ECON 2200 Exam 3 Study Guide (Moore) WITH DETAILED ANSWERS!
ECON 2200 Exam 3 Study Guide (Moore) WITH DETAILED ANSWERS! ECON 2200
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Exam 3 Study Guide (Moore / UGA) 1. Describe the original structure of the Federal Reserve System (Fed) that was created in 1913. What were the requirements for commercial banks that wished to join the Fed? The FED was created after Woodrow Wilson signed into action the Federal Reserve Act in 1913. A central bank holds a monopoly of issuing bank notes. o It was composed of 12 Federal Reserve Banks, one in each of 12 separate districts, to protect the interests of different regions (i.e. farming vs. manufacturing). st nd o The FED had a permanent charter, unlike the 1 and 2 National Banks of the U.S., which reduces political pressure upon the FED by current politics. o The system was set up to be run by the Federal Reserve Board of 7 members (Secretary of Treasury, Comptroller of the Currency Ex Officio, and 5 president-appointed members). This board overlooked the actions of the 12 FED district banks and their board of directors. o Each FED District bank was to be run by 9 directors. These 9 directors were all appointed. 3 of them were appointed by the main FED Board to represent the public. The other 6 were appointed by member banks of that district. Of these 6: 3 represented bankers 3 represented business, industry, and agriculture. Because of this, banks were underrepresented on the District (3 out of 9 directors represented bankers). In order for commercial banks to join the Federal Reserve system, a bank had to purchase shares of capital stock of the district FED bank in the amount of 3% of the bank’s combined capital and surplus (assets). And the commercial banks had to deposit their reserves with the FED bank. The bottom line is that the FED bank holds reserves for other banks and that commercial banks own the FED banks through stock purchases. 2. What are the typical functions of a central bank? List and explain each function. How well did the early Fed perform the central bank functions you’ve described? Lender of Last Resort – lend to banks when the banks are short on reserves Bankers’ Bank – serve the banking system, not personal use Clearinghouse for banking system - clears balances of checks from one bank to another bank, commercial banks keep reserves at district bank so district bank can clear the balances of checks Fiscal agent for Federal Government – be the bank of the government Exercise monetary policy – countercyclical policy to combat the idea that banks feed booms and starve recessions The early FED acted well as a clearinghouse in the beginning (and still does so), and through this, enhanced the efficiency of the U.S. banking system. However, the FED acted poorly in regards to exercising monetary policy in the 1920s and 1930s, around the time of the Great Depression. Many people claim the FED’s actions are a main cause of the downfall of the economy at that time. 3. Other than metal coins, what types of money circulated in the US in the late 1800s? State bank notes, National Bank notes, Greenbacks*, and demand deposits *Greenbacks were a fiat currency (not backed by anything) that were legal tender, issued by the U.S. government during the Civil War 4. If the US officially had a bimetallic standard until 1900, why did it operate on a de facto gold standard for most of the late 1800s? The metal that is over-valued at the mint will always be the main metal to circulate. At the time, silver was worth more on the bullion market, meaning it was under-valued at the mint. So gold was over-valued at the mint and therefore circulated more than gold. 5. Use the Quantity Theory of Money (QTM) and Figures 19.1-19.2 to discuss the relationship between the money supply (M) and the price level (P) in the late 19 century. From the 1870’s to the 1890’s, the supply of gold and silver increased and added to the nation’s money supply (M) but did not prevent deflation (falling prices). But, after 1895, there was a massive influx of gold that was added to the money supply and eventually the price level started to rise again from 1895 until World War I in 1914. 6. During the Civil War, the US was forced to suspend payment of specie. Why? Use data from Table 19.2 to support your answer. The U.S. was experiencing an outflow of gold because (1) US prices were higher than international prices so the U.S. was importing more than they were exporting, and (2) the exporting countries wanted to be paid in gold 7. What had to happen in order for specie payment to resume following the Civil War? Using the QTM, describe and explain the differing views of Republicans and Democrats on this issue. To resume specie payment, U.S. prices would have to decrease. Deflation would impact borrowers (especially farmers) negatively; and would impact lenders (especially U.S. bondholders) positively. Democrats and Republicans agreed that prices need to be obtained, but disagreed on how to achieve it. The Republicans wanted to drastically decrease the money supply by burning greenbacks, while the Democrats wanted to hold the money supply constant and let the economy grow up to the the price level. 