Reading 12: monetary and fiscal policy

Question 1

Both monetary and fiscal policy are used to:
balance the budget.
achieve economic targets.
redistribute income and wealth.

Answer 1

Both monetary and fiscal policies primarily strive to achieve economic targets such as inflation and GDP growth. Balancing the budget is not a goal for monetary policy and is a potential outcome of fiscal policy. Fiscal policy (but not monetary policy) may secondarily be used as a tool to redistribute income and wealth. (LOS 12.a)

Question 2

Which of the following statements is least accurate? The existence and use of money:
permits individuals to perform economic transactions.
requires the central bank to control the supply of currency.
increases the efficiency of transactions compared to a barter system.

Answer 2

Money functions as a unit of account, a medium of exchange, and a store of value. Money existed long before the idea of central banking was conceived. (LOS 12.b)

Question 3

If money neutrality holds, the effect of an increase in the money supply is:
higher prices.
higher output.
lower unemployment.

Answer 3

Money neutrality is the theory that changes in the money supply do not affect real output or the velocity of money. Therefore, an increase in the money supply can only increase the price level. (LOS 12.c)

Question 4

If the money supply is increasing and velocity is decreasing:
prices will decrease.
real GDP will increase.
the impact on prices and real GDP is uncertain.

Answer 4

Given the equation of exchange, MV = PY, an increase in the money supply is consistent with an increase in nominal GDP (PY). However, a decrease in velocity is consistent with a decrease in nominal GDP. Unless we know the size of the changes in the two variables, there is no way to tell what the net impact is on real GDP (Y) and prices (P). (LOS 12.c)

Question 5

The money supply curve is perfectly inelastic because the money:
supply is independent of interest rates.
demand schedule is downward-sloping.
supply is dependent upon interest rates.

Answer 5

The money supply schedule is vertical because the money supply is independent of interest rates. Central banks control the money supply. (LOS 12.d)

Question 6

The Fisher effect states that the nominal interest rate is equal to the real rate plus:
actual inflation.
average inflation.
expected inflation.

Answer 6

The Fisher effect states that nominal interest rates are equal to the real interest rate plus the expected inflation rate. (LOS 12.e)

Question 7

A central bank’s policy goals least likely include:
price stability.
minimizing long-term interest rates.
maximizing the sustainable growth rate of the economy.

Answer 7

Central bank goals often include maximum employment, which is interpreted as the maximum sustainable growth rate of the economy; stable prices; and moderate (not minimum) long-term interest rates. (LOS 12.f)

Question 8

A country that targets a stable exchange rate with another country’s currency least likely:
accepts the inflation rate of the other country.
will sell its currency if its foreign exchange value rises.
must also match the money supply growth rate of the other country.

Answer 8

The money supply growth rate may need to be adjusted to keep the exchange rate within acceptable bounds, but is not necessarily the same as that of the other country. The other two statements are true. (LOS 12.f)

Question 9

A central bank conducts monetary policy primarily by altering:
the policy rate.
the inflation rate.
the long-term interest rate.

Answer 9

The primary method by which a central bank conducts monetary policy is through changes in the target short-term rate or policy rate. (LOS 12.h)

Question 10

Purchases of securities in the open market by the monetary authorities are least likely to increase:
excess reserves.
cash in investor accounts.
the interbank lending rate.

Answer 10

Open market purchases by monetary authorities decrease the interbank lending rate by increasing excess reserves that banks can lend to one another and therefore increasing their willingness to lend. (LOS 12.i)

Question 11

An increase in the policy rate will most likely lead to an increase in:
business investment in fixed assets.
consumer spending on durable goods.
the foreign exchange value of the domestic currency.

Answer 11

An increase in the policy rate is likely to increase longer-term interest rates, causing decreases in consumption spending on durable goods and business investment in plant and equipment. The increase in rates, however, makes investment in the domestic economy more attractive to foreign investors, increasing demand for the domestic currency and causing the currency to appreciate. (LOS 12.i)

Question 12

Qualities of effective central banks include:
credibility and verifiability.
comparability and relevance.
independence and transparency.

Answer 12

The three qualities of effective central banks are independence, credibility, and transparency. (LOS 12.k)

Question 13

If a country’s inflation rate is below the central bank’s target rate, the central bank is most likely to:
sell government securities.
increase the reserve requirement.
decrease the overnight lending rate.

