to answer the following question. What were the provisions of the Financial Reform Bill as described in the article as it applied to the use of market derivatives?

Question 12

When is the Fed more likely to increase the money supply and why?

Question 13

What is the NASDAQ composite?

Question 14

What is meant by the use of the phrase "financial crisis" and how is it used?

Question 15

What is the Dow Jones Industrial Average?

Question 16

Using the graph above, if the economy is actually at Point C but policy makers think that it is still at Point B, what kind of lag problem is this? Why might this happen?

Question 17

What might have happened had the U.S. financial system not been "bailed out" by the federal government?

Question 18

How is the Fed likely to respond during periods of recessionary decline? Make sure to include in your answer the change in the money supply and interest rates.

Question 19

Use the Economics in Practice titled "Bernanke's Bubble Laboratory: Princeton Protégés of Fed Chief Study the Economics of Manias" to answer the following question. According to the article what is the explanation for why bubbles emerge?

Question 20

Using the graph above, if the economy is currently at Point B and policy makers implement a policy which shifts the aggregate demand curve to AD1, identify the lag that refers the amount of time necessary for the economy to react to this change.

Question 21

What is the most important determinant of the response lag for monetary policy?

Question 22

What is a recognition lag?

Question 23

If an increase in government spending had a multiplier expanded effect upon GDP of $200 billion and the deficit response index is .15, calculate the amount by which the deficit will rise.

Question 24

Use the graph above to explain what will happen if an expansionary policy that should have begun to take effect at point A does not actually begin to have an impact until point D, when the economy is already on an upswing.

Question 25

What kind of impact on the economy will there be from a contractionary monetary policy when the economy is suffering from stagflation?

Question 26

What is an implementation lag?

Question 27

What is a response lag?

Question 28

Explain the nature of the implementation lag for fiscal policy.

Question 29

Explain with the use of Milton Friedman's "fool in the shower" analogy why policy makers efforts to combat recession often do not work.

Question 30

Explain what economists mean by the Fed "leaning against the wind".

Question 31

Using the graph above, if economic policy causes aggregate demand curve shifts from AD2 to AD1, then what will happen to the equilibrium level of output and the price level? Explain.

Question 32

Assume two different economies: one represented by AD₁ and one represented by AD₂. Which economy would the Fed be more inclined to expand the money supply and why? Demonstrate your answer by drawing in the new demand curve that would result.

Question 33

When stock prices rise, what generally happens to the level of household wealth and consumption?

Question 34

What would be the Federal Reserve's expansionary response to offset the effects of a decrease in government spending?

Question 35

According to the above graph what kind of action is the Fed likely to take and why? You may assume at Po is highly inflationary and that Yo represents full-employment output. Draw in the new aggregate demand curve to support your answer.

Question 36

Why is it said that changes in government spending have a direct and immediate impact on the economy but changes in personal taxes have a delayed impact on the economy?

Question 37

Explain the use of stabilization policy.

Question 38

Explain why stagflation is a more difficult problem to solve for the Fed than others.

Question 39

Explain why the implementation lag for fiscal policy is typically longer than for monetary policy.

Question 40

What did Milton Friedman mean by his criticism of stabilization policy when be compared it to a "fool in the shower?"

Question 41

Why might it be imprudent for policy makers to try to cut a large government budget deficit all in one year?

Question 42

Explain the Federal Reserve's policy that is often called to "lean against the wind."

Question 43

Why would a balanced budget amendment to the Constitution be considered destabilizing during a recession in which the government is running a budget deficit?

Question 44

Identify the time lags that are associated with stabilization policies.

Question 45

Assume an economy where the deficit response index is zero. If the budget deficit is $85 billion and the multiplier is 4 how much must government spending be cut in order to drive the deficit to zero? What role does the multiplier play in the solution to this problem?

Question 46

Assume the government is running a budget deficit of $40 billion and cuts spending by this amount. Suppose that this cut in spending resulted in a new budget deficit of $30 billion. With a multiplier of 1.5 what must be the value of the deficit response index?

