Homework 3: Aggregate Demand In Context ✓ Solved

Homework 3: Aggregate Demand. In context of Aggregate Deman

Homework 3: Aggregate Demand. In context of Aggregate Demand (AD), give 2 reasons why there is an inverse relationship between CPI and quantity of real GDP demanded in the economy, explain the inverse relationship.

Fiscal policy: Help an economy move back to full employment at 10 trillion real GDP by answering: I. Is the economy facing a recessionary gap or inflationary gap? II. Should the country use expansionary or contractionary fiscal policy? III. How would the chosen fiscal policy be implemented? IV. Will successful implementation shift AD or SRAS; explain why.

Money and Banking: Tracy deposits $700 in a checking account. The bank reserve ratio is 7.5%. a. If every loan is redeposited, by how much could the total money supply expand? b. If Tracy holds $130 in cash and deposits the rest, by how much could the total money supply expand?

Demand for money: Explain how (a) a deflationary period and (b) an increase in GDP with falling unemployment affect the demand for money (shift vs movement, direction, brief explanation).

Monetary policy: For a recessionary gap, how should the central bank use: 1) Open market operations, 2) Discount rate, 3) Required reserve ratio. Then state whether successful monetary policy will increase or decrease: a) interest rate; b) consumer spending; c) real GDP; d) aggregate price level.

Open-economy macroeconomics: With only the U.S. and Japan, state what happens to U.S. exports and the value of the U.S. dollar (appreciates or depreciates) if: a) The U.S. imposes import tariffs on many Japanese goods. b) U.S. interest rates fall relative to Japanese rates.

Unemployment rates: Country A population 243 million; employed 141 million; unemployed 23 million, of whom 2 million are frictional and 4 million are structural. a. Calculate the total unemployment rate. b. Calculate the natural rate of unemployment. c. Is the country in a recession or a boom? Explain.

Present value: What is the present value of $3,000 received four years from now at an annual interest rate of 5.9%?

Does a government budget deficit crowd out investment spending? Support your response using economic reasoning.

Loanable funds: Give one reason why demand for loanable funds may increase, and one reason why supply of loanable funds may decrease.

Consumption function: Using a standard consumption function graph, explain how to find: a) autonomous consumption, b) marginal propensity to consume (MPC) from an AD curve, c) the multiplier if MPC = 0.60, d) how much autonomous consumption must rise to close a GDP gap of $7 million if multiplier = 3, e) why firms increase production when economy is operating below potential GDP.

Marginal decision-making and opportunity cost: Explain what it means to make decisions at the margin and give a personal example. Define opportunity cost and state your opportunity cost of attending this course for one month.

PPF: For a PPF showing choices between studying and playing tennis for Harry, explain: a) a point inside the PPF; b) movement from an interior point to a point on the frontier; c) movement along the frontier toward more tennis; d) a point beyond the frontier.

Real vs nominal GDP and CPI exercises: Describe how to calculate nominal GDP for multiple years, real GDP using a base year, explain why nominal and real GDP differ, how to construct a CPI for a fixed basket of goods (textbooks) and calculate inflation between two years, and how to convert a dollar value between years using CPI (example: $64,125 in 2015 with CPI 237.05; CPI 255.07 in 2018).

Explain with opportunity cost why convenience stores charge higher prices and why more people pursue graduate degrees when the job market is poor.

Paper For Above Instructions

Aggregate Demand and the CPI–Real GDP Inverse Relationship

The inverse relationship between the price level (proxied by the CPI) and quantity of real GDP demanded arises primarily for two reasons. First, the real-balance (wealth) effect: as CPI rises, the real value of money balances and nominal assets falls, reducing consumers’ real wealth and consumption, lowering aggregate demand (Mankiw, 2016). Second, the interest-rate effect: higher CPI often leads to higher nominal interest rates (or tighter real money balances), which raises borrowing costs and reduces investment and consumption financed by credit, lowering aggregate demand (Mishkin, 2019). Together these mechanisms explain why a higher price level is associated with a lower quantity of real GDP demanded (Blanchard, 2017).

Fiscal Policy to Restore Full Employment (10 trillion)

If current real GDP is below the 10 trillion full-employment target, the economy faces a recessionary gap and requires expansionary fiscal policy (increase government spending or reduce taxes). Implementation: increase G or cut taxes to raise disposable income and stimulate consumption; or increase targeted public investment. A successful expansionary fiscal policy shifts aggregate demand rightward (AD increases) because fiscal actions directly increase components of aggregate spending (Mankiw, 2016). If instead current GDP exceeds 10 trillion, the reverse applies (contractionary fiscal policy) and AD should shift left.

Money and Banking — Deposit Multiplier

With a required reserve ratio (rr) = 7.5%, the simple money multiplier = 1/rr = 1/0.075 ≈ 13.333. (a) If Tracy deposits $700 and all loans are redeposited, maximum potential expansion = $700 × 13.333 ≈ $9,333.33. (b) If she holds $130 cash and deposits $570, potential expansion = $570 × 13.333 ≈ $7,600. Note: these are theoretical maxima; in practice currency leakage and excess reserves reduce expansion (Mishkin, 2019).

Demand for Money: Shifts vs Movements

(a) Deflationary period: a decrease in the overall price level increases the real value of money. The demand for nominal money balances typically shifts left because people need fewer nominal balances to buy goods, but real money demand curve may shift depending on expectations. In general: movement toward lower nominal money demand at each interest rate (Friedman and Schwartz logic; Friedman, 1963). (b) GDP increases and unemployment falls: money demand shifts right (increase) because transactions demand rises with higher income (more spending) and precautionary balances may increase (Mankiw, 2016).