8. Describe the actual events that eventually led to resumption of specie payment in 1879. Use data from Table 19.2 to support your answer. The U.S. resumed specie payment in 1879 because the prices had fallen like they hoped for. U.S. price deflator was 104 (4% inflation), so almost down to no inflation (it had been up to 176 in 1865 and 129 in 1873). And the prices in U.S. dollars to British pounds was back down to near what it had been before the Civil War (from $4.77 in 1861, up to $7.69 in 1865, and back down to $4.85 in 1879). U.S. prices dropped, being roughly equal to British prices, and price of British pounds in dollars was back down. 9. Why did proponents of the free silver movement call the Coinage Act of 1873 “a crime?” Describe the market and mint values of silver in 1873. What happened to the silver market after 1874? Describe the market and mint values of silver after 1874. The Coinage Act of 1873 basically said that the government would not coin silver, which was not a problem at the time because gold was the only metal circulating (being over-valued at the mint). However, in 1874, silver extraction increased heavily and there was a large increase in supply of silver from miners in the U.S. and Europe. Now, the supply of silver caused the market supply to decrease, which caused silver to become over- valued at the mint. But, the Treasury was not coining silver (due to the Coinage Act) so silver was not being purchased. This angered silver producer because they were not making money off their silver production. Silver producers joined with the Reflationists in the South and West to lead up the Free Silver Movement, which would encourage the coinage of silver at the old mint ratio of 16:1 (which was more favorable than the market ratio at the time) 10. What groups tended to support the sound money position? Explain their position. Bankers, businessmen, financial sector of the economy, manufacturing sector (owners, not laborers), Urban areas, the Northeast, Republicans The Sound Money side wanted a de facto gold standard 11. What groups tended to support the free silver movement? What did they want the government to do and why? Farmers and silver producers, rural areas, the Midwest and the South, Democrats and Populists Free silver movement wanted unlimited coinage of silver at the mint ratio in order to increase money supply and thus increase price level 12. Describe the legislative response of Congress to the silver controversy (first in 1878, and again in 1890). To what extent were free silver proponents satisfied by this legislation? Support your answer with a graph illustrating changes in the silver bullion market in the 1870s and 1880s. In 1878, Congress passed the Bland-Allison Act. This act was a compromise between Free Silver and Sound Money, in that it created a hybrid of a gold standard and bimetallic standard through a “limping monetary standard”. Under this act, the Treasury had to buy $2-4 million of silver per month at the market price (not at the favorable mint ratio that the Free Silver movement wanted). Even though the Treasury purchased silver, the market price still fell. In 1890, Congress passed the Sherman Silver Purchase Act. This act nearly doubled the Treasury’s purchase of silver to 4.5 million ounces at the market price. Sellers of silver received special Treasury notes that were legal tender and redeemable in gold or silver (at the discretion of the Treasury). (Although, the Treasury was more in line with Sound Money at the time so they tended to redeem the notes as gold to maintain the de facto gold standard) 13. What happened to the US money supply following the Sherman Silver Purchase Act? Why was the Sherman Silver Purchase Act repealed? (Describe the concerns of “sound money” advocates, including President Cleveland.) Since the Treasury was purchasing silver and redeeming the notes as gold, they were stock piling silver and dispensing gold, which lowered the Treasury’s gold funds very much. Treasury officials and Sound Money advocates worried that the U.S. would lose all their gold and have to abandon the de facto gold standard The Sherman Purchase Act was repealed in 1893 by Grover Cleveland (who was a Democrat BUT supported that Sound Money movement). (Democrats were supports of Free Silver). Cleveland thought the Sherman Purchase Act may have shown less confidence in the sturdiness of gold to back the dollar, and thus thought it would cause bank panics and a recession. So he repealed the Act to go back to a gold standard to show that gold was strong enough to back the dollar. 14. While the aggregate price level fell for most of the late 1800s, after 1896 the price level began to increase. What caused this change in the movement of prices? (Use the QTM to support your answer.) How did these events impact (1) the US economy and (2) the free silver movement? There were new discoveries of gold in Alaska, California, and South Africa which led to an increase in the supply of gold in the U.S. and globally. With an increased supply of gold, money supply (M) and price level (P) increase. This impacted the U.S. economy by increasing output (Y) through a heightened money supply (M). Also as a result of this, the Free Silver Movement lost some momentum because farmers and reflationists were happy that the price level had gone up (this would help farmers by improving their revenues through higher prices when selling goods). 