Question 47

Explain why the implementation lag of fiscal policy is generally greater than the implementation lag of monetary policy.

Question 48

What does the recognition lag imply about how well economic policy might work?

Question 49

Suppose that for every $10 billion decrease in GDP, tax revenue would fall by $1 billion. With a budget deficit of $200 billion and a multiplier of 4 what will be the new budget deficit if Congress cuts government spending by $100 billion.

Question 50

Explain why is the response lag for monetary policy likely longer than the response lag for fiscal policy?

Question 51

Discuss the response lags for an expansionary monetary policy.

Question 52

Explain the relationship between changes in the money supply, interest rates, spending, and prices.

Question 53

Why would a balanced budget amendment to the Constitution be considered destabilizing during an inflationary boom in which the government is running a budget surplus?

Question 54

Explain why the time lags, in general, pose a challenge to policy makers.

Question 55

What might be the most prudent way to cut a large budget deficit if the government is concerned about driving the economy into recession?

Question 56

Assume an economy with a budget deficit of $50 billion. Suppose the income multiplier is 1.5 and the deficit response index is .20. Calculate the new budget deficit if Congress cuts spending by the exact amount of the budget deficit.

Question 57

Suppose the government is faced with a budget deficit of $50 billion. Explain why a cut in spending by precisely this amount may not balance the budget. What are the implications for policy if the goal is to balance the budget?

Question 58

Explain the important policy objectives of Federal Reserve monetary policies.

Question 59

What is the deficit response index?

Question 60

Explain stagflation and the policy dilemma it presents.

Question 61

Suppose that government tax revenues are represented by the following algebraic equation: T = - 100 + .1Y. Assume that government spending is $280 billion and the economy is operating at $3000 billion. Calculate the size of the budget deficit.

Question 62

Assume that tax revenue is represented by the following function: T = - 200 + .25Y, where the first term represents transfer payments and the second term represents gross tax revenue. Assume furthermore that government spending is $400 billion and the economy is in equilibrium at $2000 billion. Why would a cut in government spending by $100 billion not cause the budget deficit to disappear? If the income multiplier were two, what will the value of the budget deficit be after the cut in spending?

Question 63

What part of the Gramm-Rudman-Hollings Act were determined by the Supreme Court to be unconstitutional.

Question 64

Under what circumstances might the income multiplier be zero? More specifically, there were those who argued that the income multiplier was zero during the passage of the Gramm-Rudman-Hollings Deficit Reduction Act. What was their argument?

Question 65

Assume an economy with a deficit response index of -.20. With a budget deficit of $200 billion, what would be the impact on the budget deficit if the economy were to expand by $100 billion? Assume that the government takes no action to change taxes or government spending.

Question 66

Explain how deficit targeting can serve as an automatic destabilizer.

Question 67

Assume that the economy is in a recession. If the government were to increase spending while the Fed expanded the money supply, what would be the effect on interest rates and investment? Explain why your answer is likely to be ambiguous.

Question 68

What are automatic destabilizers?

Question 69

Explain how a tax cut might actually result in a decline in the budget deficit.

Question 70

Why would an income multiplier of zero make balancing the budget easier?

Question 71

What is the economic impact of automatic stabilizers during contractionary periods?

Question 72

Explain what was supposed to happen under the Gramm-Rudman-Hollings Act when a congressionally enacted budget deficit was larger than the targeted amount.

Question 73

Give a some of examples of automatic stabilizers in the economy.

Question 74

Explain how an increase in government spending might actually result in a decline in the budget deficit.

Question 75

Assume that tax revenue is represented by the following function: T = - 200 + .25Y, where the first term represents net taxes and Y represents GDP. Assume furthermore that government spending is $400 billion and the economy is in equilibrium at $2000 billion. Calculate the value of the budget deficit.

Question 76

What is the economic impact of automatic stabilizers during expansionary periods?

Question 77

Explain what the Gramm Rudman Hollings Act was meant to do.

Question 78

What is a negative demand shock?

Question 79

Explain why the pursuit of a balanced budget during a recession may be very difficult to pursue.

Question 80

What are automatic stabilizers?