Question

1. Practice with the best case:You are the central banker, and you have to decide how fast the money supply should grow. Your economy gets hit by the following AD shocks and your job is simply to neutralize them: Just push money growth in the opposite direction of the shock. In all of the following cases, assume that there’s no change whatsoever to the potential growth rate, and assume that before the shock, you’re at your optimal inflation rate and optimal real growth rate. (Yes, this really is the best case!) These are all shocks, so think of each case study as preceded by the word, “Suddenly. . . .” Given the shocks to ?v , should the central bank react by raising money growth or by cutting money growth?

a. Investors become pessimistic about future profit opportunities.

b. State governments increase spending on schools, prisons, and health care.

c. The federal government passes a national sales tax.

d. The federal government increases military spending.

e. Foreigners buy fewer American-made airplanes and movies.

f. American consumers start buying fewer domestically made Hondas and more imported Hondas.

g. Domestically made computers, cars, and furniture all become much more durable and longer-lasting.

Answer 1

a) If investors get pessimistic about future profit opportunities, then the central bank should increase the money supply so that investors start investing and the optimism is created in the economy.

b) If state governments increase spending in schools, prisons and health care, then the central bank should reduce the money supply so that the economy doesnt get overheated and the inflation doesnt go out of control.

c) The federal govt passes a nationa sales tax which would reduce disposable income and consumption. The Central bank should then increase money supply so that consumers start consuming and incomes rise.

d) If military spending is increased, central bank should reduce money supply to control inflation.

e) If foreigners buy fewer american airplanes and movies, central bank should increase the money supply so that the increase in domestic consummption can compensate for the fall in foreign demand.

f) If Americans start consuming more imported Hondas, Central bank should reduce money supply so that they dont have enough money to purchase imported Hondas and in the end settle for domestic Hondas.

g) If domestically made products become durable, Centra Bank should increase the money supply as durability would lead to a fall in demand. If incomes rise, demand would rise.