Section 14 Fernanda Matos De Oliveira Page 25 of 25 1/30/13 *Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the questions—it’s there just for Tolkien fun. Go forth and read!!! Gandalf wishes the economy of Middle Earth to operate smoothly after he sails from the Grey Havens to the never-ending lands in the West. He gathers King Elessar of Gondor, King Eomer of Rohan, Thain Pippin Took of the Shire, King Thorin III Stonehelm of the Lonely Mountain, King Bard II of Dale, King Thranduil of Mirkwood, Gimli son of Gloin of Aglarond, Prince Faramir of Ithilien, Prince Imrahil of Dol Amroth, Treebeard of Fangorn Forest and other councilors and leaders of the various countries of Middle Earth to instruct them on fiscal policies designed to smooth out the business cycle. Even as the first shadows were felt in Mirkwood there appeared in the west of Middle-earth the Istari, whom Men called the Wizards....[A]terwards it was said among the Elves that they were messengers sent by the Lords of the West to contest the power of Sauron, if he should rise again, and to move Elves and Men and all living things of good will to valiant deeds. In the likeness of Men they appeared, old but vigorous, and they changed little with the years, and aged but slowly, though great cares lay on them; great wisdom they had, and many powers of mind and hand. a) Describe a budget deficit, a budget surplus and a balanced budget. Include relationship of tax revenues and government spending. What impact will each have on the market for loanable funds? A budget deficit occurs when total expenditures exceed total revenues. A budget surplus, on the other hand, describes a situation where total revenues exceed total expenditures. Finally, a balanced budget is one where total expenditures are equal to total revenues. A budget deficit would imply that an economy would not be in a position to pay off its debts in case it is given a loan. A budget supply, on the other hand, would increase the probability of a country receiving loans. GO BACK TO HANDOUT #16 ON LOANABLE FUNDS TO STATE THE ROLE OF GOVERNMENT IN LOANABLE FUNDS IN EACH SITUATION. b) Describe and graph how an income tax affects potential GDP and aggregate supply. Indicate the income tax wedge. (2 graphs) How do taxes on expenditures affect the income tax wedge? LOOK IN HANDOUT #24. YOU NEED TO SHOW THE WEDGE IN THE LABOR MARKET AND SHOW THE CONNECTION ON THE PRODUCTION FUNCTION (LIKE WE DID IN ECONOMIC GROWTH SECTION). ( Price ) ( AS 1 ) ( AS ) ( D ) ( GDP ) ( Income Tax wedge ) ( AS 1 ) ( AS ) ( D ) ( GDP ) An increase in income tax reduces GDP and aggregate supply. This is because an income tax translates to reducedexpenditures, which reduces aggregate supply and GDP. Taxes on expenditures, on the other hand,reduce INCREASE the income tax wedge c) Draw the Laffer curve. Show whe.

1. Section 14
Fernanda Matos De Oliveira
Page 25 of 25 1/30/13
*Quotes from The Lord of the Rings, or The Hobbit by JRR
Tolkien. Nothing written in italics applies to the questions—it’s
there just for Tolkien fun. Go forth and read!!!
Gandalf wishes the economy of Middle Earth to operate
smoothly after he sails from the Grey Havens to the never-
ending lands in the West. He gathers King Elessar of Gondor,
King Eomer of Rohan, Thain Pippin Took of the Shire, King
Thorin III Stonehelm of the Lonely Mountain, King Bard II of
Dale, King Thranduil of Mirkwood, Gimli son of Gloin of
Aglarond, Prince Faramir of Ithilien, Prince Imrahil of Dol
Amroth, Treebeard of Fangorn Forest and other councilors and
leaders of the various countries of Middle Earth to instruct them
on fiscal policies designed to smooth out the business cycle.
Even as the first shadows were felt in Mirkwood there appeared
in the west of Middle-earth the Istari, whom Men called the
Wizards....[A]terwards it was said among the Elves that they
were messengers sent by the Lords of the West to contest the
power of Sauron, if he should rise again, and to move Elves and
Men and all living things of good will to valiant deeds. In the
likeness of Men they appeared, old but vigorous, and they
changed little with the years, and aged but slowly, though great
cares lay on them; great wisdom they had, and many powers of
mind and hand.
a) Describe a budget deficit, a budget surplus and a balanced

