READING 16: MONETARY AND FISCAL POLICY
Question 16.1: Money serves as a unit of account because :
A) money is accepted as the form of payment for goods.
B) money received for work or goods can be saved to purchase goods or services in the future.
C) prices of goods and services are expressed in units of money
C is correct. Money has three primary functions: it serves as a unit of account because prices of goods and services are expressed in units of money; it provides a store of value because money received for work or goods can be saved to purchase goods or services at another time; and it serves as a medium of exchange because money is accepted as a form a payment.
LOS 16.c: Explain the money creation process
Question 16.2: According to the quantity theory of money, the most appropriate means to combat inflation is to:
A) reduce the velocity of money.
B) reduce the money supply.
C) increase the excess reserves of banks.
B is correct. The quantity theory focuses on the quantity of money. The quantity theory states that velocity is not affected by monetary policy. Increasing banks' excess reserves would most likely lead to higher inflation.
Monetarists believe that velocity and the real output of the economy change only slowly. Assuming that velocity and real output remain constant, any increase in the money supply will lead to a proportionate increase in the price level. For example, a 5% increase in the money supply will increase average prices by 5%. For this reason, monetarists argue that monetary policy can be used to control and regulate inflation. The belief that real variables (real GDP and velocity) are not affected by monetary variables (money supply and prices) is referred to as money neutrality.
LOS 16.d: Describe theories of the demand for and supply of money.
Question 16.3: Assume that the long-term equilibrium money market interest rate is 4% and the current money market interest rate is 3%. At this current rate of 3%, there will be an excess:
A) demand for money in the money market, and investors will tend to be net buyers of securities.
B) demand for money in the money market, and investors will tend to be net sellers of securities.
C) supply of money in the money market, and investors will tend to be net buyers of securities
B is correct. At interest rates below 4% (the long-term equilibrium rate), the quantity of money demanded exceeds the quantity of money supplied. At below-equilibrium rates, investors will sell bonds to obtain the desired extra cash. As they sell more bonds, the prices of bonds fall, and interest rates start to move back towards the 4% equilibrium.
LOS 16.e: Describe the Fisher effect.
Question 16.4: The Fisher effect holds that a nominal rate of interest equals a real rate:
A) minus expected inflation.
B) plus expected inflation.
C) plus actual inflation.
B is correct. The Fisher effect states that a nominal rate of interest equals a real rate plus expected inflation.
RNom = RReal + E[I]
RNom = nominal interest rate
RReal = real interest rate
E[I] = expected inflation
The idea behind the Fisher effect is that real rates are relatively stable, and changes in interest
rates are driven by changes in expected inflation. This is consistent with money neutrality.
LOS 16.g: Contrast the costs of expected and unexpected inflation
Question 16.5: Under what conditions is inflation most likely to shift wealth from lenders to borrowers?
A) Only when inflation is unexpected.
B) Only when inflation is unexpected and negative.
C) When inflation is either unexpected or expected
A is correct. Inflation that is unexpected, or higher than expected, shifts wealth from lenders to borrowers. Unexpected deflation has the opposite effect. Because interest rates include a premium for expected inflation, an inflation rate that matches expectations does not shift wealth from lenders to borrowers.
Much more important are the costs imposed on an economy by unanticipated inflation, inflation that is higher or lower than the expected rate of inflation. When inflation is higher than expected, borrowers gain at the expense of lenders as loan payments in the future are made with currency that has less value in real terms. Conversely, inflation that is less than expected will benefit lenders at the expense of borrowers. In an economy with volatile (rather than certain) inflation rates, lenders will require higher interest rates to compensate for the additional risk they face from unexpected changes in inflation. Higher borrowing rates slow business investment and reduce the level of economic activity.
LOS 16.h: Describe tools used to implement monetary policy.
Question 16.6: Which of the following does the U.S. central bank most often use to change the money supply?
A) The discount rate.
B) Open market operations.
C) The required reserve ratio.
B is correct. Open market operations are the U.S. Federal Reserve's most often used tool for changing the money supply.
