Finals Chapter 15

Question 1

What are three questions that have to be answered before we get involved with the economy:

Answer 1

Should the government act?,
Can the government act?,
and, if yes, How?

Question 2

Classical economists believe that government

Answer 2

should not act, called a Laissez Faire philosophy.

Question 3

Keynesians believe that the government should

Answer 3

act, called an Activist philosophy.

Question 4

Our two basic tools are

Answer 4

fiscal policy (taxing and spending), and 
monetary policy (money supply and interest rates). 
A third tool, industrial policy, is much less often used. It involves targeting specific industries.

Question 5

In the real world, the most commonly used policy is

Answer 5

monetary, through the use of interest rates,

and the goal of most policy makers is to control inflation, and then worry about other issues if they can.

Question 6

What is the phrase used most often today by policy makers.

Answer 6

Long term price stability

Question 7

Policy does

Answer 7

not always work.
There are time lags before it takes effect, the possibility of a liquidity trap or crowding out, or, as some believe, it simply does not work.

Question 8

Fiscal policy

Answer 8

Fiscal policy is the use of the government’s taxing and spending powers to control the economy directly, usually through direct expenditure, or by changing consumption or investment.

Question 9

Monetary policy

Answer 9

Monetary policy is the use of the money supply and interest rates to control the economy.

Question 10

Industrial policy

Answer 10

Industrial policy is policy designed to encourage or promote certain industries, or industry in general.

Question 11

One of the basic problems with economic policy is

Answer 11

timing. This can be broken down into what economists call lags, which means delays.

Question 12

Recognition Lag.

Answer 12

It may take the government or Fed time to determine that, in fact, there is a problem severe enough to warrant their action.

Question 13

Implementation Lag.

Answer 13

Once it has been determined that a problem actually exists, the government or the Fed must determine the best course of action. This delay is called the implementation lag.

Question 14

Effectiveness Lag.

Answer 14

If the government or Fed executes a change such as an interest rate cut or tax cut, the effect is not instantaneous. The time it takes before the policy change actually begins to work is called the effectiveness lag.

Question 15

Crowding out

Answer 15

the tendency of fiscal policy to cause a decrease in planned investment or planned consumption in the private sector

Step 1
government spending exceeds tax revenues (tax revenues are the income gained my the government through taxes)

Step 2
the government deficit increases (amount of money the government owes has increased)

Step 3
government seeks more funds from savers to finance the deficit

Step 4
government offers a higher interest rate to get more money

Step 5
government spending crowds out private spending

Question 16

Laissez Faire

Answer 16

Let it be. Markets adjust automatically if left alone. So the Classical economists had a simple message for the government: let it be. Laissez Faire is the economic philosophy derived from the classical beliefs.

Question 17

Liquidity traps

Answer 17

The liquidity trap is the point at which further cuts in interest rates, or increases in the money supply, stop affecting the economy. In a liquidity trap, monetary policy stops working.

Question 18

three macroeconomic goals of government

Answer 18

1. Stable prices (no inflation or deflation)
2. Full employment (no recessions)
3. Maximum sustainable economic growth (make incomes rise at a reasonable rate over time).

Question 19

Fiscal policy tools

Answer 19

Changing government spending

Changing taxes

Question 20

Monetary policy tools

Answer 20

Changing money supply 
Changing interest rates
Discount rate
Federal fund rate
Special controls

Question 21

Industrial policy tools

Answer 21

Regulation/ Deregulation

Subsidies

Question 22

The classical view

Answer 22

1) The government should not control the economy.
2) The government may not be able to control the economy.
3) We don’t need to answer #3.

Question 23

The Keynesian view

Answer 23

1) The government should control the economy.
2) The government can control the economy.
3) The government should use fiscal policy to do so.

Question 24

The Federal Reserves View

Answer 24

1) The government should control part of the economy.
2) The government can control the economy.
3) The government should use monetary policy to do so.

Question 25

Fixing demand recession

Answer 25

Fiscal Policy: Increase government spending and/ or cut taxes Monetary Policy: Increase the money supply and/ or cut interest rates

Question 26

Fixing inflation

Answer 26

Fiscal Policy: Decrease government spending and/ or raise taxes Monetary Policy: Decrease the money supply and/ or raise interest rates

Question 27

The Federal Reserve leadership believes that long term price stability

Answer 27

invariably leads to few or no recessions and long term economic growth.