Prof. Bryan Caplan

bcaplan@gmu.edu

http://www3.gmu.edu/departments/economics/bcaplan

Econ 311

Fall, 1999

1. For each of the following cases, draw TWO graphs: one showing the effect in an AD-AS diagram, the other showing the effect in a money supply-money demand diagram.
1. The government increases the money supply.
2. AD increases; Money S increases.

3. The government deregulates the supply of money substitutes.
4. AD increases; Money D decreases.

5. Wallets go out of fashion; men just carry around a small money clip instead.
6. AD increases; Money D decreases.

7. A ban on ATM fees leads banks to set up fewer convenient ATM machines.
8. AD decreases; Money D increases.

9. Rumors of bad banks lead people to withdraw their money from banks.
10. AD decreases; Money D increases.

11. The government raises reserve requirements.

1. Draw two diagrams - one with real interest rates on the y-axis, the other with nominal interest rates on the y-axis. Assume that people initially expect 0% inflation. Then show the effect - on both diagrams - of an increase in inflation expectations to 5%. Note that this means that for each quantity of loanable funds, the nominal interest rate suppliers require is 5 percentage-points higher, while demanders are willing to pay 5 percentage-points more. (You should use graph paper to do this problem so it works out right).
2. On the diagram with real interest rates on the y-axis, nothing changes. On the diagram with nominal interest rates on the y-axis, supply of loanable funds decreases (lenders require 5 percentage-points extra interest to lend the same amount), and demand for loanable funds increases (borrowers are willing to pay 5 percentage-points of extra interest to borrow the same amount).

3. Suppose the government began paying interest on base money (by, for example, replacing paper money with government-issued smart cards that automatically calculate interest). Show the effect using a money supply-money demand diagram. If this happened, would interest rate changes still affect money demand? Why or why not? (2-3 sentences)
4. Money D increases. If this happened, interest rate changes would no longer affect money demand IF changed in the government's interest rate matched changes in the market for loanable funds.

5. Explain the effect of post-socialist money creation on: the money supply, the value of money, the price level, inflation, and nominal interest rates. (1 paragraph)
6. The money supply greatly increased, often by over 1000%/year. The value of money declined, and therefore the price level increases. Inflation increased as well, since the money supply was growing at a higher rate. Nominal interest rates - where unrelated - rose to take account of expected inflation.

7. Using AD-AS diagrams, show the effect of the following:
1. The government raises taxes and spends the money on an unproductive program (leaf-raking).
2. AS decreases.

3. The government borrows and spends the money opening up government restaurants (which are less efficient than privately-run restaurants).
4. AS decreases - though not as much as if it were pure waste..

5. The government prints up new money to pay Social Security recipients.
6. AD increases due to the increase in the money supply. AS is unaffected since this is just a transfer.

7. The government shuts down the (unproductive) Bureau of Leaf-Raking and uses the savings to build new (productive) roads.
8. AS increases.

9. Former socialist countries privatize half of government enterprises.
10. AS increases.

11. The government makes safety regulations stricter.

AS decreases.

8. Using two supply-and-demand for loanable funds diagrams, contrast the effect of deficit and tax finance of government expenditure.
9. For deficit spending, demand for loanable funds definitely increases - the government becomes willing to borrow more at existing interest rates. For tax-funded spending, demand for loanable funds either (both answers accepted): stays the same (if no one borrows more to make up for higher taxes), or increases by less than for deficit spending (if people borrow to partially make up for higher taxes).

10. Pick one of the 12 examples in Bastiat's essay "What Is Seen and What Is Not Seen." What effects does Bastiat say "are seen." What effects does Bastiat say "are not seen"? (1 paragraph)
11. One example Bastiat examines is taxation. The "seen" effects are the services the government provides, plus the employment it gives to government workers, subcontractors, etc. The "unseen" effects are what could have been done with the tax money instead: it could have been spent by consumers on items they actually wanted, which would also have provided employment to workers, subcontractors, etc.

12. Find a modern policy similar to the example you picked in VII. What effects "are seen" by people today? What effects "are not seen"? How does this confusion make bad policy popular? (1 paragraph)

Lawsuits provide a similar modern example. The "seen" effects of lawsuits are the money transferred to victims, real and fake. The "unseen" effects are higher prices for products, reduced incentives to exercise due care, reduced incentives to innovate, diversion of smart people into litigation, etc. This confusion leads voters to like rather than dislike politicians who harm them by making it easy to sue people; the result is that politicians supply the wealth-destroying policies the electorate confusedly favors.