Open market operations: Buying and selling of securities by the central bank is referred to as open market operations. When the central bank buys securities, cash replaces securities in investor accounts, banks have excess reserves, more funds are available for lending, the money supply increases, and interest rates decrease. Sales of securities by the central bank have the opposite effect, reducing cash in investor accounts, excess reserves, funds available for lending, and the money supply, which will tend to cause interest rates to increase. In the United States, open market operations are the Fed’s most commonly used tool and are important in achieving the federal funds target rate.
LOS 16.i: Describe the monetary transmission mechanism.
Question 16.7: A change from a neutral monetary policy to a contractionary monetary policy is most likely to be reflected in the economy by:
A) decreases in price for financial assets.
B) decreased lending rates in the banking system.
C) depreciation of the domestic currency in the foreign exchange market
A is correct. Contractionary monetary policy typically results in increased interest rates, which decrease the prices of financial assets by decreasing the present value of future cash flows. Increasing interest rates typically cause the domestic currency to appreciate.
LOS 16.j: Describe qualities of effective central banks.
Question 16.8: A central bank is said to have credibility if:
A) it issues inflation reports monthly.
B) economic actors base decisions on the central bank’s stated inflation targets.
C) it determines both the policy rate and the method for computing the inflation rate.
B is correct. If a central bank has credibility, economic actors come to believe the inflation rate will be near the central bank's target and factor this inflation rate into their decisions. Periodic inflation reports enhance the transparency of a central bank. A central bank that determines
both the policy rate and the method for computing the inflation rate is said to have independence.
Creditability: To be effective, central banks should follow through on their stated intentions. If a government with large debts, instead of a central bank, set an inflation target, the target would not be credible because the government has an incentive to allow inflation to exceed the target level. On the other hand, a credible central bank’s targets can become self-fulfilling prophecies. If the market believes that a central bank is serious about achieving a target inflation rate of 3%, wages and other nominal contracts will be based on 3% inflation, and actual inflation will then be close to that level.
LOS 16.l: Contrast the use of inflation, interest rate, and exchange rate targeting by central banks & LOS 16.n: Describe limitations of monetary policy.
Question 16.9: A central bank's ability to achieve its policy goals is most likely to be limited by available resources when which of the following actual rates is above its target rate?
A) Interest rate.
B) Inflation rate.
C) Exchange rate.
C is correct. With exchange rate targeting, a central bank's ability to increase the value of the domestic currency is limited by the amount of foreign reserves the country has available to buy its own currency in the foreign exchange market. While inflation targeting and interest rate
targeting have limitations (e.g., liquidity trap conditions may exist, interest rates are bounded by zero), the central bank's resources are not typically a limitation.
Over the short term, the targeting country can purchase or sell its currency in the foreign exchange markets to influence the exchange rate. There are limits, however, on how much
influence currency purchases or sales can have on exchange rates over time. For example, a
country may run out of foreign reserves with which to purchase its currency when the
exchange value of its currency is still below the target exchange rate.
LOS 16.k: Explain the relationships between monetary policy and economic growth, inflation, interest, and exchange rates.
Question 16.10: Open market sales of securities by a country's central bank will most likely result in:
A) decreasing short-term interest rates.
B) appreciation of the domestic currency.
C) an increasing growth rate of real GDP.
B is correct. Central bank sales of securities reduce excess reserves in the banking system, causing interbank lending rates and other short-term interest rates to increase. If the monetary policy transmission mechanism operates normally, long-term interest rates should also increase, the domestic currency should appreciate, and economic growth and inflation should decrease.
LOS 16.m: Determine whether a monetary policy is expansionary or contractionary.
Question 16.11: A central bank's policy rate is considered expansionary if it is less than:
A) the central bank’s target inflation rate.
B) the long-term growth rate of real economic output.
C) the sum of the long-term growth rate of real economic output and the target inflation rate.
C is correct. Monetary policy is said to be expansionary if the central bank's policy rate is less than the neutral interest rate, which is the sum of the long-term trend rate of real economic growth and the central bank's target inflation rate.