15. The US officially adopted the gold standard in 1900. At the time, was this a particularly controversial event? Why or why not? Farmers were experiencing good times at this point, so they were not as concerned with the Free Silver movement. 16. Carefully review “The Wizard of Oz as A Monetary Allegory” (Rockoff 1990). You may need to review some material covered in Chap 19 of your text in order to fully understand the article and the events surrounding the 1896 election. Be sure you can give detailed answers to each of the questions I have provided about the article. Use Table 1 from the article to support your answers. 17. List and define the categories of spending that contribute to aggregate expenditures (= aggregate demand, at a given price level). C + I + G + X C = Consumption I = Investment G = Government Spending X = Net Exports (Exports – Imports) 18. Review the definitions of fiscal policy and monetary policy (as defined earlier this semester). Fiscal policy – the Federal government’s discretionary policy dealing with tax rates and government spending Monetary policy – the FED’s discretionary policy to influence interest rates by altering the money supply through Open Market Operations, Discount Rate, and the Reserve Requirement. The objective of monetary policy is to affect the Big Macro Three (output, employment, and prices). 19. List and describe the 3 “traditional” monetary policy tools used by the Federal Reserve (Fed). For each policy tool, you should be able to explain the relationship Expansionary Contractionary Open Discount Reserve Open Discount Reserve Market Rate (FED Requirem Market Rate Requirem Operati charges ent Operation ent on banks) s Action Buy Lower Lower Sell Raise Raise Money Supply Increase Decrease Bank Reserves Decrease Increase Loanable Funds Increase Decrease Interest Rates Decrease Increase Aggregate Increase Decrease Demand between the policy tool, the monetary base, bank reserves, the supply of loanable funds, interest rates, the money supply and aggregate demand. Use the policy tools to discuss the difference between expansionary and contractionary monetary policy. Expansionary Monetary policy ultimately increases money supply and loanable funds, and decreases interest rates to entice growth in the economy (to try to prevent a recession). Contractionary Monetary Policy ultimately decreases money supply and loanable funds, and increases interest rates to discourage growth in the economy (to try to prevent inflation). 20. Why is it very uncommon for the Fed to use the reserve requirement to conduct monetary policy? It is difficult to change the reserve requirement because banks would constantly being altering tehe amount of loanable funds the can give out, and it does not make the banking system appear very stable in the public’s eye. 21. What is the “fed funds rate?” How does the Federal Reserve use the fed funds rate in conducting monetary policy? The federal funds rate is the rate banks charge each other for overnight loans. The FED DOES NOT use the fed funds rate at all. 22. What was the preferred policy tool of the Fed in the 1920s? Which policy tool has the Fed typically used during your lifetime? In the 1920’s the FED used OMO (which wasn’t discovered until the 1920s anyways). In our lifetime, the FED has used OMO by buying and selling bonds. 23. World War I ended in 1919. Briefly describe the American economy immediately following the War's end. Focus on the expenditure components of aggregate demand. The American economy was doing well because: The government was putting money into the economy by spending more money than the were taking in through tax revenues European demand for U.S. goods was high (due to war destructions in Europe) which meant the U.S. was exporting more (bringing in more export revenues) The FED expanded the money supply o Decrease the discount rate increase consumption and investment o The government wanted to support the war efforts and entice firms to spend High domestic demand for consumer goods o People were happy that the war was over so they were more incentivized to spend Aggregate demand increase 24. Discuss how market forces, monetary policy and fiscal policy led to changes in US aggregate demand after 1920, and describe the recession of 1921-22. Was Fed policy pro-cyclical or countercyclical during this period? Explain. Market forces: Europe had recovered from the war destruction, so now they did not need U.S. goods Monetary Policy: the FED sharply reduced money supply by increasing the discount rate (decreases consumption and investment) Fiscal Policy: the government stopped deficit spending, meaning they were spending less than before (government spending < tax revenues) Aggregate demand decreases overall. Stems from decrease in price level and GDP After these changes in the U.S., there was a “V-shaped recession” o Real net national product fell by 4% o Unemployment rate increased to nearly 10% o Deflation: price level fell by 1/3; CPI fell by over 15% The FED should not have decreased the money supply. In order to prevent a recession, the FED should have increased the money supply. 