2. budget. Include relationship of tax revenues and government
spending. What impact will each have on the market for
loanable funds?
A budget deficit occurs when total expenditures exceed total
revenues. A budget surplus, on the other hand, describes a
situation where total revenues exceed total expenditures.
Finally, a balanced budget is one where total expenditures are
equal to total revenues. A budget deficit would imply that an
economy would not be in a position to pay off its debts in case
it is given a loan. A budget supply, on the other hand, would
increase the probability of a country receiving loans. GO BACK
TO HANDOUT #16 ON LOANABLE FUNDS TO STATE THE
ROLE OF GOVERNMENT IN LOANABLE FUNDS IN EACH
SITUATION.
b)
Describe and graph how an income tax affects potential GDP
and aggregate supply. Indicate the income tax wedge. (2
graphs) How do taxes on expenditures affect the income tax
wedge?
LOOK IN HANDOUT #24. YOU NEED TO SHOW THE
WEDGE IN THE LABOR MARKET AND SHOW THE
CONNECTION ON THE PRODUCTION FUNCTION (LIKE
WE DID IN ECONOMIC GROWTH SECTION).
(
Price
)
(

3. AS
1
) (
AS
)
(
D
)
(
GDP
)
(
Income Tax wedge
)
(
AS
1
) (
AS
)
(
D
)

4. (
GDP
)
An increase in income tax reduces GDP and aggregate supply.
This is because an income tax translates to reducedexpenditures,
which reduces aggregate supply and GDP.
Taxes on expenditures, on the other hand,reduce INCREASE the
income tax wedge

5. c) Draw the Laffer curve. Show where the maximum tax
revenues would be. From this point does an increase in tax rates
increase or decrease tax revenues?
(
Tax Rate
)
(
Maximum tax revenues
)

6. (
Tax Revenue
)
From the maximum tax revenues point, any further increase in
the tax rates reduces the tax revenues. OK
d) Describe the three multipliers for government fiscal policy
and describe the differences in size of impact. How does each
affect the economy?
The three fiscal multipliers are impact multiplier, peak
multiplier and cumulative multiplier. The peak multiplier has
the greatest impact, followed by the cumulative multiplier, then
the impact multiplier. Each affects the economy depending on

7. time frame. WHERE ARE YOU GETTING THIS STUFF?
LOOK AT THE GUIDE –HANDOUT 24
e) Draw expansionary fiscal policy that is applied when the
economy is in a recessionary gap using the AD/AS model. What
are the two fiscal actions that the government could take to
implement this policy?YOU HAVE MOVED INTO AN
INFLATIONARY GAP ON YOUR GRAPH RATHER THAN
CORRECTING THE ECONOMY.
(
Price
)
(
AS
)
(
AD
1
)
(
AD
)
(

8. Q
e
) (
Q
1
)
(
GDP
)
OKThe two fiscal actions that the government can undertake to
close the recessionary gap are;
a) reduction of taxes
ii) increase of government expenditures.
f)
g) Draw contractionary fiscal policy that is applied when the
economy is in an inflationary gap using the AD/ AS model?
What are the two fiscal actions that the government could take
to implement this policy? BETTER BUT NEED ALL LABELS.
SHOULD ALSO SHOW MULTIPLIER EFFECT ON GRAPH.

9. SEE HANDOUT 24
(
Price
)
(
AS
)
(
AD
)
(
AD
1
)
(
Q
1
) (
Q
e
)
(
GDP
)
OK The two fiscal actions that the government can undertake to
close the inflationary gap are;
Increase of taxes

10. Decrease of government expenditures.
h) List and briefly describe the five lags that cause problems in
implementing fiscal policy.
1. Data lags-relate to changes that policy makers are not
cognizant of.
2. Wait-and-see lags-Relate to the tendency of policy makers to
relax even when they have identified a problem in the
economy???? WHERE DID THIS COME FROM?? SEE
HANDOUT 24
3. Legislative lags-relate to legal procedures that must be
followed once a policy has been proposed. POLLITICAL
PROCESS
4. Transmission lags-relate to the time a policy takes before in
is effected. BUREAUCRACY
5. Effectiveness lags-relate to the time a policy prescription
takes before actual effect is felt on the economy.

