Effectiveness of Fiscal & Monetary Policy

Question 1

The _____ Curve purports to show a stable relationship between the rate of unemployment and the rate of inflation.

Answer 1

Phillips

Explanation

The relationship between unemployment rate and inflation is inverse - the higher the unemployment the lower the inflation and vice versa.

Question 2

A supply _____ occurs when there is a sudden and drastic change in the supply curve.

Answer 2

shock

Explanation

An example of a supply shock would be the OPEC energy crisis of the 1970s. The effect of increasing oil prices was to shift the aggregate supply curve in the Western nations to the left, reducing output and increasing the price level. This problem continued throughout the 1970s, with two major shocks occurring in 1974 and 1979.

Question 3

The use of Monetary policy by the central bank to cushion the blow of aggregate supply shocks is called ____________.

Answer 3

accomodation

Explanation

In response to a supply shock the money supply is allowed to expand to reduce the unemployment problem, lowering interest rates, and thereby increasing investment expenditure. This shifts the aggregate demand curve to the right. The net effect of this policy is to keep unemployment relatively low, and to raise the general price level.

Question 4

_______ is a process in which the price level rises and money loses value.

Answer 4

Inflation

Explanation

Inflation is fundamentally a monetary phenomenon wherein the average level of prices is rising – inflation is not high prices and inflation is not a jump in prices. The inflation rate is the percentage change in the price level during a given period.

Question 5

_________ inflation is inflation that results from an initial increase in aggregate demand.

Answer 5

Demand-pull

Explanation

Figure (a) Initially, aggregate demand increases AD0 to AD1. Real GDP increases and the price level rises to 135. Now real GDP exceeds potential GDP and there is an inflationary gap. Figure (b) The money wage rate begins to rise and the SAS curve shifts leftward form SAS0 to SAS1. Real GDP decreases toward potential GDP and the price level rises further. This process repeats in an unending price-wage spiral. For demand pull inflation to occur, aggregate demand must persistently increase. The money supply must persistently grow at a rate that exceeds the growth rate of potential GDP.

Question 6

Cost-push inflation is an inflation that results from an initial increase in _____.

Answer 6

costs

Explanation

The two main sources of cost-push inflation are an increase in the money wage rate and an increase in the money prices of raw materials. Figure (a) initially, a factor price rises. Short-run aggregate supply decreases and the SAS curve shifts leftward. Real GDP decreases and the price level rises in a stagflation. With no subsequent change in aggregate demand, the price level eventually falls. There is no inflation. For cost-push inflation to take hold, aggregate demand must increase. Figure (b) an increase in the money supply increases aggregate demand and the AD curve shifts rightward. Real GDP increases and the price level rises. This process repeats to create an unending cost-price inflation spiral.

Question 7

Inflation accompanied by simultaneous increases in prices and unemployment is called ___________.

Answer 7

stagflation

Explanation

In stagflation an economy experiences both rising cost (inflation) and rising unemployment. There is no relief as any gain in employment is accompanied by more inflation.

Question 8

___________ economists’ view of the economy is that it may stagnate in the absence of proper work, saving and investment incentives.

Answer 8

Supply side

Explanation

Supply side economics says that governments should use the personal tax, the business tax, regulatory system, and other incentives to stimulate the long-run aggregate supply in the economy. The focus in this line of thinking is that lower tax rates would encourage more individual effort, and encourage more business investment, thus shifting AS to the right. At the same time, this larger tax base would replace the revenues that were lost because of the lower tax rates.

Question 9

Using taxes and spending to influence the level of GDP in the short run is known as ___________ fiscal policy

Answer 9

Keynesian

Explanation

This theory states that both the level of government spending and the level of taxation, through their influence on the demand for goods and services, affect the level of GDP in the short run.

Question 10

According to Keynesian theory, an increase in __________ spending leads to an increase in output.

Answer 10

government

Question 11

According to Keynesian theory an increase in _____ leads to a decrease in output.

Answer 11

taxes

Question 12

According to Keynesian economics, ____________ fiscal policy (tax cuts and increased government spending) could pull the economy out of a recession or depression.

Answer 12

expansionary

Question 13

Automatic _________ are taxes and transfer payments that stabilize GDP without requiring policymakers to take explicit actions.

Answer 13

Stabilizers

Question 14

__________ economics is based on the principle that prices adjust in a natural way to bring the markets for goods and labor into equilibrium.

Answer 14

Classical

Explanation

In the classical model, wages and prices are assumed to adjust freely and quickly to all changes in demand and supply. This flexibility in wages and prices distinguishes the classical model from the Keynesian models. GDP and wages are measured as nominal (actual money) rather than real (amount of goods and services the money can buy).

Question 15

The classical economists argue that the aggregate supply curve is ________.

Answer 15

vertical

Explanation

This means it is the exclusive determinant of the level of nominal GDP. The vertical line is located where the full employment rate is realized. Nominal GDP does not change in response to price levels.

