Chapter 16
Chapter 17
Chapter 18
Chapter 19
Chapter 20
100

What are the two main tools of fiscal policy, and what curve do they directly affect?

Government spending and taxes → directly affects aggregate demand (AD)

100

Define money and explain its three functions.
Provide one real-world example for each function.

Money is anything widely accepted as payment for goods and services.

Functions:

  • Medium of exchange → used to buy/sell goods (e.g., using cash to buy food)
  • Unit of account → measures value in a common standard (e.g., prices in dollars)
  • Store of value → holds purchasing power over time (e.g., saving money for later use)
100

What is the main goal of expansionary monetary policy, and what happens to interest rates?

Increase economic activity → interest rates fall

100

Define comparative advantage and opportunity cost.
Explain how they are related.

Opportunity cost = what you give up to produce one more unit of a good
Comparative advantage = producing a good at a lower opportunity cost

They are directly related because comparative advantage is determined by opportunity cost.

100

What does it mean when the U.S. dollar appreciates relative to another currency?

The dollar becomes more valuable → it buys more foreign currency

200

The economy is in a recession with high unemployment. What type of fiscal policy should the government use, and what happens to AD?

Expansionary fiscal policy → AD shifts right

200

Explain fractional reserve banking.
Why do banks hold only a fraction of deposits as reserves, and how does this system benefit the economy?

Banks keep only a fraction of deposits as reserves and lend out the rest.

  • This allows banks to earn profits (interest on loans > interest paid on deposits)
  • It increases the money supply through lending
  • Benefits the economy by promoting investment and spending 
200

Expansionary monetary policy starts with the Fed increasing the money supply.
What happens next to:

  1. Interest rates
  2. Investment
  3. Aggregate demand

- Interest rates ↓

- Investment ↑

- AD shifts right

200

Explain why countries gain from trade.
Include at least two benefits beyond comparative advantage.

Countries gain because:

  • Specialization increases efficiency
  • Economies of scale lower production costs
  • Increased competition leads to better quality and lower prices

Trade allows consumption beyond the production possibilities frontier (PPF).

200

If U.S. interest rates rise relative to the rest of the world:

  1. What happens to demand for U.S. dollars?
  2. What happens to the value of the dollar?

- Demand for dollars increases

- Dollar appreciates

300

The government increases spending by $50 billion but does NOT raise taxes.

  1. What happens to the budget?
  2. What happens in the loanable funds market?
  3. What happens to private investment?

1. Budget deficit increases

2. Demand for loanable funds shifts right

3. Interest rates rise → investment falls (crowding out) 

300

A bank receives a $5,000 deposit and the required reserve ratio is 20%.

  • Calculate required reserves
  • Calculate excess reserves
  • How much can the bank lend?

Required reserves = 0.20 × 5000 = $1,000

Excess reserves = 5000 − 1000 = $4,000 

Loans = $4,000 

300

The economy is overheating with high inflation.

  1. What type of monetary policy should the Fed use?
  2. What happens to interest rates?
  3. What happens to AD?

- Contractionary monetary policy

- Interest rates ↑

- AD shifts left 

300

Country A can produce 10 units of wine or 5 units of cloth.
Country B can produce 6 units of wine or 6 units of cloth.

  • Calculate the opportunity cost of each good in both countries
  • Identify comparative advantage
  • State how the countries should specialize 

Country A: 10 wine or 5 cloth

  • Opp cost of wine = 5/10 = 0.5 cloth
  • Opp cost of cloth = 10/5 = 2 wine

Country B: 6 wine or 6 cloth

  • Opp cost of wine = 6/6 = 1 cloth
  • Opp cost of cloth = 6/6 = 1 wine

Comparative advantage:

  • A --> wine (lower opp cost: 0.5 < 1)
  • B --> cloth (lower opp cost: 1 < 2)

Specialization:

  • A produces wine
  • B produces cloth 
300

The U.S. dollar depreciates.

Explain what happens to:

  1. U.S. exports
  2. U.S. imports
  3. Aggregate demand

- Exports increase (cheaper to foreigners)

- Imports decrease (more expensive)

- AD increases

400

MPC = 0.6. The government increases spending by $40 billion.

