Macroeconomics Unit 5 Practice Short Answer Essay Questions

Macroeconomics – Unit 5 – Practice Short Answer Essay Questions

a. Using monetary and fiscal policies outline an expansionary policy that would encourage long-run growth and explain why the policies will encourage this growth.

To encourage long-run growth, an expansionary policy should stimulate investment as much as possible. An expansionary monetary policy (lower discount rate), lower reserve requirement, buy bonds on the open market) will lower the interest rate and thus encourage investment. To stimulate investment, an expansionary fiscal policy should be directed toward business tax deductions. For these business tax deductions to have their full effect on investment, monetary policy would be needed to keep interest rates low. A combination of cutting business taxes and expanding money supply will be good for economic growth. b. Some economists want to decrease government spending to reduce government budget deficits. Other economists want to reduce the size of the deficit by raising taxes. Compare these two points of view using aggregate supply and aggregate demand analysis. Illustrate the effects of each program using a correctly labeled aggregate demand (AD) and short-run aggregate supply (SRAS) graph. c. Why is there a conflict between the Fed’s attempt to control both the money supply and the interest rate? What is the implication of the Fed’s attempt to control the money supply? The interest rate is determined by the interaction between the supply of and demand for money in the money market. The supply of money is primarily controlled be the Fed; the demand for money is a function of the liquidity preferences of the private sector (households and businesses) and the public sector (governments). Thus, the Fed can either expand (or contract) the money supply to control the interest rate, or it can control the growth in the money supply and let the interest rate be established by the interaction of the money supply and money demand. When the Fed controls the money supply, the interest rate is allowed to fluctuate depending on the demand for money. If the interest rate fluctuates too much, this can lead either to fluctuations in investment or to a reduced level of business investment because of the uncertainty associated with interest rates. Fluctuations in investment can cause business cycles.

d. Discuss the trade-off between unemployment and inflation in the short run. Why does this trade-off pose a dilemma for policy makers? What trade-off exists between inflation and unemployment in the long run?