25. Use a graph to illustrate changes in the US macro economy between 1919 and 1922. Does the data for this period support the predictions of your graph? Explain. 26. Discuss some of the changes in American demographics and lifestyle that characterized the “Roaring 20s.” Be sure to discuss urban migration, the growth of suburbs and increased household ownership of consumer durables. Urban migration was the movement of people to the cities in order to follow the jobs in the manufacturing industry. Immigration restrictions caused a higher demand for domestic labor. Consumers began to purchase more durables because electricity was more common in homes. Consumer durables are heavily related to the business cycle because as the economy is strong, people will feel confident purchasing goods. But if the economy is doing poorly, people will hold off on buying a new durable because the current one can still last longer. 27. Briefly describe how innovation by Ford changed the mass production process for cars (and eventually other manufactured goods). How did Ford’s innovation affect automobile output? productivity? per-unit cost? Ford capitalized on the assembly line and was the first use power-driven conveyor belts. Through the use of an assembly line, workers specialize in one thing and are involved in a division of labor. Output increases greatly because the production is more efficient and works faster than before. Per unit cost decreased because Ford takes advantage of economies of scale by having output that is greater than input costs. 28. Describe the price changes that ultimately made cars, particularly the Ford Model T, affordable for the average American household. How did increased automobile ownership affect American lifestyles? Per unit price for consumers decreased as Ford was able to cut down on his production costs so more people were able to afford the Model T and ford profited even more. With more people owning cars, there was higher demand for service stations, hotels, restaurants, etc that led to more jobs and growth in the economy. Also, government spending increased through the need for paved roads and road- building. Car ownership led to suburban growth because workers could live further away from work and be able to drive to and from the city (most people worked in the cities, apart from farmers), and increased leisure time because traveling took less time so people had more time to spend freely. 29. Discuss the impact of credit and advertising on the consumer durables market. Credit allowed consumers to “buy now pay later”, which increased consumption of durable goods. The goods themselves acted as collateral for credit payments (this only works with durable goods because consumer goods like food cannot be collateralized) Advertising made the good more durable, thus, increasing demand for the goods. 30. Discuss the rise and fall of the construction sector during the 1920s. Explain the terms of the typical home mortgage during the 1920s. Describe trends in housing prices, foreclosure rates and mortgage debt. Why did increases in outstanding mortgage debt become particularly problematic after 1925? Construction rose from 1920-1925 and then began to fall around 1925. Many new homes were being built in the growth period, which contributed to the investment factor of the economy. But by 1925, the housing market was saturated and the need for homes declined. Most mortgages were 5-year terms, with a balloon payment at the end of the term. Most home buyers would refinance and only pay off their interest payments and not be able to start paying off the principle of the loan (this caused homeowners to obtain equity very slowly). If property values are high, refinancing is not a problem because the banks view the property as a profitable asset. But when property values started to fall, banks got worried about the future value of the property. With falling property values, banks were less willing to refinance and there were more defaults on loans. This is similar to the housing bubble in the 2000’s, but in the 1920’s lenders were too lax and the policy response was too weak back then. 31. Describe increases in manufacturing output during the 1920s. How did investments in technology and capital encourage this growth? Output increased by nearly 2/3 Electricity allowed factories to manufacture with power, which created a more efficient production line and reduced the per-unit cost to produce. The use of more and better capital led to increased labor productivity. 32. Describe how existing institutions (including the executive branch, regulatory agencies and courts) encouraged the 1920s manufacturing boom and the continued growth of “big business” in America. The executive branch, led by Calvin Coolidge at the time, was pro-business and wanted to see market-economy-type action occur. Coolidge once said “After all, the chief business of the America people is business. They are profoundly concerned with buying, selling, investing and prospering in the world”. Coolidge appointed people to the FTC that would not do much in order to allow more businesses to get away with what they were doing. Under the weak FTC, mergers and consolidations among firms continued to occur in the banking, iron/steel, electronics, automobiles industries, etc. Courts were pro-business in