An economy’s long-term sustainable real growth rate is called the real trend rate or, simply,
the trend rate. The trend rate is not directly observable and must be estimated. The trend rate
also changes over time as structural conditions of the economy change. The neutral interest rate of an economy is the growth rate of the money supply that neither
increases nor decreases the economic growth rate:
Neutral interest rate = real trend rate of economic growth + inflation target
When the policy rate is above (below) the neutral rate, the monetary policy is said to be contractionary (expansionary). In general, contractionary policy is associated with a decrease in the growth rate of money supply, while expansionary policy increases its growth rate.
LOS 16.s: Determine whether a fiscal policy is expansionary or contractionary
Question 16.12: The Keynesian view suggests that the government can reduce aggregate demand by using:
A) restrictive fiscal policy to shift the government budget toward a surplus (or smaller deficit).
B) restrictive fiscal policy to shift the government budget toward a deficit (or a smaller surplus).
C) expansionary fiscal policy to shift the government budget toward a surplus (or a smaller deficit).
A is correct. According to the Keynesians, policymakers can use the budget to diminish aggregate demand through restrictive fiscal policy. Reducing government expenditures and/or increasing tax rates should lead to a decline in the expected size of the budget deficit or an increase in the budget surplus.
LOS 16.r: Explain the implementation of fiscal policy and difficulties of implementation
Question 16.13: Which of the following conditions is most likely to result in expansionary effects from fiscal policy being felt when an economic expansion is already underway?
A) Slow economic growth is being caused by supply shortages rather than low aggregate demand.
B) Expansionary fiscal policy requires policymakers to recognize an economic contraction and enact legislation.
C) Government borrowing to finance expansionary spending is increasing interest rates faced by private sector borrowers.
B is correct. Fiscal policy takes effect with a lag due to the time it takes for policymakers to recognize the business cycle stage (recognition lag) and enact legislation to change fiscal policy (action lag), and the time it takes for individuals and businesses to react to the policy changes
(impact lag). As a result of these lags, fiscal policy changes may result in pro-cyclical rather than countercyclical effects. Supply shortages and higher interest rates as a result of government borrowing (the crowding-out effect) both act to reduce the expansionary effect of expansionary fiscal policy but are not related directly to its time lags.
Recognition lag: Discretionary fiscal policy decisions are made by a political process. The state of the economy is complex, and it may take policymakers time to recognize the nature and extent of the economic problems.
Action lag: The time governments take to discuss, vote on, and enact fiscal policy changes.
Impact lag: The time between the enactment of fiscal policy changes and when the impact of the changes on the economy actually takes place. It takes time for corporations and individuals to act on the fiscal policy changes, and fiscal multiplier effects occur only over time as well.
LOS 16.o: Describe roles and objectives of fiscal policy.
Question 16.14: Automatic stabilizers are government programs that require no legislation and tend to:
A) automatically increase spending at the same growth rate as real GDP.
B) reduce interest rates, thus stimulating aggregate demand.
C) change the government budget deficit in an opposite direction to economic growth.
C is correct. Automatic stabilizers are built-in features that tend to automatically promote a budget deficit during a recession and a budget surplus during an inflationary boom, without a change in policy
Discretionary fiscal policy refers to the spending and taxing decisions of a national
government that are intended to stabilize the economy. In contrast, automatic stabilizers are
built-in fiscal devices triggered by the state of the economy. For example, during a recession,
tax receipts will fall, and government expenditures on unemployment insurance payments
will increase. Both of these tend to increase budget deficits and are expansionary. Similarly,
during boom times, higher tax revenues coupled with lower outflows for social programs tend
to decrease budget deficits and are contractionary
LOS 16.q: Describe the arguments about whether the size of a national debt relative to GDP matters.
Question 16.15: According to the crowding-out effect, the sale of government bonds used to finance excess government spending is least likely to:
A) increase the real interest rate.
B) reduce private investment spending.
C) increase the profitability of corporate investment projects.
C is correct. Increased government borrowing would decrease, not increase, the profitability of corporate investment projects since it will tend to increase interest rates and required rates of return in general.
