The Influence of Monetary & Fiscal Policy on Aggregate Demand

Question 1

Monetary Policy

Answer 1

Control of money supply by central bank

Question 2

Fiscal policy

Answer 2

Government spending and taxation by minister of finance

Question 3

Least important effect to explain the downward slope of the Aggregate Demand curve

Answer 3

Wealth effect

Question 4

Most important effect to explain the downward slope of the Aggregate Demand Curve

Answer 4

Interest Rate Effect

Question 5

Which interest rate is explained through the theory of liquidity preference?

Answer 5

Both real and nominal interest rates. Only separated by a constant inflation rate in this case. If real interest rate falls, so does nominal interest rate.

Question 6

Theory of liquidity preference

Answer 6

Keynes’ theory that the interest rate adjusts to bring money demand and money supply into balance

Question 7

Most liquid asset available

Answer 7

Money - as it is the economy’s medium of exchange

Question 8

Liquidity

Answer 8

the ease to which an asset can be converted to the economy’s medium of exchange.

Question 9

Opportunity cost of holding money

Answer 9

Interest rate

Question 10

When you hold wealth in the form of cash in your wallet, instead of interest-bearing bonds…

Answer 10

you lose interest that you could have earned.

Question 11

Although many factors determine the interest rate, the one emphasized by the theory of liquidity preference is

Answer 11

Interest rate

Question 12

Reason for negative slope of money demand

Answer 12

An increase in interest rate raises the cost of holding money. As a result, this reduces the quantity of money demanded.

Question 13

Money demand curve shifters

Answer 13

Increasing price level or Real GDP increases money demand

Decreasing price level or Real GDP decreases money demand

Question 14

When money supply increases,

Answer 14

interest rate decreases

Question 15

For a money injection in a small open economy, how should the money demand in the end adjust?

Answer 15

to equate the Canadian interest rate with the world interest rate.

Question 16

In a small open economy with a flexible exchange rate, a money injection leads to what?

Answer 16

a decrease in the exchange rate (depreciation of currency), which leads to an increase in net exports. AD curve is pushed further right.

Question 17

Where is monetary policy most effective?

Answer 17

In an open economy with a flexible exchange rate.

Question 18

Bank of Canada has maintained a policy of what type of exchange rate?

Answer 18

Flexible exchange rate

Question 19

Monetary policy is ineffective when…

Answer 19

Exchange rate is fixed

Question 20

For money injections, the Bank of Canada would do what to keep exchange rates fixed?

Answer 20

Sell foreign currencies

Question 21

Two macroeconomic effects that cause the size of the AD curve shift to differ from the change in government purchases:

Answer 21

Multiplier Effect and Crowding out effect

Question 22

Multiplier Effect

Answer 22

Also known as spending multiplier. Additional shifts in aggregate demand that result when expansionary fiscal policy increases income and therefore consumer spending.

Question 23

Marginal Propensity to Consume (MPC)

Answer 23

The fraction of extra income that a household consumes rather than saves.

Question 24

Marginal Propensity to Import (MPI)

Answer 24

The fraction of extra income that a household spends on imports.

Question 25

Spending multiplier formula in closed economy

Answer 25

1 / (1 - MPC)

Question 26

Spending multiplier formula in an open economy

Answer 26

1 / (1 - MPC + MPI)

Question 27

Crowding out effect on investment

Answer 27

The offset in aggregate demand that results when expansionary fiscal policy raises interest rates and therefore reduces investment spending.

Question 28

Fiscal policy on small open economy with flexible exchange rate has what effects?

Answer 28

None

Question 29

Two types of crowding out effects for fiscal policy

Answer 29

Crowding out on investment and crowding out on net exports.

Question 30

What happens when fiscal expansion is applied to a small open economy with a fixed exchange rate?

Answer 30

Central bank increases money supply to prevent exchange rate from changing. This lowers the interest rate back to the world interest rate. As there were no changes to the interest rate and exchange rate, crowding out disappears.

Question 31

Fiscal policy is more effective in a closed or open economy?

Answer 31

Like monetary policy, fiscal policy is more effective in an open economy, albeit with a fixed exchange rate.

Question 32

In Canada, who determines the exchange rate policy?

Answer 32

Bank of Canada

Question 33

Current minister of finance (fiscal policy)

Answer 33

Joe Oliver

Question 34

Why is coordination of monetary and fiscal policy important?

Answer 34

For fiscal policy to have a lasting effect on the position of the aggregate demand curve, the bank of Canada must choose the appropriate exchange rate policy.

Question 35

Two important instruments of fiscal policy:

Answer 35

Level of government purchases and level of taxation.

Question 36

Keynes argued that aggregate demand fluctuates because of what?

Answer 36

Animal spirits - largely irrational waves of optimism and pessimism

Question 37

The Case for an Active Stabilization Policy

Answer 37

Keynes argued that the government should actively stimulate aggregate demand when it appeared insufficient to maintain production at its full employment level.

Question 38

The Case against an Active Stabilization Policy

Answer 38

Fiscal and Monetary Policies affect the economy with a long lag.

Question 39

Automatic Stabilizers

Answer 39

Changes in fiscal policy that stimulate aggregate demand when the economy goes into recession, without any deliberate actions taken by policy makers.

Question 40

Examples of Automatic Stabilizers

Answer 40

Tax System, Unemployment Insurance, Welfare Benefits, Flexible Exchange rate

Question 41

Decrease money supply to…

Answer 41

Slow the economy down and to reduce inflationary pressure

Question 42

GDP deflator equation

Answer 42

nominal GDP / real GDP * 100

Question 43

Inflation rate calculation

Answer 43

(New - Old) / Old * 100