that they allowed firms to use injunctions and “yellow- dog contracts” Injunctions- firms are allowed to break up strikes, pickets, and boycotts Yellow-dog contracts – firms can force employees to sign a contract tat says they will not join a labor union 33. How did 1920s economic growth impact non-farm labor? Describe gains made by labor during this period. Discuss the economic forces that led to increases in real earnings. There was a high demand for labor in factories to answer the increased demand of durable goods especially. The workers had greater bargaining power because their labor was in such high demand (they could ask for better conditions, more pay, etc.) Earnings rose because workers’ skills were heavily invested and thus productivity rose, and there was a high demand for labor 34. What are “efficiency wages”? How can manufacturers (such as Henry Ford) benefit from paying efficiency wages to workers? Efficiency wages are when a firm pays their employees more than other competing firms. Higher wages entice workers to do well at their job in order to stay employed, reduce employee turnover (which reduces training costs of new employees), and will attract the best qualified workers. 35. What was the “High School Movement” of the 1920s, and why did it have so much success in the US? Discuss research by Goldin and Katz (2000) on the development of public high schools. The High School Movement was a movement to get more people to enroll in and graduate from high school. The U.S. was a world leader in the movement through the use of publically funded schools with extracurricular activities like sports, diverse curriculum, etc. Main outcomes of the movement: 1) Rate of return from going to high school was beneficial (the payoff of a high school degree helped graduates earn higher wages after graduation) 2) Rural communities voted to tax themselves in order to fund the schools (areas like Kansas, Iowa, Nebraska). These places expressed a strong sense of social cohesion. 36. Describe changes in US immigration laws in the 1920s. What forces motivated the passage of new laws limiting immigration? How did these laws affect the domestic labor market? In 1921 and 1924, legislation restricted the number immigrants allowed in the U.S. These laws were supported by domestic racism, prejudice against non-northern European descent, and worries that the end of the war would bring about immigrants looking for jobs in America. Because there were less immigrants in the U.S. the demand for domestic labor was higher 37. Describe changes in labor union membership during the 1920s. Why did labor unions fail to gain members during the growth period of the 1920s? Labor unions began as skill unions, and the moved more toward the industry side of things. But union organizers were not accustomed to industry work so they lost some momentum due to that. Courts were anti-union through their allowance of injunctions and yellow-dog contracts. Firms created company unions to attract workers to their unions rather than third party unions. However, company unions were bias towards the company and did not always have the workers best interest on its mind. Also, workers were content, therefore they didn’t feel the need to join a union. 38. Assume a progressive income tax system. Explain the difference between the typical taxpayer’s marginal tax rate and her average tax rate. A marginal tax rate is the rate at which the last taxable portion at which one’s income is taxed; it is the last bracket at which their income is taxed. Average tax rate is the average rate of all brackets that one’s income is covered by. 39. Describe the key features of US fiscal policy during the 1920s. Why, as seen in the 1920s, do decreases in marginal tax rates sometimes lead to increases in tax revenue? Describe some ways in which government spending in the 1920s differed from government spending today. During this time, the government did not intervene too much as they thought the economy would correct itself. There was limited government spending (but the government spending that did take place included: national defense, veterans’ benefits, postal service, and payments on WWI debt). The federal government reduced taxes. This entices people to work more (because they can save more from not having to pay as many taxes), but the government still profits on tax revenues because more people are working so the national income is still high, thus providing high tax revenues for the government. During this time, the government spending was focused on fewer things, whereas today, the government spends money on numerous programs. 40. Describe the key features of US monetary policy between 1922 and 1929. Use Table 22.6 to discuss trends in M, P and Y. During this time, the money supply and output grew without causing inflation. The price level remained fairly stable. 