Question 16

The Classical theory of economics states that _____ is at the root of aggregate demand.

Answer 16

money

Explanation

The amount of nominal GDP that can be purchased depends on the amount of money households and business have and the purchasing power of the money. GDP and wages are measured as nominal (actual money) rather than real (amount of goods and services the money can buy).

Question 17

Classical theory states that the aggregate demand curve is ______ if the supply of money is kept constant.

Answer 17

stable

Explanation

The key to price stability is to control the money supply and prevent unwanted shifts in aggregate demand.

Question 18

Classical theorists believe that, all things being equal, households will normally prefer to _______ than to save.

Answer 18

consume

Explanation

Consumers would save only if there was a reward (interest) for doing so. Thus the act of investment is the most sensitive to changes in the interest rate.

Question 19

In _________ economics the aggregate supply curve is horizontal.

Answer 19

Keynesian

Explanation

The core of Keynesian theory is that in the short-run prices and wages are downwardly inflexible. A decline in real GDP will have no effect on prices.

Question 20

Keynesian economists believe aggregate demand is ________.

Answer 20

unstable

Explanation

A market economy is not self-regulating and at the level of full employment there is no guarantee that firms or households will demand that level of output. This instability is due largely to the investment component - savers and investors have very different motivations. Some people save in order to purchase a large screen TV, others save for university education and others save just to have a precautionary “nest-egg.” Keynesians support active management of aggregate demand to avoid recession.

Question 21

The basic __________ economic equation is C + I + G + X = GDP.

Answer 21

Keynesian

Explanation

The aggregate amount spent determines the total value of goods and services sold.

Question 22

The _________ view is that competition in the marketplace provides economic stability.

Answer 22

Monetarist

Explanation

The market system would provide adequate levels of stability if the government did not interfere with its functioning. Programs like minimum wage, anti-monopoly legislation, pro-union legislation, etc all contribute to a downward wage/price inflexibility.

Question 23

The fundamental equation of __________ is the equation of exchange.

Answer 23

monetarism

The equation of exchange is:

• MV = PQ (amount spent = amount received)
• M = the supply of money
• V = the velocity of money (number of times/year the average dollar is spent on final goods and services)
• P = price level
• Q = physical volume of goods and services

Question 24

In the equation of exchange MV=PQ, PQ (price level * physical ______ of goods and services) is equal to nominal GDP.

Answer 24

volume

Explanation

Nominal GDP is the actual money value of the goods and services therefore P*Q equals the actual (nominal) GDP.

• Example: If nominal GDP = $500 billion and the Money Supply (M) = $50 billion then the Velocity of money (V) is V = 10.

Question 25

Keynesian economic theories believe _______ policy is a relatively weak tool for stabilizing the economy.

Answer 25

monetary

Explanation

The monetary transmission mechanism for Keynesians is:

• They contend there are loose links in the chain of events that lead a change in the money supply to a change in demand. They feel that investment is not always sensitive to changes in the interest rate and that a change in interest rates will not necessarily lead to a change in demand. They question whether banks will always be anxious to lend and whether the public will always be eager to borrow based on interest rates alone.

Question 26

The monetarists’ view is that a change in the ____________ is the most important factor in determining output, price and employment levels.

Answer 26

money supply

Explanation

Monetarists believe that an increase in the money supply drives up the demand for all types of assets (not just investment). Thus if the money supply is too high there will be inflation. They believe there is a direct link between money supply and aggregate demand.

Question 27

New ________ Economists (Rational Expectations Theorists - RET) assert that households and firms will use all available economic information to further their own self-interests.

Answer 27

Classical

Explanation

People are rational and thus they use all the relevant information available to them to make decisions regarding their consumption and savings patterns. They are well aware of the effects of fiscal and monetary policy and they plan for them. These aggregated responses to public expectations regarding economic stabilization policies render those policies useless.

Question 28

Rational Expectations Theorists (RET) believe that markets are highly ___________ and adjust prices quickly to changes in supply and demand.

Answer 28

competitive

Explanation

They believe that prices and quantities adjust almost instantaneously with new information and thus are able to quickly adjust to market shocks or policy changes.

Question 29

New Classical Economists (Rational Expectations Theorists - RET) imply that the aggregate supply curve is _____.

Answer 29

vertical

Explanation

Any increase in aggregate demand will immediately result in an offsetting increase in the price level so the GDP remains unchanged. Conversely, a decline in AD will reduce the price level.

Question 30

Rational Expectation Theorists maintains that the costs of _________ depend on whether it is anticipated or unanticipated.

Answer 30

inflation

Explanation

Unanticipated inflation can cause the following problems:

• redistribute income between firms and workers
• move real GDP away from potential GDP
• redistribute wealth between borrowers and lenders
• result in too much or too little saving and investment.

Question 31

An _______ inflation avoids some of the costs of inflation.

