2.5 Monetary and fiscal Policy

Question 1

Monetary policy

Answer 1

used by the central bank to influence the quantity of money and credit.

Question 2

Fiscal policy

Answer 2

relates to the government’s taxation and spending.

Historically, these policies have been used with positive and negative impacts on the economy.

Question 3

Money fulfills three important functions:

Answer 3

Medium of Exchange

Store of Value
Measure of Value

Question 4

The quantity theory of money

Answer 4

defines the relationship between money and the price level.

M * V = P * Y

M: is the quantity of money

V: is the velocity of money

P: is the average price level

Y: is the real output:

Question 5

The price of money is?

Answer 5

The Nominal Interest rate

Question 6

The Fisher effect

Answer 6

states the real rate of interest is stable

Changes in the nominal interest rate are a function of expected inflation

Question 7

The Roles of Central Banks

Answer 7

1. Supplier of Currency
2. Banker to Government and Bankers’ Bank
3. Lender of Last Resort

–> his provides needed liquidity to banks in difficult situations.

4. Regulator of Payments System

–> Procedures must be robust and standardized to handle the millions of daily financial transactions. International coordination is also necessary.

5. Conductor of Monetary Policy

–> This is a high-profile role in which the central bank influences the quantity of money and credit in an economy.

6. Supervisor of Banking System
7. Maintain Foreign Currency Reserves and Gold Reserves

Question 8

most important objective of central banks

Answer 8

The most important objective is that of maintaining price stability

Question 9

Expected inflation

Answer 9

represents the level of future inflation expected by economic agents

Question 10

Unexpected inflation

Answer 10

the most costly.

It includes the expected inflation cost but also creates a wealth transfer between borrowers and lenders.

Lenders will charge higher interest rates or risk premia to compensate for the extra risk of inflation.

It also reduces the information that can be found in market prices (e.g., price change could be due to inflation or increased demand).

Question 11

Central banks use three primary monetary policy tools:

Answer 11

1. Open Market Operations

–> Open market operations involve the purchase and sale of government bonds from commercial banks. If the central bank buys bonds, this increases the reserves of the private sector banks and thus increases the money supply.

2. Central Bank’s Policy Rate

–> The central bank can set the official interest rate. It usually sets the rate it will charge when lending to commercial banks. Increasing the rate will reduce the money supply. The name of the refinancing rate varies by countries, such as the refinancing rate in England and the discount rate in the United States. The federal funds rate is the interbank lending rate in the United States.

3. Reserve Requirements

–> The central bank can reduce the money supply by increasing the reserve requirement. This is not used much in developed countries because it is disruptive to the bank’s lending practice.

Question 12

The success of inflation targeting policy depends on three key concepts:

Answer 12

1. Central Bank Independence
2. Credibility

–> A government with a lot of debt would be inclined to have high inflation. Credibility would be undermined if the government were in charge of managing inflation. If the public believes the central bank will hit its target inflation, this belief can help it happen.

3. Transparency

–> Most central banks produce quarterly reports on the economy.

Question 13

Central Bank Independence

Answer 13

The central bank needs independence from the government to keep politicians out of the way. However, the central bank still has some accountability to the government.

Target independence gives the bank authority to set the interest rate level target.

Operational independence means the bank can get the target level from another branch of government, but it is otherwise not under the influence of the government.

Question 14

a currency peg

Answer 14

a fixed exchange rate

Question 15

managed exchange rate policy

Answer 15

allows the value of the domestic currency to float within a specified range relative to the currency to which it is pegged

For this strategy to be successful, investors must believe that the developing economy is credibly committed to the target exchange rate.

Question 16

dollarization

Answer 16

Other countries simply abandon their domestic currency and adopt the US dollar as their functional currency

Question 17

Contractionary policy

Answer 17

Policy rate is greater than the neutral rate of interest (to encourage saving rather than spending)

strives to reduce the rate of growth in the money supply and real economy.

This can be done by increasing the policy rate.

contrary: Decreasing the policy rate is an expansionary policy done to increase the rate of growth in the money supply and the real economy.

The policy rate is defined as high or low by comparing it to the neutral rate of interest

Question 18

Expansionary policy

Answer 18

Policy rate is smaller than the neutral rate of interest (to encourage spending rather than saving)

Question 19

The components of the nominal interest rate are most accurately described as:

A
a real required return and compensation for expected inflation only.

B
a real required return and a premium for uncertainty about future economic conditions such as real growth and inflation.

C
a real required return, compensation for expected inflation, and a risk premium for uncertainty about future values of economic variables.

Answer 19

a real required return, compensation for expected inflation, and a risk premium for uncertainty about future values of economic variables.

Question 20

Which of the following statements is most accurate? Fiat money:

A
must be backed by gold reserves.

B
is based on the convertibility principle.

C
derives its value from a government decree.