Answer 13

Decreasing the overnight lending rate would add reserves to the banking system, which would encourage bank lending, expand the money supply, reduce interest rates, and allow GDP growth and the rate of inflation to increase. Selling government securities or increasing the reserve requirement would have the opposite effect, reducing the money supply and decreasing the inflation rate. (LOS 12.j)

Question 14

Monetary policy is likely to be least responsive to domestic economic conditions if policymakers employ:
inflation targeting.
interest rate targeting.
exchange rate targeting.

Answer 14

Exchange rate targeting requires monetary policy to be consistent with the goal of a stable exchange rate with the targeted currency, regardless of domestic economic conditions. (LOS 12.l)

Question 15

Suppose an economy has a real trend rate of 2%. The central bank has set an inflation target of 4.5%. To achieve the target, the central bank has set the policy rate at 6%. Monetary policy is most likely:
balanced.
expansionary.
contractionary.

Answer 15

neutral rate = trend rate + inflation target = 2% + 4.5% = 6.5%
Because the policy rate is less than the neutral rate, monetary policy is expansionary. (LOS 12.m)

Question 16

Monetary policy is most likely to fail to achieve its objectives when the economy is:
growing rapidly.
experiencing deflation.
experiencing disinflation.

Answer 16

Monetary policy has limited ability to act effectively against deflation because the policy rate cannot be reduced below zero and demand for money may be highly elastic (liquidity trap). (LOS 12.n)

Question 17

Roles and objectives of fiscal policy most likely include:
controlling the money supply to limit inflation.
adjusting tax rates to influence aggregate demand.
using government spending to control interest rates.

Answer 17

Influencing the level of aggregate demand through taxation and government spending is an objective of fiscal policy. Controlling inflation and interest rates are typical objectives of monetary policy. (LOS 12.o)

Question 18

A government enacts a program to subsidize farmers with an expansive spending program of $10 billion. At the same time, the government enacts a $10 billion tax increase over the same period. Which of the following statements best describes the impact on aggregate demand?
Lower growth because the tax increase will have a greater effect.
No effect because the tax and spending effects just offset each other.
Higher growth because the spending increase will have a greater effect.

Answer 18

The amount of the spending program exactly offsets the amount of the tax increase, leaving the budget unaffected. The multiplier for government spending is greater than the multiplier for a tax increase. Therefore, the balanced budget multiplier is positive. All of the government spending enters the economy as increased expenditure, whereas spending is reduced by only a portion of the tax increase. (LOS 12.q)

Question 19

A government reduces spending by $50 million. The tax rate is 30%, and consumers exhibit a marginal propensity to consume of 80%. The change in aggregate demand caused by the change in government spending is closest to:
–$66 million.
–$114 million.
–$250 million.

Answer 19

fiscal multiplier = 1 / [1 – MPC (1 – T)] = 1 / [1 – 0.80(1 – 0.3)] = 2.27
change in government spending = –$50 million

change in aggregate demand = –(50 × 2.27) = –$113.64 million (LOS 12.q)

Question 20

The size of a national debt is most likely to be a concern for policymakers if:
Ricardian equivalence holds.
a crowding-out effect occurs.
debt is used to finance capital growth.

Answer 20

Crowding out refers to the possibility that government borrowing causes interest rates to increase and private investment to decrease. If government debt is financing the growth of productive capital, this should increase future economic growth and tax receipts to repay the debt. Ricardian equivalence is the theory that if government debt increases, private citizens will increase savings in anticipation of higher future taxes, and it is an argument against being concerned about the size of government debt and budget deficits. (LOS 12.p)

Question 21

A government is concerned about the timing of the impact of fiscal policy changes and is considering requiring the compilation and reporting of economic statistics weekly, rather than quarterly. The new reporting frequency is intended to decrease:
the action lag.
the impact lag.
the recognition lag.

Answer 21

More frequent and current economic data would make it easier for authorities to monitor the economy and to recognize problems. The reduction in the time between economic reports should reduce the recognition lag. (LOS 12.r)

Question 22

Fiscal policy is most likely to be expansionary if tax rates:
and government spending both decrease.
decrease and government spending increases.
increase and government spending decreases.

Answer 22

Increases in government spending and decreases in taxes are expansionary fiscal policy. Decreases in spending and increases in taxes are contractionary fiscal policy. (LOS 12.s)