11. Section 15
Thorin III Stonehelm, son of Dain, became King of the Lonely
Mountain after his father’s fall in the War of the Ring. The
dwarves of his kingdom were busy and prosperous producing
the weapons, armor and jewelry for which they were famous and
which the inhabitants of Middle Earth were demanding now that
there was peace. But Thorin III Stonehelm began to notice that
prices were rising in his kingdom and he went to consult with
King Bard II of Dale (son of Brand) to see why this was
happening.
The lands opened wide about him, filled with the waters of the
river which broke up and wandered in a hundred winding
courses, or halted in marshes and pools dotted with isles on
every side; but still a strong water flowed on steadily through
the mist. And far away, its dark head in a torn cloud, there
loomed the Mountain! Its nearest neighbours to the North-East
and the tumbled land that joined it to them could not be seen.
All alone it rose and looked across the marshes to the forest.
The Lonely Mountain!
a)
b) Draw (in the AD/AS model) and explain what happens to

12. aggregate demand in the short run. What happens to the price
level, unemployment and real GDP in the short run? Is there an
inflationary or recessionary gap?
OK BUT LRAS IS ALWAYS LABELED Qn – CHECK ALL
YOUR GRAHS In the short-run, the aggregate demand
increases, thereby causes a rightward shift of the demand curve
from AD to AD1. At the same time, the price level increases,
while the unemployment level decreases. Real GDP increases.
The economy is facing an inflationary gap.
(
LRAS
) (
Price
)
(
SRAS
)

13. (
p
1
)
(
p
e
)
(
AD
1
)
(
AD
)
(
Real GDP
) (
Q
e
) (
Q
1
)

14. c) Draw (in the AD/AS model) and explain what happens to the
Lonely Mountain economy on its own in the long run as a result
of a) if no policy response occurs. What happens to the price
level, unemployment and real GDP in the long run? Include all
the dynamics. Is this inflation? Explain why or why not. If so,
what is it called?
In the long-run, the increase in aggregated demand will be
offset by a decrease in aggregate supply. As the aggregate
demand curve shifts to the right, the aggregate supply curve will
shift to the left. This shift in the supply curve to the left will
occur because laborers will demand higher wages upon realizing
that prices have increased, yet their incomes have not increased.
This will be costly to firms since they will incur higher business
costs. This will result in a decrease in supply. Also, in the long-
run, the price level will increase, while unemployment and real
GDP will remain constant. The economy faces inflation because
the price level increases considerably. WHAT IS IT CALLED?
ADD LABELS AND Qn

15. (
LRAS
) (
Price
)
(
SRAS
1
)
(
SRAS
)
(
AD
1
)
(
Q
e
) (
Real GDP
)

16. (
AD
)
d) Draw (in the AD/AS model) and explain what happens to the
Lonely Mountain economy in the long run as a result of a) if the
Council (Fed) immediately applies monetary policy and
contracts the money supply rather than wait for the economy to
self-correct like in b). What happens to the price level,
unemployment and real GDP in the long run? What is the final
difference in the result of the monetary policy and the results in
b)?
If the Fed applies contractionary monetary policy, the AD curve
will shift to the left. This will cause a decrease in the price
level. At the same time, unemployment will increase, while real
GDP will reduce. The difference that occurs when the council
chooses to let the economy to self-correct itself and when it
chooses to apply contractionary monetary policy is that in the
former, unemployment and real GDP will remain unchanged,
GOES BACK TOO while in the latter, these will change. ONLY
PRICE MISSING LRAS AND LABELS

17. (
Price
)
(
Output
) (
SRAS
)
(
AD
)
(
AD
1
)
(
Q
e
) (
Q
1
)
c)
a)