Increased government borrowing will tend to increase interest rates, and firms may reduce their borrowing and investment spending as a result, decreasing the impact on aggregate demand of deficit spending. This is referred to as the crowding-out effect because government borrowing is taking the place of private sector borrowing
READING 17: INTERNATIONAL TRADE AND CAPITAL FLOWS
LOS 17.b: Describe benefits and costs of international trade & LOS 17.c: Distinguish between comparative advantage and absolute advantage.
Question 17.1: Costs of reducing restrictions on international trade are most likely to be borne by domestic producers:
A) as a whole.
B) that lack an absolute advantage.
C) that lack a comparative advantage.
C is correct. While increased international trade has benefits that outweigh its costs, those costs are borne by domestic producers in industries that compete with imports and lack a comparative advantage. Domestic producers that have a comparative advantage relative to foreign producers are likely to gain from increased trade.
Question 17.2: The country of Hokah can produce 35 units of cheese or 30 units of leather with one hour of labor. The country of Ymer can produce 20 units of cheese or 25 units of leather with one hour of labor. Which of the following statements is most accurate?
A) Ymer’s opportunity cost of one unit of leather is 0.80 units of cheese.
B) Hokah’s opportunity cost of one unit of cheese is 1.167 units of leather.
C) Hokah has an absolute and a comparative advantage in both cheese and leather
A is correct. The opportunity cost of one unit of leather for Ymer is 20 / 25 = 0.80 units of cheese, and the opportunity cost of one unit of cheese is 25/ 20 = 1.25 units of leather. The opportunity cost of one unit of cheese for Hokah is 30 / 35 = 0.86 units of leather, and the opportunity cost of one unit of leather is 35 / 30 = 1.167 units of cheese. Hokah has an absolute advantage in both cheese and leather but has a comparative advantage only in cheese.
LOS 17.d: Compare the Ricardian and Heckscher–Ohlin models of trade and the source(s) of comparative advantage in each model.
Question 17.3: The source of comparative advantage, according to the Heckscher- Ohlin model of international trade, is each country's:
A) labor productivity.
B) available natural resources.
C) relative amounts of labor and capital.
C is correct. In the Heckscher-Ohlin model, the source of comparative advantage is the relative amounts of labor and capital that are available in each country. Countries with more capital available relative to labor available will have a comparative advantage in producing capital intensive goods, while countries with more labor available relative to capital will have a comparative advantage in labor-intensive goods.
Heckscher and Ohlin presented a model in which there are two factors of production—capital and labor. The source of comparative advantage (differences in opportunity costs) in this model is differences in the relative amounts of each factor the countries possess
LOS 17.e: Compare types of trade and capital restrictions and their economic implications
Question 17.4: Placing a tariff on imports of a good is most likely to decrease:
A) producer surplus for domestic producers of the good.
B) quantity of the good supplied by domestic producers.
C) quantity of the good demanded in the domestic market.
C is correct. Placing a tariff on an imported good increases the good's domestic price, which reduces the quantity demanded. However, the quantity supplied by domestic firms increases with the domestic equilibrium price, as does producer surplus for domestic firms.
A tariff placed on an imported good increases the domestic price, decreases the quantity
imported, and increases the quantity supplied domestically. Domestic producers gain, foreign
exporters lose, and the domestic government gains by the amount of the tariff revenues
Question 17.5: Which of the following statements on the economic implications of trade restrictions is most accurate?
A) Quota rents are the amounts received by the domestic government when it charges for import licenses.
B) In the importing country, import quotas, tariffs, and voluntary export restraints all decrease producer surplus.
C) In the case of a quota, if the domestic government collects the full value of the import licenses, the result is the same as that of a tariff.
C is correct. If the domestic government collects the full value of the import license, a quota can have the same economic result as a tariff. Quota rents are the gains to those foreign exporters who receive import licenses under a quota if the domestic government does not charge for
the import licenses. With respect to the importing country, import quotas, tariffs, and voluntary export restraints all decrease consumer surplus and increase producer surplus.