41. Bank failures were very common in the 1920s. Describe the Fed’s position on assisting these banks. Research by Eugene White (1984) cast light on the types of banks that were most prone to failure and the institutional constraints these banks faced. Explain White’s findings and use them to critique the Fed’s position. Even though hundreds of banks failed each year, the FED did not act as lenders of last resort, as it should have. Leaders of the FED did not bail out the banks because they felt the banks were being mismanaged and that the system would be stronger as a whole once these banks failed and withered away. Rural banks were the most prone to fail because their outstanding loans were the riskiest since they practically only loan to farmers (who are high risk of a successful harvest and being able to pay back a loan). Also, interstate branch banking was illegal, so rural banks could not loan to city dwellers, and thus, the banks’ portfolios were not diverse and followed the high risk of the farmer. Once rural banks fail, it causes bank panics even at banks not related to the rural areas because everyone wants to ensure their money is safe before their own bank crashes. The FED should have lent money out as the lender of last resort to avid bank runs and panics, and also to save the rural banks form failing. 42. Why are the 25 years prior to 1920 described as a “golden era” for American farmers? What impact did World War I have on US farmers? During World War I, farmers were encouraged to increase output to help with the war efforts and the government supported crop prices to keep them from falling even thought the supply was increased. The Golden Era was comprised of high demand for crops and thus a rise in price of crops. New and improved machinery, and biological and chemical innovations helped increase productivity. Land values went up, which is the #1 asset to a farmer. Farmers made up about 27% of U.S. labor force but 90% of U.S. GDP 43. Why was the deflation of the early 1920s particularly harmful to farmers? (Describe how wartime investments in land and capital led to problems for farmers.) Describe the trend in farm foreclosures for 1918-1929. European demand for U.S. goods decreased and prices fell Wartime investments became a problem in this time because of adverse terms of trade. The price of crops fells faster than the overall price level, which reduced farmers’ profits. The farmers are having to pay back their loans with dollars at a higher purchasing power than the loan they originally received (the dollar is technically worth more to the farmer now because it can buy more products). Land purchased during the war was bought at high prices. Foreclosures on farms increased from 1918-1929; even though in 1925, crop prices had stabilized again, foreclosures continued to rise (from 2.8 per 1000 farms in 1918 to 14-17 per 1000 in the late 1920’s). 44. Describe movements in farm prices and American farmers’ terms of trade in the early 1920s. Be sure that you can explain “adverse terms of trade.” The price of crops fells faster than the overall price level, which reduced farmers’ profits. (see above answer for more detailed description) 45. In class, we noted that farmers in the 1920s faced their “traditional problems.” Discuss these problems, using the concept of elasticity. Demand for farm products is income inelastic and price inelastic. Inelastic means that demand does not change based on changes in the price or income. Farmers were receiving less income because of falling prices but still had to purchase farm product for harvest, etc. Thus, their demand for the products did not change even though it was more difficult for them to afford such products. 46. Struggling American farmers in the 1920s sought attention from the federal government. One program that was debated, but never enacted was a plan to institute parity prices for farm products. What are “parity prices?” Describe the features and legislative history of the McNary-Haugen bills. Parity prices (“fair-exchange values”) meant that farmers should get a share of the national income, but it had to be the same ratio of cost-to-profit as it was form 1910-1914. The McNary-Haughen bills wanted to implement parity prices by: 1) a tariff to protect home markets from imports 2) a chartered corporation that would buy farm output to heighten prices on the market The bills passed Congress twice and vetoed by Coolidge twice 47. What farm legislation was actually enacted to assist farmers in the 1920s? (Discuss each of the programs described in Chap 22 of your text.) How effective was this legislation in easing farmers' distress? Capper-Volstead Act: exempted farmers’ co-operations from persecution of anti- trust violations Federal Intermediate Credit Act: 12 intermediate credit banks that would rediscount agricultural paper for commercial banks and other lenders Federal Farm Loan Act: 12 federal land banks to provide long-term loans to farmers through co-operative borrowing groups. Agricultural Marketing Act: established a Federal Farm Board to encourage the formation of co-operative marketing associations and to establish “stabilizing corporations” to be owned by the cooperatives Smoot-Hawley Tariff: a tariff thought to protect and raise prices of domestic agricultural goods 48. The SUPPLY of farm products is price elastic. Why does this fact mute the impact of federal programs aimed at supporting agricultural prices? Price elasticity of supply (PES) has a value greater than 1, meaning that when prices go up (or down, supply of farm products will go up (or down) even more than the change in price
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