18. e) The Federal Council of Elrond (Fed) gets on a roll and
increases the money supply each year for 3 years. Draw (in the
AD/AS model) and explain the long-run effect of these
increases on the economy of the Lonely Mountain. What
happens to the price level, unemployment and real GDP in the
short run and in the long run? What is the end result of these
continued increases? Is there inflation? Explain why or why not.
If so, what is it called?
In the long-run, a continued increase of money supply will be
counterproductive because it will not be met by a proportionate
increase in production. The price level is likely to increase
significantly, both in the short-run and the long-run.
Unemployment is likely to increase in the short-run, but will
tend to remain constant in the long-run. As for real GDP, it will
reduce in the short-run, but will remain unchanged in the long-
run. As a result of the continued increase in money supply, the
situation experienced is one where a lot of money is chasing
few goods. This results in inflationary tendencies. ADD MORE
LEVELS. ADD AND FIX LABELS WHAT IS THIS
SITUATION CALLED? SEE HANDOUT #25
(
LRAS
) (
Price
)

19. (
SRAS
)
(
AD
1
)
(
AD
)
(
Real GDP
) (
Q
1
) (
Q
e
)

20. The economy of the Lonely Mountain is dependent on iron for
its armor and weapon manufacturing. A pack of Orcs fleeing the
destruction before the gates of Barad-Dur make their way to the
Iron Hills where the dwarves mine ore and force battle. The
attack on the Dwarves’ mines causes a temporary supply shock
to the economy of Middle Earth due to the reduction of raw
materials.
f) Draw (in the AD/AS model) and explain the short-run effect
of the supply shock on economy of the Lonely Mountain. What
happens to the price level, unemployment and real GDP in the
short run? Is there an inflationary or recessionary gap?
A supply shock is likely to cause a left-ward shift of the
demand curve to the left. As a result, the price level will
increase, while unemployment will increase. Real GDP will
reduce. The economy will face a recessionary gap. MISSING
LRAS, LABELS

21. (
Price
)
(
SRAS
1
)
(
SRAS
)
(
LRAS
)
(
Q
e
) (
Q
1
)
(
AD
)

22. (
Real GDP
)
Draw (in the AD/AS model) and explain what happens to the
Lonely Mountain economy on its own in the long run as a result
of e) if no policy response occurs. What happens to the price
level, unemployment and real GDP in the long run? Include all
the dynamics. Is there inflation? Explain why or why not. If so,
what is it called?
In the long-run, the decrease in supply will be offset by an
increase in demand. NOT UNLESS SOMETHING ELSE STEPS
IN. FIXING ITSELF MOVES YOU OUT OF A
RECESSIONARY GAP JUST LIKE USUAL—END UP BACK
WHERE UYOU STARTED. Consequently, the price level will
increase, while unemployment and real GDP will remain
constant. The situation witnessed of sluggish economy and high
inflation is called stagflation.
(
Price
) (
LRAS
)
(
SRAS

23. 1
)
(
SRAS
)
(
AD
1
)
(
Q
e
) (
Q
1
)
(
AD
)
(
Real GDP
)

24. g) Draw (in the AD/AS model) and explain what happens to the
Lonely Mountain economy in the long run as a result of e) if the
attacks continually re-occur and the Council (Fed) applies
expansionary monetary policy and increases the money supply
one time rather than wait for the economy to self-correct like in
f). What happens to the price level, unemployment and real
GDP in the long run? Include all the dynamics. Is there
inflation? Explain why or why not. If so, what is it called? What
is the final difference in the result of the monetary policy and
the results in f)?
If Fed applies expansionary monetary policy and increases
money supply, the price level is likely to reduce????, while
unemployment will reduce. Real GDP will increase. The
difference when the council chooses to let the economy to self-
correct itself and when it chooses to apply expansionary
monetary policy is that in the former, the economy will face a
mild-recession, while in the latter, it will face inflation.
BACKWARDS
(
Price
)
(
SRAS
1
)
(
SRAS
)

25. (
Q
e
) (
Q
1
)
(
AD
)
(
Real GDP
)