  1. What is the multiplier?
  2. What is the total change in GDP?

Multiplier=1/1−MPC


Multiplier = 2.5
Total GDP increase = $100 billion

400

Explain how banks create money using the lending process.
Describe how an initial deposit leads to a multiplied increase in the money supply.

When a bank lends excess reserves:

  1. A deposit is made
  2. Bank keeps required reserves and loans out the rest
  3. The loan is spent and redeposited in another bank
  4. That bank repeats the process

This cycle continues, causing the money supply to expand by a multiple of the initial deposit.

400

The Fed conducts open market purchases (buys bonds).

Explain the full chain from this action to GDP:

  • Loanable funds
  • Interest rates
  • Investment
  • AD
  • Output

Loanable funds supply ↑ → interest rates ↓ → investment ↑ → AD shifts right → output ↑

400

Explain the effects of a tariff on the domestic market.
Describe impacts on:

  • price
  • domestic producers
  • consumers
  • imports 

Price --> increases

Domestic producers --> gain (produce more)

Consumers --> lose (pay higher prices, buy less)

Imports --> decrease

400

A country experiences an increase in domestic interest rates relative to the rest of the world.

1. Explain how this affects the demand for the country’s currency
2. Explain what happens to the exchange rate (appreciation or depreciation)
3. Illustrate the change using the foreign exchange market (describe the shift and movement)

1. Higher domestic interest rates make financial assets more attractive --> Demand for the country’s currency increases (foreign investors want to buy assets)

2. Increased demand for the currency --> Currency appreciates (its value rises relative to others)

3. In the foreign exchange market:

  • Demand curve for the currency shifts right
  • Supply stays constant
  • Equilibrium exchange rate increases
500

Draw an AD–AS graph for this scenario:

  • Economy starts below full employment
  • Government increases spending
  • BUT there is significant crowding out

Explain:

  1. What happens to AD
  2. What happens to output and price level
  3. Why the final increase in GDP is smaller than expected

- AD shifts right

- Output increases, price level increases

- Crowding out raises interest rates → reduces investment → dampens the AD shift

500

The Federal Reserve conducts an open market purchase of $10,000, and the required reserve ratio is 10%.

  • Calculate the maximum change in the money supply
  • Explain how this process works step-by-step
  • Describe one reason why the actual change might be smaller than the maximum

Max change in money supply:
Money multiplier = 1 / 0.10 = 10
Total increase = 10 × 10,000 = $100,000

 Process:

  • Fed buys bonds → injects $10,000 into banking system
  • Banks lend out excess reserves
  • Loans become deposits → more lending
  • Repeats until reserves are fully used

Why actual < maximum:

  • Banks hold excess reserves
  • People hold cash (not redepositing)
  • Banks may not lend due to risk
500

Draw an AD–AS graph for this scenario:

  • Economy starts at full employment
  • Fed conducts permanent expansionary monetary policy

Explain:

  1. What happens in the short run
  2. What happens in the long run
  3. Why output eventually returns to its original level 
  • Short run:
    • AD shifts right
    • Output ↑, price level ↑
  • Long run:
    • SRAS shifts left
    • Output returns to potential
  • Why:
    • Prices and wages adjust → monetary neutrality
500

A country opens to trade and the world price is lower than the domestic equilibrium price.

  • What happens to domestic price, production, and consumption?
  • Who gains and who loses?
  • Explain whether total economic welfare increases or decreases and why 

Effects:

  • Domestic price falls to world price
  • Domestic production decreases
  • Domestic consumption increases
  • Imports increase

Who gains/loses:

  • Consumers gain (lower prices)
  • Producers lose (lower revenue)

Total welfare:

  • Increases overall
  • Gains to consumers outweigh losses to producers
  • Net benefit comes from efficiency gains and trade 
500

Suppose a country is experiencing a current account deficit.

1. Explain how this relates to the capital account

2. Identify two causes of a current account deficit

3. Explain how a recession would affect the trade deficit and why

1. Balance of payments identity: 

Current Account + Capital Account = 0
A current account deficit must be matched by a capital account surplus (foreign money flows into the country)

2. Two causes of a current account deficit:

Strong economic growth → increases imports
Low domestic savings → requires foreign investment
Government budget deficits is also correct here.

3. During a recession:

Income falls so people buy fewer imports
Imports decrease so trade deficit shrinks
Why: Lower demand for foreign goods reduces outflow of money

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