In the case of a quota, if the domestic government collects the full value of the import licenses, the result is the same as for a tariff. If the domestic government does not charge for the import licenses, this amount is a gain to those foreign exporters who receive the import licenses under the quota and are termed quota rents.
LOS 17.f: Explain motivations for and advantages of trading blocs, common markets, and economic unions
Question 17.6: An advantage of a common market, relative to a customs union or a free trade area, is that a common market:
A) adopts a single currency.
B) removes barriers to movement of labor and capital.
C) establishes common institutions and economic policy.
B is correct. A free-trade area removes barriers to the flow of goods and services, while a common market removes barriers to movement of goods, services, labor, and capital.
1. All barriers to import and export of goods and services among member countries are
2. All countries adopt a common set of trade restrictions with non-members.
1. All barriers to import and export of goods and services among the countries are
2. All countries adopt a common set of trade restrictions with non-members.
3. All barriers to the movement of labor and capital goods among member countries are
LOS 17.g: Describe common objectives of capital restrictions imposed by governments.
Question 17.7: Which of the following objectives would a national government most likely pursue by placing restrictions on inflows of foreign capital?
A) Protecting domestic industries.
B) Supporting domestic asset prices.
C) Keeping domestic interest rates low.
A is correct. National governments may seek to limit foreign investment in certain domestic industries, for example, those that are seen as essential for national defense. A government seeking to keep domestic interest rates low or support domestic asset prices would be more likely to restrict capital outflows.
Governments sometimes place restrictions on the flow of investment capital into their
country, out of their country, or both. Commonly cited objectives of capital flow restrictions
include the following:
1. Reduce the volatility of domestic asset prices
2. Maintain fixed exchange rates.
3. Keep domestic interest rates low.
4. Protect strategic industries
LOS 17.h: Describe the balance of payments accounts including their components
Question 17.8: With regard to the balance of payments, the purchase of rights to natural resources in a country by foreigners would be most likely to affect the country's:
A) capital account.
B) current account.
C) financial account.
A is correct. Sales and purchases of non-financial assets in a country are accounted for in the capital account.
The capital account comprises two sub-accounts:
Capital transfers include debt forgiveness and goods and financial assets that migrants bring when they come to a country or take with them when they leave. Capital transfers also include the transfer of title to fixed assets and of funds linked to the purchase or sale of fixed assets, gift and inheritance taxes, death duties, and uninsured damage to fixed assets.
Sales and purchases of non-financial assets that are not produced assets include rights to natural resources and intangible assets, such as patents, copyrights, trademarks, franchises, and leases
LOS 17.i: Explain how decisions by consumers, firms, and governments affect the balance of payments.
Question 17.9: Other things equal, a country is most likely to have a current account deficit if it also has:
A) a low savings rate.
B) a government budget surplus.
C) a low rate of domestic investment.
A is correct. As shown by the fundamental macro relationship (X – M) = (S – I) – (G – T), a current account deficit (X < M) is associated with a low savings rate, a high rate of domestic investment, or low government savings (i.e., a budget deficit).
Question 17.10: Other things equal, a current account deficit will tend to narrow if:
A) taxes decrease.
B) private savings decrease.
C) domestic investment decreases.
C is correct. The relation between the trade deficit (the current account), savings (both private and government) and domestic investments is stated as (X – M) = private savings + government savings – investment. A current account decit will tend to narrow if private savings increase, government savings increase (either taxes increase or government spending decreases), or domestic investment decreases.
LOS 17.j: Describe functions and objectives of the international organizations that facilitate trade, including the World Bank, the International Monetary Fund, and the World Trade Organization.
Question 17.11: Which of the following organizations is the most focused on promoting economic growth and reducing poverty by offering both monetary and technical assistance?
A) World Bank.
B) World Trade Organization.
C) International Monetary Fund.
A is correct. Promoting economic growth and reducing world poverty are among the primary goals of the World Bank. The IMF primarily promotes the growth of international trade, supports exchange rate stability, and provides a forum for cooperation on monetary problems internationally. The WTO has a primary focus on reaching trade agreements and settling trade disputes.