26. Section 16
After the War of the Rings, Legolas returns to Mirkwood, where
his father rules the Woodland Elves. Due to new ideas gained in
his wide travels, Legolas convinces King Thranduil to
implement continuing expansionary monetary and fiscal policy
to reduce unemployment in Mirkwood. (Actually, a reduction in
the consumption of barrels of wine would work better.)
There was also a strange Elf, clad in green and brown, Legolas,
a messenger from his father, Thranduil, the King of the Elves of
Northern Mirkwood.
a)
b) Draw and explain the short-run Phillips curve for the
economy of Mirkwood on which Legolas is basing his ideas.
What is held constant along the short-run Phillips curve?
In the short-run Phillips curve expected inflation and actual
inflation are held constant.
SHOULD CURVE
(
Inflation rate
)

27. (
Short-run Phillips curve
)
(
Unemployment rate
)
c) Draw the short-run and long-run Phillips curve for the
Mirkwood economy. Explain what happens to the price level
and unemployment in the long run?
In the long-run, the price level increases, while unemployment
remains at its natural rate. This occurs because laborers revise
their wages upon realizing that the price level has increased.
Others even choose to renounce their job positions. This
combination of some laborers renouncing their positions and
others revising their expectation of inflation causes wages to
increase and consequently, prices. This shift the supply curve to
the left, taking the economy back to its full potential point.
NO TRADEOFF IN LR—ADD LABELS SEE HANDOUT #26
(
Long-run Phillips curve
)
(
Inflation rate
)

28. (
Unemployment rate
)
(
Short-run Phillips curve
)
d)
Explain and show by graph the connection through

29. unemployment and changes in the price level between the
business cycle as shown by the AD/AS model and the long run
Phillips curve (show 3 points on the graph). NEED 2 GRAPHS
JUST LIKE HANDOUT #26. BE SURE TO INCLUDE U AND
Un—THAT IS HOW THEY CONNECT
(
Inflation Rate
)
(
3
)
(
2
)
(
1
)
(
U
n
) (

30. U
1
)
Point 1: Shows an increase in output following a shift of the
aggregate demand curve to the right.
Point 2: Shows the decrease in unemployment that is brought
about by an increase in aggregate demand.
Point 3: Shows how the economy moves back to its full
potential point when laborers revise their inflation expectations.
This causes the short-run aggregate supply curve to shift to the
left.
(
Unemployment Rate
)

31. e) Suppose job search time in Mirkwood suddenly becomes
easier. Draw and explain what happens to the Phillips curve in
Mirkwood.
(
Inflation Rate
)
(
2
)

32. (
1
)
(
U
n
) (
U
1
)
If job search time in Mirkwood becomes easier, this means that
the economy will move point 1 to 2. That is, the rate of
unemployment will reduce.
NEED TO MOVE BOTH LRPC AND SRPC TO LEFT SO THAT
ACTUAL INFLATION REMAINS THE SAME

33. Section 17
Elrond, Chairman of the Council, is a monetarist and believes
that prices and wages are flexible so that the economy is self-
regulating. But unlike Denethor, he feels that money is the key
to the economy.
The face of Elrond was ageless, neither old nor young, though
in it was written the memory of many things both glad and
sorrowful. His hair was dark as the shadows of twilight, and
upon it was set a circlet of silver; his eyes were grey as a clear
evening, and in them was a light like the light of stars.
Venerable he seemed as a king crowned with many winters, and
yet hale as a tried warrior in the fulness of his strength. --
a) What are the monetary policy objectives and goals of the

34. Federal Council of Elrond (Fed)? What tradeoff does the
council face for its goals? Explain.
The main objective of monetary policy is to keep prices stable
by changing money supply in the economy. In doing this, the
Fed faces tradeoffs. Because of the tendency of the economy to
self-correct itself following a recession or an inflation period,
the Fed faces the tradeoff of allowing the economy to self-
correct itself or implementing policy to correct the imbalance.
Either way, there is a cost of each decision.
AGAIN, WHERE ARE YOU GETTING THIS STUFF? IF
SOMEONE IS HELPING YOU THEY ARE NOT DOING YOU
A LOT OF GOOD. SEE THE GUIDE AND HANDOUT 27.
THERE ARE 3 GOALS SET BY LAW.
b)
c) Graph the implementation of expansionary monetary policy