Monetary Policy Tools for a Recessionary Gap

To close a recessionary gap, the central bank should pursue expansionary monetary policy: 1) Open market operations — buy government securities to inject reserves and increase the money supply. 2) Discount rate — lower the discount rate to encourage bank borrowing and reserves. 3) Required reserve ratio — reduce rr to increase the money multiplier and lending capacity. Expected outcomes: a) interest rate decreases; b) consumer spending increases; c) real GDP increases; d) aggregate price level increases moderately as AD shifts right (Mishkin, 2019; Bernanke, 2004).

Open-Economy Effects (U.S. & Japan)

(a) U.S. tariffs on Japanese goods reduce U.S. demand for yen (fewer imports), tending to appreciate the U.S. dollar relative to the yen. Exports: absent retaliation, U.S. exports to Japan are unchanged or may rise if Japanese consumers switch to U.S. goods; but retaliation could reduce U.S. exports (Krugman & Obstfeld, 2018). (b) If U.S. interest rates fall relative to Japanese rates, capital flows to Japan, causing the dollar to depreciate and U.S. exports to rise (capital mobility channel) (Krugman & Obstfeld, 2018).

Unemployment and Present Value Calculations

Labor force = employed + unemployed = 141 + 23 = 164 million. Total unemployment rate = 23 / 164 ≈ 0.1402 = 14.02%. Natural rate (frictional + structural) = (2 + 4) / 164 = 6 / 164 ≈ 0.0366 = 3.66%. Because actual unemployment (14.02%) is well above the NRU (3.66%), the economy is in recession (high cyclical unemployment) (Blanchard, 2017).

Present value of $3,000 in 4 years at 5.9%: PV = 3000 / (1.059)^4 ≈ 3000 / 1.2579 ≈ $2,386. (Calculator: see time-value formulas; Bodie, Kane & Marcus, 2014).

Crowding Out; Loanable Funds

A government budget deficit can “crowd out” private investment because increased government borrowing raises demand for loanable funds, increasing interest rates and reducing private investment. The magnitude depends on monetary policy stance and capital mobility; in open economies or when the central bank accommodates, crowding out can be limited (Mankiw, 2016).

Demand for loanable funds may increase due to profitable investment opportunities or improved business confidence. Supply may decrease if household savings fall or if capital flees abroad (reduced domestic savings) (Tobin, 1965).

Consumption Function, Multiplier, and Output Gaps

Autonomous consumption equals consumption when income is zero (the intercept of the consumption function). MPC = ΔC/ΔY measured from the slope of the consumption schedule. If MPC = 0.60, multiplier = 1/(1 − 0.60) = 2.5. To close a $7 million GDP gap with multiplier = 3, required increase in autonomous spending = 7 / 3 ≈ $2.33 million. Firms increase production when output is below potential because inventories fall as demand outstrips current production, prompting firms to hire and produce more to meet demand (Mankiw, 2016).

Marginal Decisions, Opportunity Cost, and the PPF

Decisions at the margin mean comparing the additional benefits and additional costs of a small change in behavior (e.g., choosing to study one more hour because the marginal benefit outweighs the marginal cost). Example: studying an extra 2 hours instead of working a 2-hour shift because expected grade benefit outweighs lost wages. Opportunity cost is the value of the next best alternative forgone; my opportunity cost of attending this course for a month might be foregone part-time wages or leisure time.

In a PPF: a point inside the frontier indicates inefficiency/unemployed resources. Movement from an interior point to the frontier uses idle resources to increase production (efficiency). Movement along the frontier toward more tennis shows the trade-off of producing more tennis at the cost of producing less studying (opportunity cost). A point beyond the frontier is unattainable with current resources and technology.

Real vs Nominal GDP and CPI Conversion

Nominal GDP is calculated using current-year prices × current-year quantities. Real GDP uses base-year prices × current-year quantities. Differences arise because nominal GDP reflects both price and quantity changes, while real GDP isolates quantity (real output) changes (Samuelson & Nordhaus, 2010). To convert $64,125 in 2015 dollars to 2018 dollars using CPI: adjusted income = 64,125 × (CPI2018 / CPI2015) = 64,125 × (255.07 / 237.05) ≈ $69,002. Constructing a CPI involves choosing a basket, computing total cost each year, dividing by base-year basket cost, and multiplying by 100; inflation = percentage change in CPI between years (BLS methodology).

References

• Mankiw, N. G. (2016). Principles of Economics (7th ed.). Cengage Learning.
• Mishkin, F. S. (2019). The Economics of Money, Banking, and Financial Markets (11th ed.). Pearson.
• Blanchard, O. (2017). Macroeconomics (7th ed.). Pearson.
• Krugman, P., & Obstfeld, M. (2018). International Economics: Theory and Policy (11th ed.). Pearson.
• Bernanke, B. S. (2004). The Great Moderation. Speech, Federal Reserve.
• Samuelson, P. A., & Nordhaus, W. D. (2010). Economics (19th ed.). McGraw-Hill Education.
• Bodie, Z., Kane, A., & Marcus, A. J. (2014). Investments (10th ed.). McGraw-Hill Education.
• Friedman, M. (1963). Inflation: Causes and Consequences. Asia Publishing.
• Federal Reserve Board. (2020). Monetary Policy Report. Board of Governors of the Federal Reserve System.
• Tobin, J. (1965). Commercial Banks as Creators of Money. Cowles Foundation Paper.