MBA 501 Final Exam (Exam 4)

1. Differentiate between the Federal deficit and the Federal debt.
The Federal deficit is an annual concept referring to the shortfall between Federal revenues and expenditures in one year’s budget. The Federal debt is the accumulation of borrowing which results from the series of deficits minus any surpluses.

2. Adam Smith once wrote: “What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom.” Evaluate in terms of the national debt.
This is an example of the fallacy of composition. What is true for the individual is not necessarily true for governments when it comes to borrowing. Government can refinance its debt. The government, unlike individuals, also has the power to tax.

3. Crowding out can weaken the effect of an expansionary fiscal deficit. Explain.
If public borrowing to finance the public deficit crowds out private borrowing and spending that would have increased aggregate demand, then the effect of government spending has been lessened. In other words, some of that spending would have taken place anyway as a result of private borrowing which has been crowded out.

4. What are the two reasons that people want to hold money? In other words, what are the two types of demand for money?
People want to hold money for transactions purposes and as a form of liquid assets. Thus, economists talk about a transactions demand for money and an asset demand for money.

5. Analyze what would happen to the equilibrium rate of interest in the money market if the supply of money were increased while the demand schedule remained the same.
Because the quantity of money demanded is inversely related to the interest rate, an increase in the supply of money would result in a higher equilibrium quantity of money being demanded at a lower equilibrium rate of interest.

6. Which tool of monetary policy is most important? Why?
Open-market operations are the most important tool of monetary policy. Changes in the discount rate are less effective because bank reserves are relatively small and require action by commercial banks. Reserve requirements are rarely changed. Reserves do not earn interest so an increase in reserve requirements would be costly to banks, making this policy move less attractive. Open-market operations are used most often because they are very flexible and have an immediate effect on bank reserves.

7. What interest rate has been the focus of monetary policy?
The interest rates have been highly volatile in the last decade because of the various economy slowdowns. In March 2001 recession, the rate went from 5% to 3.5 %. Following this the terrorist attacks led to further slowdown and the interest rates reduced from 3.5% to 1.75% then again in November 2002 it lowered to 1.25%. Currently it remains below 1%.

8. How do quasi-public goods differ from pure public goods? Give examples of both types. Explain the rationale as to why quasi-public goods are often provided by government rather than private businesses.
A pure public good is characterized by non rivalry and no excludability. The benefits are also not reduced when one person benefits from it, so there is non rivalry. Once this type of national security is provided, it is available for benefit by all, without exclusion. An example would be the war on terrorism. Quasi-public goods have the characteristics of both private and public goods which means that to a certain degree rivalry and exclusion do apply. Quasi-public goods such as fire protection, schools, libraries, and trash collection can be provided by private firms. The reason why such quasi-public goods are often provided by government is that there can be substantial spillover benefits from them for society and if left to the market they would be underprovided or under produced.

9. What resource problem is created by negative externalities and what methods are suggested for dealing with this problem?
When there are spillover costs in the production process, this causes an over allocation of resources to the production of a product. The reason for the over allocation is that the firm is not paying for all the costs of production. The five suggested ways for correcting for this over allocation of resources are: (1) individual bargaining; (2) the use of liability rules and lawsuits; (3) imposing a tax on producers; (4) direct controls such as legal mandates or restrictions; and (5) creating a market for externality rights.

10. Suppose a local coffee shop in the downtown area decides to purchase a neighboring abandoned lot and convert it into a garden area with outdoor seating.
(a) Does this decision create an externality? If so, what kind?
(b) Despite the city’s positive response to the coffee shop’s renovation, other businesses in the area have not followed suit in renovating the many decrepit buildings and abandoned lots. How might the presence of an externality be in part the cause of this?
(c) In response to the lack of effort on the part of businesses to renovate the downtown area, city council members to take action. What are some ways that the city government could promote this kind of revival?
a. It creates a negative externality.
b. The possible reason of the externality being a cause of this could be the fact that if other people follow suit there will be an oversupply of the same kind of a service which may further lead to the market failure
c. Government can apply specific taxes on businesses that don’t follow suit. This could push people to follow suit. Also, the government reduce this externality in a direct way by passing a legislation under which the businesses will be left with no choice but to follow suit.