Answer 31

anticipated

Explanation

However the cost is very high due to a decrease in potential GDP and a decrease in the long-term growth rate.

Question 32

A budget _____ is the amount by which a government’s expenditures exceed its revenues during a particular year.

Answer 32

deficit

Explanation

If there is no intended deficit the budget is said to be balanced.

Question 33

The ______ debt is the total of all past accumulated deficits of the government.

Answer 33

public

Explanation

The national (public) debt is the total accumulated deficit and surpluses that have occurred through time and is the total amount owing at any current time. The debt in countries such as the United States and Canada, has led some observers and politicians to push for new strategies in dealing with the size of the debt.

Question 34

A policy of an annually balanced budget requires the federal government to balance its budget on an ______ basis.

Answer 34

annual

Explanation

Until the 1930s, this was the general philosophy of governments around the world. It is currently being sought after by more conservative politicians in the United States.

Question 35

A _________ fiscal policy is necessary to balance the budget and would tend to magnify the changes in the economy and make the business cycle more pronounced.

Answer 35

pro-cyclical

Explanation

When the business cycle turns down, the government would be required to cut spending and increase taxes. Both of these are contractionary, and tend to make the recession worse.

Question 36

A __________ balanced budget exerts counter cyclical pressure on the economy, and balances its budgets in the bad times with the surpluses of the good times.

Answer 36

cyclically

Explanation

This tends to be the kind of philosophy most governments would like to have, but is difficult in practice. If the upswings are short and the downturns are long, it may be difficult to balance the budget over the business cycle.

Question 37

A system of __________ finance is based on the notion that balancing the budget is secondary to ensuring that the economy runs at a non-inflationary full employment level.

Answer 37

functional

Explanation

If this means incurring a large public debt, so be it. This philosophy stems from the notion of reducing the waste that occurs when labor and resources are left idle, and it is more important to have a large GDP than to worry about the size of the debt. Of course, they also believe that the problems of having a large debt are relatively less important than those who believe in other philosophies.

Question 38

Large annual _____ create an imbalance of trade which promotes imports and stifles exports.

Answer 38

debts

Explanation

When government debt is held by foreigners, then some of the foreign money we earn through our exports must be used to pay interest to the foreign bondholders. As a result, there is less money left to buy goods and services from abroad, and this represents the real burden of foreign indebtedness.

Question 39

When the government imposes _____ on the general population, this tends to alter the behavior of the public.

Answer 39

taxes

Explanation

If taxes are particularly onerous, people may have incentive to use accountants lawyers to search out loopholes and divert savings into tax shelters, rather than into the most productive investments. It distorts the way that people invest in efficient production.

Question 40

The need for the government to make interest payments on a large debt may result in _________.

Answer 40

inflation

Explanation

This is likely to happen if the government chooses to finance the interest payments through borrowing or through printing new money. This is often the case in many third world countries.

Question 41

____ tends to feed on itself through interest payments.

Answer 41

Debt

Explanation

The interest rates paid on the debt may be growing faster than the revenues of the government and faster than tax revenues are growing.

Question 42

Debt limits a government’s use of _____________ stabilization policies.

Answer 42

discretionary

Explanation

If the debt becomes too large, it may become very difficult for future governments to combat future recessions through fiscal policy.

Question 43

To finance its deficit a government must go into the money market and compete with the _____ sector for funds.

Answer 43

private

Explanation

This will drive up interest rates, which discourages private investment (crowding out effect).

Question 44

____ interest rates encourage foreign investment.

Answer 44

High

Explanation

The inflow of funds is helpful however the inflow represents an increase in our external debt. Paying interest and retiring debt to foreigners reduces domestic output in the future. When most of the debt is owned by domestic citizens, the future interest payments are merely a shuffle of money from one group citizens to another. Only debt owed to foreigners represents a true loss of future earning power. (this includes all debt, including corporate debt).

Question 45

Recessions are a source of ______ debt.

Answer 45

public

Explanation

When national income falls or fails to grow, tax collection decreases and more transfer payments are needed. Both of these situations cause deficits.

Question 46

Modern fiscal policy endorses __________ budgets for the purpose of stabilizing the economy.

Answer 46

unbalanced

Explanation

The government finds it to hard use fiscal activity as a stabilizing economic force when it must maintain a balanced budget.

Question 47

In an attempt to reduce the _______ the government could increase taxes.

Answer 47

deficit

Explanation

Increased taxes would create a larger inflow of cash to the government.

Question 48

In an attempt to reduce the deficit the government could ________ federal spending.

Answer 48

decrease

Explanation

Decreased federal spending would limit the cash outflows and free up more money to pay down the deficit.

Question 49

In an attempt to reduce the deficit the government could decrease ________ rates.

Answer 49

interest

Explanation

Lower interest rates would discourage foreign investment and thus reduce the interest payments on the foreign debt. Paying down foreign debt is a drain of funds from the economy and will decrease the total domestic output.