Getting Started

FINAL EXAM

1. If the Fed wants to increase the money supply through open-market operations, what does it do?

2. If inflation is less than expected, who benefits—debtors or creditors? Explain

3. Should the federal government always balance its budget? Why or why not?

4. How do falling interest rates and falling prices influence total demand in the economy? Include the “wealth effect” in your answer.

#1. An open market operation is one of the key tools that the Fed uses to "smooth out" business cycles. Generally speaking, in times of sustained economic expansion, the Fed will sell securities. By doing this, it effectively lowers the amount of money in circulation in the economy, thus raising interest rates which make borrowing money more expensive. This is used to cool off an overheated economy because if the economy gets too overheated, the downturn will be that much harsher (look at the housing market and the current recession we are in).

On the other hand, the Fed will buy securities during economic downturns in an effort to "prop up" the economy by increasing the money supply in circulation, thus lowering interest rates and encouraging investment spending.

#2. It would benefit creditor. Less inflation than expected means that income of the debtor is growing slower, because it is based on CPI. The debt payment will be constant. That means it is the hard time for debtor, while the creditor gains. On the contrary, if inflation is high, the debt payment will have a less share in income.

The debtor will gain. If inflation is less than expected, creditors benefit and debtors lose.

Creditors receive dollar payments from debtors that have a higher real value than was expected

#3. Yes, the government should balance its budget the government should balance its budget because the debt the US government has right now is unsustainable. Not only does it affect the national credit rating, but it also places a heavy burden for the...