35. on the economy of Middle Earth when there is a recessionary
gap (in both money market and AD/AS model). What happens to
the price level, unemployment and real GDP? Specify 3
different actions the Council (Fed) could do to accomplish this
policy.
(
AS
)
(
AD
1
)
(
AD
)
(
Q
e
) (
Q
1
)
(
GDP
)
Following the implementation of expansionary monetary policy,
the price level increases, while unemployment reduces. BACK
TO Un Real GDP increases BACK TO Qn
GRAPH IS MISSING LRAS, LABELS. WHERE IS THE

36. MONEY MARKET?
The three actions that the Fed can undertake to close a
recessionary gap are;
· Purchase of bonds and securities
· Decrease of interest DISCOUNT rates
· Reduction of reserve requirements.
d)
Graph the implementation of contractionary monetary policy on
the economy of Middle Earth when there is an inflationary gap
(in both money market and AD/AS model). What happens to the
price level, unemployment and real GDP? Specify 3 different
actions the Council (Fed) could do to accomplish this policy.
(
Price
)
(
AS
)
(
AD
)
(
AD
1
)

37. (
GDP
) (
Q
e
) (
Q
1
)
Following the implementation of contractionary monetary
policy, the price level will reduce, while unemployment will
increase BACK TO Un. Real GDP will reduce BACK TO Qn.
GRAPH IS MISSING LRAS, LABELS. WHERE IS THE
MONEY MARKET?
The three actions that the Fed can undertake to close an
inflationary gap are;
· Sell of bonds and securities
· Increase of interest DISCOUNT rates
· Increase of reserve requirements.

38. e)
f) Draw the effect on the federal funds rate if the Council (Fed)
performs an open market purchase. Describe in detail or graphs
the ripple effects of this action. Be sure to include the end
result in each market and how those results affect the
components of aggregate demand. THERE ARE 5 GRAPHS
YOU NEED TO DRAW AND EXPLAIN. SEE HANDOUT #27
An open market purchase is likely to increase aggregate
demand, thereby causing a shift of the aggregate demand curve
to the right. In the money market, an open market purchase will
lead to more money in the economy. The component of
aggregate demand that will be affected is consumption.
Individuals will consume more because the purchase will
increase the money they hold
(
AS
)
(
AD
1

39. )
(
AD
)
(
Q
e
) (
Q
1
)
(
GDP
)
g) Draw the effect on the federal funds rate if the Council (Fed)
performs an open market sale. Describe in detail or graphs the
ripple effects of this action. Be sure to include the end result in
each market and how those results affect the components of
aggregate demand. THERE ARE 5 GRAPHS YOU NEED TO
DRAW AND EXPLAIN. SEE HANDOUT #27
An open market sale is likely to reduce aggregate demand,
thereby causing a shift of the aggregate demand curve to the

40. left. In the money market, an open market purchase will lead to
less money in the economy. The component of aggregate
demand that will be affected is consumption. Individuals will
consume less because the sale will reduce the money they hold.
(
Price
)
(
AS
)
(
AD
)
(
AD
1
)
(
Real GDP
) (
Q
e
) (
Q
1
)

41. Then Círdan led them to the Havens, and there was a white ship
lying, and upon the quay beside a great grey horse stood a
figure robed all in white awaiting them. As he turned and came
towards them Frodo saw that Gandalf now wore openly on his
hand the Third Ring, Narya the Great, and the stone upon it was
red as fire. Then those who were to go were glad, for they knew
that Gandalf would also take ship with them....
Then Frodo kissed Merry and Pippin, and last of all Sam, and
went aboard; and the sails were drawn up, and the wind blew,
and slowly the ship slipped away down the long grey firth; and
the light of the glass of Galadriel that Frodo bore glimmered
and was lost. And the ship went out into the High Sea and
passed on into the West, until at last on a night of rain Frodo
smelled a sweet fragrance on the air and heard the sound of
singing that came over the water. And then it seemed to him
that as in his dream in the house of Bombadil, the grey rain-
curtain turned all to silver glass and was rolled back, and he
beheld white shores and beyond them a far green country under
a swift sunrise.