Answer 20

C
derives its value from a government decree.

countries largely abandoned the gold standard in favor of fiat money, which cannot be convertible into any other commodity. It is not backed by gold reserves, but rather derives its value from a government decree.

Question 21

he proposition that the real interest rate is relatively stable is most closely associated with:

A
the Fisher effect.

B
money neutrality.

C
the quantity theory of money.

Answer 21

A
the Fisher effect.

he Fisher effect is based on the idea that the real interest rate is relatively stable. Changes in the nominal interest rate result from changes in expected inflation.

Question 22

Often, the government revenue and government expenditures are measured as a percentage of GDP.

There is an automatic stabilizer effect because?

Answer 22

as economic activity decreases, taxation will decrease, and government expenditures will increase.

Question 23

Some argue there should be no concern about the national debt because:

Answer 23

Much of the debt is owed to domestic lenders.

Some of the debt could have been incurred for capital investment projects.

Beneficial tax changes could be required.

The private sector could increase saving to finance the debt.

Accumulation of debt could be increasing employment.

Question 24

Some argue there should be concern about the national debt because:

Answer 24

High debt levels could lead to high future tax rates, which may discourage economic activity.

The government may have to print money to service the debt, leading to high inflation.

Government borrowing could crowd out private sector borrowing.

Question 25

Government spending can take several forms.

Answer 25

Transfer payments are made through the social security system for things such as state pensions, income support for low-income families, and unemployment benefits. They allow the government to redistribute income. They are not a part of GDP or government spending on goods and services.

Current government spending is on such items as health, education, and defense.

Capital expenditures are made on such things as roads, hospitals, and schools.

Question 26

Government spending can be justified on economic and social grounds:

Answer 26

Provides services like the defense that benefits everyone.
Infrastructure like roads to sustain economic growth.

Guarantee a minimum level of income for poor people.

Help to obtain low inflation and unemployment.

Subsidize high-risk products like new energy

Question 27

Direct taxes

Answer 27

come from income, wealth, and corporate profits

Direct taxes take longer to change

Question 28

Indirect taxes

Answer 28

include excise duties on fuel, alcohol, tobacco, and other items.

Indirect taxes can have immediate impact and discourage unwanted behavior

Question 29

There are four desirable attributes of tax policy.

Answer 29

Simplicity (not easily manipulated)

Efficiency (should not discourage work or investment or interfere with personal choices)

Fairness (this is subjective, but most want the rich to pay more)

Revenue sufficiency

Question 30

The fiscal multiplier

Answer 30

helps determine how much the output will change for a given change in government spending or taxes

Question 31

Ricardian equivalence

Answer 31

A government’s effort to stimulate economic activity by running fiscal deficits will be unsuccessful if consumers respond by saving more in anticipation of higher future taxes that will be required to repay the government’s debts

According to this view, deficit spending will only stimulate aggregate demand if individuals fail to anticipate the need for future tax increases correctly.

Question 32

structural budget deficits

Answer 32

the deficit that would occur if the economy was at full employment.

At lower unemployment, tax revenues would be greater and social transfers lower.

Question 33

A recognition lag

Difficulties in Executing Fiscal Policy

Answer 33

occurs because it takes time for data to indicate the economy is slowing

Question 34

The action lag

Difficulties in Executing Fiscal Policy

Answer 34

It then takes time to implement the policy changes

Question 35

The impact lag

Answer 35

measures how long the actions take to impact the economy

Question 36

the impact of Easy monetary policy and Easy fiscal policy

Answer 36

Demand rises;

Lower interest rate;

Private and public sector growth

Question 37

the impact of Tight monetary policy and Easy fiscal policy

Answer 37

Higher output;

Higher interest rate;

Government spending becomes greater proportion of national income

Question 38

the impact of Easy monetary policy and Tight fiscal policy

Answer 38

Private sector increases;

Public sector shrinks

Question 39

the impact of Tight monetary policy and Tight fiscal policy

Answer 39

Private & public sector shrink;

Higher interest rate

Question 40

Studies have shown government spending increases have a much larger impact on GDP than social transfer increases because?

Answer 40

the former are seen as less likely to be reversed

Social transfers are more effective if targeted at lower-income earners rather than distributed evenly to all citizens

Question 41

Quantitative easing (QE)

Answer 41

one of the few policy options available to central banks when interest rates are zero.

Central banks implement QE by purchasing securities from individuals, institutions, and banks

The objective of QE is to lower interest rates and stimulate economic activity with direct cash transfers

However, economists note that by making large-scale purchases of government bonds, central banks are effectively printing money to fund the budget deficit and abandoning their commitment to independent monetary policy.

Question 42

Which statement regarding fiscal policy is most accurate?

A
Cyclically adjusted budget deficits are appropriate indicators of fiscal policy.

B
To raise business capital spending, personal income taxes should be reduced.

C
An increase in the budget surplus is associated with expansionary fiscal policy.

Answer 42

A
Cyclically adjusted budget deficits are appropriate indicators of fiscal policy.