less than what they lent out. No lending would take
place. It is better to hold cash than to pay people to bor-
row money.
e.Conventional monetary policy (decreasing interest rates)
can’t happen if the nominal interest rate is already zero.
This is called the zero bound OR a liquidity trap.
Module 35
Check Your Understanding
- A classical economist would have said that the aggressive
monetary expansion would have had no short-run effect
on aggregate output and would simply have resulted in a
proportionate increase in the aggregate price level. - Monetarists argue that central banks should implement
policy so that the money supply grows at some constant
rate. Had the Fed pursued a monetarist policy during this
period, we would have observed movements in M1 that
would have shown a fixed rate of growth. We would not,
therefore, have observed any of the reductions in M1 that
are observed in the figure, nor would we have observed
the acceleration in the rate of growth of M1 that
occurred in 2001. - As in Problem 2, a monetarist policy would have resulted
in a constant rate of growth in M1. Between 1996 and
2000 the velocity of M1 rose steadily. After 2000 the
velocity leveled off a bit and then rose again. Given a
constant rate of money growth, these increases in the
velocity of M1 would have been expansionary, causing
increases in aggregate demand and the aggregate price
level, other things equal. - The advocacy of fiscal policy (here in the form of tax cuts)
to boost economic activity is Keynesian because Keynes pro-
moted fiscal policy as a useful tool to dampen fluctuations
in the business cycle. The praise of aggressive monetary pol-
icy is not Keynesian because Keynes worried that a liquidity
trap would thwart the ability of monetary policy to change
interest rates and influence investment spending. - a.Rational expectations theorists would argue that only
unexpected changes in money supply would have any
short-run effect on economic activity. They would also
argue that expected changes in the money supply would
affect only the aggregate price level, with no short-run
effect of aggregate output. So such theorists would give
credit to the Fed for limiting the severity of the 2001
recession only if the Fed’s monetary policy had been more
aggressive than individuals expected during this period.
b.Real business cycle theorists would argue that the Fed’s
policy had no effect on ending the 2001 recession
because they believe that fluctuations in aggregate output
are caused largely by changes in total factor productivity.
Tackle the Test:
Multiple-Choice Questions
- e
- d
- b
- a
- d
Tackle the Test:
Free-Response Questions
- a.The aggregate supply curve is vertical so changes in the
money supply affect only the aggregate price level.
b.Changes in aggregate demand will affect aggregate out-
put.
c.Business cycles are associated with fluctuations in the
money supply.
d.To avoid inflation, the unemployment rate must be set so
that actual inflation equals expected inflation.
e.Individuals and firms make optimal decisions using all
available information.
f.Fluctuations in total factor productivity growth cause the
business cycle by causing the vertical aggregate supply
curve to shift.
Module 36
Check Your Understanding
- The modern consensus has resolved the debate over the
effectiveness of both expansionary fiscal and monetary
policy. Expansionary fiscal policy is considered effective,
although it is limited by the problem of time lags, making
monetary policy the stabilization tool of choice except in
special circumstances. Expansionary monetary policy is
considered effective except in the case of a liquidity trap.
The modern consensus has not resolved, however,
whether the Fed should adopt an inflation target,
whether it should use monetary policy to manage asset
price bubbles, and what, if any, kind of unconventional
monetary policy it should use in the situation of a liquid-
ity trap.
Tackle the Test:
Multiple-Choice Questions
- d
2 .c - e
- a
- c
Tackle the Test:
Free-Response Question
- Your answer can look like the diagram below, or it can
have the axes reversed and a curve that resembles a
mountain.
Tax
rate
Tax revenue
SOLUTIONS TO AP REVIEW QUESTIONS S-21